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Puerto Rico Public Corporations Debt Enforcement and Recovery Act Declared Inconstitutional

The U.S. District Court for the District of Puerto Rico (“Court”) issued an Opinion and Order on Friday, February 6, 2015, declaring that the Puerto Rico Public Corporations Debt Enforcement and Recovery Act (the “Recovery Act”) is unconstitutional as it violates the Supremacy Clause of the United States Constitution. The Recovery Act, adopted on June 28, 2014, enables a debt negotiation and restructuring process very similar to a petition under the provisions of Chapter 9 of the U.S. Bankruptcy Code (“Bankruptcy Code”). Puerto Rico is included in the Bankruptcy Code’s definition of a “state” for all purposes, except for filings under the provisions of Chapter 9 thereof.

Procedural Background
Franklin California Tax-Free Trust, Oppenheimer Rochester Fund Municipals, among others (“Franklin”) filed a complaint, and BlueMountain Capital Management LLC (“BlueMountain”) (collectively, “Plaintiffs”) filed suit, against the Commonwealth of Puerto Rico (“Commonwealth”) and several government officials in their official capacity, challenging the constitutionality of the Recovery Act. Franklin additionally included the Puerto Rico Electric Power Authority (“PREPA”) as a Defendant. These complaints were consolidated on August 20, 2014, for purposes of aligning the briefing schedules. Franklin filed an Amended complaint alleging that the Recovery Act is unconstitutional because it violates Article I, Section 8 of the Constitution of the U.S., which vests the power of enacting uniform bankruptcy laws exclusively in the U.S. Congress. As a result, Plaintiffs alleged that the Commonwealth was preempted from enacting the Recovery Act. Furthermore, Franklin alleged that the Recovery Act violates Article I, Section 10 and the Fifth Amendment of the U. S. Constitution because it impairs the obligations of contracts and results in an unconstitutional taking, respectively, and that the Recovery Act unconstitutionally authorizes a stay in federal court proceedings. BlueMountain included the same claims in its Amended Complaint, except for the Takings Clause claim. The Commonwealth and PREPA thereafter filed several motions to dismiss stating that the controversy is unripe because none of the eligible corporations had invoked the provisions of the Recovery Act and that the Plaintiffs lacked standing. Furthermore, among other grounds for dismissal, the Commonwealth alleged that the Recovery Act is not a bankruptcy law and does not conflict with the federal Bankruptcy Code because Puerto Rico was expressly excluded from the applicability of Chapter 9. Moreover, the Commonwealth alleged that the Recovery Act does not impair contractual obligations because the Plaintiffs have not pled that the action would be necessary to serve an important government purpose. Franklin filed a cross-motion for summary judgment for their claims on preemption and stay of federal court proceedings.

Opinion and Order
In the Court’s Opinion and Order, Judge Francisco A. Besosa granted in part Franklin’s cross-motion for summary judgment, holding that the Recovery Act is preempted by federal law and thus violates the Supremacy Clause of the U.S. Constitution. According to the Court’s reasoning, the Recovery Act is preempted by the Bankruptcy Code and is therefore void pursuant to the Supremacy Clause of the United States. The Court thus held that “[t]he Commonwealth defendants, and their successors in office, are permanently enjoined from enforcing the Recovery Act.” In so holding, the Court found that the controversy was ripe and that the Plaintiffs had standing because they were seeking a declaratory judgment based on their claim that the mere enactment, and not its application, violated the U.S. Constitution. Therefore, the claims were not based on hypothetical facts, but were conclusive in character, making them ripe for the Court’s review. Furthermore, the Court determined that the delay in deciding whether the Recovery Act violated the U.S. Constitution would continue causing hardship on Plaintiffs because the “Commonwealth’s nullification of this series of statutory and contractual security rights and remedial provisions, through its enactment of the Recovery Act, is a “direct and immediate” injury to the plaintiff bondholders.” The Court also held that the claim on the stay of federal court proceedings is unripe because it is based on hypothetical facts as no party had invoked a stay in any federal proceedings. Hence, the Court granted the Commonwealth’s motion to dismiss as to this claim.

In concluding that the Recovery Act is preempted by the Bankruptcy Code and thus violates the Bankruptcy Clause of the U.S. Constitution, the Court analyzed the Supremacy Clause and the fact that the laws of Puerto Rico are equal to the laws of a state for purposes of the application of the Supremacy Clause. The Court analyzed the text of Chapter 9 of the Bankruptcy Code and its legislative history, purpose and context. Chapter 9 of the Bankruptcy Code has an “express preemption clause” that applies to Puerto Rico and sets forth that state laws providing methods of composition of indebtedness shall not be binding to creditors unless the creditors’ consent to such composition. A composition refers to an agreement between a debtor and two or more creditors regarding the restructuring of a debt. Therefore, based on Chapter 9, the Court concluded that the Recovery Act is expressly preempted because that act allows for methods of debt restructuring without the creditors providing their consent. The Opinion recognizes that Congress has a clear and manifest purpose to preempt state laws that prescribe a method of composition of municipal indebtedness that binds non-consenting creditors, including Puerto Rico laws in this preempted arena. As a result, the Court specifically concluded that §903 of the Bankruptcy Code and the Recovery Act are in irreconcilable conflict.

The Court further found that the U.S. Supreme Court has long held that the Contract Clause prohibits states from passing laws, like the Recovery Act, that authorize the discharge of debtors from their obligations. The Court found that the Recovery Act substantially impairs the contractual relationship between bondholders and PREPA because it extinguishes numerous obligations, rights and remedies such as (i) appointment of a receiver; (ii) acceleration of payments in case of default; (iii) suing in equity or at law to enforce their rights; (iv) rendering ipso facto clauses unenforceable; (v) authorizing the sale of PREPA assets free and clear of liens; (vi) allowance to encumber collateral with liens senior to the bondholders; and (vii) modifying debts without creditors’ consent. Thus, according to the Court, the Recovery Act imposed a drastic impairment when several other moderate alternatives are available to address Puerto Rico’s financial crisis.

The Court also agreed with Franklin’s claim that the Recovery Act constitutes a taking without just compensation, in contravention of the Takings Clause. This conclusion was based on the finding that it eliminates the contract provision that gave the right to the appointment of a receiver upon a PREPA default. On the other hand, the Court denied Franklin’s contention regarding a taking without just compensation of its lien over PREPA revenues, because Franklin failed to allege an actual taking. The Court noted that Franklin still had a senior lien on PREPA revenues.

The U.S. District Court’s decision has direct implications impacting approximately $20 billion of public debt potentially affected under the Recovery Act. These amounts include approximately $9 billion in outstanding debt related to PREPA alone and which is currently under a restructuring scenario with PREPA bondholders.

The Court held that the Plaintiff’s claims have standing against the Commonwealth, but not against PREPA because the damages are traceable to the enactment of the Recovery Act. Therefore, the Court dismissed all claims against PREPA and also dismissed PREPA as a Defendant to Franklin’s complaint.

This document has been prepared for information purposes only and is not intended, and should not be relied upon, as legal advice.

If you have any questions or comments about the above-mentioned decision, the local and federal statutes and policies involved, and/or wish to obtain more information related thereto, please contact any of the following attorneys from Ferraiuoli’s Bankruptcy Law Practice Group.