Introduction

In Franklin California Tax-Free Trust v Commonwealth of Puerto Rico the US Court of Appeals for the First Circuit held that Chapter 9 of the US Bankruptcy Code pre-empts an insolvency law enacted by Puerto Rico designed to provide a path for the restructuring of financially distressed municipalities and public utilities in Puerto Rico.(1) Federal pre-emption is a US constitutional doctrine holding that where a state law conflicts with a federal law, the state law is "preempted" or trumped by the federal law.(2) The doctrine is rooted in the supremacy clause of the Constitution, which states that the Constitution and federal law "shall be the supreme law of the land".(3) Chapter 9 of the Bankruptcy Code allows insolvent municipalities – but not states – including cities, towns, counties and other defined political subdivisions, to seek relief in the federal bankruptcy court to adjust or restructure their debts, while continuing to provide municipal services. However, before availing itself of Chapter 9 relief, a municipality must receive permission from the state in which it is organised. The requirement of state authorisation was intended to avert potential federalism concerns by ensuring that states retain control over localities within their borders.

In contrast to the treatment of US states, Puerto Rico – a US territory – is expressly prohibited from authorising its municipalities to pursue bankruptcy relief under Chapter 9, as a result of a 1984 amendment to the Bankruptcy Code.(4) While there was no definitive court ruling on the subject, most commentators agreed that before the 1984 amendment, Puerto Rico, like US states, was permitted to authorise its municipalities to file Chapter 9.(5) The existing unavailability of such relief has come to the forefront given that Puerto Rico is facing the most daunting public debt crisis in its history and may be on the verge of default or insolvency. According to a statement issued by Governor Alejandro García Padilla in June 2015, Puerto Rico is presently saddled with $72 billion of debt which is not payable and, in the absence of debt relief, the territory could enter a "death spiral".(6)

In an attempt to restructure its overwhelming debt, and with Chapter 9 relief effectively foreclosed to its municipalities, Puerto Rico fashioned its own municipal insolvency law, the Puerto Rico Public Corporation Debt Recovery Act.(7) Puerto Rico enacted the act in June 2014 to have immediate effect.(8) While partially modelled after Chapter 9, the act contains significant differences and, according to the First Circuit, "appear[s] to provide less protection for creditors than the federal Chapter 9 counterpart".(9)

Facts

The Franklin action was initiated by two groups of investors which collectively hold nearly $2 billion worth of bonds issued by one of Puerto Rico's distressed public utilities, the Puerto Rico Electric Power Authority (PREPA). The two groups of bondholders brought separate actions in July and August 2014 against Puerto Rico, its governor and various other Puerto Rican officials seeking a declaratory judgment that the act was pre-empted by the Bankruptcy Code and to enjoin its implementation.(10) The US District Court for the District of Puerto Rico consolidated the cases but did not merge the suits. It issued its order and opinion in both cases on February 6 2015. The district court found that the act was pre-empted by federal law and permanently enjoined its enforcement.(11) Puerto Rico then appealed the judgment and permanent injunction to the First Circuit.(12)

Issues on appeal

The primary issue on appeal was whether Section 903 of the Bankruptcy Code pre-empted Puerto Rico from enacting its own municipal bankruptcy law. Section 903 generally prohibits states from passing laws that alter the rights between debtor municipalities and creditors in the absence of express creditor consent. Specifically, Section 903(1) provides that "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".(13)

In analysing the pre-emption issue, the First Circuit largely focused on legislative history. The court explained how Section 903 was derived from its statutory predecessor, Section 83(i) of the now-repealed Bankruptcy Act. The purpose of Section 83(i) was to overrule an earlier Supreme Court decision, Faitoute Iron & Steel Co v City of Asbury Park, which upheld a state law adjusting creditors' debts without their consent.(14) The First Circuit explained that following Faitoute, Congress enacted Section 83(i) to "restore what had been believed to be the pre-Faitoute status quo by expressly prohibiting state municipal bankruptcy laws adjusting creditors' debts without their consent".(15) As explained in the legislative history that accompanied Section 83(i), "[o]nly under a Federal law should a creditor be forced to accept such an adjustment without his consent".(16)

Thus, in the wake of Section 83(i) and its re-codification as Section 903(1) in 1978, the First Circuit concluded that Congress had expressed its clear intention to preserve this provision and prevent states from enacting their own versions of Chapter 9 relief.(17) According to the court, "[t]hese provisions on their face barred Puerto Rico and the Territories, just as they did the states, from enacting their own versions of Chapter 9 creditor debt adjustment".(18) Drawing on the legislative history as well as the text, the First Circuit concluded that Congress had expressed its unambiguous intention to maintain uniform bankruptcy laws throughout the country and to protect creditor-debtor relations.

Decision

The parties did not dispute the pre-emptive effect of Section 903, but rather disputed exactly which entities fall within the Bankruptcy Code's definition of 'state', and hence which entities are expressly pre-empted under this provision from enacting their own bankruptcy laws. As reasoned by the First Circuit, the analysis turned on whether the Bankruptcy Code – as amended in 1984 to include a separate definition of 'state' under Section 101(52) – "renders § 903(1)'s pre-emptive effect inapplicable to Puerto Rico".(19) The parties' positions on this decisive issue starkly diverged. The bondholders advanced the following textual argument: Section 101(52) clearly defines 'state' to include Puerto Rico; thus, when Section 903(1) references "State law", it must encompass the definition of 'state' as used elsewhere in the code, and consequently must plainly include Puerto Rico.(20)

Puerto Rico argued that while Section 101(52) defines 'state' to "include... Puerto Rico", the section also includes an important and express exception: "except for the purpose of defining who may be a debtor under chapter 9" of the Bankruptcy Code.(21) It posited that the state law pre-emption as used in Section 903(1) must apply only to those entities which have recourse to Chapter 9 in the first place. Since Puerto Rico is already excluded from Chapter 9, there is "no need to stipulate that the remedies of Chapter 9 do not undermine Puerto Rico's control over its own municipalities".(22) Therefore, because Puerto Rico is not enacting 'state law' as defined under Section 903(1), the pre-emption does not apply.(23)

The First Circuit ultimately found Puerto Rico's position unpersuasive. It explained that "[t]he terms of § 101(52) do not exclude Puerto Rican municipalities from federal relief; rather, they deny to Puerto Rico the authority to decide when they might access it".(24) A Puerto Rican municipality cannot pursue Chapter 9 as Puerto Rico lacks the ability to authorise its municipalities to do so.(25) The court found no basis, in the statutory text or legislative history, for holding that Section 903 did not apply equally to Puerto Rico and instead concluded that "[t]he addition of the definition of 'State' in 1984 does not, by its text or its history, change the applicability of § 903(1) to Puerto Rico".(26)

As a corollary to this discussion, the First Circuit noted that even if express pre-emption did not apply, conflict pre-emption would require the same result as the "Recovery Act frustrates Congress's undeniable purpose in enacting § 903(1)" and fashioning a "single federal law to be the sole source of authority if municipal bondholders were to have their rights altered without their consent".(27)

Finally, the First Circuit emphasised that had Congress wished to alter the applicability of Section 903 to Puerto Rico, it could easily have drafted the definition of 'state' in Section 101(52) to exclude Puerto Rico from the restrictions of Section 903 "just as it had excluded Puerto Rico from the definition of debtor under § 109(c)".(28) But Congress did not do so.

Puerto Rico also advanced another code-based textual argument: it posited that since 'creditor' under the code is defined in relation to a 'debtor', and because Puerto Rican municipalities cannot be debtors under the code, it followed that bondholders of Puerto Rican municipalities cannot be creditors under the code, and thus the Puerto Rico Public Corporation Debt Recovery Act does not bind creditors in violation of Section 903(1).(29) While acknowledging the creativity of the argument, the First Circuit found it equally unconvincing. The court explained that under this interpretation "any state could avoid the prohibition [of § 903(1)] by denying its municipalities authorization to file under § 109(c)(2)" and then passing its own municipal bankruptcy law.(30) Such a result would allow US states to effectively nullify Chapter 9. As the First Circuit cautioned, "we should not apply statutory definitions in a manner that directly undermines the legislation".(31) The court determined that 'creditor' should be given its plain meaning – "one to whom a debt is owed" – and thus neither US states nor Puerto Rico could escape the reach of Section 903(1).(32)

Similarly, the court found Puerto Rico's argument that Section 903(1)'s application raises a constitutional question under the 10th Amendment unavailing. In addressing this point on appeal, the court simply explained that the "limits of the Tenth Amendment do not apply to Puerto Rico", given that it is "constitutionally a territory" and not a state under the Constitution.(33) Hence, this argument warranted no further discussion or analysis from the court.

Concurrence

Although Judge Torruella agreed with the other judges on the First Circuit panel that the Bankruptcy Code, as currently written, compelled pre-emption of the Puerto Rico Public Corporation Debt Recovery Act, he also provided a blistering constitutional attack on Congress's non-uniform treatment of Puerto Rico under the Bankruptcy Code. In an opinion that reads far more like a strongly worded dissent, Torruella attacked the constitutionality of the 1984 amendment to the Bankruptcy Code. Citing Article I of the Constitution, he quotes with emphasis that: "Congress shall have the power… [t]o establish… uniform laws on the subject of bankruptcies throughout the United States".(34) He found that the current application of the law, which absolutely denies Puerto Rican municipalities Chapter 9 relief, is a far cry from the uniformity required under the Constitution and that the 1984 amendment, which precluded Puerto Rico from authorising its municipalities to file for Chapter 9 relief, failed the rational basis requirement and was unconstitutional.(35) In the US court system 'rational basis review' is the most lenient standard of review for legislation and requires only that government action be rationally related to some legitimate government interest.(36) This standard of review is highly deferential to the government and courts rarely strike down legislation for failing to meet rational basis review. Hence, for Torruella to suggest that the law should be invalidated on this basis demonstrated his belief that the 1984 amendment served no legitimate government interest. Indeed, he likened the discriminatory application of Chapter 9 relief to "colonial treatment" and pointed out that the majority's conclusion that Puerto Rico should simply seek redress in Congress asked it to "play with a deck of cards stacked against it" because Puerto Rico has no opportunity for participation in the democratic process.(37)

Aftermath

On August 21 2015 Puerto Rico petitioned the Supreme Court to review the First Circuit's decision. In that petition Puerto Rico argued that since its municipalities are categorically ineligible to restructure their debts under Chapter 9, Section 903(1) of Chapter 9 simply does not apply to Puerto Rico. Thus, since Chapter 9 does not encompass Puerto Rico, it similarly does not operate to displace Puerto Rico's law, and therefore the Puerto Rico Public Corporation Debt Recovery Act should not be pre-empted. Puerto Rico further explained the urgency of the request and the importance of a resolution from the Supreme Court given Puerto Rico's current status in a legal "no man's land". The Supreme Court has not yet acted on the petition.

In addition to further recourse through the court system, the legislative avenue remains open. At present, there are two identical pieces of legislation in Congress which, if passed, would allow Puerto Rico to authorise its financially strapped municipalities, including public utilities, to seek Chapter 9 relief, on par with other US states.(38)

Finally, the possibility remains that Puerto Rico will successfully negotiate mutually agreeable resolutions with its lenders and bondholders to restructure its substantial public debt. On September 22 2015 Reuters reported that the PREPA had reached a deal with its lenders to restructure $700 million in matured debt.(39) This follows an important deal reached by the PREPA earlier in September with an ad hoc group representing approximately 35% of its bondholders.(40)

Comment

While the First Circuit's majority opinion rests its holding largely on the federal pre-emption doctrine and the wording of the Bankruptcy Code, it appears to give short shrift to a significant aspect of the pre-emption doctrine, which is the judicial presumption against pre-emption, especially in fields traditionally occupied by the states.(41) Generally, pre-emption should be applied only in cases where Congress's intent to pre-empt state law is "clear and manifest".(42) Here the legislative history is murky at best. There appears to be no discussion whatsoever in the legislative history as to why the definition of 'state' was amended in 1984 so as to suddenly prohibit Puerto Rico from authorising its municipalities to pursue Chapter 9 relief.(43) This hardly seems to provide a predicate for overcoming the presumption against pre-emption, especially given that municipal bankruptcy and debt restructuring traditionally fell under state control and that federal municipal bankruptcy law did not even exist until the 1930s. The First Circuit's failure to address other equally important aspects of pre-emption adequately evinces a troublesome hole in its reasoning.

In addition to pre-emption, Torruella's concurring opinion, which as noted above reads more in the nature of a dissent, raises a number of intriguing questions as to the constitutionality more generally of the current treatment of Puerto Rico under the Bankruptcy Code. While rational basis review is undeniably a lenient standard, Torruella's commentary calls into question whether even this most deferential standard can be met in the case of Puerto Rico's treatment.

Ultimately, the question remaining in wake of this opinion and recent developments is what, if any, action Congress will take to redress Puerto Rico's circumstances. The First Circuit found that 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".(44) While the majority opinion exhibits confidence in Congress's ability to meet this challenge and find a solution, such confidence may be misplaced in light of the current Congress's near inability to move legislation. Rather, as evidenced by recent negotiations between Puerto Rico and its lenders and bondholders, this may be a crisis that it must solve within its own borders.

For further information on this topic please contact Sally J Sullivan at Caplin & Drysdale, Chartered by telephone (+1 202 862 5000) or email (ssullivan@capdale.com). The Caplin & Drysdale website can be accessed at www.capdale.com.

Endnotes

(1) Franklin California Tax-Free Trust v Commonwealth of Puerto Rico 15-1218 (1st Cir, July 6 2015).

(2) See Maryland v Louisiana 451 US 725, 746 (1981) (recognising that state laws that conflict with federal law are "without effect").

(3) US Constitution, Article VI, Clause 2.

(4) Chapter 11 permits municipalities of a 'state' to petition for bankruptcy relief under Chapter 9 of the code. However, Chapter 11 defines 'state' to include "The District of Columbia and Puerto Rico, except for the purpose of defining who may be a debtor under chapter 9" of the code (11 USC § 101(52), emphasis added). Thus, Puerto Rico may not authorise its municipalities to file under Chapter 9.

(5) See Franklin, at *15-16.

(6) Michael A Fletcher, "Puerto Rico's governor on need to postpone debt payments for years: 'It's about math'", Washington Post, June 29 2015, available at www.washingtonpost.com/business/economy/puerto-rico-says-it-cannot-pay-its-debt-setting-off-potential-crisis-in-the-us/2015/06/28/cbae1bc4-1e05-11e5-84d5-eb37ee8eaa61_story.html.

(7) Franklin, at *17.

(8) Id.

(9) Id at *18.

(10) Id at *7.

(11) Id at *7-8

(12) Id at *8.

(13) 11 USC § 903(1).

(14) Franklin, at *25-26.

(15) Id at *26.

(16) Id (quoting HR Rep 79-2246, at 4 (1946)).

(17) Id at *26-28.

(18) Id at *27.

(19) Id at *4.

(20) Id at *23-24.

(21) 11 USC § 101(52).

(22) Id at *41.

(23) Id at *40-41.

(24) Id at *44 (emphasis in original).

(25) Id at *43-44.

(26) Id at *29.

(27) Id at *45.

(28) Id at *30.

(29) Id at *33-34.

(30) Id at *36.

(31) Id at *35.

(32) Id at *38.

(33) Id at *47 (emphasis in original) (citing United States v Lopez Andino, 831 F 2d 1164, 1172 (1st Cir 1987)).

(34) Id at *52 (emphasis in original opinion).

(35) Id at *55.

(36) See United States v Carolene Products Co, 304 US 144, 152-54 (1938); see also Harris v Rosario, 446 US 651-52 (1980) (explaining that Congress may legislate differently for Puerto Rico "so long as there is a rational basis for its actions").

(37) Id at *72-73.

(38) The proposed bills are HR 870 and S 1774.

(39) "Puerto Rico utility PREPA says reached deal with lenders", Reuters, September 22 2015, available at www.reuters.com/article/2015/09/22/us-usa-puertorico-prepa-idUSKCN0RM2L120150922.

(40) Id.

(41) See Medtronic, Inc v Lohr, 518 US 470, 485 (1996) (quoting Rice v Santa Fe Elevator Corp, 331 US 218, 230 (1947)): "[i]n all pre-emption cases, and particularly in those in which Congress has 'legislated… in a field which the States have traditionally occupied,'… we 'start with the assumption that the historic police powers of the States were not be superseded by the Federal Act unless that was the clear and manifest purpose of Congress'."

(42) Id.

(43) See Franklin, at *15-16, 53, 58-60.

(44) Id at *48-49.

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