Rudolph J. Di Massa, Jr.

Jarret P. Hitchings

Puerto Rico is in the midst of a ­financial crisis. Over the past few years, its public debt skyrocketed while its government revenue sharply declined. In order to address its economic problems and to avoid mass public-worker layoffs and cuts in public services, the unincorporated U.S. territory issued billions of dollars in face value of municipal bonds. These bonds were readily saleable to investors in the United States due to their tax-exempt status and comparatively high yields.

Now, however, Puerto Rico is unable to service its extraordinary public debt and has begun to default. While the specific causes of this crisis can be debated, the U.S. Supreme Court in Puerto Rico v. Franklin California Tax-Free Trust, No. 15-233 (U.S. June 13, 2016) recently confirmed that two restructuring tools are unavailable to Puerto Rico and its distressed municipalities: relief under Chapter 9 of the U.S. Bankruptcy Code and local legislation providing for the nonconsensual ­restructuring of municipal indebtedness.

Chapter 9 enables an insolvent ­municipality to restructure its debts. In order to be afforded Chapter 9 protection, a municipal entity must first qualify under the gateway provision of Section 109, which, as indicated by the section's title, describes "[w]ho may be a debtor" under Chapter 9. Pursuant to that section, an entity may be a debtor under Chapter 9 only if such entity: is a municipality; and is specifically authorized to be a debtor by state law. In ­effect Section 109 provides that an insolvent municipality must first obtain authorization from the state of which it is a subdivision. This gateway requirement is intended to avoid federal encroachment on the ­constitutionally reserved power of the states "to manage their own affairs" with respect to their constituent municipalities.

In order to achieve this purpose, and to give effect to the gateway provision, Bankruptcy Code Section 109(c)(2) ­relies upon the Bankruptcy Code's definition of the term "state." Under Section 101(52), a 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." As applied to Section 109(c)(2), this definitional exception denies Puerto Rico the ability to authorize, in the first instance, any of its municipalities to be a Chapter 9 debtor. As a result, a Puerto Rican municipality has no "state" from which to obtain the "specific ­authorization" needed to pass through the gateway into Chapter 9, and thus cannot benefit from Chapter 9's protections.

At the same time, Section 903(1) of the Bankruptcy Code provides that the federal bankruptcy laws preempt all state legislation that might provide for the restructuring of municipal indebtedness without the consent of all affected creditors. Though this section is titled "Reservation of state power to control municipalities," it has the effect of overriding all state-level statutory schemes that provide for nonconsensual municipal debt restructuring. Like Section 109, this ­section also uses the word "state." However, because the Bankruptcy Code definition of "state" only disqualifies Puerto Rico as a debtor under Chapter 9, it would appear that Puerto Rice is a "state" for all other Bankruptcy Code purposes (including the preemption purposes of Section 903), and is therefore preempted from enacting any of its own nonconsensual municipal ­bankruptcy legislation.

In Puerto Rico v. Franklin California Tax-Free Trust, the Supreme Court recently concluded that Congress intended that Puerto Rico be a "state" that is ­preempted from passing its own nonconsensual bankruptcy legislation under Section 903, but that it not be a "state" for the purposes of ­authorizing any municipality to file for Chapter 9 protection.

In 2014, Puerto Rico enacted the Puerto Rico Corporation Debt Enforcement and Recovery Act (the PRCDERA), which enabled public utilities in Puerto Rico to implement a recovery or restructuring plan for their debts (under Section 101(4) of the Bankruptcy Code, public utilities are considered ­municipalities). Importantly, the PRCDERA did not require the unanimous consent of affected creditors as part of any utility's restructuring plan; rather it allowed for such a plan to be binding on all creditors if approved only by a certain majority of creditors. As a result, a group of investment funds that owned bonds issued by various Puerto Rican public utilities sought to enjoin enforcement of the PRCDERA, arguing that Bankruptcy Code Section 903 prohibited Puerto Rico from ­implementing a nonconsensual municipal bankruptcy scheme.

The U.S. District Court for the District of Puerto Rico agreed, concluding that Bankruptcy Code Section 903 precluded Puerto Rico from implementing the PRCDERA, and therefore enjoined ­enforcement of the act. Puerto Rico appealed the district court's decision, and the U.S. Court of Appeals for the First Circuit affirmed.

On appeal to the Supreme Court, Puerto Rico argued that the exception clause in Section 101(52)'s definition of state ­excluded Puerto Rico from Chapter 9 entirely: as a consequence, Puerto Rico ­reasoned that it was not subject to the Section 903 preemption provision, and could therefore pass municipal bankruptcy legislation allowing for restructuring schemes that could bind nonconsenting creditors. The investment funds disagreed, urging that the exception clause be narrowly construed as precluding only Puerto Rico's ability to specifically authorize its municipalities to seek Chapter 9 relief as required by the Section 109(c) gateway provision, leaving the ­territory subject to the balance of the chapter's provisions.

Relying on the plain definitional language of Section 101(52), the court concluded that "Congress intended to exclude Puerto Rico from [the] gateway provision delineating who may be a debtor under Chapter 9." As a result, the court recognized that "Puerto Rico's municipalities cannot satisfy the requirements of Chapter 9's gateway provision," and thus cannot avail themselves of the Bankruptcy Code's protections "until Congress intervenes." The court further found that the "text of the [Section 101(52)] definition extends no further" and that the "exception excludes Puerto Rico only for purposes of the gateway provision." Again looking to the language of the statute, the Court reasoned that the section 903 preemption clause prohibits a "State" from enacting its own nonconsensual municipal bankruptcy schemes, and that the preemption clause is unrelated to a state's statutory ability to authorize its municipalities to file for Chapter 9 protection. According to the court, the fact that a "state" does not specifically authorize its municipalities to be Chapter 9 debtors—whether because it chooses not to or lacks the authority to do so—does not mean that the "state" itself is not subject to the other provisions of Chapter 9. In other words, the state need not pass through the Section 109 gateway in order to be subject to Section 903's ­preemption provision.

While the court's holding in this case is not necessarily a surprise, it has the effect of leaving Puerto Rico and its municipal entities lingering in restructuring limbo, unable to resort to our federal bankruptcy laws, yet barred from providing any practical relief through local legislation. Based on the court's opinion, it appears that Puerto Rico will have to rely on Congress to provide it access to Chapter 9 of the Bankruptcy Code or to some other alternative statutory scheme upon which its municipalities can rely to restructure their debts over the ­objection of nonconsenting creditors.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.