by Zack A. Clement
Originally published in the Federal Bar Association Puerto Rico – Hon. Raymond L. Acosta Chapter Newsletter (Issue No. 52)
Puerto Rico is insolvent, unable to pay current maturities of debt for itself and its municipal corporations and unable to pay that debt in full. Continued support of its public corporations is placing an ongoing financial strain on Puerto Rico and addressing their solvency would improve Puerto Rico’s solvency (1).
Recrimination about what led to this state of affairs is not helpful. Puerto Rico is not alone. Many states and municipalities have the same problem—huge bond debt and pension liability built up over 50 years since World War II. There is $3.7 trillion of outstanding municipal debt and over $1.5 trillion of unfunded pension liability in the 50 states; together, these are 1/3 the size of the national debt (2).
To Lead or Not
Puerto Rico is at a crossroads. It could choose to take charge of its challenges like a “debtor-in-possession” in a U.S. Chapter 11 case (3), imposing cost-cutting austerity on itself, assessing how to raise more revenue, and proposing a fair and equitable financial restructuring plan that offers to pay what it can feasibly afford. If Puerto Rico does not do so, the capital community will tell it how much austerity and tax increase it must impose in order to receive the next bailout loan. The proceeds of that loan are likely to be used to repay existing bondholders who currently have a claim against an insolvent borrower and weak remedies to collect that claim. The austerity and tax increases the capital community demands might actually be counter-productive and further depress the Puerto Rican economy; it has happened before.
To lead like a debtor-in-possession, Puerto Rico will need to analyze (i) whether and how much more it can cut expenses and raise revenues without ruining its economy and (ii) how it should deal with its contracts and bonds claiming to be fully secured. It can then formulate a plan to pay its secured creditors the value of their collateral and its unsecured creditors all it can reasonably afford to pay.
Puerto Rico can meet with creditors and present its economic analysis to persuade them to agree to its plan premised on that analysis. If the plan proposes substantial principal reductions, creditors might refuse to believe Puerto Rico’s economic analysis or to agree to the restructuring plan, and a payment moratorium might be necessary to finish persuading them that they should accept the bargain offered in the plan (4). During such a moratorium, Puerto Rico might need to defend against collection lawsuits and live off its tax receipts. Eventually, Puerto Rico might persuade many creditors to go along with its plan because its economic study shows it is all Puerto Rico can reasonably afford to pay, the plan is better than continued non-payment during the moratorium, and it is better than creditors would get if they continued pursuing their remedies.
Chapter 9 Principles
What court procedures are available to Puerto Rico or its municipalities to force a fair and equitable plan on holdout creditors who will not agree to such a plan? Chapter 9 would provide an excellent substantive and procedural law to deal with the insolvency of Puerto Rico’s municipalities, including its public corporations. Chapter 9 provides for deference to the sovereignty of a state (5) and its municipalities (6). In U.S. v. Bekins, 304 U.S. 27 (1938), the Supreme Court found that, unlike a predecessor statute, the then recently amended municipal bankruptcy act was constitutional because it contained protections for the sovereignty of a state which can choose to waive limited amounts of its sovereignty to permit its municipalities to use federal bankruptcy power to breach contracts to solve their financial problems. States are prohibited from exercising this power because of the U.S. Constitution’s prohibition against states impairing contracts (7).
To protect state sovereignty, chapter 9 provides that a creditor cannot file an involuntary bankruptcy case against a municipality, only the municipal debtor can file a plan, and a chapter 9 case cannot be converted to a chapter 7 liquidation to sell the municipality’s assets to pay creditors. A chapter 9 case of an eligible debtor can only be dismissed if the court finds it was not filed in “good faith” or the debtor has not made timely progress toward confirming a plan of debt adjustment (8).
There are three basic standards for confirming a chapter 9 plan. First, the plan must be feasible. This means that a plan of debt adjustment should leave the government with adequate resources to be able to pay its restructured debts and to provide adequate services to its citizens (9).
Next, the plan must be in the “best interests of creditors.” Congress did not make applicable in a chapter 9 case the chapter 11 test based on the hypothetical liquidation of a debtor’s assets (10). Rather, in chapter 9, best interests of creditors means that creditors will receive at least as much as they would get if the case were dismissed, and they were left to pursue their state law remedies (11).
Finally, a plan must be fair and equitable if it is to be enforced against holdout creditors. Fair and equitable treatment of secured claims generally means providing secured creditors with the value of their collateral (12). By contrast, fair and equitable treatment can be provided to unsecured claims as long as no junior class recovers any value (13). Since a municipality has no equity holders to receive any value, this standard is easy to prove even though unsecured claims are paid less than in full. Since the Great Depression, federal courts have applied a subjective test in municipal bankruptcies that asks whether creditors have been paid all they can reasonably expect under the circumstances (14). These cases have analyzed whether the debtor has made reasonable cuts in expenditures (in the language of modern sovereign debt restructures, had “reasonable austerity”) and made reasonable use of taxation to be able to pay all it can reasonably afford.
In Detroit’s chapter 9 case, where the Detroit Art Museum is allegedly worth billions of dollars, questions have arisen about whether there is a duty to make reasonable efforts to monetize that asset for the benefit of creditors. Requiring a city to sell assets to confirm a chapter 9 case would be at odds with the required deference to a municipality’s decisions about the use of its assets as required under Bekins and sections 903 and 904 of the Bankruptcy Code, and at odds with Congress’ decision not to apply a hypothetical asset liquidation test in Chapter 9 (15). If the fair and equitable standard requires a municipality to consider monetizing its assets, then, at a minimum, section 904 requires deference to the judgment of the debtor’s elected officials (16).
It Will Be Difficult for Puerto Rico to Use Chapter 9
Although Chapter 9 would provide an ideal framework for the resolution of Puerto Rico’s economic challenges, the Bankruptcy Code specifically provides that Puerto Rico is not a “State” that can authorize its municipalities to file a chapter 9 case.17 It is not clear why Congress, empowered by the Bankruptcy Clause of the Constitution to pass uniform bankruptcy laws throughout the United States,18 chose to so explicitly discriminate against Puerto Rico.
As Chapter 9 appears unavailable to Puerto Rico’s municipalities, can Puerto Rico find other ways to apply central sovereign debt restructuring principles — that a plan should pay unsecured creditors all the government debtor can reasonably afford, more than they would receive by exercising their remedies, still leaving enough money to feasibly provide services to citizens?
The Limits of a Puerto Rico Restructuring Law
If Puerto Rico tries to pass its own debt restructuring law it will be far less powerful than federal bankruptcy law. Bekins described how state law cannot fully resolve municipal insolvency, noting that:
There is no hope for relief through statutes enacted by the States, because the Constitution forbids the passing of State laws impairing the obligations of existing contracts (19).
This is illustrated in a bill currently being considered in the Puerto Rico legislature to establish a bankruptcy style proceeding under Puerto Rico law (the “Bill”). It provides explicitly that there should not be any “significant” impairment of contract (20). Moreover it would permit creditors to pursue an involuntary bankruptcy proceeding against a Puerto Rico municipal corporation and permit liquidation of the corporation if no agreement can be reached on a plan approved by 75% of creditors during such a case, a substantial new remedy (21).
The only other state law municipal bankruptcy procedure ever approved by the Supreme Court was enacted in New Jersey during the Great Depression at a time when there was no applicable federal municipal bankruptcy statute. It permitted a municipal debtor to propose a restructure plan, did not permit an involuntary bankruptcy filing by creditors and certainly did not provide for the possible liquidation of the municipality (22).
Puerto Rico law currently provides for limited remedies against the Commonwealth (23). The Bill under consideration in the legislature would give creditors the ability to initiate a state bankruptcy proceeding that could result in a liquidation sale of a public corporation’s assets would provide them a substantial new remedy. It would substantially increase creditors’ leverage in negotiations with Puerto Rico, permitting them to demand greater austerity, tax increases and asset liquidation as a precondition to any deal restructuring Puerto Rico’s finances.
Beyond the will to cut costs and raise revenue reasonably without ruining Puerto Rico’s economy, and the tenacity to endure a payment moratorium long enough to persuade creditors to agree to a reasonable debt restructuring plan, what other power does Puerto Rico have to force holdout creditors to accept its plan?
Federal Equity Receivership
Puerto Rico’s municipal debt problem bears many similarities to the U.S. railroad industry in the late 1800’s. It was in the national interest of the United States to support the creation of a nationwide rail transportation network. Many of these railroad companies became insolvent as they were building their railroad systems and would have been worth very little if they had been liquidated in a series of foreclosure sales concerning different segments of track. The only way to preserve going-concern value and ultimately get the rail network built was to stay foreclosure, keep the rail network together and approve fair and equitable plans of reorganization negotiated with creditor majorities.
Federal courts did this through equity receivership proceedings that preserved going concern value and allocated it fairly. These proceedings developed the concepts of “fair and equitable” and the “best interests of creditors” that Congress later codified in bankruptcy acts and the current Bankruptcy Code concerning railroads, corporations and municipalities (24). Thus, in response to a very substantial economic problem in the growth of the United States, federal equity receiverships developed principles that Congress later repeatedly codified as federal bankruptcy law.
Recently, the Northern Mariana Islands Retirement Fund used a federal equity receivership after unsuccessfully trying to use chapter 9 to address its insolvency. The bankruptcy court praised the Fund for trying to solve its problems but dismissed the bankruptcy case because the Fund was not an “instrumentality” of a state eligible to be a chapter 9 debtor under the Bankruptcy Code (25). The Fund then developed a plan to resolve its insolvency by settling claims against third parties who owed funding to the Fund, by agreeing with certain beneficiaries to reduce benefits owed and filing a federal equity receivership proceeding to implement the restructuring plan contained in the global settlement agreement (26).
Following the general analysis of Bekins and the example of the Northern Mariana Island Retirement Fund, the federal court system could act again through federal equity receiverships for Puerto Rico and its municipalities to address a substantial public problem – unsustainable public debt that they cannot afford to pay without ruining their economies and their ability to provide services to their citizens.
In Bekins the Supreme Court praised cooperation between a state and the federal government where the federal government provided bankruptcy power to solve a specific economic problem that the state lacked the power to solve.
In the instant case we have cooperation to provide a remedy for a serious condition in which the States alone were unable to afford relief. . . . The natural and reasonable remedy through composition of the debts of the district was not available under state law by reason of the restriction imposed by the Federal Constitution upon the impairment of contracts by state legislation. The bankruptcy power is competent to give relief to debtors in such a plight and, if there is any obstacle to its exercise in the case of the districts organized under state law it lies in the right of the State to oppose federal interference. [When] the State steps in to remove that obstacle[,] the State acts in aid, and not in derogation, of its sovereign powers. It invites the intervention of the bankruptcy power to save its agency, which the State itself is powerless to rescue. Through its cooperation with the national government the needed relief is given. We see no ground for the conclusion that the Federal Constitution, in the interest of state sovereignty, has reduced both sovereigns to helplessness in such a case (27).
What Puerto Rico Can Do
It is not possible to guarantee that the federal courts will exercise their powers to deal with unsustainable public debt in Puerto Rico as they did in the Northern Mariana Islands and the railroad receiverships. However, there are good policy reasons and precedents for the federal courts to do so. If the prospect of the federal court conducting an equity receivership to implement a restructuring plan encourages Puerto Rico to lead like a debtor-in-possession, it will have a much better chance of negotiating an acceptable deal with its creditors.
Zack A. Clement is a Partner in the Houston, Texas office of Fulbright & Jaworski LLP, part of Norton Rose Fulbright.
The views expressed in this article are those of the author, not of the law firm or its clients.
1 This article summarizes a PowerPoint presentation made by the author to the Puerto Rico Federal Bar Association on May 14, 2014, entitled “Modification or Discharge of Debt in a Chapter 9 Case and How this Could be Relevant to Puerto Rico”, and an article published in April 2014 in the American Bankruptcy Law Journal, Zack A. Clement and R. Andrew Black, “How City Finances Can Be Restructured: Learning from Both Bankruptcy and Contract Impairment Cases”, 88 Am. Bankruptcy L.J., 41-84 (2014). Both the PRFBA PowerPoint and the ABLJ article are available by request to the author.
2 Clement and Black, pp, 42-46.
3 Chapter 11 of the United States Bankruptcy Code permits a debtor corporation’s officers and directors to remain in control of its assets and to lead to its reorganization. 11 U.S.C. § 1107. They only lose control to the appointment of a trustee if they fail to provide proper leadership to reorganization. 11 U.S.C. § 1104.
4 According to an attorney who has represented many governments restructuring their sovereign debt over the last 30 years, “[b]y far the most popular—one is often tempted to say ‘ubiquitous’—technique for discouraging holdouts is to threaten them with a prolonged payment default unless they join the restructuring.” R. Lastra and L. Buchheit, Sovereign Debt Management (Oxford, 2014), at 17. In some cases, a payment moratorium has been combined with reducing the remedies available to bondholders. Id. at 20. In one case, the United Nations issued a de facto injunction against actions to collect on old bonds against the assets of the debtor country. Id.
5 “This [chapter 9] does not limit or impair the power of the state to control, by legislation or otherwise, a municipality of or in such state in the exercise of the political or governmental powers of such municipality….” 11 U.S.C. § 903.
6 “Notwithstanding any power of the court, unless the debtor consents or the plan [of debt adjustment] so provides, the court may not … interfere with (1) any of the political or governmental powers of the debtor, (2) any of the property or revenues of the debtor; or (3) the debtor’s use or enjoyment of any income producing property.” 11 U.S.C. § 904.
7 U.S. Const., Article 1, sec. 10. 8 11 U.S.C. §§ 921(c), 930(a)(4), (5), and (6).
8 11 U.S.C. §§ 921(c), 930(a)(4), (5), and (6).
9 Clement and Black, p. 49. 10 Id.
11 Id., pp. 49-52. Creditor remedies against governments under state law are severely limited. Execution of a judgment against government assets is generally prohibited, see, e.g., Tex. Const. Art. XI, § 9, and judgments may only be enforced for a limited period. For example, in California and Texas, judgments are valid for 10 years, with a possibility of a one- time extension. Cal. Gov. Code § 970.1; Tex. Civ. Prac. and Rem. Code § 34.001. Under most state law, sovereign immunity has been waived no further than to permit a creditor to seek a writ of mandamus from a court. Moreover, mandate orders are limited in at least two respects. For example, in California (i) they can only enforce clear and present duties; and (ii) the duty must be ministerial rather than involve discretion. People ex rel. Younger v. County of El Dorado, 5 Cal. 3d 480, 491 (Cal. 1971); Sklar v. Franchise Tax Bd., 185 Cal. App. 3d 616, 624 (Cal. App. 1st Dist. 1986) (the “fundamental constitutional principle [of separation of powers] has given rise to the rule that ‘[m]andamus will not lie to compel a legislative body to perform legislative acts in a particular manner’”). Separation of powers places obvious limits on mandamus, which the U.S. Supreme Court has characterized as an “empty right to litigate.” Faitoute Iron & Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942).
12 This can be done either by (1) allowing secured creditors to retain their liens and to receive cash payments over time equal to the value of their collateral, or (2) selling the collateral at an auction in which secured creditors can credit bid their lien, or (3) by abandoning the collateral to the secured creditor. 11 U.S.C. § 1129(b)(2)(A).
13 11 U.S.C. § 1129(b)(2)(B).
14 Clement and Black, pp. 52-55
15 Id. at 49-52.
16 11 U.S.C. § 1129(a)(3); Clement and Black, pp. 52-55.
17 11 U.S.C. § 101(52)
18 U.S. Const. Article I, § 8(4).
19 Bekins, 304 U.S. at 51 (quoting the report of the Committee on the Judiciary of the House of Representatives, H. Rep. No. 517, 75th Cong., 1st Sess.).
20 Senate Bill 993, presented by Senators Rosa Rodriguez and Power Nadal to create the Restructuring Act Public Corporations.
21 Id. at Articles 5 and 12.
22 Faitoute Iron & Steel Co. v. City of Asbury Park, 216 U.S. at 504-05.
23 Even if a bond is covered by the “continuous appropriation” contained in 13 L.P.R.A. § 141d, the remedy for non-payment appears to be a mandamus action which might result in a $500 fine against a public official. 32 L.P.R.A. §§ 3431, 3433. Otherwise, authorization is granted to bring civil actions against Puerto Rico for up to $75,000 [32 L.P.R.A. § 3077(c)] and the Commonwealth “shall promptly settle any judgment against it up to the maximum set forth in § 3077 of this title.” 32 L.P.R.A. § 3082. Where a judgment is rendered against the Commonwealth in excess of the $75,000 limit in § 3077(c), the holder of that judgment can seek specific legislative authority that it be paid more. Valentin v. Commonwealth, 84 P. R. R. 108 (1961).
24 See Clement and Black, pp. 63-65, fn. 126 and 127.
25 In re: N. Mar. I. Ret. Fund, 2012 U.S. Dist. LEXIS 131709 *8 (2012).
26 Clement and Black, p. 63.
27 U.S. v. Bekins, 304 U.S. at 53–54.