News & Events

Puerto Rico’s Recovery Act declared Unconstitutional by the U.S. Court of Appeals for the First Circuit

On Monday, July 6, 2015, the U.S. Court of Appeals for the First Circuit (the “Appellate Court”) upheld theU.S. District Court for the District of Puerto Rico’s decision that declared unconstitutional Act no. 71 of 2014known as the “Puerto Rico Public Corporation Debt Enforcement and Recovery Act” (the “Recovery Act”).On February 6, 2015, the U.S. District Court for the District of Puerto Rico (the “District Court”) had issuedan Opinion and Order declaring the Recovery Act unconstitutional as it violates the Supremacy Clause ofthe United States Constitution. The Recovery Act, adopted on June 28, 2014, enables a debt negotiationand restructuring process similar to a petition under the provisions of Chapter 9 of the U.S. BankruptcyCode (“Bankruptcy Code”). On March 16, 2015, the Government appealed the District Court’s opinion tothe First Circuit.1

In the appeal, the Government argued The Government’s position was that since the post-1984 definition of “state” precluded Puerto Rico and itspublic companies from seeking relief under Chapter 9 of the Code, it should also be precluded from the prohibition contained in § 903(1) that bars the enactment of local relief legislation. Franklin California Tax-Free Trust, Oppenheimer Rochester Fund Municipals andargued among other things, that Congress’ intent was to barstates from enacting local equivalents to chapter 9 and that Puerto Rico and the District of Columbia be (i) that the Court erred by holding that the Recovery Act is preempted by Chapter 9 of the Bankruptcy Code even though that provision does not apply to Puerto Rico; and (ii) that the Court erred by proceeding to address claims based on the contract and takings clause, after holding that the Recovery Act is preempted. The central question on appeal was whether Chapter 9 of the Bankruptcy Code, which by its terms does not apply to Puerto Rico, preempts local laws that attempt to restructure the debts of Puerto Rico’s public corporations, agencies, and instrumentalities.2 In their opposition, BlueMountain appellees, Capital Management LLC (the “Appellees”), ineligible for protection under such chapter. Thus, the Appellees argued that the District Court followed Congress’ mandate and the U. S. Court of Appeals for the First Circuit should do the same.

The Appellate Court disagreed with the Commonwealth’s contention, and echoed the Appellees’ policy concerns in its ruling. The legal basis for the decision is that the Recovery Act is preempted by section 903(1) of the Bankruptcy Code. The court’s ruling relied heavily on the post-1984 definition of “state”. The Appellate Court explained that the definition is intended only to exclude Puerto Rico from defining a municipal debtor for purposes of claiming protection under Chapter 9, and not from the prohibitions of section 903(1). The court stated that “[i]f Congress had wanted to exclude Puerto Rico from § 903(1), it would have done so directly without relying on the creativity of the parties arguing before the courts.”3 The Appellate Court also stated that although Congress changed the definition of “state” in 1984, it did not, by its text or history, change the applicability of § 903(1) as to Puerto Rico.4 Therefore, since Congress intended to preempt states from enacting their own bankruptcy procedures, the Recovery Act frustrated Congress’s purpose in enacting § 903(1).5

Furthermore, the Appellate Court held that conflict preemption applied in this case “because the Recovery Act frustrated Congress’s undeniable purpose in enacting § 903(1)… [A]ll of the relevant authority shows that Congress quite plainly wanted a single federal law to be the sole source of authority if municipal bondholders were to have their rights altered without their consent.”6 Moreover, Appellate Court affirmed that Congress is not constrained “in addressing Puerto Rican municipal insolvency owing to Puerto Rico’s different constitutional status,” as it was constrained in creating Chapter 9 relief due to the applicability to states of the Tenth Amendment of the U.S. Constitution.7 Therefore, the Appellate Court concluded that “Congress has retained for itself the authority to decide which solution best navigates the gauntlet in Puerto Rico’s case.”8

Former Chief Judge Sandra Lynch, who was born in Illinois and educated in Boston, wrote the opinion of a panel of First Circuit that also included recently-appointed Chief Judge Jeffrey R. Howard and Puerto Rico native, also former Chief Judge, Juan R. Torruella. Interestingly, Judge Torruella concurred in the judgment but wrote separately to express his views on the validity of the 1984 amendment to the Bankruptcy Code. Judge Torruella said in his opinion that the 1984 amendments to the Code are invalid because they violate the uniformity requirement of the Constitution by treating Puerto Rico’s creditors differently than any other creditors in the United States. Additionally, he opined that the 1984 amendments failed to meet the rational basis standard of review, the most lenient standard of review, which requires that government action be rationally related to a legitimate government interest.9 In addition, he also made strong expressions regarding the court’s alleged discriminatory treatment towards Puerto Rico as a result of its political status.10

This ruling starts another chapter on the Commonwealth’s fiscal crisis and represents another hurdle in the Commonwealth’s move towards restructuring its debt. We will continue to monitor these developments and keep our clients informed of any issues arising in relation thereto.

If you have any questions or comments about the above-mentioned decision, the local and federal statutes and policies involved, and/or wish to obtain more information related thereto, please contact any of the following attorneys from Ferraiuoli’s Bankruptcy Law Practice Group.

This document has been prepared for information purposes only and is not intended, and should not be relied upon, as legal advice.

1 Franklin California Tax-Free Trust, et al., v. Commonwealth of Puerto Rico, et al., Appeal No. 15-1218 (1st Cir. filedFeb. 18, 2015).
2 For background purposes, note that Puerto Rico is included in the Bankruptcy Code’s definition of a “state” for allpurposes, except for filings under the provisions of Chapter 9 thereof. Since 1984, when Congress redefined “state”to include Puerto Rico except for the purposes of defining a municipal debtor, Puerto Rico and its public companieshave been unable to seek relief under Chapter 9 of the U.S. Bankruptcy Code (the “Code”). In response, theGovernment enacted the Recovery Act as a non-federal mechanism to provide public corporations the option, amongothers, to restructure their debt.
3 Id. at 34.
4 Id. at 29.
5 Id. at 45.
6 Id. at 45.
7 Id. at 48.
8 Id. at 48-49.
9 Id. at 51.
10 Id. at 73.