It has happened before. An insolvent public entity, whether a sovereign nation, state, county, or other, can’t pay its bills and blames the crisis on the ‘vulture’ hedge funds taking its instruments from their first buyers for pennies on the dollar. The leaders of the insolvent entity thereby deflect blame from themselves and they indignantly refuse to engage in serious talks with the bond holders.
Now coming to the plate, the government of Puerto Rico, which owes $73 billion.
In the summer of 2014, the commonwealth’s legislature passed “The Puerto Rico Public Corporation Debt Enforcement and Recovery Act,” a complicated law designed to provide chapter 9-ish relief to the island’s public corporations.
Preemption and Supremacy
Almost immediately, bondholders filed a lawsuit in the U.S. district court, asking that it find the Act in violation of the U.S. Constitution. The first-named plaintiff in this action was the Franklin California Tax-Free Trust, holder of bonds issued by the Puerto Rico Electric Power Authority, or PREPA. Plaintiffs make several arguments: perhaps the most important is that the U.S. government has preempted the field through section 903(1) of the Bankruptcy Code, which provides that “a State law prescribing a method of composition of indebtedness of such municipality may not bind any creditor that does not consent to such composition.” Given this preemption, the action of Puerto Rico’s legislature violates the Supremacy Clause of the U.S. Constitution.
In February 2015, the district court agreed. The Hon. Francisco A. Besosa ruled that “The Recovery Act is preempted … and is therefore void….The Commonwealth defendants and their successors in office, are permanently enjoined from enforcing the Recovery Act.”
The First Circuit later upheld this decision on appeal.
Accounting is Important
Last summer, Puerto Rico made public a report it had commissioned by various veterans of Bretton Woods organizations, called the Krueger Report for Anne Krueger, the former chief economist at the World Bank who is the first named of the three authors.
One of the key takeaways from the Krueger report ought to be that accounting principles are important. They aren’t niceties or obscure angels-on-the-head-of-a-pin debating points. Part of Puerto Rico’s problem is that it long underestimated its true deficit and the consequent size of the challenge by focusing on its General Fund, and excluding too many other agencies from the computations of that Fund. It excludes some 150 agencies in total including importantly the health insurer Administración de Seguros de Salud (ASES). One should presumably at this point resist the temptation to pun on that acronym.
Now, in the spring of 2016, the issue of the validity of PREPA is before the U.S. Supreme Court, which heard arguments of the subject on March 22. Justice Samuel Alito has recused himself from the case. The reason for that isn’t known to the public: he may simply be a bondholder himself. Alito’s absence, and the late Justice Scalia’s still-empty seat, together means that Puerto Rico’s debt and the extent of its ability to govern itself going forward are alike in the hands of seven Justices.
Puerto Rico’s lawyers seem to have made one critical convert during the argument. Justice Kagan said that she thought the attorneys for the different sides had offered competing “stories” as to what Congress might have meant by section 903(1) and other relevant legislative clauses. But she bluntly asked the bondholders’ attorney, Matthew M. McGill, “Why aren’t those [stories offered by the Commonwealth’s attorneys] better than yours?” Then she added her own view, at least as of that moment, “I didn’t think that going in. Now I think it.”
The Obligation of Contracts
Still – and this is an important point – if Puerto Rico wins this specific dispute, much will be left undecided. For, as I noted above, the preemption argument was only one of the alleged grounds for the invalidity of this statute back at the district court level. There was also a contracts-clause argument, drawn from Article I, section 10, clause 1: “No state shall … pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts….”
The applicability of the “obligation of contracts” language to situations such as this has been governed in recent decades by the Supreme Court’s decision in United States Trust Co. v. New Jersey. The rule is that an impairment of contract by a state that legislates to lessen its own obligations can be upheld against challenge only if it both reasonable and necessary to serve an important public purpose. The courts entertaining such a challenge look at whether the state (and in this context the word “state” would include Puerto Rico) could have achieved the same public purpose with a less drastic modification of the promisee’s rights.
That is a complicated argument, and the point here is that the U.S. court system won’t even begin to get to that argument until and unless the question of preemption is settled in Puerto Rico’s favor.
So buckle your seatbelts, everyone. This is going to be a long and bumpy flight.