This article was originally published by Law360.com
May 17, 2017, 5:40 PM EDT
On May 3, 2017, the commonwealth of Puerto Rice, a United States territory, filed a petition for bankruptcy relief under the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA, 48 United States Code §§ 2101 et seq.). PROMESA is a law that was enacted in 2016 to create a vehicle for U.S. territories, but primarily Puerto Rico, to restructure debt in a bankruptcy-like proceeding. The petition was filed in the U.S. District Court for the District of Puerto Rico.
Puerto Rice has been in financial difficulty for several years due to a poor economy and the exodus of hundreds of thousands of citizens seeking jobs in the United States. A combination of factors, including the population decline, led to shrinking demand for goods and services and reduced tax revenues. For several years, the government of Puerto Rico borrowed in order to provide government services and pensions. It was able to borrow fairly freely, because Congress made Puerto Rico bonds exempt for federal or state income taxes. Eventually the territory’s tax revenues were insufficient to pay principal or interest on the bonds. Similarly, all available funds were used to pay existing pensions, and almost nothing was set aside for future pension obligations, which are less than 2 percent funded.
Puerto Rico’s bankruptcy is quite similar to municipal bankruptcies under Chapter 9 of the U.S. Bankruptcy Code, and, in fact, PROMESA incorporates most provisions of Chapter 9, as discussed in more detail below. As in many municipal bankruptcies, the Puerto Rico case is likely to devolve into a battle between bondholders on the one hand and the holders of pension obligations on the other. (There also may be disputes within the bondholders as to priority among them.) The battle between bonds and pensions appears quite obviously keyed up in the Puerto Rico case. According to the statement of the oversight board filed in the case, the collective debts of the commonwealth amount to $74 billion and the pension obligations amount to $49 billion. There simply is not enough money to go around to satisfy all those obligations. One or both of these constituencies will have to take a so-called “bankruptcy haircut.”
Two municipal bankruptcies completed within the past decade confronted the pension issue. If those cases are treated as precedent, U.S. District Judge Laura Taylor Swain, assigned to preside over the Puerto Rico case by Chief Justice John Roberts, may consider that a plan of adjustment can modify pension rights despite Puerto Rico laws protecting pensions. As an aside, it should be noted that unlike Chapter 9, where the municipality remains in control of its case and proposes a plan of adjustment, the government of Puerto Rico will be replaced by the oversight board created by PROMESA, which has the exclusive authority to propose a plan of adjustment.
In the bankruptcy of the city of Detroit, the court held that pensions could be reduced under the Bankruptcy Code notwithstanding state law protecting the pensions, and a plan was approved by consent that did in fact reduce pensions.
Likewise, in the bankruptcy of the city of Stockton, California, one of the major bondholders aggressively opposed the city’s plan that left the pension rights of present and retired employees unimpaired. Although Bankruptcy Judge Christopher Klein ruled that, under the Bankruptcy Code, the city could have proposed a plan that impaired pension rights, he also ruled that the city’s plan satisfied the criteria for confirmation. He found that impairing pensions would have had a devastating effect on the morale of city employees, would have led to an exodus of experienced police and fire personnel, and would have jeopardized the city’s safety. He reached that decision based on the city’s and the unions’ presentation of strong evidence supporting the city’s arguments about the effect of impairing pensions.
A similar argument should be able to be made and supported in the Puerto Rico case due to the ability of Puerto Ricans, who are U.S. citizens, to move freely to the mainland in search of better opportunities. Presumably the population exodus that Puerto Rico already has experienced included many of the most qualified and employable people, a category that is likely to include experienced public safety officers. Those representing the pension holders will have the job of convincing the oversight board of the perils of reducing pensions. In this regard, they will be bolstered by 48 U.S.C. §§ 2141(b)(1)(B) and (C), which provide that any fiscal plan adopted by the oversight board shall provide adequate funding for essential public services and for public pension systems.
The battle lines undoubtedly are already drawn. Much depends on the aggressiveness of the bondholders in going after pensions to enhance their own recovery. However, Puerto Rico bondholders may not have the most sympathetic case. Many of the present bondholders purchased their bonds at heavily discounted prices and may profit from their decision to buy discounted Puerto Rico bonds even if they are repaid at a substantial markdown from the face value of the bonds. On the other hand, the impact of reducing pensions in an already distressed economy will not only cause individual hardship, but would be another drag on the ultimate recovery of the Puerto Rico economy.
This case may play out much like the prominent municipal bankruptcies earlier this decade mentioned above: Detroit and Stockton. As noted above, PROMESA has been rightly compared to Chapter 9 municipal bankruptcy in the United States Bankruptcy Code, because the statute incorporates most of Chapter 9. There are some significant differences, however, two of which relate to the creation of the Financial Oversight and Management Board created by PROMESA. That makes the Puerto Rico case more like Detroit, where the governor had appointed an emergency manager for the city and denied any significant role to elected city officials. In contrast, in Stockton the elected city officials made the key decisions and, among other things, obtained a local tax increase from the city’s voters in order to fund the plan.
Only the oversight board could authorize Puerto Rico to commence a bankruptcy proceeding, and the oversight board, rather than the territory debtor, manages the case. This arrangement contrasts with Chapter 9, where the bankruptcy court is not authorized to appoint a trustee over the debtor, whereas in the PROMESA proceeding, the oversight board is in effect the trustee of the debtor.
Any financial plan prepared by the government of Puerto Rico must be approved and certified by the oversight board, and only the oversight board can propose a plan of adjustment for the debts of the territory based on a certified financial plan. This is another change from Chapter 9 in which only the municipal debtor may propose a plan of adjustment.
Another distinction between Chapter 9 and PROMESA is the appointment of the judge to preside in the case. In Chapter 9, the chief judge of the applicable U.S. court of appeals appoints a bankruptcy judge to preside, whereas under PROMESA, the chief justice of the U.S. Supreme Court appoints a U.S. district judge to preside. (These procedures are apparently designed to avoid having a judge preside over the case of a government where the judge is a resident.) In the Puerto Rico case, Chief Justice Roberts has appointed U.S. District Judge Laura Taylor Swain of the Southern District of New York to preside. Judge Swain may preside over portions of the case in either New York or Puerto Rico.