Excluded & Preempted – Puerto Rico Hamstrung by Double Whammy

10/1/2016

First published in the Oregon State Bar Debtor-Creditor Newsletter Vol. XXXV, No. 3

Puerto Rico v. Franklin California Tax-Free Trust, 136 S.Ct. 1938 (2016)

In 1984, Congress amended the Bankruptcy Code in a manner that prevents municipalities in Puerto Rico from utilizing Chapter 9. Specifically, the definition of “State” under section 101(52) was amended to read, the “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” (emphasis added). In turn, section 109(c)(1)-(2) provides that a “debtor” under Chapter 9 can only be a “municipality” that is “specifically authorized … to be a debtor under such chapter by State law … .” Strangely, there does not appear to be any legislative history explaining the rationale or need for this change.

Puerto Rico has been struggling with excessive public debt for a number of years (currently over $70 billion). It borrowed funds by issuing municipal bonds and then used the money to compensate for declining government revenue in an effort to maintain essential public services (e.g., schools, heath care, etc.). In response to this debt crisis and in an effort to fill the gap left by the above Bankruptcy Code exclusion, Puerto Rico enacted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”).

The Recovery Act was designed to allow Puerto Rican public utility corporations to restructure their debt.2 (Three of Puerto Rico’s largest utilities account for approximately $20 billion of its debt.) Puerto Rican cities and Puerto Rico itself were excluded from the Recovery Act. Notably, the Recovery Act was designed to provide relief to entities who were specifically ineligible for relief under the U.S. Bankruptcy Code (as well as for those who could propose “consensual” restructuring plans). A group of investment funds and utility bondholders sought to enjoin enforcement of the Recovery Act, arguing that it is explicitly preempted by the Bankruptcy Code. The District Court agreed, the First Circuit affirmed, and the Supreme Court subsequently heard the resulting appeal.

The Supreme Court’s analysis focused on three Code provisions – §§ 109, 101(52), and 903(1). The Court explained that the exclusionary definition of “State” (under § 101(52)) is “tantamount to barring Puerto Rico from ‘specifically authorizing’” municipalities from filing Chapter 9 petitions (under 109). 136 S.Ct. at 1947 (referring to §109 as the “gateway” provision). Next, the Court turned to the issue of federal preemption under section 903(1). That provision stands for the proposition that “states” may not enact their own municipal bankruptcy schemes. See 11 U.S.C. § 903 (explaining that although Chapter 9 does “not limit or impair the power of a State to control … a municipality” it does prevent a state law from “prescribing a method of composition of indebtedness” to bind a nonconsenting creditor (emphasis added)). Among other things, Puerto Rico argued that since it was excluded from Chapter 9, section 903 simply does not apply to it nor preempt the Recovery Act.

The Court disagreed and concluded that the “exception excludes Puerto Rico only for purposes of the gateway provision” and not for any other section of Chapter 9. In other words, Puerto Rican municipalities are prevented
from being “debtors” under section 109, but Puerto Rico itself continues to be treated as a “state” under Chapter 9. Since Puerto Rico is considered a “state” under the Code, it is bound by this preemption provision. The Court further concluded that if Congress intended to exclude Puerto Rico entirely from Chapter 9 it “would have said so.”

Lastly, the Court rejected the argument that the Recovery Act is not a “State law” constraining “creditors.” The Government Development Bank for Puerto Rico argued that since Puerto Rican municipalities were not “debtors” under § 109, they did not have “creditors” as defined under the Code. See 11 U.S.C. § 101(10) (a creditor is an “entity that has a claim against the debtor”). The Court concluded that the “subtle” changes to these definitions in 1978 did not “support such a fundamental change in the scope of Chapter 9’s pre-emption provision.” 136 S.Ct. at 1977 (internal quotation and citation omitted). In the end, the Court explained that the hardships created by the 1984 exclusion of Puerto Rico from Chapter 9 must be addressed by Congress.

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