United States Court of Appeals for the First Circuit: United States Bankruptcy Code Preempts Puerto Rico from Providing Municipalities with Statutory Bankruptcy Relief

On July 6, 2015, the First Circuit held that the United States Bankruptcy Code preempts the Commonwealth of Puerto Rico’s attempt to enact laws to provide its municipalities with bankruptcy relief. More specifically, in its opinion in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico, the First Circuit held that section 903(1) of Chapter 9 of Bankruptcy Code (“Chapter 9”) preempted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (“Recovery Act”), which was passed by the Puerto Rican legislature in an effort to provide Puerto Rican municipalities with bankruptcy relief.

1.Background

Under the United States Constitution, States cannot independently provide statutory bankruptcy relief to its municipalities because doing so “would require impairing the obligation of contracts in violation of the Contracts Clause.” See Franklin at 10. Generally speaking, the “Contracts Clause”, found at Art. I, §10, clause 1  of the U.S. Constitution, prohibits States from passing laws that retroactively impair contract rights. As a result of this prohibition, in 1933, Congress enacted Chapter 9 of the Bankruptcy Code to provide state municipalities with bankruptcy relief that the Contracts Clause barred states from enacting themselves.

Chapter 9 provides that a municipality qualifies as a debtor only if it “is specifically authorized . . . to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to [so] authorize.” 11 U.S.C. § 109(c)(2). Therefore, while local municipalities can qualify for bankruptcy relief, the federal government cannot independently authorize a municipality to be a debtor for purposes of Chapter 9 bankruptcy relief because only a State has that power.

In 1938, Congress revised the Bankruptcy Code to give Puerto Rico the ability to authorize its municipalities to obtain federal municipal bankruptcy relief under Chapter 9. However, in 1984, Congress amended the Chapter 9 definition of “State” to include Puerto Rico “except for the purpose of defining who may be a debtor under [C]hapter 9 of [the Bankruptcy Code].” 11 U.S.C. § 101(52). As a result of the Chapter 9 amendment, Congress expressly barred Puerto Rico and its municipalities from obtaining federal bankruptcy relief under Chapter 9.

However, due to the recent and grave financial crisis plaguing the island, in June, 2014, Puerto Rico attempted to allow its utility companies and municipalities to restructure their debt by enacting its own municipal bankruptcy law, called the “Recovery Act”. It was the passage of the Recovery Act and the anticipated bankruptcy of a financially distressed Puerto Rican public utility, the Puerto Rican Electric Power Authority (“PREPA”), that sparked this action.

Here, the plaintiffs, Franklin, Oppenheimer Rochester, Blue Mountain Capital Management, LLC, (collectively “Plaintiffs”), who collectively hold two billion dollars in bonds issued by PREPA, brought suit against the Commonwealth of Puerto Rico, Puerto Rico’s governor, Puerto Rico’s Secretary of Justice, and the Government Development Bank (collectively “Defendants”) to challenge the Recovery Act and enjoin its implementation. The District Court ruled in Plaintiffs’ favor and permanently enjoined the Recovery Act, ruling that the Act is preempted under 11 U.S.C. § 903(1). The First Circuit confronted the issue on appeal.

2.The First Circuit’s Determination

The First Circuit stated that “[t]he primary issue on appeal is whether § 903(1) preempts Puerto Rico’s Recovery Act. That question turns on whether the definition of ‘State’ in the federal Bankruptcy Code—as amended in 1984—renders § 903(1)’s preemptive effect inapplicable to Puerto Rico.” See Franklin at 4.

Section 903(1) provides as follows: “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.” 11 U.S.C. § 903(1). As explained by the First Circuit, “§903(1), ensures the uniformity of federal bankruptcy laws by prohibiting state municipal debt restructuring law that bind creditors without their consent.” Franklin, at 4.

In finding that § 903(1) applies to Puerto Rico, the First Circuit noted that there is no indication in Chapter 9 that suggests that Puerto Rico or its municipalities are exempt from § 903(1) prohibitions. In fact, the 1984 amendment of Chapter 9 explicitly states that Puerto Rico is a “State” “except for the purpose of defining who may be a debtor under chapter 9 of [the Bankruptcy Code].” 11 U.S.C. § 101(52). Thus, under § 903(1), Puerto Rico is barred from restructuring municipal debt without the consent of the municipalities’ creditors.

Here, although Puerto Rico modeled the Recovery Act after Chapter 9, the First Circuit found that it provided less protection for creditors than the federal Chapter 9 counterpart. The Recovery Act provides two ways of obtaining bankruptcy relief: Chapter 2 “Consensual Debt Relief,” and Chapter 3 “Debt Enforcement.” According to the First Circuit, Chapter 2 “permit[ed] a binding modification, including debt reduction, to a class of debt instruments with the assent of creditors holding just over one-third of the affected debt,” which reduced protections for creditors. See Franklin at 18-19. The First Circuit also found that Chapter 3 debtors “may [have] avoid[ed] certain contractual claims,” which again reduced protections for creditors. See Franklin at 19. Additionally, unlike Chapter 9, the Recovery Act allowed the Puerto Rican governor to issue an involuntary proceeding if the Government Development Bank found that it would be in the best interest of both the municipality and the Commonwealth.

The Recovery Act attempted to make municipalities barred from filing for federal bankruptcy relief eligible for bankruptcy relief at the Commonwealth level through the Puerto Rican Government Development Bank. The First Circuit found that the Act made municipalities eligible to seek both Chapter 2 and Chapter 3 relief and request an involuntary proceeding, each of which reduced protections for creditors investing in Puerto Rico by binding them without their consent. Thus, the First Circuit found that the Recovery Act was preempted by § 903(1)’s prohibition.

3.Impact on Industry

Puerto Rico claims that its debt-saddled municipalities and utilities are left with no relief as a result of the First Circuit’s determination. However, the First Circuit indicated that Puerto Rico’s recourse lies with Congress, not the courts. The First Circuit noted that Puerto Rico may request that Congress amend Chapter 9 or enact legislation to provide the territory with federal bankruptcy relief because  Congress, not the courts, maintains the power to grant Puerto Rican municipalities federal bankruptcy protection.

Puerto Rico is currently seeking authorization and other relief directly from Congress. Judge Torruella’s concurrence in Franklin, however, pointed out that Puerto Rico has no political representation in Congress, and therefore, holds little to no bargaining power when requesting aid from the federal legislature. Thus, Puerto Rican municipalities in need of bankruptcy relief hopefully await on Puerto Rico to request relief through Congressional legislation or for Puerto Rico to appeal to obtain a Supreme Court determination.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of tax, tax litigation, and complex administrative litigation. Should you have any questions or need further assistance, please contact us by email at contact@fidjlaw.com or telephone at 305.350.5690.