Puerto Rico and the Netherworld of Sovereign Debt Restructuring
Article by Mitu Gulati & Robert K. Rasmussen
From Volume 91, Number 1 (November, 2017)
Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) in an attempt to pull Puerto Rico back from the abyss. The reason for this drastic action—a special insolvency regime available only for Puerto Rico—was plain: the Commonwealth had accumulated debts well beyond its ability to repay. Its economy was in such a dreadful state that even if one were to declare an indefinite moratorium on all of its debt payments, it would still be the case that the island could not make ends meet without a drastic overhaul of both its operations and its finances. Yet prior to congressional action there was no moratorium. The island’s creditors were demanding money, and the government’s cash reserves were nearing depletion. Disaster seemed imminent.
Congress provided a glimmer of hope to the American citizens of Puerto Rico. PROMESA, at least temporarily, put a halt to the creditors’ collection efforts. It also created a proceeding that in essence replicates Chapter 9 of the Bankruptcy Code for the Commonwealth, as well as an alternative path relying on consensual restructuring coupled with the power to bind holdout creditors. Puerto Rico gained two options that it lacked prior to the legislation’s passage. But the price for these protections was steep. A control board was put in place that effectively took over control of the territory’s finances and the conduct of any insolvency proceedings. The members of this board were appointed by elected officials in Washington. The elected government of Puerto Rico had no right to appoint or veto any members. Given potential constitutional infirmities with the control board, it remains to be seen whether this last-minute action is sufficient to save the island from total financial collapse.
We here are interested in a different type of abyss than the one that spurred Congress to act. Prior to the passage and signing of PROMESA, Puerto Rico inhabited a netherworld of debt adjustment. In Puerto Rico v. Franklin California Tax-Free Trust, the U.S. Supreme Court held that the Bankruptcy Code provided no relief for Puerto Rico or its municipalities and at the same time precluded Puerto Rico from enacting an insolvency regime of its own. The Commonwealth could neither repair to federal law to restructure some of the debts plaguing it nor could it enact legislation to address the fiscal crisis. In essence, Puerto Rico was faced with crushing debt and no mechanism to take action, other than attempts to have bondholders voluntarily agree to haircuts (something that bondholders are loath to do). Puerto Rico gamely undertook such efforts for some of its debt, but while these attempts may have shown glimmers of optimism to some, each of them eventually fell apart. Not a single group of creditors was willing to restructure its debt to a sustainable level. Puerto Rico was in fiscal purgatory.
While the issue was not before the Supreme Court in Franklin, we want to explore whether the Constitution allows Congress to put Puerto Rico into such a bind. Can it take away a government’s power to enact a restructuring regime and put nothing in its place? Put in contractual terms, do the implicit terms of the deal struck between Puerto Rico and the U.S. federal government when Puerto Rico transitioned from the status of a colony to a “freely associated state” in 1952 allow Congress to eliminate in full Puerto Rico’s ability to restructure the debt of its municipalities? This question encompasses both the situation that existed in Puerto Rico prior to the enactment of PROMESA and the potential lacuna that could arise should a state enact a restructuring law for its own debts and Congress seek to void such action. We submit that the answer is no.
Our analysis proceeds in three parts. In the first, we describe the financial situation facing Puerto Rico, its attempts to address that situation, and the Supreme Court’s recent decision in Franklin. This articulation of the problem highlights the ills that can occur when a sovereign entity has the power to issue debt but lacks a means for resolving financial distress. We then ask the question of whether, when it comes to states, the allocation of authority between them and the federal government would allow Congress to put them in such an untenable situation. States under our federal system retain core functions. The power to issue and restructure debts, we submit, resides in this core. Indeed, prior Supreme Court precedent holds that the power to issue debt necessarily includes the power to create a mechanism for restructuring that debt. We argue that while Congress can adjust this power by replacing a state’s scheme with one of its own, it cannot, consistent with federalism, prohibit state action while putting nothing in its place.
We then turn our attention to Puerto Rico. The much-vilified Insular Cases seem to imply that Congress has substantial leeway in all matters regarding Puerto Rico. We show, however, that the colonial conception of the relationship between Puerto Rico and the U.S. federal government, on which those cases rest, cannot form the basis for determining what the allocation of authority between Congress and Puerto Rico is today. Congress transferred sovereignty to Puerto Rico. It established and implemented a process by which the island became a commonwealth. As part of that transfer of sovereignty—something that was done in the post-Second World War era, when colonial outposts were to be phased out as a matter of the new international order—Congress authorized and then approved Puerto Rico’s constitution, which expressly gave the Puerto Rican government the power to issue debt and impose taxes. This action, we submit, necessarily also gave Puerto Rico the power to enact a restructuring regime. Congress could negate Puerto Rico’s right to put in place a restructuring regime, but only if it were to put in place some substitute mechanism. Prohibiting the enactment of any means of restructuring its obligations cannot pass constitutional muster.
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