Puerto Rico enacted the Public Corporations Debt Enforcement and Recovery Act on June 30. The legislation was pushed through without public discussion or debate and presented on the last day on which the legislature could consider such a bill.
The stated aim of the bill is to create a clear legislative framework to assist financially stressed public corporations overcome their problems “through an orderly, statutory process” that allows them to handle their debts fairly and equitably, while ensuring the continuity of essential services to citizens and infrastructure upgrades.
At a news conference, PR Treasury Secretary Melba Acosta-Febo and Government Development Bank Chairman David H Chafey emphasized that the legislation was not a bankruptcy law and would not apply to the majority of public agencies, nor the Commonwealth’s own debt.
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Puerto Rico corporations in a no-man’s-land
“United States law provides a framework for the nation’s companies and municipal entities to address their financial challenges while continuing their services,” said Chafey. “However, Puerto Rico’s public corporations fall through the cracks of these laws.”
It was explained that the bill was primarily aimed at aggregate debt of approximately $ 20 billion owed by agencies such as the Puerto Rico Electric Power Authority (PREPA), the Aqueduct and Sewer Authority, and the Highways and Transportation Authority (HTA).
According to the government, which would like such public corporations to be financially independent, in their present distressed situation a default could result in creditors claiming their rights in a piecemeal or disorderly fashion. “The absence of an orderly process could threaten the Puerto Rico government’s capacity to safeguard the public and promote the general welfare of the people. For these reasons, the Recovery Act is urgently needed.”
However, two mutual funds that owned approximately $ 1.7 billion worth of PREPA bonds filed a complaint in the federal district court for Puerto Rico claiming the legislation was invalid.
Puerto Rico: The mechanism of the Act
In the graphic above, chapter 2 is the first option available to a distressed corporation and is an out of court (consensual) route. The corporation and affected creditors mutually negotiate and agree on the restructuring and their plan is then approved by a judge. The process requires ratification by a majority of the affected creditors and is also subject to the corporation presenting a recovery program to ensure future financial viability.
Chapter 3 however is the court-supervised route intended to tackle a stalemate in restructuring negotiations. The creditors’ interest is represented by a committee. The court ensures that all creditors receive payment equal to what they would receive if they all demanded immediate payment while corporation was in its present distressed financial condition.
An in-depth look at Puerto Rico’s recovery act
On July 11th, BTIG hosted a conference call with Lawrence Larose, Partner, Christy Rivera, Counsel, and Eric Daucher, Associate at Chadbourne & Parke to discuss the Recovery Act, its implications for bond-holders, constitutionality of the Recovery Act, and the PREPA bondholders suit and possible challenges. Some of the highlights of this conference call are presented in this article.
- The Act is clearly aimed at agencies such as PREPA and HTA. Significantly, it does not cover COFINA, Puerto Rico’s sales tax bonds. The Commonwealth itself and other named corporations are exempt.
- A distressed corporation (obligor) may commence restructuring under Chapter 2 by itself. However the Governor, acting through the GDB may also initiate such a process.
- A new special Branch has been established by the Puerto Rico Supreme Court to preside over proceedings under chapters 2 or 3 of the Act.
- The obligor need not be insolvent to take recourse under chapter 2 – it may simply determine that its financial condition requires such a step in its best interest.
- The obgligor needs to post a suspension notice on its website of its decision to seek restructuring under chapter 2, triggering a suspension period in respect of the debt (a stay)
- After such a notice, the obgligor would have about nine months to consummate the restructuring.
- A recovery program as mentioned before
- The restructuring and recovery program are subject to approval by the GDB.
- Chapter 3 is a judicial proceeding and broadly similar to Bankruptcy Code chapter 9 but without many of the latter’s reliefs. However, this route is only open if the obgligor is insolvent.
- The proceeding commences by filing a petition and a statement of the existing claims against the obgligor.
- An automatic stay on the operation of those claims will be triggered once proceedings commence under chapter 3.
- Creditors are prohibited from terminating or amending their arrangements with the obgligor once the stay is operational.
- The creditors’ committee in this case has limited functionality (compared to the Bankruptcy code) such as new debt, large asset transfers etc.
- The corporation may emerge chapter 3 proceedings by either (1) restructure through a planned process, or (2) transfer all of its assets in a transaction and then distribute proceeds to creditors through a final allocation statement.
‘Disturbing’ aspects of Puerto Rico’s new act
- The Governor and GDB have control of proceedings under chapter 2 as well as chapter 3. Commencement of proceedings must have approval of the GDB as well as the Governor. The GDB has standing in both types of cases on every issue during the proceedings.
- In fact, the GDB is given some rights as the obgligor itself including the ability to appoint lawyers on behalf of the obgligor and to give them directions.
- The Governor may also appoint an emergency manager who could override the management of the obgligor.
- Most disturbingly, the collateral of the creditors is vulnerable and may be utilized by the corporation to finance its administration or public function obligations, in the event that other financing is not available during the proceedings. (Priming the liens of secured creditors without providing true adequate protection)
- This could affect pledged revenue streams, and are of serious concern to creditor interests.
Puerto Rico: Hidden ‘mines’ in chapter 2 and 3
- Chapter 2 allows an obgligor to cherry-pick the particular debt which it seeks to restructure under the act and to stay the operation of.
- There is no requirement that junior debt be restructured before senior debt.
- Only 50% of the creditors representing that particular debt are required to vote on the proceedings and of that percentage only 75% have to approve (effectively 37.5% – “far cry from consensual”).
- The recovery plan envisaged under chapter 2 “really has no teeth” if the obgligor ends up violating its provisions. Non-binding recommendations and/or public reprimands are the worst that can follow.
- The automatic stay in chapter 3 will apply not just to the obgligor but also in respect of certain other enumerated entities that are connected with the obgligor – the scope of this study is therefore much wider than that provided under the Bankruptcy Code.
Puerto Rico: Lawsuit challenging the Act by Franklin and Oppenheimer Funds
- The Act violates the US Constitution’s Bankruptcy Clause
(however, it may be noted that the uniform bankruptcy code prohibits all ‘states’ from enacting their own debt composition laws – it could therefore be said that the legislation proposed by a ‘territory’ such as Puerto Rico is not prohibited. Note also that this is the precise reason why the Puerto Rico entities are unable to avail of US bankruptcy chapter 9.)
- Violates the U.S. Constitution’s Contract Clause
- Violates the Takings Clause
- Bars access to Federal courts (Supremacy clause) and centralizes the dispute in Puerto Rico courts
No emergency relief has been requested by the funds in the lawsuit, which is on a regular litigation track and is more in the nature of an advisory opinion from the court on the constitutionality of the legislation – something the courts are loath to provide.
Puerto Rico’s action is unprecedented… or is it?
In fact, the City of New York was in a financial mess in the 1970s, similar to Puerto Rico, and did not have access to Chapter 9 due to a technical difficulty.
New York therefore promulgated its own Emergency Moratorium Act (EMA) that prohibited creditors from enforcing their debt for three years during which they were paid interest at only 6% per annum (a below-market rate at the time).
The EMA met with a storm of litigation. There were no injunctions, however, and the city of New York was able to obtain valuable breathing space to fix its finances. The EMA, therefore, fulfilled its purpose.