Stage Set for Puerto Rico Debt Case at High Court

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By Diane Davis

March 14 — The U.S. Supreme Court will hear oral argument March 22 about a Puerto Rico law that would let its debt-ridden public utilities restructure their obligations.

The case arises out of the “most acute fiscal crisis in Puerto Rico history,” the Commonwealth of Puerto Rico, Governor Alejandro García Padilla, and Secretary of Justice César Miranda Rodríguez said in their petition filed with the court.

When Congress revised the Bankruptcy Code in 1984, it added a definition of “state” to Bankruptcy Code Section 101(52), which includes Puerto Rico and the District of Columbia, “except for the purpose of defining who may be a debtor under Chapter 9” of the Bankruptcy Code.

Chapter 9 is reserved for municipalities. Thus, under Section 109(c), the Commonwealth of Puerto Rico's municipalities don't meet the requirements for filing bankruptcy under Chapter 9.

“The case turns on the question of what, if anything, to make of Congress's 1984 change to the definition of ‘state,' which suddenly treated Puerto Rico and Washington DC more like Guam for purposes of Chapter 9, whereas previously they had been treated as if they were states,” Prof. Stephen J. Lubben, Harvey Washington Wiley Chair in Corporate Governance & Business Ethics at Seton Hall University School of Law, Newark, N.J., told Bloomberg BNA March 11.

“Thus, Puerto Rico could no longer authorize its municipalities to file under Chapter 9,” Lubben said.

Congressional Efforts Stalled

Supreme Court intervention in this case comes amid congressional efforts to address the Puerto Rico crisis , but with no agreement on how to handle the situation. The Obama administration and congressional Democrats argue that Puerto Rico should be granted broad bankruptcy powers while Republications have been looking at proposals that could include a financial control board .

The Commonwealth of Puerto Rico has recently faced an economic recession, high unemployment, and a declining population, and this fiscal crisis has hit the commonwealth's three public utilities particularly hard for a combined debt of $20 billion. The Puerto Rico Electric Power Authority (PREPA), which employs more than 7,000 people and supplies almost all of the island's electric power, has been severely affected.

The commonwealth is on the brink of insolvency, according to the petitioner.

Act Allows Utilities to Restructure Debts

After the principal rating agencies downgraded the commonwealth's general obligation bonds to below investment grade, the Legislative Assembly declared a state of fiscal emergency in 2014. On June 25, 2014, the Legislative Assembly enacted the Public Corporation Debt Enforcement and Recovery Act (the Recovery Act) to allow its public utilities to restructure their debts “for the benefit of their creditors in the aggregate while continuing to provide essential public services like electricity and water,” according to the petitioner's brief.

The act provides two types of procedures to address a public corporation's debt burden. One procedure allows Puerto Rico's public utilities to seek relief that is modeled on Chapter 9 of the Bankruptcy Code.

The day the governor signed the Recovery Act into law, the respondents Franklin California Tax-Free Trust (mutual funds that hold more than $1.7 billion in PREPA bonds) filed a lawsuit challenging the act's validity and seeking declaratory and injunctive relief. Shortly thereafter, respondents BlueMountain Capital Management LLC brought a similar lawsuit alleging that the Recovery Act is preempted by Section 903(1) of the Bankruptcy Code.

The district court granted the respondents summary judgment without hearing oral argument and permanently enjoyed the petitioners from enforcing the Recovery Act.

Bankruptcy Code Preempts Recovery Act

The U.S. Court of Appeals for the First Circuit affirmed the district court, concluding that Section 903(1) expressly preempts the Recovery Act (Franklin Cal. Tax-Free Tr. v. Puerto Rico, 805 F.3d 322 (1st Cir. 2015) . According to the appeals court, “Puerto Rico may turn to Congress for recourse.”

Judge Juan R. Torruella concurred in the appeals court's judgment, but wrote a separate opinion opining that Congress's 1984 amendments are invalid as they attempt to establish bankruptcy legislation that isn't uniform with regard to the rest of the U.S., violating the uniformity requirement of the Bankruptcy Clause of the Constitution.

The Supreme Court granted certiorari to hear the case Dec. 4, 2015 .

Recusal Means Only Seven Justices Will Hear Case

Justice Samuel A. Alito Jr. has recused himself from the case. His financial disclosure report indicates that either he or his wife owns shares in a Franklin fund that holds Puerto Rico municipal bonds.

With Justice Antonin Scalia's absence, there will only be seven justices deciding the case.

“The absence of Justice Scalia will be seen if the Court is at all receptive to Puerto Rico's argument that the Code should be read with common sense, and not strictly literally,” Lubben told Bloomberg BNA.

According to Lubben, “the Court has to address what the [Bankruptcy] Code as it currently reads actually means—if that leaves the Commonwealth in something of a dead zone. The current case is the product of what seems like a kind of sloppy amendment done back in 1984, and the question of what to do with that amendment has real consequences today,” Lubben said. Lubben is a contributing author of .

Puerto Rico's argument “appeals to common sense—how could a provision in a chapter of the Bankruptcy Code Puerto Rico can never invoke nonetheless apply to Puerto Rico?” Lubben said.

No Framework to Reorganize Debt

Congress hasn't created any framework for Puerto Rico's municipalities to reorganize their debts, petitioners Melba Acosta-Febo, as agents of the Government Development Bank for Puerto Rico (GDB), argued in their brief, and there is no reason to believe that “Congress intended this lack of regulation to preempt Puerto Rico's ability to exercise its police powers to address the debt crisis plaguing its municipalities.”

According to the petitioners, the First Circuit erred by holding that the Recovery Act is preempted by Section 903(1), and the court should reverse the judgment.

No Danger of Shutdown

The commonwealth's fiscal crisis has nothing to do with the Recovery Act, according to respondents Franklin California Tax-Free Trust, noting that the act applies only to PREPA and a few other government corporations and not to the commonwealth itself. There is no danger of a shutdown of public services, they contended in their brief, because PREPA's trust agreement requires revenues to be used to pay operating expenses prior to any debt service payments. “There is no danger of a race to the courthouse, because Puerto Rico law protects PREPA from seizure of assets by creditors,” the respondents said in their brief.

Section 903(1) expressly preempts the Recovery Act, according to respondent BlueMountain Capital Management, LLC's brief. Section 903(1) doesn't place Puerto Rico in a “no man's land” by precluding its municipalities from seeking bankruptcy relief as argued by the petitioners, BlueMountain said. “Municipalities of numerous States are identically situated,” BlueMountain said.

What petitioners really seek, BlueMountain said, is to “change the Code for policy reasons to allow the Commonwealth and the District to do what States cannot.” This accommodation is for Congress, not federal courts, to make and, thus, the judgment of the First Circuit should be affirmed, BlueMountain argued in their brief.

According to Lubben, “the bondholders have literalism on their side—the 1984 change to the definition of ‘state' only changed the definition for purposes of authorizing municipalities to file under Chapter 9.” “[I]t does not say that it changes the definition for other purposes related to Chapter 9,” he told Bloomberg BNA.

“There is also a lingering question of whether Section 903(1) is Constitutional,” Lubben added. “The Court may not need to address that issue in this case, but there is a question of whether Congress can basically say ‘it's Chapter 9 or nothing' with regard to municipal bankruptcy,” Lubben said.

Christopher Landau, P.C. of Kirkland & Ellis LLP, Washington, D.C., represents petitioners Commonwealth of Puerto Rico, Alejandro Garcia Padilla, and Cesar Miranda Rodriguez; Martin J. Bienenstock Proskauer Rose LLP, New York, N.Y., represents petitioners Melba Acosta-Febo, and John Doe; Thomas Moers Mayer of Kramer Levin Naftalis & Frankel LLP, New York, N.Y., represents respondents Franklin California Tax-Free Trust; and Theodore B. Olson and Matthew D. McGill of Gibson, Dunn & Crutcher LLP, Washington, D.C., represent respondent BlueMountain Capital Management, LLC.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com