distressed debt investing legal fault lines over puerto rico restructuring law come into focus

11/10/2014 Distressed Debt Investing: Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

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7.29.2014

Legal Fault Lines Over Puerto Rico Restructuring LawCome Into Focus

In my estimation, and from talking to our clients, Reorg Research is providing the verybest, most informed news, analysis, and commentary on the hottest topic in distressed:Puerto Rico. As I've told many people recently, this is a situation that we will be talkingabout for many years to come.

Last week, a few members of our team wrote a piece laying down some of the legal issuesinherent in the some of the various litigations coming out of the U.S. District Court for theDistrict of Puerto Rico. For more information on Reorg Research or to inquire about asubscription, please shoot us an email questions [at] reorg-research [dot] com. Enjoy!

Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

The battle against Puerto Rico's independent restructuring efforts is becoming more clearas a third opponent, BlueMountain, joined Franklin Templeton and Oppenheimer inlitigation challenging the recently enacted Public Corporation Debt Enforcement andRecovery Act. With BlueMountain's complaint, funds managing more than $2.1 billion ofthe $8.6 billion PREPA bonds outstanding, the litigating parties represent a heavypercentage of PREPA bondholders actively opposed to the Recovery Act.

When viewed together, the complaints provide a clear picture both of what is at stake andwhat challenges the Recovery Act will face. The theme of the opposition is that theRecovery Act violates both the U.S. Constitution and the Puerto Rico Constitution as wellas federal law. While both complaints seek to invalidate the law, BlueMountain alsorequests injunctive relief against any attempts by Puerto Rico or its publicly ownedcorporations to enforce or implement the Recovery Act.

The recently filed motions to dismiss filed by the Commonwealth of Puerto Rico and thePuerto Rico Electric Power Authority, or PREPA, also display the legal roadmap for effortsto defend the Recovery Act. PREPA and Puerto Rico stress that the Recovery Act is a validexercise of the legislature, as evidenced by language introducing the legislation, whichprovides that the Recovery Act "is not a bankruptcy act, but an orderly debt enforcement actfor the eligible public corporations."

Anti-Injunction Act

At least one thing appears certain: The litigation will not be resolved overnight. Aninitiation of procedures in the Puerto Rican courts under the new restructuring law byPREPA or any other eligible Puerto Rico publicly owned corporation could complicatethings even more and push out any timeline for a resolution of the litigation because theability of the U.S. District Court for the District of Puerto Rico to enjoin a proceeding underPuerto Rican law may be slowed by the Anti-Injunction Act (28 U.S.C. 2283), whichprovides that "[a] court of the United States may not grant an injunction to stayproceedings in a State court except as expressly authorized by Act of Congress, or wherenecessary in aid of its jurisdiction, or to protect or effectuate its judgment." Theapplicability of this law to the unique situation of Puerto Rico's new restructuring law isuncertain, and fighting over the issue will likely take some time. If the Anti-Injunction Actapplies, a Puerto Rican court process could conceivably continue in the face of legalchallenges. That being said, the U.S. constitutional issues raised by Franklin,Oppenheimer and BlueMountain will likely be raised in the Puerto Rican proceedings,particularly at the eligibility hearing proscribed by section 306 of the Recovery Act.

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Preemption and Conflicts with the Bankruptcy Code

The Bankruptcy Code of the U.S. Constitution provides that "[t]he Congress shall havePower To...establish...uniform Laws on the subject of Bankruptcies throughout the UnitedStates. . . ." Here, the parties disagree over whether the Bankruptcy Clause and/or conflictsbetween the Bankruptcy Code and the Recovery Act invalidate the newly enactedlegislation based on preemption.

The parties do not dispute that the Bankruptcy Code expressly excludes Puerto Rico fromeligibility under Chapter 9. However, what is less clear and the focal point of debatebetween the parties is whether the Bankruptcy Clause preempts Puerto Rico from creatingits own restructuring laws and also whether those laws include impermissible conflictswith the Bankruptcy Code.

Puerto Rico and PREPA dispute the preemption arguments, citing to the 1942 SupremeCourt case Faitoute Iron & Steel Co. v. City of Asbury Park, N.J., in which the courtconcluded that a state's police power justified New Jersey's enactment of its own publicdebt enforcement and adjustment statute. They cite Asbury for the argument that "state andlocal governments retain the power to pass their own restructuring statutes, so long asthey do not conflict with federal law." Puerto Rico argues that the principals of AsburyPark comports with the "sovereign police power" set forth in the Puerto Rico Constitution,providing that "[t]he power of the Legislative Assembly to enact laws for the protection ofthe life, health and general welfare of the people shall . . . not be construed restrictively."

Puerto Rico's also argues that its public entities "are not currently governed by any federalbankruptcy law," similar to banks and insurance companies who are expressly excludedfrom the Bankruptcy Code's eligibility provisions set forth in section 109(b). In this case,Puerto Rico argues that while Congress enacted federal bankruptcy law in the form of theBankruptcy Code, Puerto Rico is excluded as a debtor from the Bankruptcy Code and itspublicly owned business entities are "governmental units" ineligible to seek relief underchapter 11. Based on these exclusions, Puerto Rico argues that the Recovery Act is anappropriate exercise of its police power because it is effectively filling the gap created by theBankruptcy Code.

In rejecting Puerto Rico's arguments that the Recovery Act does not conflict with theBankruptcy Code, the plaintiffs cite to section 903(1) of the Bankruptcy Code, which wasenacted following the decision in Asbury Park and precludes a state from binding acreditor to an adjustment or discharge of obligations without the creditor's consent. Thecomplaints note that while Puerto Rico is excluded from the meaning of "State" foreligibility purposes, it is not excluded for purposes of other Bankruptcy Code provisionssuch as section 903(1). They say that the Recovery Act provides for binding adjustmentswithout creditor consent, in clear contravention of section 903(1).

Puerto Rico, however, responds that "[s]ection 903 can and should be read to permitPuerto Rico to enact restructuring legislation that complements-and in no way conflictswith-its federal counterpart." In support of its argument, Puerto Rico argues that "becausePuerto 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 tothe Commonwealth." Puerto Rico's motion to dismiss goes on to characterize the plaintiff'sreading of section 903 and the related definition of a "State" under section 101(52) as"absurd" because such an interpretation would deprive Puerto Rico of its ability to exerciseits "traditional police power" and preempt Puerto Rico from enacting the restructuringlegislation necessary to help it escape the "financial ruin" in which it finds itself.

Beyond preemption based on the alleged conflict between the Recovery Act and section 903of the Bankruptcy Code, BlueMountain cites to the Supreme Court's 1929 decision in Int'lShoe Co. v. Pinkus, which provides that "[s]tates may not pass or enforce laws to interferewith or complement the Bankruptcy Act or to provide additional or auxiliary regulations."The Recovery Act, BlueMountain argues, "is preempted because it improperly operates in afield that Congress has comprehensively occupied." Further, BlueMountain asserts thateven if Congress has not completely preempted state regulation of bankruptcy, "the Actwould still be preempted because its bankruptcy-like provisions would stand as an obstacleto accomplishing and executing Congress's purposes and objectives in enacting a uniformbankruptcy code."

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At some level, this last argument presupposes that Congress' objective was to excludePuerto Rican-owned entities from bankruptcy protection. Defenders of the new law imply,however, that PREPA and other island-owned companies fall into a "hole" in theBankruptcy Code.

Contract Clause

The Contract Clause of the United States Constitution provides that "No State shall . . . passany . . . Law impairing the Obligation of Contracts." The complaints of BlueMountain,Franklin and Oppenheimer argue that the Recovery Act "substantially impairs" theobligations contained in the PREPA bonds, most notably because it deprives thebondholders "of their contractual rights to payment in full of their claims." The partieschallenge the Recovery Act as law that provides an impermissible discharge of acontractual obligation. In support of their arguments, the plaintiffs cite to the 1819Supreme Court decision from Sturges v. Crowninshield, which held that New York law "sofar as it attempts to discharge the contract on which this suit was instituted, is a lawimpairing the obligation of contracts within the meaning of the constitution of the UnitedStates."

Responding to the Contract Clause challenges, PREPA and Puerto Rico point out that "[t]he Contract Clause's prohibition on the enactment of laws impairing contractualobligations 'is not an absolute one' and 'does not make unlawful every state law thatconflicts with any contract.'" Beyond the initial inquiry of impairment, Puerto Rico stressthat any Contract Clause inquiry must go beyond impairment and must demonstrate thatthe Recovery Act is not "reasonable and necessary to the achievement of a sufficientlyimportant government interest so as to render them constitutional exercises of the state'spolice power." Puerto Rico cites to the motives set forth in the Recovery Act, most notablythe most-severe "fiscal emergency" in the Commonwealth's history as adequate support forthe contractual impairment provisions of the Recovery Act.

Similarly, in the case of Asbury Park, the Supreme Court cited to Sturges, which providedthat "a state insolvency act is limited by the Contract Clause of the Constitution inauthorizing composition of pre-existing debts," but the Court also pointed out that anyContract Clause analysis "depends on what is affected by such a composition, and whatstate power it brings into play." The Supreme Court in Asbury Park applied a practicalapproach in addressing whether the Contract Clause "bars the only proven way forassuring payment of unsecured municipal obligations," discounting the contractimpairment argument where "a most depreciated claim of little value has, by the veryscheme complained of, been saved and transmuted into substantial value."

The Asbury Park decision implies that the Contract Clause is somewhat malleable andwill yield to legislation up to a certain point. The question now is whether the Recovery Acthas reached or exceeded that point for purposes of a Contract Clause challenge.

Takings Clause

The Franklin/Oppenheimer complaint also argues that the Recovery Act violates theTakings Clause of the Fifth Amendment and Fourteenth Amendments to the U.S.Constitution. The concept of adequate protection is a cornerstone of the Bankruptcy Codethat provides "just compensation" upon the granting of a superior lien or a diminishmentin a party's property, thereby giving effect to the Takings Clause. In response, Puerto Riconotes that the Recovery Act does not violate the Takings Clause, instead arguing that thelegislation affecting creditors' property rights is within its authority as a sovereign. Themotion to dismiss also points out that "the Act-like the Bankruptcy Code-satisfies the FifthAmendment requirements of the U.S. Constitution by providing adequate protection forsecurity interests."

Although the Recovery Act provides a definition of adequate protection that parallels theBankruptcy Code, it also provides instances where adequate protection is discretionary, notmandatory, raising significant Takings Clause concerns. Most notably, subsection (d) ofsection 129 of the Recovery Act, which defines adequate protection, provides that:

"Notwithstanding any section of this Act conditioning the eligibleobligor's or the petitioner's use or transfer of its property on adequateprotection of an entity's interest in the property, if and when the policepower justifies and authorizes the temporary or permanent use or



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transfer of property without adequate protection, the Court mayapprove such use or transfer without adequate protection."

Similar exceptions found in chapters 2 and 3 of the Recovery Act allow the debtor to foregoadequate protection payments "to the extent that sufficient revenues are unavailable for payment of such principal, interest or other amounts after full payment of such currentexpenses or operating expenses." This justification based on "police power" and publicnecessity would seem to go squarely against the Supreme Court's 1935 decision inLouisville Joint Stock Land Bank v. Radford, in which it concluded "[f]or the FifthAmendment commands that, however great the Nation's need, private property shall not bethus taken even for a wholly public use without just compensation."

Stay of Federal Litigation

One of the more interesting arguments presented by both complaints is the permissibilityof the Recovery Act's automatic stay on proceedings in federal courts. With only a limitednumber of exceptions, the automatic stay under the Bankruptcy Code is incredibly broadwith the power to stay almost all causes of action filed in both state and federal courts.

Here, Puerto Rico argues that the Recovery Act is outside of the umbrella of the BankruptcyCode, expressly rejecting preemption arguments, while also seemingly enacting its ownautomatic stay with similar effects, namely staying all litigation, which presumablyincludes both state and federal causes of action. However, citing to the Supreme Court inDonovan v. City of Dallas, the Franklin/Oppenheimer complaint points out that "statecourts lack any power under the Constitution to enjoin proceedings in federal court."

While Puerto Rico argues that the federal courts should "'respect and not interfere with astate court's prior in rem jurisdiction," both Puerto Rico and PREPA may still remainsubject to ongoing litigation in the federal courts regardless of a filing under the RecoveryAct because of the litigation that has already been filed, particularly the constitutionalarguments. Puerto Rico's intrastate comity arguments based on in rem jurisdiction mayalso fail when considering the relationship between state law receivership and the federalprovisions of the Bankruptcy Code.

Standing and Ripeness

A major argument in Puerto Rico and PREPA's motions to dismiss theFranklin/Oppenheimer suit is that the plaintiffs lack standing to bring their claimsbecause "neither PREPA - nor any other Puerto Rico public corporation - has sought reliefunder the Recovery Act" and, therefore, have not sustained the level of injury necessary tochallenge the statute. Instead, PREPA characterizes the plaintiffs' claims as "whollyhypothetical, and predicated upon an invocation of the Recovery Act by PREPA that maynever occur." The motions to dismiss also argue that the plaintiffs' constitutionalchallenges are both premature and unripe until PREPA, or any other Puerto Rico publiccorporation, seeks relief under the Recovery Act.

As if in response to the motions to dismiss, which were filed only a day beforeBlueMountain's complaint, the BlueMountain complaint argues that the bondholders havealready suffered injuries as a result of the laws enactment, most notably by the Act'selimination of the bondholders' right to seek appointment of a receiver upon theoccurrence a default under the 1974 Trust Agreement that governs PREPA's bonds.BlueMountain also cites to the already noticeably "depressed" value of the PREPA bonds asanother form of actual harm resulting from the Relief Act.

Conclusion

Each of the above arguments, and many that have yet to surface, will undoubtedly cloudPuerto Rico's attempts to restructure its public corporations. A critical issue is timing. Asthe existing constitutional lawsuits unfold, PREPA faces the expiration of two short-termlines of credit in August, totaling $671 million and including a $550 million line withScotiabank which must be repaid on Aug. 14. As noted above, disputes over the Anti-Injunction Act could take center stage in the immediate aftermath of a PREPA filing underthe new law. That being said, a final resolution of the interplay between the federalConstitution and the new restructuring law will almost certainly involve many levels ofappellate review.



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hunter [at] distressed-debt-investing [dot] com

ABOUT ME

I have spent the majority of my career as a valueinvestor. For the past 8 years, I have worked onthe buy side as a distressed debt and high yieldinvestor.

DisclaimerThis website is about distressed debt investing. Under no circumstances is this an offer to sell or a solicitation to buy securities discussed on this site. Anyinvestments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk,financial or otherwise. Distressed-Debt-Investing.com, its editor and/or related parties may have positions in companies discussed. All data, information andopinions are subject to change without notice.

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