In a 5-2 decision, the Supreme Court of the United States in Commonwealth of Puerto Rico et al. v. Franklin California Tax-Free Trust et al., 579 U.S. ___ (2016), rejected the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) as preempted by the Bankruptcy Code on June 13, 2016. The practical implication of the decision is that Puerto Rico is currently without options to restructure its billions of dollars in municipal debt, and the only feasible path forward will most likely have to come from Congress.

Background

Puerto Rico is in the midst of a dire fiscal crisis. More than US$20 billion of Puerto Rico’s debt is shared by three government-owned public utility companies -- for the fiscal year ending in 2013, these three utilities operated with a combined deficit of US$800 million. Moreover, the Commonwealth’s bank is facing a fiscal crisis of its own and Puerto Rico’s access to capital markets is essentially non-existent. The Recovery Act was enacted in response to the ongoing financial crisis in order to enable the Commonwealth to restructure its debt. Portions of the Recovery Act mirror Chapters 9 and 11 of the Bankruptcy Code. 

Discussion

The Preemption Provision (as defined below) of the Bankruptcy Code preempts state bankruptcy laws that enable insolvent municipalities to restructure their debts over the objections of creditors and instead requires municipalities to restructure such debts under Chapter 9 of the Bankruptcy Code. There are three provisions of the Bankruptcy Code as relevant to the Supreme Court’s decision:

  • Section 109(c): requires a Chapter 9 debtor to be an insolvent municipality that is “specifically authorized” by a State “to be a debtor” (the “Gateway Provision”).
  • Section 101(52), as amended in 1984, “includes . . . Puerto Rico, except for the purpose of defining who may be a debtor under chapter 9” (the “State Provision”).
  • Section 903(1): expressly bars States from enacting municipal bankruptcy laws which attempt to bind non-consenting creditors (the “Preemption Provision”), which the Recovery Act specifically attempted to do.

A group of investment funds and utility bondholders sought to enjoin the Recovery Act, arguing that Bankruptcy Code explicitly preempts the Recovery Act. The District Court enjoined the Recovery Act’s enforcement, and the First Circuit affirmed.

In a nutshell, Puerto Rico argued that since it is excluded from the definition of a “State” thus prohibiting Puerto Rican municipalities from availing themselves of Chapter 9, Chapter 9 no longer applies to it, resulting in the inapplicability of the Preemption Provision. The Supreme Court rejected the broad sweep of Puerto Rico’s argument. 

In delivering the majority opinion, Justice Thomas affirmed the decision of the First Circuit, as the majority adopted a narrow reading of the exclusion of Puerto Rico from the definition of “State.” The Court held that the plain text and unambiguous language of the Preemption Provision contains the best evidence of Congress’ preemptive intent. Central to the Court’s analysis is that the Bankruptcy Code long included Puerto Rico as a “State” in the State Provision, however, a 1984 amendment changed the State Provision to exclude Puerto Rico “for the purpose of defining who may be a debtor under chapter 9” under the Gateway Provision. 

The Supreme Court rejected Puerto Rico’s argument that the effect of the amendment to the State Provision is that Chapter 9 no longer applies to it, resulting in the inapplicability of the Preemption Provision. The Court disagreed, noting that “[t]he plain text of the Bankruptcy Code begins and ends our analysis.” Following the plain meaning of the definition of “State” in the Bankruptcy Code, the Court concluded: “The text of the definition extends no further. The exception exclude Puerto Rico only for purposes of the gateway provision.” Given that the text of the State Provision does not specifically exclude Puerto Rico from Chapter 9 altogether, the Court concluded that Puerto Rico is a State for all other purposes and thus is subject to the Preemption Provision.

Writing for the dissent, Justice Sotomayor (joined by Justice Ginsburg), agreed with Puerto Rico that the correct reading of the 1984 amendment to the State Provision is that Puerto Rico is excluded from Chapter 9’s coverage, and is not subject to the Preemption Provision. The dissent asserts that since Puerto Rico is prohibited from authorizing its municipalities to file a bankruptcy case, there is simply no federal insolvency option available to these municipalities. Under these circumstances, the Bankruptcy Code should not be read to prohibit Puerto Rico from adopting the Recovery Act. As the dissent reads the Bankruptcy Code, states retain the power to control their municipalities, including, under section 903, the power to authorize or refuse to authorize their filing for bankruptcy, but may not adopt state insolvency statutes. The purpose of the Preemption Provision is to prevent the states from adopting municipalities’ insolvency regimes. But that purpose has no application to Puerto Rico since it may not authorize a bankruptcy filing by its municipalities. Thus, read in that context, the dissent concludes that the Preemption Provision “is directed to States that can approve their municipalities for Chapter 9 bankruptcy.” 

What’s Next?

It appears that Congress is taking some action to avert Puerto Rico’s financial crisis. The U.S. House of Representatives voted last week to pass proposed legislation that would create an oversight board to control Puerto Rico’s finances and restructuring. The Senate has indicated that it will take up the bill before the end of the month, but it is unclear whether the Senate will pass the legislation with, or without changes. 

Read the decision »