After swearing up and down that I would blog more about Puerto Rico’s 70 billion dollar debt crisis, I of course was remiss and did not. But a new paper by Mitu Gulati and Robert Rasmussen, “Puerto Rico and the Netherworld of Sovereign Debt Restructuring” has provided me the impetus to dive into this topic again.
Recall that unlike U.S. municipalities (such as Detroit), Puerto Rico bodies and utilities aren’t considered debtors for purposes of Chapter 9 of the U.S. Bankruptcy Code and therefore don’t have access to the municipal bankruptcy process. See 11 U.S.C. § 101(52). Puerto Rico attempted to address its fiscal woes by enacting the 2014 Puerto Rico Public Corporation Debt Enforcement and Recovery Act, which created a debt restructuring mechanism analogous to Chapter 9 municipal bankruptcy. However, the U.S. Supreme Court ruled on June 13, 2016 that the Act was preempted by Section 903(1) of the U.S. Bankruptcy Code. Puerto Rico v. Franklin California Tax-Free Trust, 136 S. Ct. 1938 (2016). [Fn. 1]
After the Franklin Trust decision, Congress stepped in and passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) legislation on June 30, 2016, to allow Puerto Rico to restructure without filing for Chapter 9 bankruptcy. Briefly, PROMESA establishes an independent oversight board, provides for a bankruptcy-like debt restructuring process, and requires submission of a Fiscal Plan by Puerto Rico. Puerto Rico’s required Fiscal Plan was approved by the Oversight Board on March 13, 2017; however, that plan has come under criticism from bondholders.
This all begs the question, however, of what would have happened had Congress NOT passed the PROMESA legislation. Puerto Rico would have been left in a bind in which it had no access to the U.S. municipal bankruptcy process but was preempted from enacting any analogous debt restructuring mechanism by Section 903(1) of that same Bankruptcy Code, per Franklin California Tax-Free Trust. [Fn. 2]
Gulati and Rasmussen’s paper focuses on this question, arguing that, as a constitutional matter, the United States may not prohibit Puerto Rico from enacting its own bankruptcy-like restructuring process while offering no alternative mechanism. This leaves Puerto Rico in an untenable “netherworld,” in which it has the power to issue debt without the mechanisms for dealing with financial distress on the back end.
Reasoning from the case of states, Gulati and Rasmussen argue that under principles of federalism, Congress may not prevent a state from performing a “core function” if it does not provide a federal alternative regime. With respect to municipal debt restructuring, they argue—based largely on the Supreme Court’s 1942 Ashbury Park holding—that the power to restructure is integrally linked to the municipality’s power to tax and to issue debt. Municipal debt is purchased in reliance on the municipality’s ability to service the debt primarily through taxation. However, it is sometimes necessary that taxes collected be spent on public expenditures, rather than debt servicing. In situations where the municipal government cannot use tax revenue to both perform public provision and service its debt, it needs to have access to a debt restructuring procedure. Otherwise, shutdown and dysfunction may occur, which would make everyone worse off. Congress may preempt this state power via federal municipal bankruptcy law, but it cannot prevent states from exercising that power while providing no alternative.
The same principle should apply, the argument goes, to Puerto Rico. In 1950, Congress permitted Puerto Rico to organize a government and adopt a constitution (subject to congressional veto). Puerto Rico’s constitution was adopted and approved in 1952. While the significance of this is contested, Gulati and Rasmussen argue that by inviting and approving the Puerto Rico constitution, the United States essentially gave Puerto Rico sovereignty and fundamentally changed its relationship to its territory. Moreover, Article 6 of Puerto Rico’s constitution expressly grants the power to tax and in so doing also grants the power to restructure debts.
There are several aspects of the analysis that are notable, including whether or not the federalism constitutional analysis with respect to states is really transferable to the case of a territory. I also found myself wondering what really would have happened had PROMESA not been acted. After all, the lack of a restructuring alternative to municipal bankruptcy did not stop lenders from lending ex ante. It would be interesting to know what sort of risk-reward calculus underpinned those decisions to extend credit, given the absence of a clear ex post restructuring regime. For example, it is possible that creditors (correctly it turns out) assumed that the game of legislative chicken would eventually end in the enactment of some sort of non-bankruptcy restructuring regime if financial distress did come to pass.
From the point of view of a tax scholar, I also found most interesting the 1942 Ashbury Park holding that the power to restructure is an integral aspect of the power to tax and to issue debt. In Ashbury Park, the court seems to have held that the power to restructure is fundamental because that is the only mechanism via which the taxing power (what Justice Frankfurter called “the goose which lays its golden eggs”) can be safeguarded and the repayment rights of creditors—which come largely through tax revenue—maintained. Thus, the taxing power renders the power to restructure fundamental.
In any case, the paper is well worth a read.
[Fn. 1] Puerto Rico also attempted some revenue-raising legislation, including the enactment of a “Walmart Tax”– which hiked Puerto Rico’s corporate AMT’s tangible property tax rate (with the top rate only applying to Walmart Puerto Rico). As my co-blogger David Herzig described, that tax was struck down by the First Circuit as violating the dormant Commerce Clause. Wal-Mart Puerto Rico, Inc. v. Zaragoza-Gomez, 834 F.3d 110 (1st Cir. 2016).
[Fn. 2] I’ll note that there’s a mirror-image question on the back end: In light of criticisms of PROMESA, would it be constitutional if Congress simply repealed the law and once more left Puerto Rico without a restructuring regime?