PR Chapter 9

FURTHER THOUGHTS ON THE RECOVERY ACT ORAL ARGUMENT

 

 

As I was reviewing something a friend sent me, and it got me curious about an old SCOTUS case, Faitoute Iron & Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942). In this case, the SCOTUS allowed a New Jersey law that changed obligations on some municipal bonds. Due to this case, in 1946, Congress amended the Bankruptcy Code to prohibit a state from providing the composition of debts by its municipalities.

 

As I reviewed the case, did some digging and found some interesting facts. In United Trust Company of New York v. New Jersey, 431 U.S. 1, 28 (1977), the issue was the repeal of a statutory covenant made by the two states (New York and New Jersey) that had limited the ability of the Port Authority to subsidize rail passenger transportation from revenues and reserves. A New Jersey superior court dismissed the complaint after trial, holding that the statutory repeal was a reasonable exercise of New Jersey’s police power and was not prohibited by the Contract Clause, and the New Jersey Supreme Court, affirmed the dismissal of the suit that challenged the provision. The SCOTUS reversed the New Jersey Court and found that the action violated the impairment of contractual obligations. The Court stated as follows:

 

Under the specific composition plan at issue in Faitoute, the holders of revenue bonds received new securities bearing lower interest rates and later maturity dates. This Court, however, rejected the dissenting bondholders’ Contract Clause objections. The reason was that the old bonds represented only theoretical rights; as a practical matter the city could not raise its taxes enough to pay off its creditors under the old contract terms. The composition plan enabled the city to meet its financial obligations more effectively. “The necessity compelled by unexpected financial conditions to modify an original arrangement for discharging a city’s debt is implied in every such obligation for the very reason that thereby the obligation is discharged, not impaired.” Id., at 511, 62 S.Ct. at 1134. Thus, the Court found that the composition plan was adopted with the purpose and effect of protecting the creditors, as evidenced by their more than 85% approval. Indeed, the market value of the bonds increased sharply as a result of the plan’s adoption.

 

It is clear that the instant case involves a much more serious impairment than occurred in Faitoute. No one has suggested here that the States acted for the purpose of benefiting the bondholders, and there is no serious contention that the value of the bonds was enhanced by repeal of the 1962 covenant. Appellees recognized that it would have been impracticable to obtain consent of the bondholders for such a change in the 1962 covenant, Brief for Appellees 97-98, even though only 60% approval would have been adequate. See n. 10, supra. We therefore conclude that repeal of the 1962 covenant cannot be sustained on the basis of this Court’s prior decisions in Faitoute and other municipal bond cases.

 

This narrowing of the Faitoute doctrine has been recognized by other courts. In In Re Detroit, 504 B.R. 97, 144-45 (B. E. D. Mich 2013) Judge Rhodes had the same view as did the Court in In Re Jefferson County, 465 B.R. 243, 293 n. 21 (B. N. D. Alabama). The Supreme Court of Illinois in Harding, Inc. v. Village of Mount Prospect, 99 Ill.2d 96, 103-104 (1983) held in a similar fashion and said:

 

In our judgment the opinion of the United States Supreme Court in United States Trust Co. v. New Jersey (1977), 431 U.S. 1, 97 S.Ct. 1505, 52 L.Ed.2d 92, is dispositive of this case, for the circumstances there considered insufficient to sustain legislative alteration of contractual obligations were substantially more compelling than here. In that case, the States of New York and New Jersey, by a 1962 statutory covenant, limited the ability of the Port Authority of New York and New Jersey to divert, for purposes of subsidizing rail-passenger transportation, certain revenues and reserves previously pledged as security for bonds issued by the Port Authority. Concurrent legislation in both States some 12 years later purported to retroactively repeal the earlier covenant. That legislation was attacked as impermissibly impairing the obligations of the Authority bonds issued prior to repeal. While the State court held the repealing legislation was a reasonable exercise of the State’s police power (United States Trust Co. v. State (1976), 69 N.J. 253, 353 A.2d 514), the Supreme Court reversed on the ground that the 1974 repealer statute was an unconstitutional impairment of the Port Authority’s contract with its bondholders. In reaching this conclusion, the court reviewed at length the history of the contracts clause and noted that it has upheld State legislation impairing contracts in very few cases. Only once in this century, in the case of Faitoute Iron & Steel Co. v. City of Asbury Park (1942), 316 U.S. 502, 62 S.Ct. 1129, 86 L.Ed. 1629, has the court upheld a statute that impaired contract rights of municipal bondholders. In that case, the challenged legislation permitted a bankrupt local government to go into receivership, but it also provided significant protections for all creditors: any bankruptcy repayment plan required approval of 85% of all creditors, and nonconsenting creditors were to be bound by the plan only after a State court determination that the municipality could not otherwise pay its creditors and that the repayment plan was in the best interest of all creditors.

 

Only in one of the respondents merits briefs is Faitoute discussed in this fashion. At page 28 of Franklin California’s brief this issue is discussed. In addition, in Franklin California v. PR, 85 F.Supp.3d 577, 606 (D.P.R. 2015) Judge Besosa discussed the case and said:

 

The United States Supreme Court has long held that the Contract Clause prohibits states from passing laws, like the Recovery Act, that authorize the discharge of debtors from their obligations. See Ry. Labor Execs.’ Ass’n, 455 U.S. at 472 n. 14, 102 S.Ct. 1169 (“[T]he Contract Clause prohibits the States from enacting debtor relief laws which discharge the debtor from his obligations.”); Stellwagen v. Clum, 245 U.S. 605, 615, 38 S.Ct. 215, 62 L.Ed. 507 (1918) (“It is settled that a state may not pass an insolvency law which provides for a discharge of the debtor from his obligations.”); Sturges, 17 U.S. at 199 (Contract Clause prohibits states from introducing into bankruptcy laws “a clause which discharges the obligations the bankrupt has entered into.”).

 

The Commonwealth Legislative Assembly cites Faitoute Iron & Steel Co. v. City of Asbury Park, New Jersey, 316 U.S. 502, 62 S.Ct. 1129, 86 L.Ed. 1629 (1942), as support for the Recovery Act’s “constitutional basis.” Recovery Act, Stmt. of Motives, § C. In Faitoute, the Supreme Court sustained a state insolvency law for municipalities in the face of a Contract Clause challenge. 316 U.S. at 516, 62 S.Ct. 1129. The state law was narrowly tailored in three important ways: (1) it explicitly barred any reduction of the principal amount of any outstanding obligation; (2) it affected only unsecured municipal bonds that had no real remedy; and (3) it provided only for an extension to the maturity date and a decrease of the interest rates on the bonds. Id. at 504–07, 62 S.Ct. 1129. The Supreme Court was careful to state: “We do not go beyond the case before us. Different considerations may come into play in different situations. Thus we are not here concerned with legislative changes touching secured claims.” Id. at 516, 62 S.Ct. 1129. Unlike the state law in Faitoute, the Recovery Act (1) permits the reduction of principal owed on PREPA bonds, (2) affects secured bonds that have meaningful remedies, including the appointment of a receiver, and (3) permits modifications to debt obligations beyond the extension of maturity dates and adjustment of interest rates. Thus, Faitoute is factually distinguishable and provides no support for the Recovery Act’s constitutionality.

 

What does all this mean? Simple, even if the SCOTUS says that section 903 does not apply to PR since it is not eligible for Chapter 9, after the law clerks review the cases again, they may conclude and so inform the Justices, that the island cannot restructure its debts by affecting bondholders. Of course, the SCOTUS may modify or distinguish United Trust Company of New York to allow the restructuring or it can completely reverse it. On the other hand, since this issue is in one brief and the District Court opinion, the SCOTUS should not simply ignore it. If it does, Judge Besosa would have another issue to declare the Recovery Act unconstitutional.

PREPA DEAL GONE WRONG

 

 

On Friday night we all went to bed thinking PREPA had obtained a new extension but woke up to the end of the Forbearance Agreement. On the one hand, PREPA says the bondholders wanted further guarantees before they lent it $115 million such as the approval of the Energy Board to the rate increase, which would take months without PS 1523 being approved. On the other hand, the bondholders blame PREPA for the break-up of negotiations.

 

What happened? What are the implications of what we know? Let’s see the history of this problem.

 

PREPA realized in June of 2014 that it would not be able to pay its bondholders in July. The Board brought the problem to the Governor and it decided to take the money to pay bondholders from reserves. This was a technical default of the 1974 PREPA Bondholders Agreement. Due to this, PREPA and its bondholders sat down to talk. On August 14, 2014, PREPA announced agreements with its creditors, the so-called “Forbearance Agreement”, which included that the company had to hire a restructuring officer that would be approved by the Forbearing Bondholders. As per the agreement, on March 2, 2015, PREPA was to deliver a business plan and the agreement was to expire on March 31. On March 30, PREPA announced a 15-day extension on the Forbearance Agreement. On April 15, it announced another 15-day extension and on April 30, 2015, one until June 4, 2015. On June 1, PREPA presented to bondholders the Recovery Plan but not to the public.

 

On June 5, PREPA announced another extension to the Forbearance Agreement until June 18, 2015. On June 18, another extension was announced until June 30, 2015. On July 1, 2015, an extension was announced until September 15. On September 2, 2015, PREPA announces agreement with 35% of its bondholders. On September 21, an extension was announced until October 1, 2015, which was again extended to October 15, which was again extended on October 23 until October 30. It was extended again until November 3. On November 3, the Restructuring Support Agreement (RSA) is announced and on November 10, 2015, Ms. Lisa Donahue testified before the PR Senate Energy Commission on behalf of the PREPA Revitalization Act, which implements parts of the RSA. The RSA states RSA that PREPA must make a rate review request from the PR Energy Board no later than December 21 and that the Legislature must approve the bill no later than November 20 2015. It also states that the rate increase must be in place on or before March 1, 2016 pages 31-32 of the RSA.

Since the bill, PS 1523, had been filed on November 4 and had 159 pages, the legislators, with good reason demurred. Subsequently, everyone assumed Governor García Padilla would call for an extraordinary but he refused. The RSA was extended to December 17 and then December 23 and finally to January 22. On December 23, PREPA announced an agreement with the monolines and now had 70% of bondholders on line with the RSA.

Continuing with these events, Ms. Donahue told the US Congress on January 11, 2016 that PREPA could not get a better deal in Chapter 9 or that its rates would go down under that regime starting at 1.07 minutes Moreover, she said PREPA would run out of money to pay for fuel and that there would be blackouts.  See also Ms. Donahue’s testimony at 1.19 minutes.

What does all this mean? Why has a deal with 70% of bondholders on board, vital to PREPA gone down the tubes? We don’t know yet but there are various possibilities. I have always believed PS 1523 did not have the votes to be approved in the House where a group of six leftists legislators could with three votes block any legislation. Also, the PR Legislature wanted to change the bill substantially. Obviously, this is not what bondholders wanted to hear.

Today, Governor García Padilla made a press release emphasizing the need for the PREPA bill to be approved, but he forgets he did not call for an extraordinary session to discuss the law in December, wasting precious time. In addition, he said, “Our legislature has requested more time to bring to the table other options, other proposals.” After 18 months of negotiations, it is surprising and irresponsible for the legislature to require time to bring about “other options, other proposals.” Good or bad, Ms. Donahue is the person designated by PREPA to do the negotiations, which were approved by the PREPA Governing Board. To change things now would mean months of negotiations and the distinct possibility that bondholders would not accept them.

The more we read of this press release, the more it is obvious that the Governor does not have control of his Legislature. Also, although the Governor acknowledges the need for the agreement due to the difficult situation with PRASA and the Government’s debt, he arrogantly says at the end of the press release “I warn creditors, at the same time, it is not time for pressure games. I accept reasons, not pressures.”

It almost seems that the Governor, PREPA and their advisors have decided to scuttle the agreement in order to push Congress for a Chapter 9. It was clear that this agreement belittled the need for PR to have access to bankruptcy. By playing the blame game, PR could be hoping to move a reluctant Congress. The problem with that is that now creditors can claim that PREPA did not negotiate in good faith, a requirement of Chapter 9, see, 11 U.S.C. § 109(c). Bondholders accepted haircuts, offered to provide money, granted several extensions to continue negotiating, all to naught. In any event, this situation will make the eligibility issue a mayor battle if Chapter 9 was authorized for PR.

Question is, what now? Bondholders could decide to buckle and accept PREPA’s refusal and continue negotiating a deal until July when the company must pay over $400 million in bonds as well as over $700 million to banks for fuel purchase. On the other hand, bondholders could get tough and file on Monday a request in federal court for the appointment of a receiver to run PREPA and get paid. Or they could do both. Who wins? The lawyers involved in the litigation. Let’s see what happens.