U.S. District Court Holds That Puerto Rico's Recovery Act Is Unconstitutional

On February 6, 2015, Judge Francisco Besosa of the U.S. District Court for the District of Puerto Rico held that the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the "Recovery Act") is expressly preempted by section 903 of the Bankruptcy Code and is therefore unconstitutional. The court also denied the Commonwealth's motion to dismiss the plaintiffs' claims under the Contracts Clause and certain of the plaintiffs' claims under the Takings Clause. The decision is among the first to explicitly hold that section 903 of the Bankruptcy Code preempts the States, including Puerto Rico, from enacting a municipal debt adjustment scheme that results in the discharge of indebtedness. The court's ruling also removes a major leverage point for the Commonwealth and its public agencies attempting to negotiate restructurings with creditors and restores remedies available to bondholders, including the right to appoint a receiver.

Background

On June 25, 2014, Puerto Rico's legislature introduced and approved the Recovery Act. Shortly thereafter, Governor Alejandro Garcia Padilla signed the Recovery Act into law. The Recovery Act permits Puerto Rico's three major public corporations (PREPA, PRHTA, and PRASA)1 to pursue two non-consensual alternatives to a restructuring of their debts. The first alternative, Chapter 2, permits a public corporation to modify, amend, or exchange certain of its debt instruments if (i) at least 50 percent of the debt in a given class votes on whether to accept the changes and (ii) at least 75 percent of participating voters approve the changes to the debt instruments. The second alternative, Chapter 3, is modeled after chapter 9 of the Bankruptcy Code and permits a debtor to propose a plan that adjusts its debts without the consent of all of its creditors. The Chapter 3 plan may be confirmed if at least one class of affected debt has voted to accept the plan by a majority of the votes cast in such class and two-thirds of the aggregate principal amount of affected debt in such class that is voted. In addition, the Recovery Act:

Eliminated existing statutory remedies for certain secured bondholders, including the right for PREPA bondholders to appoint a receiver; Permitted debtors to use cash collateral and obtain DIP financing with a priming lien without providing any adequate protection to prepetition creditors, provided that the use of cash collateral or the DIP financing would be to serve a public function; Permitted debtors to sell their assets with court approval; and Stayed prepetition creditors from enforcing remedies against the debtor during the pendency of the Chapter 2 or 3 case. Two groups of creditors filed complaints against the Commonwealth of Puerto Rico and PREPA, seeking a declaration that the Recovery Act is unconstitutional because it infringed on the federal bankruptcy power and a declaration that the Recovery Act is expressly preempted by section 903(1) of the Bankruptcy Code. The plaintiffs also sought declarations that the Recovery Act violated the Takings and Contracts Clauses of the U.S. Constitution and that provisions in the Recovery Act that would stay federal proceedings are unconstitutional. The Commonwealth moved to dismiss these claims, and the creditors cross-moved for summary judgment.

The Court's Decision

In Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico and Blue Mountain Capital Management LLC v. Governor Alejandro Garcia-Padilla,2 the court first addressed ripeness, concluding that the plaintiffs' preemption and Contracts Clause claims were ripe for review because, among other things...