Puerto Rico’s financial woes have recently been front and center in financial news. Although a recent decision by the U.S. Supreme Court curtailed Puerto Rico’s ability to enact its own legislation to address its debt situation, late last month President Obama signed into law legislation designed to allow Puerto Rico to restructure its vast public debt, giving new hope to the Commonwealth’s financially strapped public utilities. The particulars of how this legislation will be implemented will have significant implications for these public utilities, which bear a combined debt exceeding $20 billion. Stakeholders in Puerto Rico’s financial fortunes are closely reviewing the developing legal landscape.

PROMESA: Congress Adopted Legislation to Aid Puerto Rico in Restructuring

A bill that was recently approved with bipartisan support in both the House of Representatives and the Senate could provide a way for Puerto Rico to restructure some of its heavy debt load by creating a process for what may be the largest municipal debt workout in U.S. history. The legislation creates a seven-member board to oversee the process and balance the island’s finances. Members of the oversight board will be appointed by the president from lists of candidates submitted by congressional leaders.

The Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) does not provide for federal funds to be contributed to assist Puerto Rico to resolve its financial problems. Instead, PROMESA establishes procedures and requirements for the oversight board to initiate a procedure to restructure the island’s debt, with the board operating as Puerto Rico’s representative.

Certain aspects of PROMESA provide procedures similar to provisions of the Bankruptcy Code. Establishment of the oversight board operates as an automatic stay preventing creditors from enforcing claims against the Commonwealth’s government. The board will also be empowered to divide creditors into different pools based on the characteristics of the debt, and each pool can vote on a plan to restructure debt. And also similar to a case under the Bankruptcy Code, if a certain percentage of the outstanding principal amount of a pool agrees with the restructuring plan, the pool can file a petition in court to bind the dissenting creditors to the plan.

PROMESA also empowers the oversight board to approve and enforce budgets, and approve a fiscal plan proposed by Puerto Rico’s governor.

The U.S. Supreme Court Holds That Puerto Rico’s Recovery Act Is Preempted

Passage of PROMESA comes in the wake of a loss for Puerto Rico before the Supreme Court. In a 5-3 decision, Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust, No. 15-233, Slip Op. (June 13, 2016), the Supreme Court ruled that a law enacted by Puerto Rico to put itself on the path toward fiscal recovery was preempted by Chapter 9 of the Bankruptcy Code. The decision, which affirms decisions by the District Court and the U.S. Court of Appeals for the First Circuit, ends a dispute between Puerto Rico and a group of investment funds (the Funds) about the feasibility of the Puerto Rico Corporation Debt Enforcement and Recovery Act (the Recovery Act), which enabled Puerto Rico’s public utilities to execute a plan to restructure their debt.

In Puerto Rico, the Funds sought to enjoin the Recovery Act, arguing that section 903(1) of the Bankruptcy Code, which bars “states” from enacting municipal bankruptcy laws, preempted the Act. The Commonwealth responded that it was excluded from the scope of the preemption provision because the definition of “state” in section 101(52) of the Bankruptcy Code excluded Puerto Rico for the purpose of defining who may be a debtor under Chapter 9. The Commonwealth also argued that the Recovery Act is not a “state law” that can be preempted under section 903(1). The District Court enjoined the enforcement of the Recovery Act and the First Circuit affirmed, ruling that the exception in section 101(52) did not remove Puerto Rico from the ambit of the preemption provision.

The Supreme Court affirmed, holding that the Recovery Act is precluded by Chapter 9. The Court first turned to the “gateway” provision, section 109(c), which requires a Chapter 9 debtor to be an insolvent municipality that is “specifically authorized” by the state “to be a debtor.” The Court then turned to the definition provision, section 101(52), and held that under its plain text, the provision excluded Puerto Rico “for the single purpose” of defining who may be a Chapter 9 debtor under the “gateway” provision. Puerto Rico, Slip Op. at 9-11. The Court concluded that if Congress had intended to exclude Puerto Rico from Chapter 9 altogether, including the preemption provision, then Congress would have done so. Id. Addressing the Commonwealth’s argument that the Recovery Act was not a “state law” subject to preemption under section 903(1), the Court held that the Commonwealth’s reading was excessively technical to support such a “[f]undamental chang[e] in the scope” of Chapter 9’s preemption provision. Id. at 11-14.

Justice Sotomayor and Justice Ginsberg dissented. The dissent reasoned that if Puerto Rico municipalities, including its fiscally desperate public utilities, cannot access Chapter 9 bankruptcy, they effectively have no other legal options to restructure. Puerto Rico, Dissenting Opinion at 1-2. The dissent also reasoned that the preemption provision applies only to states that have the power to authorize their municipalities to seek Chapter 9 protection, arguing that the provision must be read “in context of the overall statutory scheme.” Id. at 5-6, 8.

What Happens Next

The Supreme Court’s decision in Puerto Rico limited Puerto Rico’s options for comprehensive financial restructuring. The decision also comes on the heels of a recent opinion by the Court holding that Puerto Rico does not have the same rights to sovereignty with respect to criminal proceedings as U.S. states. See Puerto Rico v. Sanchez Valle, 136 S.Ct. 1863 (June 9, 2016). Together, these two decisions define the limits of the island’s ability to address its public debt obligations. Yet the passage of PROMESA suggests that the path to financial recovery lies through Congress. How swiftly the law is implemented, how effectively the board employs its powers, and who will win or lose are unanswered questions, given limited precedent for such a large-scale financial recovery. Distressed debt traders, Puerto Rico’s creditors and others with a financial stake in Puerto Rico’s financial well-being are monitoring developments.