On June 13, 2016, the U.S. Supreme Court upheld lower court rulings declaring unconstitutional a 2014 Puerto Rico law, portions of which mirrored chapter 9 of the Bankruptcy Code, that would have allowed the commonwealth’s public instrumentalities to restructure a significant portion of Puerto Rico’s bond debt (widely reported to be as much as $72 billion). In Commonwealth v. Franklin Cal. Tax-Free Tr., 2016 BL 187308 (U.S. June 13, 2016), the Court ruled by a 5-2 margin (with one justice abstaining) that the Puerto Rico Public Corporations Debt Enforcement and Recovery Act (the “Recovery Act”) is preempted by a provision of chapter 9 invalidating any “State” law purporting to implement a nonconsensual “method of composition” of a municipality’s debts, even though Puerto Rico’s municipalities are not eligible to file for relief under chapter 9. Following the ruling and facing the prospect of a July 1, 2016, default by Puerto Rico on a $2 billion bond payment, Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act.

Municipal Bankruptcy Law

Ushered in during the Great Depression to fill a vacuum that previously existed in both federal and state law, federal municipal bankruptcy law has been plagued by a potential constitutional flaw that endures in certain respects to this day—the Tenth Amendment reserves to the states sovereignty over their internal affairs. This reservation of rights caused the U.S. Supreme Court to strike down the first federal municipal bankruptcy law as unconstitutional in Ashton v. Cameron County Water Improvement Dist. No. 1, 298 U.S. 513 (1936), and it accounts for the limited scope of chapter 9, as well as the restricted role played by the bankruptcy court in presiding over a chapter 9 case and in overseeing the affairs of a municipal debtor.

The Supreme Court later validated a revised municipal bankruptcy statute in United States v. Bekins, 304 U.S. 27 (1938), concluding that revisions to the law designed to reduce the opportunity for excessive federal control over state sovereignty struck a constitutionally permissible balance. The present-day legislative scheme for municipal debt reorganizations was implemented in the aftermath of New York City’s financial crisis and bailout by the New York State government in 1975, but chapter 9 has rarely been used.

Historically, relatively few cities or counties have filed for chapter 9 protection—with notable exceptions, including the City of Detroit and Orange County, California. The vast majority of chapter 9 filings have involved municipal “instrumentalities,” such as irrigation districts, public-utility districts, waste-removal districts, and health-care or hospital districts.

In fact, according to the Administrative Office of the U.S. Courts, fewer than 700 municipal bankruptcy petitions have been filed in the 79 years since Congress established a federal mechanism for the resolution of municipal debts in 1937. Fewer than 300 chapter 9 cases have been filed since the current version of the Bankruptcy Code was enacted in 1978—although the volume of chapter 9 cases has increased somewhat in recent years. By contrast, there were 7,241 business chapter 11 cases filed in 2015 alone.

Access to chapter 9 is limited to municipalities under section 109(c)(1) of the Bankruptcy Code. A “municipality” is defined by section 101(40) as a “political subdivision or public agency or instrumentality of a State.” Section 109(c) of the Bankruptcy Code identifies other mandatory prerequisites to relief under chapter 9, including the requirement that the municipality be “specifically authorized, in its capacity as a municipality or by name, to be a debtor under [chapter 9] by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under [chapter 9].” Section 109(c) is sometimes referred to as a “gateway” provision.

Various provisions of chapter 9 establish strict limitations to preserve the delicate constitutional balance between state sovereignty and federal bankruptcy power. For example, section 903 of the Bankruptcy Code expressly reserves to the states the power “to control, by legislation or otherwise,” municipalities that file for chapter 9 protection, with the caveat—and the significant limitation—that any state law (or judgment entered thereunder) “prescribing a method of composition of indebtedness” among a municipality’s creditors is not binding on dissenters. As discussed in more detail below, section 903—sometimes referred to as the “preemption” provision—is generally understood to preempt state municipal bankruptcy laws.

Municipal Bankruptcy Law and Puerto Rico

Puerto Rico has been a territory of the U.S. since 1898. Like the states, it cannot file for bankruptcy protection. Among other reasons, the Contracts Clause of the U.S. Constitution (Art. I, § 10, cl. 1) prohibits any “state”—which has been held to include Puerto Rico (see Auto Workers v. Fortuño, 633 F.3d 37 (1st Cir. 2011)—from “impairing the obligation of contracts.”

However, at least from 1938 until the Bankruptcy Code was enacted in 1978, Puerto Rico’s municipalities, like state municipalities, could obtain federal municipal bankruptcy relief. See Franklin Cal. Tax-Free Tr. v. Puerto Rico, 805 F.3d 322, 329 (1st Cir. 2015), aff’d, 2016 BL 187308 (U.S. June 13, 2016). Section 84 of the Bankruptcy Act of 1898, as amended, provided that “[a]ny State’s political subdivision or public agency or instrumentality” could file for relief under chapter IX—the predecessor to chapter 9—under certain specified circumstances. See 11 U.S.C. § 403(e)(6) (repealed 1978). The Bankruptcy Act of 1898 originally defined “State” to include “the Territories, the Indian Territory, Alaska, and the District of Columbia.” 30 Stat. 545. The statutory definition was later amended to include “the Territories and possessions to which this Act is or may hereafter be applicable,” see 11 U.S.C. § 1 (29) (repealed 1978), which included Puerto Rico. See 48 U.S.C. § 734.

The Bankruptcy Code omitted any definition of the term “State” when it was enacted in 1978. Congress remedied that oversight in 1984, when it amended the Bankruptcy Code to address jurisdictional infirmities in the statutory framework highlighted by the Supreme Court’s ruling in Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982). The re-introduced definition, however, provides that “ ‘State’ includes the District of Columbia and Puerto Rico, except for the purpose of defining who may be a debtor under chapter 9 of this title.” 11 U.S.C. § 101(52) (originally designated 11 U.S.C. § 101(44) (emphasis added)). As a result of this exception, Puerto Rico municipalities became expressly (though indirectly) barred from filing for relief under chapter 9. The legislative history of the 1984 amendments does not indicate why Puerto Rico was excluded from the definition of “State” for the purpose of chapter 9 eligibility.

Preemption

The Bankruptcy Clause of the U.S. Constitution grants authority to Congress to establish a uniform federal law of bankruptcy. U.S. Const. art. I, § 8, cl. 4. The Supremacy Clause of the Constitution mandates that federal laws, such as those concerning bankruptcy, “shall be the supreme Law of the Land; . . . [the] Laws of any State to the Contrary notwithstanding.” U.S. Const. art. VI, cl. 2. Thus, under the doctrine of preemption, “state laws that interfere with or are contrary to federal law are preempted and are without effect pursuant to the Supremacy Clause.” In re Loranger Mfg. Corp., 324 B.R. 575, 582 (Bankr. W.D. Pa. 2005); accord Hillsborough County v. Automated Medical Labs, Inc., 471 U.S. 707, 712 (1985). “For preemption purposes, the laws of Puerto Rico are the functional equivalent of state laws.” Antilles Cement Corp. v. Fortuño, 670 F.3d 310, 323 (1st Cir. 2012).

Through the years, three types of federal-law preemption over state law have been developed by the courts: (i) express preemption; (ii) field preemption; and (iii) conflict preemption. In re Nickels Midway Pier, LLC, 332 B.R. 262, 273 (Bankr. D.N.J. 2005). Express preemption applies “when there is an explicit statutory command that state law be displaced.” Id. Field preemption applies when federal law “is sufficiently comprehensive to warrant an inference that Congress ‘left no room’ for state regulation.” In re Miles, 294 B.R. 756, 759 (B.A.P. 9th Cir. 2003); Hillsborough County, 471 U.S. at 713. Conflict preemption applies when state law conflicts with federal law such that: “(1) it is impossible to comply with both state law and federal law; or (2) the state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.” Nickels Midway Pier, 332 B.R. at 273.

Congress enacted a provision expressly preempting state municipal bankruptcy laws in 1946 in response to the U.S. Supreme Court ruling in Faitoute Iron & Steel Co. v. Asbury Park, 316 U.S. 502 (1942), which rejected the contention that field preemption prohibited such laws. See Act of July 1, 1946, 60 Stat. 415. That express preemption provision is now codified in section 903(1) of the Bankruptcy Code.

Puerto Rico’s Recovery Act

On June 28, 2014, Puerto Rico’s governor, Alejandro García Padilla, without access to chapter 9 of the Bankruptcy Code, signed legislation—the Recovery Act—creating a judicial debt-relief process for three Puerto Rico instrumentalities with approximately $20 billion in bond debt. Portions of the Recovery Act mirrored provisions of chapter 9 of the Bankruptcy Code.

Under the Recovery Act, an eligible public corporation could have pursued two courses of action: (i) a “consensual debt relief transaction” akin to a prepackaged or prenegotiated chapter 11 case; and/or (ii) the filing of a petition for relief with the court.

Under the first option, the court could approve debt relief if: (a) creditors holding at least 50 percent of the amount of debt within a class of substantially similar obligations participated in a vote or a consent solicitation for a proposed amendment, modification, waiver, or debt exchange; and (b) at least 75 percent of participating voters approved the proposed relief. Upon approval by a class of creditors, the applicable debt relief would have been binding on all creditors within the applicable class.

Under the second option, the court could approve a debt adjustment plan if at least one class of impaired debt voted to accept the plan. A class was deemed to approve a plan if: (i) creditors in the class holding at least two-thirds of the amount of the debt involved voted on the plan; and (ii) of the class members who actually voted, the holders of more than one-half of the debt in the class approved the plan.

Impaired creditors had to receive at least as much under a debt adjustment plan as they would have received if all creditors had been allowed to enforce their claims on the petition filing date. Also, each impaired creditor had to receive its pro rata share of 50 percent of the debtor’s positive free cash flow, if any, after payment of certain specified expenses, during the 10 fiscal years following the first anniversary of the plan’s effective date, until creditors were paid in full.

Constitutional Challenges

The Recovery Act’s obvious similarities to chapter 9 and chapter 11 of the Bankruptcy Code, as well as the fact that the legislation was not enacted in accordance with the U.S. Constitution, immediately provoked attacks on its constitutionality. Bond funds affiliated with Franklin Resources Inc., Oppenheimer Rochester Funds, and BlueMountain Capital Management, LLC, which collectively hold approximately $2 billion in bonds issued by the Puerto Rico Electric Power Authority, filed a lawsuit on June 30, 2014, in the U.S. District Court for the District of Puerto Rico, alleging, among other things, that the Recovery Act is unconstitutional because the legislation is preempted by chapter 9. The district court subsequently consolidated the cases.

The District Court’s Ruling

The court ruled that “by enacting section 903(1) [of the Bankruptcy Code], Congress expressly preempted state laws that prescribe a method of composition of municipal indebtedness that binds nonconsenting creditors.”

According to the district court: (i) Puerto Rico is a “State” within the meaning of section 903, which “says nothing of who may be a Chapter 9 debtor”; (ii) the Recovery Act, because it establishes procedures for indebted public corporations to adjust or discharge their obligations to creditors, “prescribes a method of composition of indebtedness, which is exactly what section 903(1) prohibits”; (iii) the Recovery Act applies to the debts of Puerto Rico “instrumentalities,” which are “municipalities” for purposes of section 903(1); and (iv) because the Recovery Act does not require unanimous creditor consent, the compositions prescribed in the Recovery Act may bind nonconsenting creditors, contrary to section 903(1).

The court wrote that Congress’s decision not to permit Puerto Rico municipalities to be chapter 9 debtors “reflects its considered judgment to retain control over any restructuring of municipal debt in Puerto Rico.” It rejected the argument that section 903 does not apply to Puerto Rico because Puerto Rico municipalities are not eligible to be debtors under chapter 9. According to the court, “Nothing in the text, context, or legislative history of section 903 remotely supports the Commonwealth defendants’ inferential leap that Congress intended the prohibition in section 903(1) to apply only to states whose municipalities are eligible to file for Chapter 9 bankruptcy.”

The First Circuit’s Ruling

The U.S. Court of Appeals for the First Circuit affirmed the ruling in Franklin Cal. Tax-Free Tr. v. Puerto Rico, 805 F.3d 322 (1st Cir. 2015).

The First Circuit framed the issue before it as “whether the preemption provision of § 903(1) still applies in the face of the 1984 amendment.” It concluded that the addition of the definition of “State” in 1984 did not, “by its text or its history, change the applicability of § 903(1) to Puerto Rico.” According to the court, if Congress had wanted to alter the applicability of section 903(1) to Puerto Rico, it “easily could have written § 101(52) to exclude Puerto Rico laws from the prohibition of § 903(1), just as it had excluded Puerto Rico from the definition of debtor under § 109(c).”

Instead, the First Circuit reasoned, lawmakers reserved the authority to determine what debt relief, if any, is appropriate for Puerto Rico and its instrumentalities:

In denying Puerto Rico the power to choose federal Chapter 9 relief, Congress has retained for itself the authority to decide which solution best navigates the gauntlet in Puerto Rico’s case. The 1984 amendment ensures Congress’s ability to do so by preventing Puerto Rico from strategically employing federal Chapter 9 relief under § 109(c), and from strategically enacting its own version under § 903(1), to avoid such options as Congress may choose. . . . We must respect Congress’s decision to retain this authority.

The Supreme Court granted Puerto Rico’s petition for a writ of certiorari on December 4, 2015.

The Supreme Court’s Ruling

The Supreme Court affirmed. Writing for the 5-2 majority (with Justice Samuel Alito abstaining), Justice Clarence Thomas explained that the cases required the Court to parse three provisions of the Bankruptcy Code: the gateway provision (section 109(c)), the preemption provision (section 903(1)), and section 101(52) (defining “State”). The majority ruled that “Puerto Rico is still a ‘State’ for purposes of the pre-emption provision . . . and this provision pre-empts the Recovery Act.”

The 1984 amendment that added section 101(52), Justice Thomas wrote, “precludes Puerto Rico from authorizing its municipalities to seek relief under Chapter 9, but it does not remove Puerto Rico from the reach of Chapter 9’s pre-emption provision.” This conclusion he based on the plain text of the Bankruptcy Code, “which begins and ends our analysis.”

According to the majority, the exception in section 101(52) “excludes Puerto Rico only for purposes of the gateway provision.” Puerto Rico, Justice Thomas wrote, “is no less a ‘State’ for purposes of the pre-emption provision than it was before Congress amended the definition.” He explained that, had Congress, which does not “ ‘hide elephants in mouseholes,’ ” intended to alter the 70-year prohibition of state and territory municipal bankruptcy schemes in 1984, “we would expect the text of the amended definition to say so” (citation omitted).

Justice Thomas was critical of the argument—made by both Puerto Rico and the dissent—that Puerto Rico is not a “State” for the purpose of chapter 9. According to the majority, even if Puerto Rico is not a “State” for the purpose of the gateway provision, this does not mean that Puerto Rico is not a “State” for purposes of the other provisions in chapter 9, such as the preemption provision. Although a municipality that cannot obtain state authorization to file a chapter 9 petition is excluded from chapter 9 entirely, Justice Thomas wrote, “the same cannot be said about the State in which that municipality is located.” Finally, Justice Thomas responded to the argument that the government and people of Puerto Rico should not have to wait for congressional action to avert the consequences of the fiscal crisis. “[O]ur constitutional structure,” he wrote, “does not permit this Court ‘to rewrite the statute that Congress has enacted’ ” (citation omitted).

Dissenting Opinion

Justice Sonia Sotomayor filed a dissenting opinion in which Justice Ruth Bader Ginsburg joined. The dissent expressed, among other things, the view that the gateway provision (section 109(c)) “by its terms presupposes that Chapter 9 applies only to States who have the power to authorize their municipalities to invoke its protection.” Because Puerto Rico does not have that power, the dissent maintained, the preemption provision should not apply to preempt the Recovery Act:

By amending the definition of State to exclude Puerto Rico, the District of Columbia, and their municipalities from §109(c)’s gateway, Congress excluded Puerto Rico from Chapter 9 for all purposes—it shut the gate and barred it tight. And because Chapter 9’s process and rules by their terms can only affect municipalities and States eligible to pass through the gateway in §109(c), that must mean that none of Chapter 9’s provisions—including §903’s pre-emption provision—apply to Puerto Rico and its municipalities.

Finally, the dissent faulted the majority for ignoring the “real-world consequences” of preemption for Puerto Rico and its people, who the dissent described as facing a looming humanitarian crisis.

Outlook

The majority opinion in Commonwealth v. Franklin is true to Justice Thomas’s “structuralist” approach to statutory interpretation. In the absence of ambiguity, the analysis begins and ends with the statutory language. Thus, Puerto Rico is a state for the purpose of preemption, yet precluded from authorizing its municipalities to seek debt relief under chapter 9. The upshot is that access of Puerto Rico instrumentalities to chapter 9 of the Bankruptcy Code was not entrusted to Puerto Rico.

Facing a July 1, 2016, deadline for Puerto Rico to make a $2 billion debt payment, U.S. lawmakers forged bipartisan support for the “Puerto Rico Oversight, Management, and Economic Stability Act” (“PROMESA”), Pub. L. No. 114-187 (2016) (H.R. 5278 and S. 2328). PROMESA was approved by the House of Representatives on June 9, 2016, and by the Senate on June 29. President Obama signed the bill into law on June 30, 2016. PROMESA creates an oversight board appointed by the president with the power to restructure Puerto Rico’s debts. The law also includes an automatic stay upon enactment of all creditor collection efforts against Puerto Rico or its instrumentalities, a mandate to continue funding pensions, and a lower minimum wage for young workers. PROMESA also contains a preemption provision that contains similarities to section 903 of the Bankruptcy Code. A more detailed discussion of PROMESA is available elsewhere in this edition of the Business Restructuring Review.

Subsequent to the lower court rulings striking down the Recovery Act, Puerto Rico signed into law the Puerto Rico Emergency Moratorium and Financial Rehabilitation Act. That legislation too is the subject of challenge by certain creditors under, among other things, the reasoning of the Supreme Court’s Franklin decision and the provisions of PROMESA.