Last Tuesday, Puerto Rico sold its much-ballyhooed $3.5 billion in non-investment grade general obligation bonds. Two days later, two legislators in Puerto Rico’s Senate filed a bill which, if enacted, would permit insolvency filings by Puerto Rico’s public corporations in Puerto Rico’s territorial trial court. The juxtaposition of the two events has some bond investors crying foul. But though the timing of the insolvency bill must have Puerto Rico’s investor relations personnel swallowing ibuprofen, Puerto Rico itself is not a “public corporation” and the proposed legislation would not establish a process for an insolvency filing affecting the territory’s general obligation bonds. (Although the legislation authorizes a bankruptcy-like process, the process is referred to in this post as “insolvency” to distinguish it from the federal bankruptcy process.)
The proposed legislation is of greater interest to holders of bonds issued by Puerto Rico’s public corporation bond issuers. To the extent the legislation responds to requests by one or more public corporations, it is not good news for bondholders, as it suggests that some of those public corporations may be actively considering an insolvency-related process. However, press reports indicate that Puerto Rico’s Governor opposes enactment of this particular legislation. Accordingly, the existence of the Senate bill, and its details, may deserve attention not so much because of any likelihood that such an insolvency process will be implemented in the short term, but rather as a case study in the legal complexity of any attempted restructuring of Puerto Rico’s governmental debt.
Whether legislation of the type represented by the Puerto Rico Senate bill, if enacted, would be constitutional would likely involve years of litigation following an attempt by any public corporation to avail itself of such protection as it provides. As suggested in the bill’s preamble, Puerto Rico’s authority to create its own non-federal process to address insolvent public corporations is uncertain. Puerto Rico’s instrumentalities are excluded from the definition of “municipality” under Chapter 9, which governs municipal bankruptcies. Whether under the U.S. Constitution’s supremacy and bankruptcy clauses the existence of Chapter 9 preempts Puerto Rico’s ability to establish its own bankruptcy-like process for its public corporations, or whether Puerto Rico’s exclusion from Chapter 9 suggests that Congress did not intend such preemption, is the main constitutional question. Further complicating the resolution of that question is Puerto Rico’s status as a federally-approved U.S. territory that has been recognized as akin to a “state” for at least some constitutional purposes by the U.S. Court of Appeals for the First Circuit.
If legislation of the type filed in Puerto Rico’s Senate were enacted, and if the constitutionality of such a non-federal insolvency process in Puerto Rico were ultimately upheld, such legislation by its terms limits a public corporation’s ability to restructure its debts. The legislation precludes a “significant” impairment of the public corporation’s major contractual obligations unless it is reasonable and necessary to serve an important public purpose. The legislation defines an “important public purpose” as including (somewhat perplexingly) the obligation to comply with existing contracts, but, perhaps more significantly, as including “the stability and continuity of essential public infrastructure, utilities and services.” In other words, the bill would create a “bankruptcy-lite” statute designed to permit approval of restructuring plans only to the extent they satisfy the federal constitutional test for impairment of contracts. The “contracts clause” of the U.S. constitution has been judicially interpreted not as a prohibition on contract impairment but rather as a balancing test under which contracts may be impaired if there is sufficient public necessity for doing so and there are no less onerous means of addressing such public necessity .
The limits on what can be achieved under the proposed legislation are compelled by the fact that, if it were enacted, in contrast to Chapter 9 it would not be enacted under Congress’s constitutional power to provide a bankruptcy process. Whereas the constitutionally-sanctioned federal bankruptcy act expressly contemplates certain judicially approved contract impairments to give a debtor a “fresh start”, a Puerto Rican public corporation insolvency statute not enacted pursuant to the constitutional bankruptcy provisions would need to comply with the anti-impairment provisions of the U.S. Constitution. Accordingly, any plan under a Puerto Rico statute that impairs bondholder rights would be subject to challenge on whether the statute’s definition of “important public purpose” correctly incorporates the federal constitutional balancing test for permissible contract impairment and, if so, whether that test has been properly applied in the context of any particular impairment by any particular bonding authority of particular bondholder rights. This is an inefficient process relative to the federal bankruptcy statute, which provides a process for bankruptcy plan approval that obviates the need to address on a case by case basis whether an approved contract impairment is constitutional.
The bill introduced in Puerto Rico’s Senate reinforces a risk already faced by Puerto Rico bondholders that Puerto Rico may seek by direct legislation or by legislatively-established process to impair to the extent constitutionally permissible the contractual rights of bondholders of insolvent bonding authorities. That risk is already playing itself out for a different class of Puerto Rico’s creditors, its public employees and teachers, in legislation imposing certain pension cuts and in court challenges to such legislation. If there is good news for Puerto Rico’s public corporation bondholders in the specific legislation filed in the Puerto Rico Senate, it is that the insolvency process outlined in such legislation, unlike the federal bankruptcy statute, lacks a “cramdown” provision and would require approval of any restructuring plan by 75% in amount of affected creditors. In other words, any cutbacks in bondholder rights under the proposed legislation would, in most conceivable instances, require the consent of a substantial proportion of the bondholders.