Missed opportunities in Puerto Rico ruling

In a narrowly focused decision issued on June 13, the U.S. Supreme Court struck down as unconstitutional the Puerto Rico Corporation Debt Enforcement and Recovery Act (Recovery Act). Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust, 2016 DJDAR 5671. The Recovery Act was enacted by Puerto Rico in 2014 in response to a severe fiscal crisis to enable the commonwealth's public utilities to implement a recovery or restructuring plan for their debt. The Supreme Court held, however, that the act was preempted by the Bankruptcy Code. Specifically, the court found that the "gateway" provision providing access to Chapter 9 bankruptcy relief for municipal entities excluded Puerto Rico (and the District of Columbia). Nonetheless, the court held that the prohibition contained in Chapter 9 against any state law providing for a non-consensual restructuring of debt applied to Puerto Rico. The dissenting opinion asserts that since the gateway to Chapter 9 was closed to it, there is no pre-emption because none of the provisions of Chapter 9 apply to Puerto Rico.

The Supreme Court did not address that the Recovery Act could have also been held to be an unconstitutional violation of the contracts clause of the U.S. Constitution. Nor did it discuss that there is an argument that the exclusion of Puerto Rico and the District of Columbia from access to Chapter 9 relief may be a violation of the bankruptcy clause.

Chapter 9 of the Bankruptcy Code provides a framework for eligible governmental entities to restructure debt. Chapter 9 is designed to balance the powers provided under federal bankruptcy law to restructure a municipality's debt against the mandate of the 10th Amendment to the Constitution guaranteeing state sovereignty. This balance is maintained by the gateway provision, which requires, in part, that in order for a governmental entity to be eligible for Chapter 9 relief it must be specifically authorized under state law to enter Chapter 9. 11 U.S.C. Section 109(c)(2). In 1984, Congress amended the Bankruptcy Code, without comment, to bar Puerto Rico and the District of Columbia from authorizing their governmental entities to access Chapter 9.

Article I, Section 8 of the Constitution gives Congress the power to establish uniform laws on the subject of bankruptcies throughout the United States. Moreover, the Article 1, Section 10 of the Constitution prohibits the states from passing any law that impairs the obligation of contracts. Accordingly, courts have recited as a statement of black letter law that "[o]nly federal law can give the type of relief afforded by chapter 9." In re City of Bridgeport, 128 B.R. 688, 694 (Bankr. D. Conn. 1991) (citing United States v. Bekins, 304 U.S. 27, 53-54 (1938)). However, it has been argued that the contracts clause does not bar a state from enacting its own legislation impairing municipal contracts if required by a financial emergency. See Thomas M. Mayer, "State Sovereignty, State Bankruptcy, and Reconsideration of Chapter 9," 85 AM. BANKR. L.J. 363, 376-77 (2011). Nonetheless, the commonly accepted view is that "[o]utside of bankruptcy a non-consensual alteration of contracted debt [of a municipal government] is, at the very least, severely restricted, if not impossible." In re Jefferson County, Ala., 465 B.R. 243, 293 n.21 (Bankr. N.D. Ala. 2012) ("There has been only one instance ... when the Supreme Court ... has sustained the alteration of a municipal bond contract outside a bankruptcy case. Faitoute Iron & Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942). In a later case, U.S. Trust Co. of N.Y. v. New Jersey, 431 U.S. 1, 27-28 (1977), Faitoute was distinguished and its precedent status, if any, is dubious.").

After the Recovery Act was signed into law, mutual funds and hedge funds holding bonds of the Puerto Rico Electric Power Authority brought lawsuits seeking to enjoin implementation of the act. The district court found that the Bankruptcy Code preempts the Recovery Act and therefore the act is unconstitutional under the supremacy clause of the U.S. Constitution.

The district court also found, in response to Puerto Rico's motion to dismiss, that the plaintiffs had made a plausible claim that the Recovery Act violated the contracts clause. The district court stated that despite the unequivocal language of the contracts clause providing that no state shall pass any law impairing the obligation of contracts, courts must reconcile the contracts clause with the state's sovereign power to safeguard the welfare of its citizens. The district court identified a two-pronged test to be applied to contracts clause claims: (1) whether the state law operates as a substantial impairment of a contractual relationship; and (2) if there is substantial impairment, whether the impairment is reasonable and necessary to serve an important public purpose. The district court recognized that "[t]he United States Supreme Court has long held that the Contracts Clause prohibits states from passing laws, like the Recovery Act, that authorize the discharge of debtors from their obligations." The district court, however, did not rule on the merits of the contracts clause claim other than to deny the commonwealth's motion to dismiss.

The 1st U.S. Circuit Court of Appeals affirmed the district court judgment. The concurring opinion explains that the 1984 amendments to the Bankruptcy Code stripping Puerto Rico of access to Chapter 9 were enacted by Congress pursuant to its power under the Bankruptcy Clause, which provides that Congress shall have the power to establish uniform laws on the subject of bankruptcies throughout the United States. The concurring opinion finds the language of the term "uniform" to be unequivocal and unambiguous. Accordingly, the concurring opinions concludes that "[i]t would be absurd to argue that the exclusion of Puerto Rico from the protection of the Bankruptcy Code by the enactment of the 1984 Amendments is not prohibited by the unequivocal language of the Bankruptcy Clause of the Constitution." Under the view expressed in the concurrence, Puerto Rico would not be barred from Chapter 9 relief.

The Supreme Court did not address either the contracts clause claim or any question regarding violation of the uniformity requirement of the bankruptcy clause. Rather, the sole focus was on the narrow preemption issue. The dissent laments that "[b]ecause Puerto Rico municipalities cannot access Chapter 9's federal bankruptcy process, however, a nonfederal bankruptcy solution is not merely a parallel option; it is the only existing legal option for Puerto Rico to restructure debts that could cripple its citizens." In conclusion the dissent acknowledges that Congress could step in to resolve Puerto Rico's crisis.

Following the Supreme Court's decision, Congress passed and Obama signed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). At the bill signing, referring to PROMESA, the president stated that "[i]t's not, in and of itself, going to be sufficient to solve all the problems that Puerto Rico faces, but it is an important first step on the path of creating more stability, better services, and greater prosperity over the long term for the people of Puerto Rico." However, PROMESA does not provide Puerto Rico's governmental entities with access to Chapter 9, something local officials had sought. While application of the contracts clause by the Supreme Court could have provided another basis for invalidating the Recovery Act, application of the uniformity provision of the bankruptcy clause, as advocated by the 1st Circuit's concurring opinion, would have opened the door to Chapter 9 relief for Puerto Rico.

David Kupetz is a shareholder in SulmeyerKupetz PC. He is an expert in restructuring, business reorganization, bankruptcy, assignments for the benefit of creditors, and other insolvency solutions. You can reach him at dkupetz@sulmeyerlaw.com.