Legal Analysis: Puerto Rico Justice Department to Appeal to Supreme Court, Torruella Calls Fed Bankruptcy Law “Equally Invalid”

On July 6, 2015, the United States Court of Appeals for the First Circuit (the “First Circuit”) affirmed the decision of Judge Francisco A. Besosa of the United States District Court for the District of Puerto Rico ruling that the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) is preempted by the United States Bankruptcy Code and is therefore invalid.

The majority opinion recognized that even though its decision arguably leaves Puerto Rico with no current options for debt relief, “Puerto Rico may turn to Congress for recourse.”

The First Circuit’s decision is noteworthy not for its straightforward affirmance of the preemption issue, but rather for the impassioned concurring opinion authored by Judge Juan R. Torruella.

Judge Torruella concurs in the majority’s conclusion that the Recovery Act contravenes 11 U.S.C. § 903(1) but writes separately to emphasize that the 1984 amendments to the Bankruptcy Code, which removed Puerto Rico’s ability to authorize municipal debt relief under chapter 9, are “equally invalid” because they create a bankruptcy law that violates the uniformity requirement of the Bankruptcy Clause of the Constitution and are unsupported by a rational basis or clear policy reasons, in contravention of existing law.

The Justice Department of Puerto Rico appears to have been encouraged by Judge Torruella’s opinion. On July 9, 2015, the Justice Secretary César Miranda said in a written statement that the defendants intend to appeal the First Circuit’s decision to the United States Supreme Court.

Echoing the concurrence, Justice Secretary Miranda stated, “We are turning to the Supreme Court because we believe that the First Circuit Court of Appeals decision was wrong in that it validates an irrational action by Congress to exclude Puerto Rico from the application of Chapter 9 of the U.S. Bankruptcy Code” and “there is no conceivable reason for Puerto Rico to be deprived of an instrument to allow an orderly negotiation of public debt. . . Because it is an urgent issue for the security of essential services for our citizens, we must insist on the validity of our [Recovery Act], which was approved through legislation in Puerto Rico to attend to the debts of our public corporations in an orderly manner.”

The Justice Department’s statement follows the issuance of a permanent injunction by District Judge Besosa on July 8. The district court order permanently enjoined the defendants (and their successors) from enforcing the Recovery Act.

In its decision, the First Circuit considered whether the federal Bankruptcy Code preempts Puerto Rico’s Recovery Act. In technical terms, the “question turns on whether the definition of ‘State’ in the federal Bankruptcy Code – as amended in 1984 – renders [Bankruptcy Code] § 903(1)’s preemptive effect inapplicable to Puerto Rico.”

The court began its analysis with a brief history of federal municipal debt relief, noting that “[m]odern municipal bankruptcy relief is shaped by two features: the difficulties inherent in enforcing payment of municipal debt, and the historic understanding of constitutional limits on fashioning relief.” First, municipal entities are governmental entities, and therefore, traditional bankruptcy remedies—such as the seizure of assets, corporate reorganization, liquidation or judicial oversight of a debtor’s day-to-day affairs—are not available to enforce the payment of municipal debt. Second, any federal municipal bankruptcy law must navigate the limitations of the Contracts Clause, which prohibits federal impairment of “the obligation of contracts,” and the Tenth Amendment, which prohibits federal interference with states’ rights.

In 1933, Congress enacted the predecessor to chapter 9 to offer states “a mechanism for addressing municipal insolvency that they could not create themselves.”

Although the Supreme Court invalidated the first federal municipal bankruptcy law on federalism grounds, Congress subsequently enacted a “cooperative scheme” for addressing municipal insolvency that “avoid[ed] a Tenth Amendment problem” by requiring state consent to the federal municipal bankruptcy regime before permitting municipalities of that state to utilize it.

Today, this requirement is found in Bankruptcy Code section 109(c), which provides that a municipality may be a debtor under chapter 9 only if it “is specifically authorized . . . to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to [so] authorize.”

The First Circuit recognized that from 1938 until 1984, Puerto Rico had the ability to authorize its municipalities to obtain federal municipal bankruptcy relief. (The court noted that the omission of a definition of “State” from the modern Bankruptcy Code in 1978 was erroneous and ascribed no significance to its omission.)

In 1984, however, Congress re-introduced a definition of “State” to the Bankruptcy Code. The court observed that, as before, “§ 101(52) defines ‘State’ to ‘include[] . . . Puerto Rico.’ But importantly, and unlike previous versions of the definition, the re-introduced definition of ‘State’ includes Puerto Rico ‘except for the purpose of defining who may be a debtor under chapter 9’ of [the Bankruptcy Code].”  The First Circuit concluded that, with this change, “Puerto Rico municipalities became expressly (though indirectly) forbidden from filing under Chapter 9 absent further congressional action,” as Puerto Rico no longer had the power to grant its municipalities the required authority under Bankruptcy Code section 109(c)(2) to file for relief.

Puerto Rico passed the Recovery Act in June 2014 in an attempt to address its fiscal crisis, particularly the precarious financial situation of three Puerto Rican public corporations (Puerto Rico Electric Power Authority ( PREPA), Puerto Rico Aqueduct and Sewer Authority (PRASA), and Puerto Rico Highways & Transportation Authority (PRHTA)), and its inability to authorize these entities to seek relief under chapter 9 of the Bankruptcy Code. The Recovery Act provides two methods for restructuring debt, both of which may bind creditors without their consent, and contrary to the Bankruptcy Code, it also permits the governor of Puerto Rico to institute an involuntary proceeding for a distressed municipality in certain circumstances.

The First Circuit held that the Recovery Act is preempted by the federal Bankruptcy Code. Specifically, Bankruptcy Code section 903(1) provides that “a State law prescribing a manner of composition of indebtedness of [a] municipality may not bind any creditor that does not consent to such composition.” The court stated that this provision expressly bars a state law like the Recovery Act, which can bind creditors to a particular composition of indebtedness without their consent. The court then analyzed “the context and [legislative] history of this provision” to “confirm . . . that this provision was intended to have a preemptive effect.”

In light of the 1984 amendment including Puerto Rico as a “State” except for the purpose of defining who may be a debtor under chapter 9, the court considered whether the preemption provision of Bankruptcy Code section 903(1) still applies and held that “it does.” Section 903(1) does not define who may be a debtor under chapter 9; rather, it prohibits a municipal composition of indebtedness that binds creditors without their consent. Thus, “§ 101(52) confirms that the ‘State law[s]’ prohibited [by § 903(1)] include those of Puerto Rico, as has always been the case.”

The First Circuit rejected the Puerto Rican government’s “creative but unsound” alternative statutory interpretations.

First, the court refused to define “creditor” in relation to “debtor” as the defendants urged, rejecting the argument that since Puerto Rico cannot authorize its municipalities to commence a chapter 9 case, creditors of those municipalities are not “creditors” under the Bankruptcy Code and, therefore, the Recovery Act does not bind “creditors” without their consent in violation of Bankruptcy Code section 903(1).

Second, the court rejected the defendants’ argument that Puerto Rico laws, like the Recovery Act, are not really “State law[s]” for purposes of Bankruptcy Code section 903(1): since “Puerto Rico is already excluded from Chapter 9 . . . § 903 – including § 903(1) – does not apply because there is no need to stipulate that the remedies of Chapter 9 do not undermine Puerto Rico’s control over its own municipalities” (emphasis in original). The court rejected, gave short shrift to, or did not reach the defendants’ remaining arguments regarding the legal presumption against preemption, conflict preemption and the Tenth Amendment.

The majority opinion concluded, “In denying Puerto Rico the power to choose federal Chapter 9 relief, Congress has retained for itself the authority to decide which solution best navigates the gauntlet in Puerto Rico’s case.” Congress is currently considering two bills related to this very issue.

In his concurring opinion, Judge Torruella takes umbrage at the majority’s suggestion that Puerto Rico should be content to rely on Congress for a remedy. Although Judge Torruella agrees that the Recovery Act contravenes Bankruptcy Code section 903(1) and is therefore invalid, he contends that the 1984 amendments with the “Puerto Rico exception” are “equally invalid” for two reasons. First, they establish bankruptcy legislation as to “one regional debtor” that is not uniform with regard to the rest of the United States, in violation of the Bankruptcy Clause of the Constitution requiring uniform bankruptcy laws. Second, there is no rational basis or clear policy reason to treat Puerto Rico differently from the States regarding chapter 9.

Judge Torruella praises Puerto Rico for attempting to solve its own problems and laments that “Puerto Rico is effectively excluded from the political process in Congress.” He contends that the current political structure perpetuates a “discriminatory relationship [that] allows legislation – such as the 1984 Amendments – to be enacted . . . This is clearly a colonial relationship, one which violates our Constitution and the Law of the Land . . .” Judge Torruella concludes, “The 1984 Amendments are unconstitutional. Puerto Rico should be free to authorize its municipalities to file for bankruptcy protection under the existing Chapter 9 of the Bankruptcy Code if that is the judgment of its Legislature.”

The defendants have taken up Judge Torruella’s call to arms. The deadline for the defendants to file a petition for certiorari with respect to the First Circuit decision is October 5, 2015.