Washington and San Juan: A “Tale of Two Cities”, Moratorium or Oversight Board
Editor’s note: The following opinion piece was written by former Judge Gerardo A. Carlo-Altieri. He was the chief judge of the U.S. Bankruptcy Court for the District of Puerto Rico (1994-2009) and a member of the Bankruptcy Appellate Panel in First Circuit Court of Appeals in Boston, Mass., from 1996 – 2009.:
The economic news on Puerto Rico this past week was all about the match between congressional oversight initiatives in Washington and the counter-punch blow by the governor of Puerto Rico with his controversial “moratorium” law.
The Congressional Oversight Bill:
The first strike was thrown by Congress with the release of an initial draft oversight bill (the “Bill”) labeled positively as “PROMESA”. The release by a committee of Congress was received by local politicians with disbelief and even disgust. In the midst of an election year, the highly charged rhetoric between the Republican controlled Congress and President Obama’s proposal for resolving the fiscal woes of the island has led to a standoff. On the island, the political scene is highly charged with election year frenzy, not conducive to consensus. Instead it has produced a display of anti-American sentiment and “vulture” name calling, which has escalated due to the alleged loss of local sovereignty and power over budgets and spending that the congressional draft bill requires.
It could be said that “political testosterone” is running very high both in Washington and in San Juan as the November elections get close. As a consequence, Puerto Rico residents, especially at the lower end of the economic pyramid are pawns of this politicized and insensitive wrestling match between Republicans, the Obama administration and local politicians.
The congressional draft bill starts by blaming the Puerto Rican administrators for inefficiency and mismanagement; however, for the first time Republicans admit that “inconsistent federal policies” are also to blame, which would probably justify some sort of action by Congress to rescue the territory from its crisis. The draft bill starts by naming three items that are considered to be proven: a) that private enterprise wants to invest in Puerto Rico; b) that voluntary restructuring is possible; and c) that there is a need for a “strong” independent federal oversight to insure reform on the island. These three conclusions (interest of private enterprise, voluntary and non-coercive solutions, and federal rather than local oversight), constitute the fundamentals behind the congressional response proposed in form of a control or oversight board (the “Board”).
The “comprehensive tools” that Congress intends to give the board include the power to require audits of the Commonwealth and its entities, and the intent to work with local government to create efficiency and reforms. It also specifies that the board should act in an equitable manner; respect to rule of law, self governance and protecting the rights of all parties. The formula described is complex and requires a delicate balancing of conflicting interests, which is difficult to achieve in a private creditor non-judicial restructuring practice. It becomes more complicated by the fact that inclusion of Puerto Rico in the U.S. Bankruptcy Code is not envisioned by PROMESA to guide and nudge the parties through the process, rather a voluntary non-coercive approach is required, at least in the first two voluntary stages of the process. Federal court intervention only appears at the last stage of the process.
The bill requires “equities” and “rule of law respect,” which seems to be tailored somehow to protect creditor and bondholder contracts and avoid if possible any form of haircut or cramdown of minority creditors as allowed in normal bankruptcy practice. It also disallows readjustments of debt under Chapter 9 of the bankruptcy code.
The mechanics of the bill require an initial first phase determination by the board on whether there is a need to restructure any type of government debt, based on an analysis of the traditional government efficiency metrics including accountability, transparency in fiscal matters, balanced budgets, etc. If the board determines in this first phase the need for restructuring, the process spills over into a second stage, which is also non-judicial and requires voluntary negotiations with creditors but supervised by the board.
Creditor “coercive” type mechanisms normally found in insolvency practice and in the restructuring chapters of the U.S. Bankruptcy Code are avoided by the draft bill by specifically excluding chapter 9 of the code and alleging a chapter 9 re-inclusion would violate the “rule of law.” Also, any possibility of a bailout for Puerto Rico seems to be a toxic “bad word” and bound to be banned by Congress. The drafters of the bill want to avoid placing the resolution of Puerto Rico’s economic crisis on the backs of U.S. taxpayers and pension recipients, who are said to have invested their savings in Puerto Rico obligations.
The drafters also take a shot at President Obama’s proposal to Congress and Puerto Rico’s requests for assistance and chapter 9 inclusion, saying these requests undermine the rule of law, are ill-conceived, that a bailout is not needed and would be on the backs of U.S. taxpayers, would undercut the reforms needed in Puerto Rico and constitutes irresponsible fiscal policy. Finally, they say the Obama administration proposals would cut off the island from the capital markets and prioritize pension benefits over creditor bondholders, which they consider the wrong medicine since it changes established policy as to creditor-debtor relationships.
The board being considered is a five-member body created within the P.R. government structure but not subject to the local government’s control. It requires regular audited statements, fiscal plan and budget controls, a study of pensions and benefits, and will influence the restructuring of debt, if needed. The draft bill also has an automatic stay mechanism to halt all litigation or claims on government debt against the Puerto Rico government for 18 months starting on the date of enactment and from Dec. 18, 2015.
The bill also mentions debt restructuring negotiations as a second stage of the process, to happen after financials are produced, fiscal plans are in place, budgets are approved and after the board determines that such a second step is needed. If the second phase of non-judicially supervised negotiations fails to produce the desired results, the bill contemplates a final court-supervised restructuring process in lieu of a chapter 9 readjustment of debt. The restructuring would require filing of a petition in federal courts but does not contemplate that the traditional Chapter 9 readjustment process or bankruptcy court system be used for this purpose.
To answer the P.R. government’s requests that economic development be advanced, an infrastructure and revitalization officer is named, who would recommend to the board the projects that would be required, with an expedited permitting process in place and federal agency “encouragement.”
Conclusions on the oversight bill:
At this preliminary stage of the legislative process, there are many positive angles to the draft proposal put out by Congress, including the creation of a federal court supervised restructuring mechanism. This is probably the most important part of this draft bill, even if this option only comes available at the end, when the voluntary negotiation process fails. Also positive is the fact that the board being created is involved in the voluntary negotiations from the beginning, and determines if the matter requires referral to the federal court for final restructuring of debt.
The judicial restructuring being mentioned should be clarified or amended to make sure it provides the possibility, if needed, of reducing principal, interest or the “haircuts” the U.S. Bankruptcy Code provides, with the usual fairness, due process and protection of creditor rights, in lieu of Chapter 9 inclusion. The advantage of this formula is that the allowance of a judicially supervised readjustment of debt is done, without running the gauntlet of the contract clause of the U.S. Constitution, which a congressional law can bypass under the “paramount powers” that Congress is said to have in legislating for territories.
Moreover, the board itself is placed inside the P.R. government structures, which ensures some form of local government participation and relieves the anti-sovereign and “undemocratic” features of the bill, which have been strongly objected by local political leaders.
In reality, local politicians should understand that Chapter 9 is very limited in scope. Also that this draft bill creates a special judicially supervised bankruptcy process, much like a Chapter 9 but only for the territories; with a non-judicial but federally supervised pre-bankruptcy negotiations gateway requirement, which could accomplish more than regular inclusion in the bankruptcy code process itself.
The Puerto Rico moratorium law:
In tandem with the congressional oversight draft, the government of Puerto Rico approved an overnight law (PS 1591) allowing for a moratorium of debt (the “moratorium law” or the “Law”) which, as expected, has not been well received by creditors and players of the credit markets. The law itself describes the island’s emergency situation by repeating the conclusions of the Krueger Report: the crisis is structural, public debts are not payable and must be restructured, the liquidity scenario threatens a government shutdown, a humanitarian crisis is eminent and finally, that austerity is not an option.
The drastic character of this measure and the haste in which it was passed leaves no doubt that the government’s situation is worse than expected, and that they are resolved to default on the payments due this summer, a conclusion nobody dares to now question. The legislative explanation of the law restates the many measures that this administration has put in effect, including tax increases, pension reforms, work study groups and plans, budget and expense cuts and reforms, negotiations with the Puerto Rico Electric Power Authority (Prepa) and other groups of creditors, intra-agency financing, clawbacks and even withholding tax refunds and supplier payments. Lobbying Congress and litigating Act 71, the local bankruptcy law to the Supreme Court level, is also mentioned. The legislative history of the law concludes that if public debt is paid, even with all the above measures, salaries can’t be affordable, facilities may be shut down, schools closed, meals to children ended, and power and water supply interrupted.
The legal basis for the law is said to be Article II, Section 19 of the local Constitution, which empowers the legislative branch to enact laws that protect life, health and welfare of the citizens, said to be a broad power encompassing the suspension of payments and extending loan terms in emergency situations such as these. The law clarifies that the application of these powers will be done on an individual basis and case-by-case only as needs arise in different agencies, entities and branches of government. The law carefully clarifies that the intent is not to allow a cramdown, a forced restructuring or an involuntary haircut on dissident bondholders, but rather to delay payment of the obligations for an interim period.
In terms of protecting the Government Development Bank (GDB), whose insolvency is obviously a major cause of concern for the government and a principal reason why this measure was passed with such haste, the law clarifies that no “composition of debt” will be required. Meaning that no cuts are expected to be required from bondholders, but merely a delay in payment is envisioned. Again, the idea is to allow no cramdowns, as the terms are used in a Chapter 11 private bankruptcy, in an attempt to circumvent the U.S. constitutional federal preemption and contract impairment attacks used by creditors in the recent Act 71 litigation still pending before the Supreme Court.
The law provides for an emergency moratorium declaration and also suspension of the rights and remedies of creditors or an “automatic stay” on litigation by bondholders. The third, fourth and fifth chapters amend the enabling act of the GDB, creating a new mechanism for receiver appointments and administration. A form of “bridge-bank” solution to financial institution insolvency is provided, as an alternative to liquidation and receivership, as well as the possibility of creating subsidiary operations to transfer toxic assets or operations.
The law creates a form of automatic stay following the guidelines of Section 363 of the U.S. Bankruptcy Code to stop all actions and litigation against the government to collect debts, but only if needed and in a case-by-case basis. It also allows the governor to take any action for the protection of health, safety and well-being of residents including condemnation of private property, but only as permitted under constitutional safeguards.
The law further divides the payments of interest due on “public debt” defined to include only the general obligations, full faith and credit guaranteed bonds and the GDB’s, to be paid up to July 2016; thereafter, interest would be paid at the governor’s discretion. Other so-called non-public debt obligations will have no payment of interest or principal until the end of the moratorium period. The only exception is that those non-public debt obligations with a guaranteed deposit or trust fund will be paid currently from reserved funds, if any.
The U.S. Bankruptcy Code requirement known as “adequate protection” may be required in favor of secured or guaranteed debtholders. The question in regard to adequate protection will be what constitutes a secured or guaranteed bond, if such can be said to exist at all. Finally, a new authority is created as the fiscal agent for the commonwealth, with consulting and informational powers and also put in charge of renegotiation of debt with general creditors and bondholders of the government.
Conclusions on the moratorium law:
To say the least, the government has taken a very aggressive and dangerous stance in passing this law, which may even affect the possibilities of negotiating a favorable relief package with Congress and also current negotiations with bondholders. On the other hand, it shows Congress and bondholders that the commonwealth means business when it says it will not shut down the government and cut public essential services to pay bondholders when the next payments are due in two months. It also sends a message to all, that creditors should agree to start negotiating immediately to avoid a default.
The situation unfortunately will probably end in hands of the judicial branch very soon, which means it may take a long time before the constitutionality of the law is finally determined. But the option of buying time through litigation, aside of saving the GDB from a disastrous shutdown and receivership / liquidation process, may have been the prime reasons for the governor to sign this law. Also the law puts pressure on Congress to create a legislative solution to keep the matter outside a long and expensive litigation mode, which bondholders don’t want. The possibility is always open of having to litigate against the commonwealth in a local court and in the Spanish language, which can’t be seen by bondholders very favorably.
The constitutional attack on this moratorium law will probably come soon, to be filed before the U.S. District Court for Puerto Rico or in other federal courts with jurisdiction based on the different trust indenture choice of court provisions. The arguments brought up by bondholders in the Franklyn v. Commonwealth Act 71 lawsuit, including violation of federal preemption, contract clause, due process under the 5th and 14th amendments as applicable to the States, and the “taking of property” without due process are expected.
The law has been carefully tailored to withstand a challenge based on the contract clause by saying that no reduction of debt is required and that the act merely provides for a delay in payments; however, creditor rights doctrines may be read to include any change in the debtor’s obligations on the basis of impairment. Any involuntary extension or change in the terms of the obligations by the debtor may be held in some instances to constitute an impairment of the debt, which could render the same contrary to law or the Constitution in absence of a federal law, like the U.S. Bankruptcy Code, allowing such unilateral modification.
Another weapon available to attack the law would be Article 8, Section 6 of the Puerto Rico Constitution that requires, in situations of the commonwealth’s insolvency, for the priority payment of the public debt or government full faith and credit type GOs before all other expenses are covered.
The jury is still out on whether the local government’s latest move is a courageous or reckless act, but it behooves both Congress and the local government to take a step back, lower the tone and search for common ground. There is a lot at stake for Puerto Rico, but also for Congress and the federal government. Congress has to accept that the unequal, undemocratic political relations with the island have created an economic monster that needs to be taken apart.
The original explanation for Congressional inaction was that the island’s economic slide would not affect the economic and political interests of the U.S., meaning that Puerto Rico was not “too big to fail.” An idea that appears to be disappearing. The credit markets, pension funds, monoline insurance companies and many other investor groups and individuals on the continent and locally, including banks and loan cooperatives, stand to be affected. Some local institutions may even fail. The irony of a federal bailout for financial institutions and credit market players, while having denied relief for government entities, is almost surreal.