The Commonwealth of Puerto Rico's efforts to deal with more than $70 billion in debt have been a magnet for media scrutiny during the last two years. A question frequently asked in connection with the island territory's struggles to stay afloat is whether Puerto Rico, as an unincorporated territory of the U.S., could resort to a bankruptcy filing as a means of alleviating its financial problems. 

Puerto Rico, however, is statutorily barred from seeking protection under the Bankruptcy Code. In addition, Puerto Rico's municipalities and instrumentalities cannot be debtors under chapter 9. On June 28, 2014, Puerto Rico's governor, Alejandro García Padilla, attempted to remedy this problem in part when he gave his imprimatur to legislation that created a judicial debt-relief process modeled on chapters 9 and 11 of the U.S. Bankruptcy Code for certain public corporations, including the Puerto Rico Electric Power Authority ("PREPA"), which has $9 billion in bond debt. The Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the "Recovery Act") was intended to ring-fence Puerto Rico from potential liabilities arising from defaults by its public corporations and to give the corporations a framework for restructuring their obligations. 

Puerto Rico's public corporation debt-relief initiative was dealt a severe blow on February 6, 2015, when a federal district court judge struck down the law as unconstitutional. In BlueMountain Capital Management, LLC v. García-Padilla, No. 3:14-cv-01569 (D.P.R. Feb. 6, 2015), the court ruled, among other things, that "[b]ecause the Recovery Act is preempted by the federal Bankruptcy Code, it is void pursuant to the Supremacy Clause of the United States Constitution." The ruling, which has been appealed by Puerto Rico, is a setback not only for PREPA and other public corporations attempting to restructure their bond debt (e.g., the Puerto Rico Aqueduct and Sewer Authority and the Puerto Rico Highways and Transportation Authority), but also for Puerto Rico itself. 

The Recovery Act 

As noted, the Recovery Act is patterned on chapters 9 and 11 of the U.S. Bankruptcy Code (with certain important distinctions) and is in all practical respects a nonfederal bankruptcy law. 

Under the Recovery Act, an eligible public corporation may pursue two alternatives, simultaneously or in sequence. The first is a "consensual debt relief transaction" akin to a prepackaged or prenegotiated chapter 11 case. 

To commence such a proceeding, an eligible entity must file a notice of a "suspension period," which stays collection actions by all identified creditors for up to 360 days, unless the entity elects not to seek approval for specified debt relief from a special Public Sector Debt Enforcement and Recovery Act Court (created under the Recovery Act). If court approval is requested, the stay remains in place until either: (i) any court order approving debt relief becomes final; or (ii) 60 days after the denial of such relief. 

Debt relief may be approved by the court only if: (a) creditors holding at least 50 percent of the amount of debt within a class of substantially similar obligations participate 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 approve the proposed relief. Upon approval by a class of creditors, the applicable debt relief would be binding on all creditors within the applicable class. 

The second avenue for debt relief involves the filing of a petition with the court by or on behalf of an eligible public corporation, which triggers an automatic stay banning creditor collection efforts. This avenue, similar to chapter 11 of the Bankruptcy Code, provides that the court may approve a debt adjustment plan if at least one class of impaired debt votes to accept the plan. A class is deemed to approve a plan if: (i) creditors in the class holding at least two-thirds of the amount of the debt involved vote on the plan; and (ii) of the class members who actually vote, the holders of more than one-half of the debt in the class approve the plan. 

All impaired creditors must 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 filing date of the petition. Also, each impaired creditor must 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 are 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 (collectively, the "Bond Funds") affiliated with Franklin Resources Inc. and Oppenheimer Rochester Funds, which collectively hold approximately $1.6 billion in PREPA bonds, 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 of the Bankruptcy Code. Investment fund manager BlueMountain Capital Management, LLC ("BlueMountain"), which holds PREPA bonds and manages funds that hold more than $400 million of PREPA bonds, filed a similar lawsuit seeking invalidation of the Recovery Act on the basis of preemption. The district court subsequently consolidated the two cases. 

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 if 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. 

In BlueMountain Capital Management, Puerto Rico and PREPA moved to dismiss the lawsuits brought by the Bond Funds and BlueMountain, arguing that: (i) the claims are unripe for adjudication because no actual case has yet been filed under the Recovery Act; and (ii) the plaintiffs lack standing due to, among other things, the absence of any specific injury traceable to PREPA. The Bond Funds and BlueMountain cross-moved for summary judgment. 

The District Court's Ruling

At the outset, the court ruled that the preemption claim was ripe for review even though neither PREPA nor any other entity had actually attempted to restructure its obligations under the Recovery Act. According to the court, the "plaintiffs' preemption and contract clauses claims rely on the enactment of the Recovery Act, not on its application." The court explained that the plaintiffs were seeking a declaration, not that the Recovery Act would be preempted if enforced in a hypothetical way, but that it is unconstitutional because federal law preempts it. The court also concluded that delaying adjudication on the merits of the plaintiffs' constitutional claims until PREPA invokes the Recovery Act "would continue to inflict hardship on plaintiffs" due to Puerto Rico's nullification, by enacting the Recovery Act, of a series of statutory and contractual security rights and remedial provisions "with no identifiable corresponding gain." 

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." 

Section 903 provides as follows: 

This chapter [chapter 9] does not limit or impair the power of a State to control, by legislation or otherwise, a municipality of or in such State in the exercise of the political or governmental powers of such municipality, including expenditures for such exercise, but– 

  1. a State law prescribing a method of composition of indebtedness of such municipality may not bind any creditor that does not consent to such composition; and 
  2. a judgment entered under such a law may not bind a creditor that does not consent to such composition. 

According to the court: (i) Puerto Rico is a "State" within the meaning of section 903 because section 101(52) of the Bankruptcy Code provides that "[t]he term '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," and section 903 "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 explained that the legislative history of section 903(1) bolsters its conclusion that Congress intended to preempt any Puerto Rico law creating municipal debt restructuring 

procedures that purport to bind nonconsenting creditors. It rejected the defendants' argument that it would be "anomalous" to read the Bankruptcy Code as both precluding Puerto Rico municipalities from filing for chapter 9 protection and preempting Puerto Rico laws that govern debt restructuring for Puerto Rico municipalities. The court wrote that Congress's decision not to permit Puerto Rico municipalities to be chapter 9 debtors (under section 101(52), which, as noted, excludes Puerto Rico from the definition of "State" for purposes of chapter 9 eligibility), "reflects its considered judgment to retain control over any restructuring of municipal debt in Puerto Rico." 

The court also rejected the defendants' contention 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, "[n]othing 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." 

Finally, the court was not persuaded by the defendants' argument that section 903 "by its terms is limited to the relationship between an 'indebted[]' municipality and its 'creditors' in Chapter 9 cases" and that "[u]nless a municipality can qualify as a 'debtor' under Chapter 9, it obviously cannot be an 'indebted[]' municipality with a 'creditor' under Chapter 9." This "strained reading" based on the definition of "creditor" in section 101(10) of the Bankruptcy Code must fail, the court wrote, because "nothing in that definition indicates that the term 'creditor' is limited to entities eligible to bring claims pursuant to Chapter 9." 

The court acknowledged that federal preemption of a state law "is strong medicine" and that preemption "will not lie absent evidence of clear and manifest congressional purpose" (citation omitted). However, the court wrote, "[d]espite this high bar, this is not a close case." It accordingly ruled that "[t]he Commonwealth defendants, and their successors in office, are permanently enjoined from enforcing the Recovery Act." 

Outlook 

If upheld on appeal, the ramifications of BlueMountain Capital Management may extend beyond the fate of PREPA, Puerto Rico's other public corporations, and their collective $20 billion in bond debt. The Recovery Act was designed to insulate the Puerto Rico fisc and its far greater general obligation bond debt from the financial troubles of the commonwealth's instrumentalities. Moreover, without the threat of recourse to the Recovery Act as a means of bringing PREPA and other public corporation creditors to the table for meaningful restructuring negotiations, creditors may simply walk away from the process. 

On February 19, 2015, the defendants urged the U.S. Court of Appeals for the First Circuit to issue an expedited ruling on the appeal. According to the defendants, the Recovery Act represented an "emergency response to the most profound fiscal crisis in Commonwealth history." They also stated that unilateral action by creditors, such as accelerating debt repayments from PREPA, suing to raise electricity rates, or seeking to appoint a receiver, would "disrupt the provision of essential public services in Puerto Rico." 

Given the consequences for Puerto Rico, the ruling could spur Congress to act. Among other things, lawmakers could amend the Bankruptcy Code to permit Puerto Rico's public corporations to file for chapter 9 protection. Resident Commissioner Pedro Pierluisi, the Commonwealth of Puerto Rico's representative in Congress, reintroduced a bill on February 11, 2015 (the Puerto Rico Chapter 9 Uniformity Act of 2015 (H.R. 870)) that would allow Puerto Rico's public agencies to be debtors under chapter 9. The bill is nearly identical to one Pierluisi introduced in 2014. The House Judiciary Subcommittee on Regulatory Reform, Commercial and Antitrust Law held a hearing on February 26, 2015, to examine H.R. 870. A summary of the testimony given at the hearing is available here.