By LEN WEISER-VARON and BILL KANNEL

Today’s U.S. Supreme Court decision in Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust puts an end to one of Puerto Rico’s multi-pronged efforts to deleverage itself.  Given the comprehensiveness of the First Circuit’s intermediate appellate opinion upholding the district court’s invalidation of Puerto Rico’s Recovery Act, it was surprising that the highest court took the case, a decision apparently prompted by Justice Sotomayor’s interest in obtaining a reversal.  Comments of some other Justices at oral arguments raised the possibility of Sotomayor attracting a majority for the proposition that the preemption provisions of Section 903 of the U.S. Bankruptcy Code were inapplicable to Puerto Rico, but in the end only Justice Ginsburg joined what turned out to be Sotomayor’s dissenting opinion in a 5-2 ruling upholding the relegation of the Recovery Act to the dustbins of history.

As  we have written previously, the Recovery Act was damaged goods from the beginning: even if the fairly clear preemption argument had not prevailed, the Contracts Clause constraints on non-federal bankruptcy legislation would have severely constrained, if not eliminated, the effective use of  the Recovery Act to break bond contracts. In any event, the Recovery Act, and the Supreme Court’s decision, were  a couple weeks away from being moot, as it appears evident that Congress will pass PROMESA, the federal oversight and debt restructuring legislation that has always constituted the logical legal mechanism for those favoring a less chaotic denouement to Puerto Rico’s debt woes.

By LEN WEISER-VARON and BILL KANNEL

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

  • Due to Justice Scalia’s death and Justice Alito’s recusal, only 7 Justices heard the case and only 4 votes are needed for a majority.  Almost all of the questioning at oral argument came from Justices Sotomayor, Kagan and Breyer, plus a couple noteworthy questions from Justice Ginsburg.  With the standard disclaimer that questions at oral argument are not necessarily predictive of a Justice’s votes, it seems clear from the questioning that Justice Sotomayor will vote to reinstate the Recovery Act and is the most passionate of the Justices about the issue, and, even if the relatively silent Chief Justice Roberts and the silent Justice Kennedy and Justice Thomas vote to affirm,  the questions and musings of Justices Kagan, Breyer and Ginsburg suggest that Justice Sotomayor could sway them to her position and thereby obtain the 4 votes necessary for reversal of the First Circuit’s holding and reinstatement of the legislation.
  • All that can be said about the actual statutory language that the Supreme Court will interpret is that the drafting does not represent Congress’s finest work.  (Justice Breyer provided the only moment of merriment on the Scalia-less panel when, after a suggestion that the opaque statutory language requires a contextual reading, he responded, “That may be, but I can’t say that an ‘airplane’ means a horse.”) There is no relevant legislative history, so it is not clear that Congress, when it amended the Bankruptcy Code to exclude Puerto Rico’s (and the District of Columbia’s) government instrumentalities from Chapter 9 eligibility, thought about the question of how that would or should impact Puerto Rico’s and D.C.’s right to enact their own insolvency statutes.  So while nominally a statutory interpretation case, this is, on a technical level, almost purely a “what makes the most sense” case.
  • The First Circuit was persuaded that it would make no sense for Congress to act affirmatively to withhold from Puerto Rico the right to authorize its insolvent instrumentalities to file for bankruptcy under Chapter 9, while intending that Puerto Rico have the right to authorize such filings under some insolvency statute of its own creation.  That seems almost unassailably correct; basic common sense suggests that whatever distrust of Puerto Rico must have motivated Congress to close the door to Puerto Rico’s ability to authorize its instrumentalities to file under Chapter 9 cannot be reconciled with Congressional intent that Puerto Rico be allowed to authorize such filings under its own version of an insolvency statute that might be identical to, or differ in unpredictable ways from, Chapter 9.
  • However, Puerto Rico seems to have gotten some traction before the Supreme Court with the proposition (which the First Circuit correctly rejected) that Congress cannot have intended to leave Puerto Rico’s instrumentalities in a “no man’s land” where they had no access to Chapter 9 and no access to an alternative insolvency regime. The short answer is that there is a high likelihood that Congress, if it had an intent on the matter when it eliminated Puerto Rico instrumentalities from Chapter 9 eligibility, precisely intended that Puerto Rico instrumentalities would not have access to an insolvency process unless and until Congress specifically authorized the applicable process (as it is currently being pressed to do by Puerto Rico and the U.S. Treasury.)  Such federal control would be and is consistent with Puerto Rico’s status as a U.S. territory, however it is labeled in the Bankruptcy Code.
  • Justice Sotomayor also raised the issue of whether the principles of federalism and state sovereignty that make the federal Chapter 9 available only to instrumentalities of states that have elected into the Chapter 9 regime would be violated if Chapter 9 were the only insolvency regime available to a state, i.e. whether interpreting Section 903 of the Bankruptcy Code as applicable to states that have not exercised such option (as well as to Puerto Rico and D.C., which have no such option to exercise) would be unduly coercive and raise Tenth Amendment issues.  The First Circuit left that question unaddressed on the grounds that Puerto Rico is not protected by the Tenth Amendment.  But as Section 903 applies to any “State”, if the Supreme Court interprets it, and its restriction on a “State’s” ability to enact insolvency legislation for its instrumentalities, as applying to Puerto Rico, it also will be interpreting it as applying to the 50 states, including those that have not opted to authorize their instrumentalities to use Chapter 9.  Whether or not any of the other Justices would view such an interpretation as presenting a substantial Tenth Amendment concern cannot be discerned from the oral argument, but the Court often interprets ambiguous statutes in a manner that avoids a potential constitutional concern, and Sotomayor’s apparent invocation of that principle may be targeted at her fellow Justices as a counterweight to the proposition that Congress, in eliminating Chapter 9 access for Puerto Rico’s instrumentalities,  must have intended to preclude any access to bankruptcy by such  instrumentalities absent direct authorization by Congress.  In divining what Congress intended by Section 903, Sotomayor appears to be suggesting, the Supreme Court cannot focus myopically on what Congress would have intended for Puerto Rico.
  •  As we have previously discussed, even if the Court revives the Recovery Act, the Recovery Act is, from Puerto Rico’s perspective, a problematic, and possibly ineffective, insolvency process.  A principal purpose of bankruptcy is to adjust, restructure and impair contracts.  The federal government is not subject to the constitutional restriction on impairment of contracts, and therefore the federally-enacted Chapter 9 process can impair debts and contracts.  Puerto Rico, and therefore its Recovery Act, have been held to be subject to the constitutional restriction on impairment of contracts.  A couple of the Justices noted this constraint, both in questioning what benefit Puerto Rico would derive from a reinstatement of the statute and as a potential protection that Congress might have taken into account if it did not intend to preclude non-federal insolvency law.  If the Recovery Act is reinstated and used by Puerto Rico, one can expect years of litigation on the question of whether any debt adjustment (or other contract adjustment) effected thereunder does or doesn’t meet the high bar of public necessity and unavailability of reasonable alternatives required for such adjustment not to constitute an unconstitutional “impairment.”
  • Puerto Rico’s persistence in seeking reinstatement of the Recovery Act reflects a calculus that an insolvency process that produces a legally questionable and potentially unenforceable result is better than no process, and provides creditors more incentive for consensual resolutions than no process.  Chapter 9 eligibility for Puerto Rico’s instrumentalities, and, if Congress were to grant it, “super Chapter 9“ eligibility for Puerto Rico itself,  would clearly, in Puerto Rico’s view, constitute a far more advantageous and conclusive process.  However, there is some risk to Puerto Rico that if the Supreme Court reinstates the Recovery Act before Congress acts on federal legislation to address Puerto Rico’s financial woes, the revival of the Recovery Act would undercut any Chapter 9 momentum, leaving Puerto Rico with its legally wobbly Recovery Act.  But Puerto Rico appears willing to gamble that the Supreme Court will issue its decision after Congress has done whatever it will do, and, in any event, to believe that a constitutionally vulnerable local bankruptcy statute in the hand is worth a constitutionally bulletproof federal bankruptcy statute in the bush.

 

By LEN WEISER-VARON, BILL KANNEL and ERIC BLYTHE

It is said that muddy water is best cleared by leaving it be.  The Supreme Court’s December 4 decision to review the legality of Puerto Rico’s local bankruptcy law, the Recovery Act, despite a well-reasoned First Circuit Court of Appeals opinion affirming the U.S. District Court in San Juan’s decision voiding the Recovery Act on the grounds that it conflicts with Section 903 of the U.S. Bankruptcy Code, suggests, at a minimum, that at least four of the Justices deemed the questions raised too interesting to let the First Circuit have the last word. This discretionary granting of Puerto Rico’s certiorari petition further muddies the already roiling Puerto Rican waters.

As a result of the Supreme Court’s granting of the Commonwealth’s petition for a writ of certiorari, eight Justices will hear the case (Justice Alito has recused himself), with oral arguments likely in March, 2016.  A decision would then be expected in June, 2016, coinciding with the Commonwealth’s fiscal year end.  At first glance, the decision to grant “cert” appears to be a victory for the Commonwealth (according to SCOTUSblog, over the past three terms the Supreme Court has reversed approximately 72% of cases it has accepted for review).  Of course, the Supreme Court could weigh-in in a manner or on a topic that does not fully resolve the status of the Recovery Act.  At the very least, the review may hinder creditor negotiations and the chances of a consensual resolution.  And a consensual resolution may be Puerto Rico’s best hope.

Even as Puerto Rico legislators laud the Supreme Court’s decision, their pleas for alternate solutions—namely, Chapter 9 eligibility and/or a voluntary debt exchange—continue.  They argue that, absent these solutions, the territory will reach its breaking point before the Supreme Court rules.  The reappearance of the Recovery Act as an arguable solution to Puerto Rico’s quest for a debt restructuring process will likely only contribute to the gridlock in Congress regarding Puerto Rico’s campaign for Chapter 9 eligibility or for “Super Chapter 9” legislation that would enable it to restructure its general obligation debt.  Consensual creditor resolutions may be the Commonwealth’s most realistic option; indeed, the Commonwealth was hopeful it could implement a voluntary debt exchange by May, 2016.  But that was before cert was granted.

Creditors may now be even more wary of negotiating given the greater uncertainty the Supreme Court’s review engenders.  Parties striking deals with the Commonwealth and its entities are going to want to make sure the arrangements reached are “Recovery Act remote”, “Chapter 9 remote”, “Super Chapter 9 remote” and “Whatever the heck Congress, the courts or the Puerto Rico legislators do remote”.  Given the uncertainties regarding Recovery Act implementation (if/when/how), creditors may be unwilling to bear these risks and may choose to leave the muddy water be, for now.  That could be disastrous for Puerto Rico.

Finally, even if the Supreme Court reinstates the Recovery Act, the Recovery Act may still be an ineffectual vehicle for debt restructuring.  Because it is not enacted by the federal government, any plan confirmed under its provisions will be subject to a variety of constitutional challenges under the contracts clause and the takings clause of the U.S. Constitution.

The future’s not ours to see.

By LEN WEISER-VARON and BILL KANNEL

We previously discussed the Puerto Rico Supreme Court’s decision in the Hernandez case, in which by a 5-4 vote the court upheld the constitutionality under federal and Puerto Rico law of pension reform legislation affecting public sector employees, holding that though such legislation substantially impairs contract rights, the measures are reasonable and necessary to salvage the actuarial soundness of the pension system and that less onerous measures are unavailable.  Holders of bonds issued by Puerto Rico and its instrumentalities have now shifted their attention to the Puerto Rico Supreme Court’s handling of a constitutional challenge to recently enacted legislation reforming the teacher pension system.  The legislation currently under court review requires additional teacher contributions while deferring retirement age for current teachers with at least 30 years’ service from 50 to 55.

 

On January 14, 2014, the Puerto Rico Supreme Court issued an order taking over jurisdiction of the case from the trial court, and staying the effectiveness of the legislation pending further court action.  The court also appointed a special master to conduct an evidentiary hearing and present findings of fact to the court no later than today, February 7.  The court’s action, particularly the stay, is being evaluated by bond market participants as a potential sign that the constitutional challenge to this legislation may have more traction in the court than the Hernandez challenge mustered.

 

Bondholders have a mixed rooting interest in the outcome of the current pension reform litigation.  On the one hand, the cutbacks on future pension benefits effected by such legislation are viewed as a positive step by Puerto Rico’s legislative and executive branches to manage the liability side of Puerto Rico’s balance sheet, and therefore as a positive credit development.  On the other hand, such legislation impairs the contractual expectations of Puerto Rico’s teachers, much like the statute upheld in Hernandez impaired the pension rights of other public employees.  To the extent such impairments continue to survive constitutional challenges in Puerto Rico’s courts, questions are raised about how Puerto Rico’s courts would react should Puerto Rico feel compelled to adopt future measures that defer or reduce debt service payments or that otherwise impair its contracts with bondholders.

 

The tea-leaf reading in the teacher pension case includes review of brief statements delivered by some of the Puerto Rico Supreme Court justices in connection with the court’s stay order.  The Chief Justice indicated that he would have postponed the decision on the stay request until after the evidentiary hearing and findings of fact.  He indicated that such postponement would be consistent with court precedent to the effect that injunctive relief is not granted without a prior hearing.  One of the associate justices stated that she would not have granted direct Supreme Court review or the stay, but would have ordered the trial court to process the case on an expedited basis.  Three associate justices filed a concurring opinion citing precedent that the Puerto Rico Supreme Court can intervene in cases pending in lower courts that raise new questions of law or questions of high public interest that include any substantial constitutional question.  The concurring opinion states that the court order is appropriate given the high public interest for review of the changes to the teachers’ pension system and the urgent need to address the constitutionality of the challenged statute.  The concurring opinion asserts the need for a speedy resolution not only for the State of Puerto Rico and the teachers, but for the peace of mind of thousands of parents and children that the applicable justices assert are being deprived of education.  It also notes that the uncertainty over the teachers retirement system could force over 40,-000 teachers to decide in the coming days whether to resign, causing irreparable harm to the education system.

 

It is clear from the Chief Justice’s statement that the stay prior to a hearing is a departure from precedent. Whether that indicates that there is a majority of the court that favors a finding of unconstitutionality, or simply reflects the enormous public and political pressure associated with this case and the desire to temporarily mitigate the unrest sparked by the legislation remains to be seen.  What seems notable is the emphasis on fact-finding, which may include fact-finding on the key question of the existence of less onerous means of addressing the system’s solvency.  As described in our analysis of the Hernandez decision, the dissenters in that case castigated the majority for rubber-stamping the legislature’s findings of crisis and lack of alternative.  The Puerto Rico Supreme Court has given the plaintiff teachers, as well as the government, the ability to make presentations in a Supreme Court sponsored fact-finding that was not present in the Hernandez case.  Given the emphasis placed by the court on a speedy resolution of the challenge, whether that fact-finding results in a different outcome should be known fairly soon.

 

 

By LEN WEISER-VARON

Legislatures legislate, and courts decide what they meant.  The principal federal law recourse for investors in municipal bonds and other unregistered securities for investment losses caused by fraudulent disclosure arises from a judicial reading of SEC Rule 10b-5 as creating an “implied” private cause of action.  (The appellate courts in most of the federal circuits have determined that  Section 17(a) of the Securities Act of 1933, the only other section of the federal securities laws that applies to municipal securities, does not create an implied private right of action.)

But what a court giveth, a court can take away.  In a 5-4 ruling on June 14, 2011 in Janus Capital Group, Inc. v. First Derivative Traders, http://www.supremecourt.gov/opinions/10pdf/09-525.pdf, the U.S. Supreme Court effectively limited private investor recourse under Rule 10b-5 for fraudulent disclosure to claims against issuers, and held that other parties to bond transactions (as well as other unregistered securities offerings) generally have no Rule 10b-5 liability to investors, whatever their role in preparing the issuer’s disclosure.

What this means is that bankers, consultants, advisers, lawyers and other participants in the preparation of an official statement face no federal securities law liability to investors under Rule 10b-5, with a possible but undecided exception for materials expressly attributed to such parties in the official statement (for example, a summary of a legal document attributed to its author or a legal opinion published in the official statement under the letterhead of the counsel rendering such opinion.)   The decision does not affect the SEC’s ability to bring regulatory enforcement actions against non-issuer participants in disclosure preparation.

Among many interesting questions raised by the Janus decision is the status of private 10b-5 claims against conduit borrowers, which may involve future litigation over whether the conduit borrower “controls” the disclosure made in an official statement which is, technically and legally, the official statement of the public conduit issuer.  Although conduit issuers typically disclaim responsibility for portions of an official statement describing the conduit borrower and various other matters, nuances in verbiage within a particular official statement as to which party has ultimate control over the content may influence the outcome of future 10b-5 securities fraud litigation.            

The Janus case involved a claim against Janus Capital Management LLC, the investment adviser to and management company for a Janus family mutual fund that was sued for alleged fraudulent disclosure in its mutual fund prospectus.  The fund shareholders alleged that the management company participated in the preparation of the fraudulent disclosure.  Rule 10b-5 makes it illegal for “any person, directly or indirectly ,… [t]o make any untrue statement of material fact” in connection with the purchase or sale of securities. Each faction on the Supreme Court pulled out its own dictionary for purposes of interpreting the verb “make.” 

The technical details of the decision will be of interest principally to wordophiles.  The five justices in the majority relied upon the 43rd definition of “make” in the 1934 edition of Webster’s New International Dictionary: “(‘Make followed by a noun with the indefinite article is often nearly equivalent to the verb intransitive corresponding to that noun’). For instance, ‘to make a proclamation’ is the approximate equivalent of ‘to proclaim,’ and ‘to make a promise approximates to promise.’”  Under that interpretation, the majority held, “The phrase at issue in Rule 10b–5, ‘[t]o make any . . . statement,’ is thus the approximate equivalent of ‘to state.’”

The four justices in the minority, as well as the SEC,  preferred an interpretation per the 1958 edition of the same dictionary (defining “make” as “[t]o cause to exist, appear, or occur”)). The majority dismissed that interpretation, opining that “[t]his definition, although perhaps appropriate when ‘make’ is directed at an object unassociated with a verb (e.g., ‘to make a chair’), fails to capture its meaning when directed at an object expressing the action of a verb.”

The bottom line after this battle-of-the-dictionaries gobbledygook? Per the majority: “For purposes of Rule 10b–5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker.” 

Accordingly, the Court dismissed the claim against Janus Management Company, holding that whatever responsibility the Janus fund had delegated to the management company for the preparation of the mutual fund prospectus, the mutual fund, not its management company, had the ultimate legal control over the content of the prospectus, and therefore the management company did not “make” any statement even if it drafted the disclosure on the mutual fund’s behalf.