11/10/2014

Distressed Debt Investing: Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

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Legal Fault Lines Over Puerto Rico Restructuring Law

Come Into Focus

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best, most informed news, analysis, and commentary on the hottest topic in distressed:
Puerto Rico. As I've told many people recently, this is a situation that we will be talking
about for many years to come.
Last week, a few members of our team wrote a piece laying down some of the legal issues
District of Puerto Rico. For more information on Reorg Research or to inquire about a
subscription, please shoot us an email questions [at] reorg-research [dot] com. Enjoy!

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as a third opponent, BlueMountain, joined Franklin Templeton and Oppenheimer in

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litigation challenging the recently enacted Public Corporation Debt Enforcement and

The battle against Puerto Rico's independent restructuring efforts is becoming more clear

Recovery Act. With BlueMountain's complaint, funds managing more than $2.1 billion of
the $8.6 billion PREPA bonds outstanding, the litigating parties represent a heavy

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percentage of PREPA bondholders actively opposed to the Recovery Act.

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When viewed together, the complaints provide a clear picture both of what is at stake and

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Recovery Act violates both the U.S. Constitution and the Puerto Rico Constitution as well

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as federal law. While both complaints seek to invalidate the law, BlueMountain also

what challenges the Recovery Act will face. The theme of the opposition is that the

requests injunctive relief against any attempts by Puerto Rico or its publicly owned
corporations to enforce or implement the Recovery Act.

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The recently filed motions to dismiss filed by the Commonwealth of Puerto Rico and the

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inherent in the some of the various litigations coming out of the U.S. District Court for the

Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

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CONTRIBUTORS

Legal Contributors:

Puerto Rico Electric Power Authority, or PREPA, also display the legal roadmap for efforts
to defend the Recovery Act. PREPA and Puerto Rico stress that the Recovery Act is a valid
exercise of the legislature, as evidenced by language introducing the legislation, which
provides that the Recovery Act "is not a bankruptcy act, but an orderly debt enforcement act

Proskauer Rose
Martin Bienenstock
Phil Abelson

for the eligible public corporations."

Vincent Indelicato

Anti-Injunction Act

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At least one thing appears certain: The litigation will not be resolved overnight. An
initiation of procedures in the Puerto Rican courts under the new restructuring law by
PREPA or any other eligible Puerto Rico publicly owned corporation could complicate
things even more and push out any timeline for a resolution of the litigation because the

Schulte Roth Zabel

David J. Karp

ability of the U.S. District Court for the District of Puerto Rico to enjoin a proceeding under
Puerto Rican law may be slowed by the Anti-Injunction Act (28 U.S.C. 2283), which
provides that "[a] court of the United States may not grant an injunction to stay
proceedings in a State court except as expressly authorized by Act of Congress, or where
necessary in aid of its jurisdiction, or to protect or effectuate its judgment." The
applicability of this law to the unique situation of Puerto Rico's new restructuring law is
uncertain, and fighting over the issue will likely take some time. If the Anti-Injunction Act
applies, a Puerto Rican court process could conceivably continue in the face of legal
challenges. That being said, the U.S. constitutional issues raised by Franklin,
Oppenheimer and BlueMountain will likely be raised in the Puerto Rican proceedings,
particularly at the eligibility hearing proscribed by section 306 of the Recovery Act.

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Distressed Debt Investing: Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

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Preemption and Conflicts with the Bankruptcy Code

Jun (1)

The Bankruptcy Code of the U.S. Constitution provides that "[t]he Congress shall have

Apr (1)

Power To...establish...uniform Laws on the subject of Bankruptcies throughout the United

Mar (1)

States. . . ." Here, the parties disagree over whether the Bankruptcy Clause and/or conflicts
between the Bankruptcy Code and the Recovery Act invalidate the newly enacted
legislation based on preemption.
The parties do not dispute that the Bankruptcy Code expressly excludes Puerto Rico from
eligibility under Chapter 9. However, what is less clear and the focal point of debate

Feb (2)
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between the parties is whether the Bankruptcy Clause preempts Puerto Rico from creating

2011 (103)

its own restructuring laws and also whether those laws include impermissible conflicts

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with the Bankruptcy Code.

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Puerto Rico and PREPA dispute the preemption arguments, citing to the 1942 Supreme

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concluded that a state's police power justified New Jersey's enactment of its own public

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debt enforcement and adjustment statute. They cite Asbury for the argument that "state and

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local governments retain the power to pass their own restructuring statutes, so long as

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they do not conflict with federal law." Puerto Rico argues that the principals of Asbury

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Court case Faitoute Iron & Steel Co. v. City of Asbury Park, N.J., in which the court

Park comports with the "sovereign police power" set forth in the Puerto Rico Constitution,
providing that "[t]he power of the Legislative Assembly to enact laws for the protection of
the life, health and general welfare of the people shall . . . not be construed restrictively."
Puerto Rico's also argues that its public entities "are not currently governed by any federal
bankruptcy law," similar to banks and insurance companies who are expressly excluded

distressed debt
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list (1)

from the Bankruptcy Code's eligibility provisions set forth in section 109(b). In this case,

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publicly owned business entities are "governmental units" ineligible to seek relief under

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appropriate exercise of its police power because it is effectively filling the gap created by the

distressed debt
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Puerto Rico argues that while Congress enacted federal bankruptcy law in the form of the

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Bankruptcy Code, Puerto Rico is excluded as a debtor from the Bankruptcy Code and its
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chapter 11. Based on these exclusions, Puerto Rico argues that the Recovery Act is an
Bankruptcy Code.

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In rejecting Puerto Rico's arguments that the Recovery Act does not conflict with the

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Bankruptcy Code, the plaintiffs cite to section 903(1) of the Bankruptcy Code, which was
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enacted following the decision in Asbury Park and precludes a state from binding a

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eligibility purposes, it is not excluded for purposes of other Bankruptcy Code provisions

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without creditor consent, in clear contravention of section 903(1).

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creditor to an adjustment or discharge of obligations without the creditor's consent. The

complaints note that while Puerto Rico is excluded from the meaning of "State" for

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such as section 903(1). They say that the Recovery Act provides for binding adjustments

Puerto Rico, however, responds that "[s]ection 903 can and should be read to permit
Puerto Rico to enact restructuring legislation that complements-and in no way conflicts
with-its federal counterpart." In support of its argument, Puerto Rico argues that "because
Puerto Rico's public corporations may not avail themselves of Chapter 9, Section 903which, by its own terms, applies only when Chapter 9 is invoked-is wholly inapplicable to

double dip
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(1)

the Commonwealth." Puerto Rico's motion to dismiss goes on to characterize the plaintiff's

due diligence (1)

its "traditional police power" and preempt Puerto Rico from enacting the restructuring

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legislation necessary to help it escape the "financial ruin" in which it finds itself.

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Beyond preemption based on the alleged conflict between the Recovery Act and section 903

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(3)

of the Bankruptcy Code, BlueMountain cites to the Supreme Court's 1929 decision in Int'l

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series (1)

The Recovery Act, BlueMountain argues, "is preempted because it improperly operates in a

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reading of section 903 and the related definition of a "State" under section 101(52) as
"absurd" because such an interpretation would deprive Puerto Rico of its ability to exercise

Shoe Co. v. Pinkus, which provides that "[s]tates may not pass or enforce laws to interfere
with or complement the Bankruptcy Act or to provide additional or auxiliary regulations."
field that Congress has comprehensively occupied." Further, BlueMountain asserts that
even if Congress has not completely preempted state regulation of bankruptcy, "the Act
would still be preempted because its bankruptcy-like provisions would stand as an obstacle
to accomplishing and executing Congress's purposes and objectives in enacting a uniform

European
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bankruptcy code."

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Distressed Debt Investing: Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

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At some level, this last argument presupposes that Congress' objective was to exclude

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Bankruptcy Code.

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Puerto Rican-owned entities from bankruptcy protection. Defenders of the new law imply,
however, that PREPA and other island-owned companies fall into a "hole" in the

Contract Clause
The Contract Clause of the United States Constitution provides that "No State shall . . . pass
any . . . Law impairing the Obligation of Contracts." The complaints of BlueMountain,
Franklin and Oppenheimer argue that the Recovery Act "substantially impairs" the
obligations contained in the PREPA bonds, most notably because it deprives the
bondholders "of their contractual rights to payment in full of their claims." The parties
challenge the Recovery Act as law that provides an impermissible discharge of a
contractual obligation. In support of their arguments, the plaintiffs cite to the 1819
Supreme Court decision from Sturges v. Crowninshield, which held that New York law "so
far as it attempts to discharge the contract on which this suit was instituted, is a law
impairing the obligation of contracts within the meaning of the constitution of the United

hedge fund jobs

(1)

States."

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(8)

Responding to the Contract Clause challenges, PREPA and Puerto Rico point out that "

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[t]he Contract Clause's prohibition on the enactment of laws impairing contractual

obligations 'is not an absolute one' and 'does not make unlawful every state law that
conflicts with any contract.'" Beyond the initial inquiry of impairment, Puerto Rico stress

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(2)

that any Contract Clause inquiry must go beyond impairment and must demonstrate that

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important government interest so as to render them constitutional exercises of the state's

howard marks (2)

the Recovery Act is not "reasonable and necessary to the achievement of a sufficiently
police power." Puerto Rico cites to the motives set forth in the Recovery Act, most notably
the most-severe "fiscal emergency" in the Commonwealth's history as adequate support for
the contractual impairment provisions of the Recovery Act.

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Similarly, in the case of Asbury Park, the Supreme Court cited to Sturges, which provided
that "a state insolvency act is limited by the Contract Clause of the Constitution in
authorizing composition of pre-existing debts," but the Court also pointed out that any
Contract Clause analysis "depends on what is affected by such a composition, and what

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state power it brings into play." The Supreme Court in Asbury Park applied a practical

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assuring payment of unsecured municipal obligations," discounting the contract

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approach in addressing whether the Contract Clause "bars the only proven way for
impairment argument where "a most depreciated claim of little value has, by the very
scheme complained of, been saved and transmuted into substantial value."

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The Asbury Park decision implies that the Contract Clause is somewhat malleable and
will yield to legislation up to a certain point. The question now is whether the Recovery Act

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has reached or exceeded that point for purposes of a Contract Clause challenge.

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Takings Clause

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The Franklin/Oppenheimer complaint also argues that the Recovery Act violates the
Takings Clause of the Fifth Amendment and Fourteenth Amendments to the U.S.
Constitution. The concept of adequate protection is a cornerstone of the Bankruptcy Code
that provides "just compensation" upon the granting of a superior lien or a diminishment
in a party's property, thereby giving effect to the Takings Clause. In response, Puerto Rico
notes that the Recovery Act does not violate the Takings Clause, instead arguing that the
legislation affecting creditors' property rights is within its authority as a sovereign. The
motion to dismiss also points out that "the Act-like the Bankruptcy Code-satisfies the Fifth

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Amendment requirements of the U.S. Constitution by providing adequate protection for

Marty Whitman (1)

security interests."

MF Global (2)

Although the Recovery Act provides a definition of adequate protection that parallels the

Michael Burry (3)

Bankruptcy Code, it also provides instances where adequate protection is discretionary, not

michael milken (1)

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interview (1)
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mandatory, raising significant Takings Clause concerns. Most notably, subsection (d) of
section 129 of the Recovery Act, which defines adequate protection, provides that:

"Notwithstanding any section of this Act conditioning the eligible

obligor's or the petitioner's use or transfer of its property on adequate
protection of an entity's interest in the property, if and when the police
power justifies and authorizes the temporary or permanent use or

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Distressed Debt Investing: Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

non-agency rmbs
(2)

transfer of property without adequate protection, the Court may

approve such use or transfer without adequate protection."

oaktree capital (1)

Paulson (1)
Perry Capital (2)
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(1)
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(5)

Similar exceptions found in chapters 2 and 3 of the Recovery Act allow the debtor to forego
adequate protection payments "to the extent that sufficient revenues are unavailable for
payment of such principal, interest or other amounts after full payment of such current
expenses or operating expenses." This justification based on "police power" and public
necessity would seem to go squarely against the Supreme Court's 1935 decision in
Louisville Joint Stock Land Bank v. Radford, in which it concluded "[f]or the Fifth
Amendment commands that, however great the Nation's need, private property shall not be
thus taken even for a wholly public use without just compensation."

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Stay of Federal Litigation

Randy Smith (1)

One of the more interesting arguments presented by both complaints is the permissibility

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of the Recovery Act's automatic stay on proceedings in federal courts. With only a limited

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number of exceptions, the automatic stay under the Bankruptcy Code is incredibly broad
with the power to stay almost all causes of action filed in both state and federal courts.

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conference (1)

Here, Puerto Rico argues that the Recovery Act is outside of the umbrella of the Bankruptcy

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Code, expressly rejecting preemption arguments, while also seemingly enacting its own

rouse bonds (1)

includes both state and federal causes of action. However, citing to the Supreme Court in

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Donovan v. City of Dallas, the Franklin/Oppenheimer complaint points out that "state

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automatic stay with similar effects, namely staying all litigation, which presumably

courts lack any power under the Constitution to enjoin proceedings in federal court."
While Puerto Rico argues that the federal courts should "'respect and not interfere with a
state court's prior in rem jurisdiction," both Puerto Rico and PREPA may still remain
subject to ongoing litigation in the federal courts regardless of a filing under the Recovery
Act because of the litigation that has already been filed, particularly the constitutional
arguments. Puerto Rico's intrastate comity arguments based on in rem jurisdiction may
also fail when considering the relationship between state law receivership and the federal
provisions of the Bankruptcy Code.

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Credit (3)

Standing and Ripeness

A

major

argument

in

Puerto

Rico

and

PREPA's

motions

to

dismiss

the

Franklin/Oppenheimer suit is that the plaintiffs lack standing to bring their claims
because "neither PREPA - nor any other Puerto Rico public corporation - has sought relief
under the Recovery Act" and, therefore, have not sustained the level of injury necessary to
challenge the statute. Instead, PREPA characterizes the plaintiffs' claims as "wholly

Third Point (2)

hypothetical, and predicated upon an invocation of the Recovery Act by PREPA that may

tousa (1)

never occur." The motions to dismiss also argue that the plaintiffs' constitutional

trade claims (2)

challenges are both premature and unripe until PREPA, or any other Puerto Rico public
corporation, seeks relief under the Recovery Act.

tronox (1)
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Visteon (2)

As if in response to the motions to dismiss, which were filed only a day before
BlueMountain's complaint, the BlueMountain complaint argues that the bondholders have
already suffered injuries as a result of the laws enactment, most notably by the Act's
elimination of the bondholders' right to seek appointment of a receiver upon the
occurrence a default under the 1974 Trust Agreement that governs PREPA's bonds.
BlueMountain also cites to the already noticeably "depressed" value of the PREPA bonds as

WAMU (1)

another form of actual harm resulting from the Relief Act.

Warren Buffett (2)

Conclusion
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Each of the above arguments, and many that have yet to surface, will undoubtedly cloud
Puerto Rico's attempts to restructure its public corporations. A critical issue is timing. As
the existing constitutional lawsuits unfold, PREPA faces the expiration of two short-term
lines of credit in August, totaling $671 million and including a $550 million line with
Scotiabank which must be repaid on Aug. 14. As noted above, disputes over the AntiInjunction Act could take center stage in the immediate aftermath of a PREPA filing under
the new law. That being said, a final resolution of the interplay between the federal
Constitution and the new restructuring law will almost certainly involve many levels of
appellate review.

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Distressed Debt Investing: Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus
Posted by Hunter

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ABOUT ME

hunter [at] distressed-debt-investing [dot] com

I have spent the majority of my career as a value

investor. For the past 8 years, I have worked on
the buy side as a distressed debt and high yield
investor.

Disclaimer
This website is about distressed debt investing. Under no circumstances is this an offer to sell or a solicitation to buy securities discussed on this site. Any
investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk,
financial or otherwise. Distressed-Debt-Investing.com, its editor and/or related parties may have positions in companies discussed. All data, information and
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