Barbara M. Goodstein
Barbara M. Goodstein ()

The unprecedented financial crisis in the Commonwealth of Puerto Rico has required an equally unprecedented response from both creditors and the U.S. government. With over $70 billion of indebtedness outstanding, Puerto Rico’s debt level is roughly seven times that of Detroit when it filed for bankruptcy. “Factbox—Puerto Rico versus Detroit: What’s Different?,” Reuters (May 3, 2017). Unlike Detroit, however, it does not have the benefit of U.S. Bankruptcy Code Chapter 9 to help it navigate through this calamity.

Chapter 9 of the Bankruptcy Code provides for and governs municipal bankruptcies.11 U.S.C. §§901-946. It does not cover states (or commonwealths), nor, due to a notable exception to the definition of “State,” does it cover municipalities or government corporations of Puerto Rico. In mid-2015 we discussed in this column an attempt by Puerto Rico to bridge this gap by enacting its own municipal debt adjustment and restructuring law called the Puerto Rico Corporation Debt Enforcement and Recovery Act. See Barbara M. Goodstein and Christophe Wassaf, “Puerto Rico Confronts a Dilemma of Constitutional Proportions” 254 N.Y.L.J. 25 (Aug. 6, 2015). But the U.S. Supreme Court in Puerto Rico v. Franklin Cal. Tax-Free Trust, 136 S. Ct. 1938 (2016), subsequently quashed that attempt, finding the act preempted by the U.S. Bankruptcy Code.

A second, more successful, attempt to provide a framework to manage Puerto Rico’s debt came in the form of the Puerto Rico Oversight, Management, and Economic Stability Act, commonly known as PROMESA. 48 U.S.C. §§2101-2241. This bill was introduced into Congress on May 18, 2016 and signed into law by President Barack Obama on June 30, 2016. Notably, the statute was passed under the powers granted to Congress by article IV, §3 of the U.S. Constitution, which provides Congress the power to “dispose of and make all needful rules and regulations for territories” and not by the powers granted under the “Bankruptcy Clause” of the Constitution (Article 1, §8, clause 4), which gives the federal government the ability to regulate bankruptcy for states.

PROMESA, through its title III, and less so title VI, establishes a basis for bankruptcy-type procedures for both the Commonwealth and its public corporations and municipalities. Among other things, title III enables Puerto Rico or another covered entity through an “adjustment of debts” to reorganize much as a municipal entity can under Chapter 9 of the Bankruptcy Code. In fact, less than a year later, on May 3, 2017, the Financial Oversight and Management Board for Puerto Rico approved, certified and filed on behalf of the Commonwealth a voluntary petition for relief under title III with the U.S. District Court of the District of Puerto Rico. Two days later it took the same actions in respect of a voluntary petition on behalf of the Puerto Rico Sales Tax Financing Authority (known as COFINA). It has since filed petitions as well for the Puerto Rico Highways and Transportation Authority and the Employees’ Retirement System for the Commonwealth of Puerto Rico.

Though deeply rooted in Chapter 9 of the Bankruptcy Code, title III also has some very distinctive features. But to understand title III one must appreciate some of the other features of PROMESA.

Section 101 of PROMESA created an eight-person federally-appointed Financial and Oversight Management Board for Puerto Rico (notwithstanding its name, the act provides that boards may also be appointed for Guam, the Virgin Islands, America Samoa and the Commonwealth of the Northern Mariana Islands). All members are appointed by the U.S. president. Six must be recommended by Congress and one member must be a resident of Puerto Rico. The board has significant authority and autonomy in regard to its territory (in this case, Puerto Rico) and the right to designate what will be “covered territorial instrumentalites,” being political subdivisions, public agencies or other instrumentalities (including any instrumentality that is also a bank) or public corporations of such territory, that will be subject to PROMESA. Each territory and its designated covered territorial instrumentalities must develop and comply with fiscal plans and budgets. In turn, those plans and budgets must be approved and certified by the Oversight Board. The board is also required to approve and certify proposed consensual restructuring agreements among debtholders of the territory or instrumentality. Finally, the board has the power to certify and commence a title III proceeding in regard to any such entity.

PROMESA Title III

Much like Chapter 9, the central premise of title III is to facilitate an in-court debt restructuring.

Title III establishes several hurdles to filing a petition (similar to §109 of the Bankruptcy Code). First, no entity can be the subject of a title III proceeding unless the Oversight Board is able to certify under §206 of PROMESA, as determined in its sole discretion, that: (A) the entity: (1) has made good-faith efforts to reach a consensual restructuring with creditors; (2) has adopted procedures necessary to deliver timely audited financial statements; and made public draft financial statements and other information sufficient for any interested person to make an informed decision with respect to a possible restructuring; and (3) has adopted a Fiscal Plan approved by the Oversight Board; and (B) no order approving certain debt consensual adjustment amendments under title VI have been entered or if entered the entity is unable to make its debt payments notwithstanding the approved amendments.

It is interesting to compare the somewhat less rigorous conditions for title III under PROMESA to those under Chapter 9. Both PROMESA §302 and Bankruptcy Code §109(c) (governing Chapter 9 debtors) require the debtors to “desire to effect a plan to adjust its debts.” However, §109(c) also requires the debtor to be insolvent. Moreover, while PROMESA mandates that the debtor make good faith efforts to achieve a consensual restructuring, §109 requires that it either have obtained the agreement of a majority in proposed impaired claim amounts of each class; negotiated in good faith and has failed to obtain the agreement of such majority of creditors; is unable to negotiate with creditors because such negotiation is impracticable or reasonably believes that a creditor may attempt to obtain a transfer that is avoidable.

One of the more distinctive aspects to title III is that its proceeding will be held in a U.S. District Court before a U.S. District Court Judge (in this case Judge Laura Taylor Swain of the Southern District of New York) rather than in a bankruptcy court presided over by a bankruptcy judge. As further discussed below, given the possible constitutional challenges facing this title III proceeding, this may turn out to be a fortuitous feature.

In addition, in contrast to Chapter 9, only the Oversight Board (and not the debtor) may file a plan of adjustment of debts of the debtor; creditors may not file competing plans; and there is no statutory time by which the Oversight Board must file its plan, although the court can set a date.

On the other hand, title III and Chapter 9 share many features. Title III expressly incorporates over 90 sections from the Bankruptcy Code, including some of its most powerful tools. For example, PROMESA includes (1) §362, which imposes the automatic stay upon filing of the petition and then provides a safe harbor exempting certain items, including financial contracts, from such stay; (2) §364(c) and (d) to permit and facilitate DIP financing; (3) §902, which preserves a pre-existing lien on special revenues; (4) §922, which prevents the automatic stay from affecting the application of pledged special revenues to payment of the related secured indebtedness; (5) §926, which prevents the preferential avoidance powers from applying to the transfer of property by a municipality to or for the benefit of a bondholder; and (6) the “cramdown” provisions under §1129 to permit a plan of adjustment to be approved (if it meets all other requirements) by a single impaired class provided the plan is in the “best interests of creditors.”

Like Chapter 9 debtors, title III debtors need not obtain court approval to use, sell, or lease property, including cash collateral (§363 of the Bankruptcy Code is not incorporated). Finally, like Chapter 9, title III allows a court to issue a broad confirmation order that would discharge a variety of obligations, designed ultimately to facilitate a debtor’s return to fiscal strength.

Is It Constitutional?

An “automatic stay” took effect upon PROMESA’s enactment, preventing creditors from taking action against Puerto Rico in order to collect their debts. That stay expired at midnight on May 1, 2017. The expiration of that stay witnessed the almost immediate commencement of a variety of lawsuits, several among them challenging provisions of PROMESA as unconstitutional under both the Puerto Rico as well as U.S. Constitution. Many creditors remain poised to raise those constitutional challenges to any plan of adjustment in the title III proceeding before Judge Swain.

Puerto Rico’s constitution limits the ability of the Commonwealth to issue debt unless it satisfies certain financial tests. Certain creditors may argue that certain debt issuances secured by special revenues should have been subject to such limitation and therefore are not entitled to be secured by their special revenue collateral and/or are in excess of the permitted amount of debt. Creditors may also assert that certain bond issuances violated a constitutionally-imposed maximum 30-year term for Commonwealth bonds or that certain Commonwealth general obligations bonds have a constitutional priority that is not being preserved.

Other creditors have asserted that the Commonwealth’s fiscal plan under PROMESA violates the Contracts Clause, the Takings Clause, and the Due Process Clause of the U.S. Constitution, arguing that the plan alters the priorities laid out in bond issuance contracts, diverts pledged special revenues from their “contractually agreed upon purposes” and unconstitutionally takes property belonging to the relevant authority to use for Commonwealth purposes without just compensation.

The potential challenges and litigation surrounding PROMESA and title III could carry on for months, or even years. While there is plenty of uncertainty surrounding how creditors’ and Puerto Rico’s interests will finally intersect, the only certainty is that the process is far from over. Hopefully, at the end of the day, it will achieve its aim of enabling Puerto Rico to reach economic health and stability.

The unprecedented financial crisis in the Commonwealth of Puerto Rico has required an equally unprecedented response from both creditors and the U.S. government. With over $70 billion of indebtedness outstanding, Puerto Rico’s debt level is roughly seven times that of Detroit when it filed for bankruptcy. “Factbox—Puerto Rico versus Detroit: What’s Different?,” Reuters (May 3, 2017). Unlike Detroit, however, it does not have the benefit of U.S. Bankruptcy Code Chapter 9 to help it navigate through this calamity.

Chapter 9 of the Bankruptcy Code provides for and governs municipal bankruptcies.11 U.S.C. §§901-946. It does not cover states (or commonwealths), nor, due to a notable exception to the definition of “State,” does it cover municipalities or government corporations of Puerto Rico. In mid-2015 we discussed in this column an attempt by Puerto Rico to bridge this gap by enacting its own municipal debt adjustment and restructuring law called the Puerto Rico Corporation Debt Enforcement and Recovery Act. See Barbara M. Goodstein and Christophe Wassaf, “Puerto Rico Confronts a Dilemma of Constitutional Proportions” 254 N.Y.L.J. 25 (Aug. 6, 2015). But the U.S. Supreme Court in Puerto Rico v. Franklin Cal. Tax-Free Trust , 136 S. Ct. 1938 ( 2016 ) , subsequently quashed that attempt, finding the act preempted by the U.S. Bankruptcy Code.

A second, more successful, attempt to provide a framework to manage Puerto Rico’s debt came in the form of the Puerto Rico Oversight, Management, and Economic Stability Act, commonly known as PROMESA. 48 U.S.C. §§2101-2241 . This bill was introduced into Congress on May 18, 2016 and signed into law by President Barack Obama on June 30, 2016. Notably, the statute was passed under the powers granted to Congress by article IV, §3 of the U.S. Constitution, which provides Congress the power to “dispose of and make all needful rules and regulations for territories” and not by the powers granted under the “Bankruptcy Clause” of the Constitution (Article 1, §8, clause 4), which gives the federal government the ability to regulate bankruptcy for states.

PROMESA, through its title III, and less so title VI, establishes a basis for bankruptcy-type procedures for both the Commonwealth and its public corporations and municipalities. Among other things, title III enables Puerto Rico or another covered entity through an “adjustment of debts” to reorganize much as a municipal entity can under Chapter 9 of the Bankruptcy Code. In fact, less than a year later, on May 3, 2017, the Financial Oversight and Management Board for Puerto Rico approved, certified and filed on behalf of the Commonwealth a voluntary petition for relief under title III with the U.S. District Court of the District of Puerto Rico. Two days later it took the same actions in respect of a voluntary petition on behalf of the Puerto Rico Sales Tax Financing Authority (known as COFINA). It has since filed petitions as well for the Puerto Rico Highways and Transportation Authority and the Employees’ Retirement System for the Commonwealth of Puerto Rico.

Though deeply rooted in Chapter 9 of the Bankruptcy Code, title III also has some very distinctive features. But to understand title III one must appreciate some of the other features of PROMESA.

Section 101 of PROMESA created an eight-person federally-appointed Financial and Oversight Management Board for Puerto Rico (notwithstanding its name, the act provides that boards may also be appointed for Guam, the Virgin Islands, America Samoa and the Commonwealth of the Northern Mariana Islands). All members are appointed by the U.S. president. Six must be recommended by Congress and one member must be a resident of Puerto Rico. The board has significant authority and autonomy in regard to its territory (in this case, Puerto Rico) and the right to designate what will be “covered territorial instrumentalites,” being political subdivisions, public agencies or other instrumentalities (including any instrumentality that is also a bank) or public corporations of such territory, that will be subject to PROMESA. Each territory and its designated covered territorial instrumentalities must develop and comply with fiscal plans and budgets. In turn, those plans and budgets must be approved and certified by the Oversight Board. The board is also required to approve and certify proposed consensual restructuring agreements among debtholders of the territory or instrumentality. Finally, the board has the power to certify and commence a title III proceeding in regard to any such entity.

PROMESA Title III

Much like Chapter 9, the central premise of title III is to facilitate an in-court debt restructuring.

Title III establishes several hurdles to filing a petition (similar to §109 of the Bankruptcy Code). First, no entity can be the subject of a title III proceeding unless the Oversight Board is able to certify under §206 of PROMESA, as determined in its sole discretion, that: (A) the entity: (1) has made good-faith efforts to reach a consensual restructuring with creditors; (2) has adopted procedures necessary to deliver timely audited financial statements; and made public draft financial statements and other information sufficient for any interested person to make an informed decision with respect to a possible restructuring; and (3) has adopted a Fiscal Plan approved by the Oversight Board; and (B) no order approving certain debt consensual adjustment amendments under title VI have been entered or if entered the entity is unable to make its debt payments notwithstanding the approved amendments.

It is interesting to compare the somewhat less rigorous conditions for title III under PROMESA to those under Chapter 9. Both PROMESA §302 and Bankruptcy Code §109(c) (governing Chapter 9 debtors) require the debtors to “desire to effect a plan to adjust its debts.” However, §109(c) also requires the debtor to be insolvent. Moreover, while PROMESA mandates that the debtor make good faith efforts to achieve a consensual restructuring, §109 requires that it either have obtained the agreement of a majority in proposed impaired claim amounts of each class; negotiated in good faith and has failed to obtain the agreement of such majority of creditors; is unable to negotiate with creditors because such negotiation is impracticable or reasonably believes that a creditor may attempt to obtain a transfer that is avoidable.

One of the more distinctive aspects to title III is that its proceeding will be held in a U.S. District Court before a U.S. District Court Judge (in this case Judge Laura Taylor Swain of the Southern District of New York ) rather than in a bankruptcy court presided over by a bankruptcy judge. As further discussed below, given the possible constitutional challenges facing this title III proceeding, this may turn out to be a fortuitous feature.

In addition, in contrast to Chapter 9, only the Oversight Board (and not the debtor) may file a plan of adjustment of debts of the debtor; creditors may not file competing plans; and there is no statutory time by which the Oversight Board must file its plan, although the court can set a date.

On the other hand, title III and Chapter 9 share many features. Title III expressly incorporates over 90 sections from the Bankruptcy Code, including some of its most powerful tools. For example, PROMESA includes (1) §362, which imposes the automatic stay upon filing of the petition and then provides a safe harbor exempting certain items, including financial contracts, from such stay; (2) §364(c) and (d) to permit and facilitate DIP financing; (3) §902, which preserves a pre-existing lien on special revenues; (4) §922, which prevents the automatic stay from affecting the application of pledged special revenues to payment of the related secured indebtedness; (5) §926, which prevents the preferential avoidance powers from applying to the transfer of property by a municipality to or for the benefit of a bondholder; and (6) the “cramdown” provisions under §1129 to permit a plan of adjustment to be approved (if it meets all other requirements) by a single impaired class provided the plan is in the “best interests of creditors.”

Like Chapter 9 debtors, title III debtors need not obtain court approval to use, sell, or lease property, including cash collateral (§363 of the Bankruptcy Code is not incorporated). Finally, like Chapter 9, title III allows a court to issue a broad confirmation order that would discharge a variety of obligations, designed ultimately to facilitate a debtor’s return to fiscal strength.

Is It Constitutional?

An “automatic stay” took effect upon PROMESA’s enactment, preventing creditors from taking action against Puerto Rico in order to collect their debts. That stay expired at midnight on May 1, 2017. The expiration of that stay witnessed the almost immediate commencement of a variety of lawsuits, several among them challenging provisions of PROMESA as unconstitutional under both the Puerto Rico as well as U.S. Constitution. Many creditors remain poised to raise those constitutional challenges to any plan of adjustment in the title III proceeding before Judge Swain.

Puerto Rico’s constitution limits the ability of the Commonwealth to issue debt unless it satisfies certain financial tests. Certain creditors may argue that certain debt issuances secured by special revenues should have been subject to such limitation and therefore are not entitled to be secured by their special revenue collateral and/or are in excess of the permitted amount of debt. Creditors may also assert that certain bond issuances violated a constitutionally-imposed maximum 30-year term for Commonwealth bonds or that certain Commonwealth general obligations bonds have a constitutional priority that is not being preserved.

Other creditors have asserted that the Commonwealth’s fiscal plan under PROMESA violates the Contracts Clause, the Takings Clause, and the Due Process Clause of the U.S. Constitution, arguing that the plan alters the priorities laid out in bond issuance contracts, diverts pledged special revenues from their “contractually agreed upon purposes” and unconstitutionally takes property belonging to the relevant authority to use for Commonwealth purposes without just compensation.

The potential challenges and litigation surrounding PROMESA and title III could carry on for months, or even years. While there is plenty of uncertainty surrounding how creditors’ and Puerto Rico’s interests will finally intersect, the only certainty is that the process is far from over. Hopefully, at the end of the day, it will achieve its aim of enabling Puerto Rico to reach economic health and stability.