Public Finance Matters

Updates on recent public finance and municipal bond developments

PREPA Bondholders Seek Summary Judgment Invalidating Puerto Rico’s Public Corporation Bankruptcy Legislation

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

On August 11, Franklin Funds and Oppenheimer Rochester Funds filed a second amended complaint, opposition to motion to dismiss and cross-motion for summary judgment in the litigation they previously filed in the United States District Court for Puerto Rico challenging the constitutionality and validity of Puerto Rico’s so-called Recovery Act.  The second amended complaint reiterates that a PREPA filing under the Recovery Act, which establishes debt adjustment procedures for most of Puerto Rico’s public corporations, is both “probable and imminent.”  The motion seeks summary judgment on two of the plaintiffs’ claims: that the Recovery Act is constitutionally and statutorily preempted, and that the Recovery Act’s automatic stay provisions are illegal to the extent they purport to preclude a federal court action.  The motion asserts that these two claims are “purely legal, and will not be clarified by further factual development.”

The summary judgment motion re-enforces our prior assessment that, once the court is persuaded to address the merits, one of the plaintiffs’ strongest arguments is that Section 903 of the federal Bankruptcy Code precludes enforcement of any Recovery Act debt adjustment against non-consenting bondholders.

The motion, referencing legislative history and prior case law,  effectively dispenses with Puerto Rico’s relatively weak arguments that Section 903 cannot or should not be read as applicable to Puerto Rico’s public corporations.   Puerto Rico has argued that Congress could not have intended to leave its public instrumentalities without access to any debt adjustment process, which, given Puerto Rico’s express exclusion from eligibility under Chapter 9 of the Bankruptcy Code, would be the effect of  applying Section 903 to Puerto Rico’s own public corporation insolvency legislation.  Whether Congress indeed intended to leave Puerto Rico in such a predicament is unclear.  The plaintiff’s brief suggests that because Puerto Rico’s bonds, unlike any state’s bonds,  benefit from nationwide triple tax-exemption (which accounts for Puerto Rico’s status as the third highest volume issuer of tax-exempt bonds after California and New York), “Congress did not want Puerto Rico to restructure its municipal debt through either its own laws or Chapter 9.”  Whether this or any other rationale for Puerto Rico’s statutory treatment under the Bankruptcy Code exists, the plaintiffs’ motion argues that the statutory language in Chapter 9 is explicit, and that if Puerto Rico is unhappy with its position, “Puerto Rico’s remedy lies … with Congress.”

Although Section 903 does not technically preempt or prohibit all of the Recovery Act, if a court agrees that Section 903 is applicable, any debt adjustment produced by the Recovery Act’s procedures could not be enforced against non-consenting creditors, thereby rendering the Recovery Act largely ineffective as a debt adjustment mechanism.

For an adjudication of the plaintioffs’ challenge to take place in federal court, plaintiffs must establish standing and ripeness.  The Commonwealth and PREPA have asserted the obvious argument that PREPA has not filed under the Recovery Act, and that therefore there is no case or controversy to adjudicate. The plaintiffs’ summary judgment motion, like the original complaint, argues that the plaintiff PREPA bondholders have suffered a devaluation of their bonds as a result of the Recovery Act’s enactment, and that they are forced to litigate before a filing because the automatic stay provisions of the Recovery Act would preclude them from pursuing federal court litigation after a PREPA filing under the Recovery Act.  (As noted, the plaintiffs simultaneously seek summary judgment on the unconstitutionality of any such application of the Recovery Act’s automatic stay to preclude or freeze a federal court action.) Whether these arguments that the case is ripe for adjudication will find traction with the court remains to be seen.

The filing also previews arguments that will be further litigated if the Recovery Act survives the plaintiffs’ preemption claim.  The plaintiffs assert that the Recovery Act’s provisions effect an unconstitutional impairment of contracts.   As we have previously discussed, courts have interpreted the “Contracts clause” not as an absolute bar to impairment of contracts by state action, but rather as a balancing test in which the state’s interests and needs and the extent of the contractual impairment are weighed against each other.  This makes contract impairment claims highly fact-sensitive and unlikely candidates for summary judgment.  For example, the plaintiffs’ brief argues that PREPA has the following alternatives to impairing its bonds through debt adjustment:

(1)    PREPA can raise rates.

(2)    The Commonwealth of Puerto Rico could repay over $640,000,000 it owes to PREPA.

(3)    The Commonwealth could reduce PREPA’s taxes and subsidies which the brief asserts amount to over $1 billion from 2014 through 2018.

(4)    PREPA should collect its full accounts receivable and pay subsidies after debt service instead of permitting customers to offset subsidies from their payments.

(5)    PREPA should cut costs and address inefficiencies.

(6)    PREPA should strengthen its capital markets reputation by hiring an investment banker and making public presentations.

If PREPA, or any other public corporation, eventually seeks protection and debt adjustment under the Recovery Act, these types of arguments about whether the applicable issuer requires any debt adjustment in order to maintain financial and operational viability (and, if so, whether the proposed amount of debt adjustment is necessary for such viability) will be front and center in such proceedings.

Puerto Rico and PREPA Seek Dismissal of Bondholder Challenge to Territory’s Bankruptcy Statute

Posted in Bankruptcy

 

By LEN WEISER-VARON and BILL KANNEL

The Commonwealth of Puerto Rico and the Puerto Rico Electric Power Authority (PREPA) yesterday filed separate motions to dismiss the federal court complaint filed last month by some PREPA bondholders seeking to invalidate the recently-enacted Puerto Rico Public Corporation Debt Enforcement and Recovery Act.  As anticipated, the motions to dismiss assert that the plaintiffs lack standing and the claims lack ripeness because PREPA has not, to date, sought relief under the challenged legislation.

PREPA’s motion is limited to standing and ripeness arguments; the Commonwealth’s motion to dismiss also engages the bondholders’ substantive claims, arguing that the bondholders have failed to state claims on which relief can be granted.  In our prior analysis of the bondholders’ complaint, our assessment was that the bondholders’ strongest argument is the statutory argument that Section 903 of the federal Bankruptcy Code preempts Puerto Rico’s bankruptcy legislation.   The Commonwealth’s motion to dismiss confirms that assessment, as its attempts to rebut the preemption argument consist principally of an argument that Congress cannot have intended to leave Puerto Rico’s public corporations without recourse to a bankruptcy process, even though that is exactly what Section 903 appears to do as a literal matter.

Section 903 provides that “a State law prescribing a method of composition of indebtedness of [a] municipality may not bind any creditor that does not consent to such composition.”   The Commonwealth’s motion argues that “because Puerto Rico’s public corporations may not avail themselves of Chapter 9, Section 903—which, by its own terms, applies only when Chapter 9 is invoked—is wholly inapplicable to the Commonwealth.” (emphasis added)  The Commonwealth’s motion to dismiss does not corroborate its assertion that Section 903 “by its own terms … applies only when Chapter 9 is invoked” with any identification of the “terms” of Section 903 that allegedly limit its application to jurisdictions that are eligible to adopt Chapter 9.

Apparently recognizing that its textual analysis of what Section 903 literally says may be unpersuasive, the Commonwealth’s motion next asserts that Section 903 cannot possibly mean what it apparently says.  According to the motion: “That Congress would have denied Puerto Rico and its public corporations [the] ability to escape financial ruin in a brief statutory provision unrelated to Puerto Rico strains credulity.”   Finally, the Commonwealth argues that if Section 903 says what it appears to say, Section 903 of the Bankruptcy Code may be unconstitutional because it discriminates against Puerto Rico: “In any event, even if Section 903 could plausibly be read to pre-empt the Act—and it cannot—Plaintiffs’ construction of Section 903—under which Puerto Rico would not only be excluded from Chapter 9, but also barred from enacting a nearly identical restructuring mechanism of its own—would force this Court to confront constitutional concerns about whether Congress properly exercised its power to establish ‘uniform laws on the subject of bankruptcies through the United States.’”

With regard to the Commonwealth’s suggestion that it might be unconstitutional for Congress to exclude Puerto Rico from access to a bankruptcy process that binds non-consenting creditors, it should be noted that the federal courts have held that “Congress, which is empowered under the Territory Clause of the Constitution, U.S.Const., Art. IV, § 3, cl. 2, to ‘make all needful Rules and Regulations respecting the Territory . . . belonging to the United States,’ may treat Puerto Rico differently from States so long as there is a rational basis for its actions.” New Progressive Party v. Hernandez Colon, 779 F. Supp. 646, 661 (D.P.R. 1991)(citing Harris v. Rosario, 446 U.S. 651 (1980)).

In sum, the motions to dismiss seek to defer adjudication of the validity of Puerto Rico’s bankruptcy legislation until one or more of Puerto Rico’s public corporations seek protection under the legislation.  As to the merits of the challenge, the Commonwealth’s motion to dismiss raises predictable counter-arguments to the constitutional challenges, but contains little firepower on what is likely to be the central issue, the federal Bankruptcy Code’s statutory prohibition on non-federal debt composition statutes that purport to bind nonconsenting creditors.  The motion’s arguments that Section 903 doesn’t say what it appears to say, can’t say what it appears to say, and is unconstitutional if it says what it appears to say, do little to dispel our perception that this legislation faces a battle under Section 903.

Be PREPAred: PREPA Bondholders Greet Puerto Rico’s Bankruptcy Legislation With Federal Lawsuit

Posted in Uncategorized

By LEN WEISER-VARON and BILL KANNEL

On Saturday, June 28, Puerto Rico’s Governor Padilla signed into effect Puerto Rico’s new bankruptcy law for certain revenue bond issuers.  Within 24 hours of the statute’s enactment, two mutual fund complexes owning approximately $1.7 billion in bonds of the Puerto Rico Electric Power Authority (PREPA) filed a complaint in the federal district court for Puerto Rico, seeking a declaratory judgment invalidating the fledgling legislation.

The complaint is efficient and straightforward.  It asserts that the legislation is preempted by Section 903 of the United States Bankruptcy Code, which precludes “States” from enacting laws for the composition of debt of “municipalities” that purport to bind non-consenting creditors.  The complaint additionally alleges that, even if not preempted, certain provisions of the legislation effect unconstitutional impairments of contract and/or takings of property of secured creditors.

Puerto Rico has yet to file a response to the complaint, but the Section 903 argument is compelling and, subject to likely objections by Puerto Rico to adjudication of the statute’s validity before a specific issuer seeks its protection, has the potential to make short shrift of Puerto Rico’s attempt to create a bankruptcy process applicable to its financially challenged revenue bond issuers.

 

 

Puerto Rico Poised to Enact Bankruptcy-Like Legislation for Certain Revenue Bond Issuers

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

Puerto Rico’s Governor Alejandro Garcia Padilla today introduced debt restructuring legislation which, upon enactment, would provide a judicial debt relief process in Puerto Rico’s courts for certain public corporations, including the Puerto Rico Electric Power Authority (“PREPA”), the Puerto Rico Aqueduct and Sewer Authority (“PRASA”) and the Puerto Rico Highways and Transportation Authority (“PRHTA”).  Despite a semantic effort at today’s press conference by the Governor and in the legislative preamble to distinguish the proposed legislation from “bankruptcy” legislation, the legislation is modeled on Chapter 9 and Chapter 11 of the U.S. Bankruptcy Code (with some significant distinctions) and is in all practical respects a non-federal bankruptcy statute.  The Governor urged Puerto Rico’s legislature to adopt the proposed legislation by June 30, and enactment is considered a virtual certainty.

Under the proposed legislation, entitled “The Puerto Rico Public Corporation Debt Enforcement and Recovery Act,” an eligible public corporation may pursue either or both of two alternatives, simultaneously or sequentially.  The first is a “consensual debt relief transaction” (which can be analogized to a “prepack” and will likely be known as a “Chapter 2″ proceeding.)  To initiate a Chapter 2 proceeding, an eligible entity files a notice of “suspension period” on its website, which notice stays any remedial action by any creditor identified in such notice for a period of up to 360 days if the entity does not seek court approval of specified debt relief, or, if such approval is requested, until the final unappealable approval of such relief or 60 days following denial of such relief.

The applicable consensual debt relief in a Chapter 2 proceeding may only be approved by the court if at least 50% of the amount of debt within a class of substantially similar debt identified by the issuer participates in a vote or consent solicitation relating to the proposed amendments, modifications, waivers or debt exchanges relating to the applicable debt, and at least 75% of the amount of debt in such class that so participates approves the proposed relief.  If so approved, the applicable debt relief is purportedly binding on all creditors within the applicable class.

The second avenue for debt relief (which will likely be known as a Chapter 3 proceeding) involves the filing of a petition with the court by, or on behalf of, an eligible public corporation, which filing triggers an automatic stay protecting  the applicable public corporation from remedial efforts by creditors.  Chapter 3 provides for judicial confirmation of a debt adjustment plan if at least one class of impaired debt has voted to accept the plan by a majority of all votes cast in such class and if two-thirds of the aggregate amount of impaired debt in such class is voted.

Under the proposed legislation, all impaired creditors in a Chapter 3 proceeding must receive payments and/or property having a present value of at least the amount the claims in the applicable class would have received if all creditors had been allowed to enforce their claims on the date the issuer’s petition for relief was filed.  In addition, every such impaired creditor must also receive its pro rata share of 50% of the issuer’s positive free cash flow, if any, after payment of operating expenses, capital expenditures, taxes, debt service, reserves, changes in working capital, cash payments of other liabilities and extraordinary items, during a period of 10 full fiscal years following  the first anniversary of the plan’s effective date.  Such recovery is capped at the amount necessary, together with the present value payment described above, to provide for repayment of the applicable creditor’s full claim on the petition date, with any excess reallocated among remaining impaired creditors.

If enacted, attacks on the legislation’s constitutionality and on the constitutionality of particular provisions are inevitable.  Because the legislation would not be enacted pursuant to the U.S. Constitution’s bankruptcy power, it would have no federal constitutional protection from other provisions of the U.S. Constitution, including those protecting contracts from impairment by state action (which for this purpose would include action by the territory of Puerto Rico.)

The legislative preamble devotes significant attention and argument to the proposition that the legislation is constitutional.  However, the legislation also includes a provision stating that if a contractual creditor demonstrates that its contractual rights are substantially impaired by a Chapter 2 or Chapter 3 proceeding, the impairment shall be allowed only if the issuer (or the Government Development Bank (“GDB”), acting on its behalf) demonstrates that the impairment is a reasonable and necessary means to advance a legitimate government interest, and the creditor “fails to carry the burden of persuasion to the contrary.”  This statutory description, which loosely parallels the federal judiciary’s interpretation of the circumstances under which contract impairments are permitted notwithstanding the “contracts clause” of the U.S. Constitution, fails to mention a key element of that judicial test, namely the requirement that the government establish that no less burdensome alternatives exist for achieving the legitimate government interest.

Another consequence of the legislation being non-federal is that Puerto Rico cannot avail itself of the far-reaching jurisdictional provisions of the federal Bankruptcy Code.  This may permit some creditors to assert jurisdictional challenges to the binding nature of any proceeding conducted in the Court of First Instance, San Juan Part, as the bill requires.  The bill provides for appeals to the Puerto Rico Supreme Court.

Eligibility for the relief provided in the proposed legislation is limited to specific public corporations.  Such corporations may file their own Chapter 3 petitions or GDB, acting at the Governor’s request, may do so on their behalf; any Chapter 2 debt relief must be approved by GDB.  As noted, eligible corporations include (among others) PREPA, PRASA and PRHTA, and the legislative preamble specifically catalogues their financial difficulties in justifying the need for a debt relief mechanism.  In addition, to be eligible to file a Chapter 3 petition, a public corporation must be “insolvent” and must be ineligible for relief under the U.S. Bankruptcy Code because it is not a “municipality” eligible to file under Chapter 9 and is a “government unit” ineligible to file under Chapter 11.

The bill defines “insolvent” as “currently unable to pay valid debts as they mature while continuing to perform public functions” or “at serious risk of being unable, without further legislative acts and without financial assistance from the Commonwealth or GDB, to pay valid debts as they mature while continuing to perform public functions.”

Certain entities are expressly excluded from filing under the proposed statute, including (among others) the Commonwealth of Puerto Rico, Puerto Rico’s municipalities, the GDB and its subsidiaries and affiliates, the Puerto Rico Sales Tax Financing Corporation (COFINA), the Municipal Finance Agency, the Municipal Finance Corporation, the Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority and the Puerto Rico Infrastructure Financing Authority.

Certain classes of creditors and claims are expressly protected from impairment under a Chapter 3 plan.  Such protected claims include employee claims for wages, salaries, commissions, vacation, severance and sick leave pay, and similar employment benefits, unless such claims arise under a collective bargaining agreement or retirement or post-employment benefit plan.

Much remains to be said and analyzed on this legislation.  At first blush, however, the legislation (if enacted and determined to be constitutional) would, in some cases, provide more favorable treatment to Puerto Rico’s eligible revenue bond issuers, and less favorable treatment to their creditors, than would Chapter 9 of the United States Bankruptcy Code.  For example, the special revenue provisions of Chapter 9 appear absent from the Puerto Rico legislation, though it is focused on revenue bond issuers.

Municipal Bond Market Absorbs Puerto Rico Supreme Court’s Decision that Teacher Pension Reform Legislation is Unconstitutional Contract Impairment

Posted in State Law

BY LEN WEISER-VARON and BILL KANNEL

The latest swerve in the rollercoaster that is Puerto Rico public finance occurred on April 11 with the release of the Puerto Rico Supreme Court’s ruling striking down as unconstitutional the bulk of the territory’s teacher pension reform legislation.  The outcome of the case creates some disarray in the executive and legislative branches’ efforts to stabilize Puerto Rico’s finances, as well as in the Puerto Rico Supreme Court’s contracts clause jurisprudence.

We have previously discussed both the teacher pension reform litigation and the Puerto Rico Supreme Court’s prior ruling in the Hernandez case upholding the territory’s public employee pension reform legislation.  In the 5-4 Hernandez case, the dissents included strongly worded accusations that the majority had rubber-stamped the legislature’s conclusion that there were no less onerous alternatives to the  challenged impairments of the employee’s pension rights.   In the 5-3 teacher pension case, the majority went to the other extreme and concluded that the legislature and governor had acted unreasonably in enacting the legislation, because (according to the majority) the legislation failed to take into account the high number of accelerated teacher retirements the legislation would provoke, which (according to the majority) would further strain, rather than improve, the teacher pension system’s finances.

In other words, the court majority concluded that the teacher pension reform legislation did not promote the public purpose to which it was addressed.  As we have previously discussed, the “contracts clause” in the U.S. and Puerto Rico constitutions has been interpreted as permitting state action that impairs contracts if such action promotes a necessary public purpose and there are no less onerous means of achieving that public purpose.  Because the Puerto Rico Supreme Court concluded that the teacher pension reform legislation did not serve its stated public purpose of preserving the viability of the teacher pension system, it did not have to address whether there were less onerous means of achieving that purpose than the legislation’s benefit cutbacks and contribution increases.

In particular, the court referenced certain provisions of the legislation that preserved certain benefits for teachers retiring prior to a near-term cutoff date, economic studies presented by the teachers’ union regarding the impact of the early retirement of 7000 teachers, and an actuarial study forecasting the consequences of the early retirement of 5,000, 7000, 10,000 and 15,000 teachers, respectively.  The court also referenced testimony to the effect that approximately 4,100 teachers had contacted the pension system about early retirement since the legislation was enacted, and that 10,000 or more teachers would be eligible for early retirement.  The court interpreted the actuarial studies as showing that if such large-scale early retirements occurred, the pension fund would be depleted at an earlier date than if no legislation were enacted.  The court noted that the legislation had been enacted during a 6-day period and that the legislature had commissioned no studies about the early retirements the legislation might trigger or the impact of such early retirements on the system’s solvency.  The majority concluded that the teachers’ union had met its burden of proof that the challenged legislation, instead of increasing the system’s solvency, would leave it in a more precarious position.

The court upheld the legislation as applicable to teachers who began or begin service subsequent to its enactment, and also upheld certain cutbacks on system contributions to teachers’ health plans and annual Christmas bonuses to retired teachers, concluding that those benefits were not pension rights or contract rights.

It is unusual for a court, in a situation of fiscal crisis,  to hold that the other branches of government are effectively wrong about the financial effect of legislation being positive rather than negative.  There no doubt are genuine distinctions between the evidence presented in the Hernandez case and in the teachers’ pension case; it is also clear that there was a change in the receptiveness of certain of the court’s members to the government’s arguments regarding the necessity of the applicable pension reform.  To understand the difference in analysis and result, one may need to go no further than the majority opinion’s second paragraph, which states that “Teachers are the ones that mold the knowledge of the members of our society.  They are a fundamental piece of the educational system.”   A majority of the court appears to have credited the teachers’ presentation on this difficult public policy matter over the government’s.

Puerto Rico bondholders have been following this case for its credit implications as well as its legal implications.  The result may be a mixed bag from both perspectives.  From a credit perspective, the decision invalidates teacher pension reform that the Puerto Rico government has touted as an important component of its financial stabilization plan; on the other hand, the court invalidated the legislation on the stated grounds that the reform would make things worse, not better.  From a legal perspective, the court’s closer scrutiny of contract impairment may be somewhat heartening to bondholders concerned that Puerto Rico’s debt may be next on the impairment list.  Whether any comfort is warranted remains to be seen, but it seems less likely that the Puerto Rico Supreme Court would second-guess the financial efficacy of any future attempts to legislate debt restructuring.

Negligent Disclosure and Imputed Scienter: Recent SEC Enforcement Actions Against Municipal Bond Issuers

Posted in Disclosure

 

The post on our securities litigation and compliance blog titled “SEC Steps Up Scrutiny of Municipal Bonds: Recently Filed Enforcement Actions”  surveys recent SEC enforcement actions against municipal bond issuers.  As discussed in the post, the SEC’s charges in these actions include charges based on issuer negligence (versus the “scienter” standard of knowingly or recklessly misleading disclosure applicable to private securities law claims against municipal bond issuers), and also notes the SEC’s position that an officer’s state of knowledge can be imputed to a municipal bond issuer for purposes of establishing the issuer’s “scienter” in a securities fraud action.

 

Mintz Levin to Conduct Webinar on SEC Enforcement and Self-Reporting Initiatives Relating to Municipal Bond Issuers and Underwriters

Posted in Disclosure

As indicated in the adjacent blog posts, the SEC is increasing its enforcement presence in the municipal bond market, including enforcement and self-reporting initiatives relating to disclosures about an issuer’s historic compliance with Rule 15c2-12 continuing disclosure agreement obligations.  Mintz Levin is hosting a webinar to review these developments and the conundrums the self-reporting initiative may cause for issuers and underwriters.   Registration for the free webinar is available through the link below.

 

A New Era of SEC Muni Enforcement

Tuesday, April 29

1:00 pm ET

 

Over the last few years, the SEC has put its spotlight on the municipal market, increasing its scrutiny of issuers and underwriters alike. This new and aggressive approach has broken unspoken barriers that long defined the SEC’s long-standing policy of minimal regulation and intervention in the municipal market. Most notably, the SEC has increased its enforcement actions and imposed steep sanctions against individuals, issuers, and underwriters.

Join us for a review of the SEC’s recent enforcement actions and a discussion of its priorities and initiatives for 2014, including the new Municipalities Continuing Disclosure Cooperation (MCDC) Initiative.

Register Here: http://w.on24.com/r.htm?e=777668&s=1&k=70279BACFC42C416B572DBE16785E538&partnerref=pfblog

 

 

SEC Enforcement Staff Continues Sweep of Financially Distressed Municipal Bond Issuers

Posted in Disclosure

For an analysis of the SEC Enforcement Staff’s recent announcement that it is one year into a general sweep of financially distressed municipal bond issuers and that it has commenced formal investigations against some of these issuers, please view the post on our securities litigation and compliance blog titled, “SEC Enforcement Staff’s Investigations of Financially Stressed Municipal Issuers.”

That blog post examines several legal issues arising out of this sweep and the resulting investigations, including how this announcement by the Staff could be intended to put further pressure on municipal issuers and underwriters to self-report inaccurate disclosures, how investors may be swept up into these investigations, and the potential collateral legal issues that can arise if the SEC brings more actions in this area.

Legislative Trial Balloon for Puerto Rico Public Corporation Insolvency Process Attracts Bondholder Attention

Posted in Bankruptcy, State Law, Workouts

By LEN WEISER-VARON and BILL KANNEL

Last Tuesday, Puerto Rico sold its much-ballyhooed $3.5 billion in non-investment grade general obligation bonds.  Two days later, two legislators in Puerto Rico’s Senate filed a bill which, if enacted, would permit insolvency filings by Puerto Rico’s public corporations in Puerto Rico’s territorial trial court.  The juxtaposition of the two events has some bond investors crying foul.  But though the timing of the insolvency bill must have Puerto Rico’s investor relations personnel swallowing ibuprofen, Puerto Rico itself is not a “public corporation” and the proposed legislation would not establish a process for an insolvency filing affecting the territory’s general obligation bonds.  (Although the legislation authorizes a bankruptcy-like process, the process is referred to in this post as “insolvency”  to distinguish it from the federal bankruptcy process.)

The proposed legislation is of greater interest to holders of bonds issued by Puerto Rico’s public corporation bond issuers.  To the extent the legislation responds to requests by one or more public corporations, it is not good news for bondholders, as it suggests that some of those public corporations may be actively considering an insolvency-related process.  However, press reports indicate that Puerto Rico’s Governor opposes enactment of this particular legislation.  Accordingly, the existence of the Senate bill, and its details, may deserve attention not so much because of any likelihood that such an insolvency process will be implemented in the short term, but rather as a case study in the legal complexity of any attempted restructuring of Puerto Rico’s governmental debt.

Whether legislation of the type represented by the Puerto Rico Senate bill, if enacted, would be constitutional would likely involve years of litigation following an attempt by any public corporation to avail itself of such protection as it provides.  As suggested in the bill’s preamble, Puerto Rico’s authority to create its own non-federal process to address insolvent public corporations is uncertain.  Puerto Rico’s instrumentalities are excluded from the definition of “municipality” under Chapter 9, which governs municipal bankruptcies.  Whether under the U.S. Constitution’s supremacy and bankruptcy clauses the existence of Chapter 9 preempts Puerto Rico’s ability to establish its own bankruptcy-like process for its public corporations, or whether Puerto Rico’s exclusion from Chapter 9  suggests that Congress did not intend such preemption, is the main constitutional question.  Further complicating the resolution of that question is Puerto Rico’s status as a federally-approved U.S. territory that has been recognized as akin to a “state” for at least some constitutional purposes by the U.S. Court of Appeals for the First Circuit.

If legislation of the type filed in Puerto Rico’s Senate were enacted, and if the constitutionality of such a non-federal insolvency process in Puerto Rico were ultimately upheld, such legislation by its terms limits a public corporation’s ability to restructure its debts.   The legislation precludes a “significant” impairment of the public corporation’s major contractual obligations unless it is reasonable and necessary to serve an important public purpose.  The legislation defines an “important public purpose” as including (somewhat perplexingly) the obligation to comply with existing contracts, but, perhaps more significantly, as including “the stability and continuity of essential public infrastructure, utilities and services.”   In other words,  the bill would create a “bankruptcy-lite” statute designed to permit approval of restructuring plans only to the extent they satisfy the federal constitutional test for impairment of contracts.  The “contracts clause” of the U.S. constitution has been judicially interpreted not as a prohibition on contract impairment but rather as a balancing test under which contracts may be impaired if there is sufficient public necessity for doing so and there are no less onerous means of addressing such public necessity .

The limits on what can be achieved under the proposed legislation are compelled by the fact that, if it were enacted, in contrast to Chapter 9 it would not be enacted under Congress’s constitutional power to provide a bankruptcy process.  Whereas the constitutionally-sanctioned federal bankruptcy act expressly contemplates certain judicially approved contract impairments to give a debtor a “fresh start”, a Puerto Rican public corporation insolvency statute not enacted pursuant to the constitutional bankruptcy provisions would need to comply with the anti-impairment provisions of the U.S. Constitution.  Accordingly, any plan under a Puerto Rico statute that impairs bondholder rights would be subject to challenge on whether the statute’s definition of “important public purpose”  correctly incorporates the federal constitutional balancing test for permissible contract impairment and, if so, whether that test has been properly applied in the context of any particular impairment by any particular bonding authority of particular bondholder rights.   This is an inefficient process relative to the federal bankruptcy statute, which provides a process for bankruptcy plan approval that obviates the need to address on a case by case basis whether an approved contract impairment is constitutional.

The bill introduced in Puerto Rico’s Senate reinforces a risk already faced by Puerto Rico bondholders that Puerto Rico may seek by direct legislation or by legislatively-established process to impair to the extent constitutionally permissible the contractual rights of bondholders of insolvent bonding authorities.  That risk is already playing itself out for a different class of Puerto Rico’s creditors, its public employees and teachers, in legislation imposing certain pension cuts and in court challenges to such legislation.  If there is good news for Puerto Rico’s public corporation bondholders in the specific legislation filed in the Puerto Rico Senate, it is that the insolvency process outlined in such legislation, unlike the federal bankruptcy statute,  lacks a “cramdown” provision and would require approval of any restructuring plan by 75% in amount of affected creditors.  In other words, any cutbacks in bondholder rights under the proposed legislation would, in most conceivable instances, require the consent of a substantial proportion of the bondholders.

Legal Highlights in Puerto Rico’s “Draft POS” for Upcoming General Obligation Bond Issue

Posted in State Law

By LEN WEISER-VARON and BILL KANNEL

Although Puerto Rico’s much-discussed sub-investment grade general obligation bond issue is not yet being marketed via an official preliminary official statement, it appears that a draft POS has been making the rounds.  The draft POS, dated February 28, 2014, has been posted on at least one website and has been referenced in Bloomberg news reports.

From a legal perspective, an initial review of the draft POS includes the following items of interest:

  • The bonds as offered will not be subject to acceleration upon default.  Accelerability is one of the items that had been mentioned on the buy-side wish list, as otherwise a payment default on a particular coupon or maturity would only entitle bondholders to institute remedial action for the payment of that particular coupon or maturity.
  • Unsurprisingly, there is a lengthy “Risk Factors” section, atypical for general obligation bonds but not for sub-investment grade bonds.
  • The draft POS indicates that Puerto Rico’s Secretary of the Treasury has exercised his new statutory authority to provide for application of New York law and to expressly agree to the jurisdiction of New York’s state and federal courts (as well as Puerto Rico’s) in any action relating to this issue of general obligation bonds. As we have previously discussed, this item was higb up on the buy-side wish list.  However, the draft POS indicates that “no assurance can be given that any such litigation will be accepted by or, once accepted, be continued in a New York court or federal court in New York if the particular court determines by law that it does not have jurisdiction over the Commonwealth or that it should be removed to a court in Puerto Rico, as being more suitable on grounds of judicial fairness to the parties involved.” Furthermore, the draft POS states that “[a]lthough a judgment from a New York court should be given effect in Puerto Rico pursuant to the full faith and credit clause of the U.S. Constitution, such a judgment must meet certain minimum requirements before a Puerto Rico court will give it effect” and that “[t]here is no assurance that any judgment from a New York court would be given effect by a Puerto Rico court.”
  • The draft POS acknowledges the priority status of debt service payments on Puerto Rico’s “public debt” under Puerto Rico’s constitution, but indicates that “public policy considerations relating to the safety and well-being of the residents of the Commonwealth, as well as procedural matters, could result in delays in the judicial enforcement of this remedy, and in limitations on the effectiveness of such remedy” and that “the remedies available to bondholders are dependent on judicial actions, which are often subject to substantial discretion and delay.”
  • The draft POS notes the “clawback” provisions relating to Puerto Rico revenues assigned to Puerto Rico Highways and Transportation Authority (“Highways Authority”), Puerto Rico Infrastructure Financing Authority (“PRIFA”) and Puerto Rico Convention Center District Authority (“PRCCDA”), but states that the availability of such assigned revenues for debt service on the general obligation bonds “is subject to there being no other ‘available Commonwealth resources’” and that “[i]t is not certain what steps a general obligation bondholder would be required to take or what proof such bondholder would be required to produce to compel the diversion of such funds from any such instrumentality to the payment of public debt, or how the necessary available Commonwealth resources would be allocated between each such instrumentality.”
  • As required under SEC Rule 15c2-12, the draft POS discloses that “the Commonwealth has failed to file the Commonwealth’s Annual Financial Report before the May 1 deadline in three of the past five years.”  The draft POS states that “[a]lthough the Commonwealth has implemented certain mechanisms to ensure timely compliance with its continuing disclosure obligations, there is no assurance that the mechanisms put in place will be effective in ensuring timely compliance.”
  • There is no reference in the draft POS to the designation of purchasers’ counsel to represent prospective purchasers of the bonds in assessing the legal risks, legal opinions, continuing disclosure rights and other legal matters relating to this unusual offering. The funding of purchasers’ counsel by Puerto Rico or the underwriters has been requested by some prospective bondholders.