by James Spiotto
On December 1, 2015, the United States Senate Committee on the Judiciary held a hearing on whether and how best to assist Puerto Rico and its related municipalities and public corporations now facing severe financial challenges and economic distress. On December 4, 2015 at the request of the Commonwealth of Puerto Rico, the U.S. Supreme Court granted certiorari to review the decision of the United States Court of Appeals for the First Circuit holding that Puerto Rico’s Corporation Debt Enforcement and Recovery Act (“DERA”), enacted in 2014 by Puerto Rico as a resolution mechanism to $22 billion of public corporation debt that was in distress, was unconstitutional. Both the District Court in Puerto Rico and the First Circuit had held that the Bankruptcy Clause of the U.S. Constitution preempts the right of Puerto Rico as territory and commonwealth of the United States to legislate on this topic and that Puerto Rico must adhere to the principles of the U.S. Constitution, including the Supremacy, Territorial and Bankruptcy Clauses.
Some may now argue Congress should stand down and not enact new needed legislation for Puerto Rico under the Territorial and Bankruptcy Clauses to address the Puerto Rico plight. However, the Supreme Court may well have taken the appeal, not to overturn the lower courts, but to clarify and remove any doubt that Puerto Rico cannot write its own bankruptcy laws with involuntary debt adjustment contrary to the principles of government finance and the Federal Bankruptcy Code. Further, even if the Supreme Court were to rule that DERA was not preempted, there would be lingering and continuing other issues of whether DERA is still unconstitutional since it attempts to take pledged revenues without just compensation, contradicts traditional remedies of public utility defaults (receivers and rate covenant enforcement) and purportedly will produce a result contrary to the protection of “special revenues” enacted by Congress in the 1988 Amendments to Chapter 9 of the Federal Bankruptcy Code, which is federal policy and part of the municipal market bedrock of premises.
Accordingly, the U.S. Supreme Court is not going to be and was not intended to be the deus ex machina for Puerto Rico’s version of a Greek tragedy. Every effort should now be made to encourage Congress (the Senate and House) to pass needed legislation to address Puerto Rico’s distress and avoid financial meltdown.
Congress and others, as part of this inquiry, may find instructive how other countries as sovereigns as well as States in the United States of America have addressed these problems and the alternatives and opportunities available in the form of legislation including not only authorization to file for Chapter 9, municipal bankruptcy, under Federal Bankruptcy Law 11, U.S.C. 901, et seq but also financial oversight, refinancing and recovery assistance. I was asked to submit a written statement to the Senate Judiciary Committee in connection with the December 1, 2015 hearing, which I did. That written statement addressed the need and justification for prompt action by Congress, which would fulfill its constitutional role as enactor of needed rules and regulations for Territories. The statement also suggested, from past lessons learned sovereign debt restructuring and legislation of various States, how a blend of financial oversight by a Federal Authority to help Puerto Rico help itself develop an effective recovery plan and the development of new legislation for Territories in financial distress under the uniform Bankruptcy Clause of the U.S. Constitution might provide a better alternative to impending financial meltdown and a perceived lack of viable alternatives for Puerto Rico and its local governmental entities.
Dealing with the financial distress of a government requires not merely short-term actions to reduce debt obligations, increase tax revenues and lower costs, but also the long-term reinvestment in the government, its economy and its people. As a parade of over 600 sovereign debt defaults since 1950 involving 95 countries has demonstrated, there are too many repetitive problems because of a limited focus on reducing external debt without addressing the systemic problem that caused the economic distress. We in the United States, with a few exceptions, have been blessed with our State and local governments weathering the storm of 11 economic downturns since 1950.
The missing and needed ingredient in these failed sovereign restructuring of debt is the long-term reinvestment in the government and its people to improve and expand governmental services and infrastructure and stimulate business opportunities. This creates growth of new businesses and new jobs, resulting in new taxpayers to increase tax revenues that brings about the recovery for the health, safety and welfare of citizens. Such an approach is likely in the best interests of not only the government but also its citizens and taxpayers and its creditors, including employees and retirees. It is only through a robust recovery plan that creditors, including employees and retirees, will be paid to the fullest extent possible.
As Congress considers Puerto Rico’s fiscal problems and explores possible solutions, Congress and Puerto Rico, its citizens and creditors should desire to know the answer to the following questions:
(1) What is the extent of financial distress of Puerto Rico and its municipalities and related governmental entities?
(2) Does Puerto Rico’s fiscal distress require action by Congress?
(3) Is Congress authorized to act?
(4) How can Puerto Rico’s sovereignty be respected?
(5) Is the ability to use Chapter 9 municipal debt adjustment necessary and appropriate for Puerto Rico and its municipalities and other governmental entities in dealing with their financial obligations?
(6) Has past history shown there are better alternatives for governmental financial recovery and debt resolution mechanisms?
Need for Congressional Action Now
The financial challenges, loss of business and jobs resulting in many not being meaningfully employed, the need for economic stimulus and business development, the demands for social programs and governmental services, the level of poverty and financial strain on programs to address human distress have been well documented by Puerto Rico, its community leaders, its creditors and the financial markets. Puerto Rico has over 45% of its residents living at or below poverty level, it has lost over 250,000 jobs since 2006, labor force participation in Puerto Rico is at 39.7% compared to average of 62.4% in the states, and, most distressing 58% of its children (its future) are living below the federal poverty level. There should be no debate over whether assistance is needed now, only by whom and what form the assistance will take need to be answered. Congress, under the Territorial and Bankruptcy Clauses of the U.S. Constitution, has the mandate, mission and ability to provide needed rules and regulations. The federal government is the governmental parent of Puerto Rico. It is a Commonwealth and still a territory and therefore the federal government is not a mere spectator but an interested party with the ability to effect and play a role in the solution.
Chapter 9 is Not a Universal or Desired Solution
Chapter 9 bankruptcy is a process not a solution. Chapter 9 bankruptcy is expensive, time consuming, unpredictable and seldom accomplishes the desired results. For that reason, Chapter 9 is rarely used. Only 664 Chapter 9s have been filed since 1937, of which almost two-thirds are municipal utilities and special tax districts. Use of Chapter 9 by cities, towns, villages and counties is less than 20% of the total Chapter 9 filings. There have been only a handful of large municipal Chapter 9s [Orange County (1994), Jefferson County (2011), Stockton (2012), San Bernardino (2012) and Detroit (2013)]. Chapter 9 is a difficult process, especially for larger governmental bodies and complex economies and services. Chapter 9 was drafted and intended to be used by a sub-sovereign of a State where there are established constitutional and statutory laws which are to be honored and which act as a point of reference for governmental action going forward and the legal premise of a recovery plan. Chapter 9 was not constructed for use by States as sovereigns given the Tenth Amendment and the required respect by the federal government for the States as co-sovereigns. The controls and limitations a State imposes under its laws and constitutional mandates on a municipality’s exercise of governmental powers, revenue and property cannot be interfered with or impaired by the Federal Bankruptcy Court. This has been acknowledged from the very birth of Chapter 9 in the United States Supreme Court decisions in Ashton and Bekins. Ashton v. Cameron County Water Improvement Dist. No. 1, 298 U.S. 513, 80 L. Ed. 1309, 56 S. Ct. 892 (1936), reh’g denied 299 U.S. 619, 81 L. Ed. 457, 57 S. Ct. 5 (1936); United States v. Bekins, 304 U.S. 27, 82 L. Ed. 1137, 58 S. Ct. 811 (1938), reh’g denied 304 U.S. 589, 82 L. Ed. 1549, 8 S. Ct. 1043 (1938).
Chapter 9 is Not Designed for the Commonwealth of Puerto Rico
Puerto Rico as a Commonwealth desires to be treated as a State, and some federal legislation and the definition of “State” in the Bankruptcy Code at times recognize Puerto Rico’s unique sovereignty and treatment as a “quasi state” subject to the principles of the U.S. Constitution and in particular its Supremacy and Territorial Clauses. To the extent Congress desires to treat Puerto Rico like a State, allowing it to file under Chapter 9 would create a conflict with Puerto Rico’s unique “sovereignty” and raise constitutional questions regarding its statutory laws and constitution and whether the action could be taken under the Territorial Clause or the Bankruptcy Clause.
Further, if Chapter 9 were to apply to the Commonwealth of Puerto Rico, as opposed to its municipalities, such would require a significant redraft of Chapter 9 since it was never intended to apply to an entity like a State or a “quasi state” like the Commonwealth of Puerto Rico out of respect for its autonomy subject to the principles of the U.S. Constitution. Therefore, Chapter 9 does not work for the Commonwealth of Puerto Rico. However, this does not mean Congress should not enact a uniform bankruptcy law for financially distressed Territories such as Puerto Rico.
Puerto Rico Should Be Authorized to Allows its Municipalities and Public Corporations to Use Chapter 9 as a Last Resort with a “Second Look”
Like a State, the Commonwealth should be authorized, if needed, to allow its sub-sovereign municipalities, public corporations and related governmental entities to file Chapter 9 as the absolute last resort. The stigma and cost of Chapter 9 require that any authorization for a municipality to file should be after a “second look” effort by the sovereign to ensure every effort at consensual resolution has been explored. This “second look” historically has been shown to have statistical and practical merit. Municipalities in States that require a “second look” approval by a State elected official or agency were six times less likely to use Chapter 9. Many municipalities have found the ability to use Chapter 9 as benefit without actually filing. The threatened use of Chapter 9 from its very beginning in the late 1930’s has demonstrated Chapter 9 is more effective as an “or else” threat rather than as actually used. The very existence of the availability of Chapter 9 may have a salutary effect on efforts to resolve municipal difficulties outside of a Chapter 9 proceeding. This was recognized in hearings before the United States House of Representatives Committee on the Judiciary as early as 1942. The legislative history for hearings on the extension of the Municipal Debt Composition Act reported that the passage of the Municipal Bankruptcy Act in 1934 permitted the City of Detroit to restructure its outstanding municipal debt outside of bankruptcy through a composition of creditors requiring 100% approval of affected creditors. Since 8% of bondholders were holdouts with 92% approval of creditors, the Mayor and Civic Leaders of Detroit were major supporters of municipal bankruptcy in the passage of 1930’s Chapter IX not because they were clairvoyant that in 2013 they would use it. Rather, they supported the bankruptcy option realizing that a more drastic alternative would convince the holdouts to accept the plan approved by the 92% given the alternative municipal bankruptcy treatment was perceived to be far worse.
The Need for Financial Oversight and a Recovery Plan for the Commonwealth of Puerto Rico
The inappropriateness of Chapter 9 for the Commonwealth of Puerto Rico does not mean there is nothing for the Federal Government and Congress to do to assist Puerto Rico. The Commonwealth and others have pointed out a needed review of federal law, rules, regulations and policy to ensure appropriate fairness compared to the treatment of States and others. Puerto Rico contends it has lost billions of dollars due to unequal treatment under Medicaid and Medicare for 50 years, under Supplemental Security Income (“SSI”), Earned Income Tax Credit (“EITC”) programs for over 40 years and under the Child Tax Credit (“CTC”) program for nearly 20 years. The lack of a stimulus for economic and business development in Puerto Rico following the repeal of Section 936 tax exemption for U.S. companies, the claimed disproportionate burden of Medicaid and social programs, the need for effective tax reform and efficient collection methods mandate the consideration of review and, where needed, assistance. Further, the extent and duration of the economic and financial distress of Puerto Rico and past failed efforts by it to find the appropriate solution have resulted in increasing the erosion of its financial credibility and doubt about its ability to effectively and fully address these issues without additional assistance. Many of the 600 sovereign debt restructuring in 95 countries have been band-aids and not permanent fixes. That is because they have merely addressed external debt issues and did not address the systemic problems that brought the financial crisis to a boil. The failure to address the systemic problem is fatal to successful recovery. What is needed is a detailed Recovery Plan that takes a holistic approach, which: (a) determines what is sustainable and affordable and what is not, (b) allows for development of accurate, transparent and mutually agreed-upon financial statements and projections, (c) provides appropriate funds for needed governmental services and infrastructure improvements, (d) permits, if necessary, restructuring of debt consistent with the traditions and principles of government finance (best practiced by U.S. States and local governments such as respecting special revenue pledges and constitutional and statutory liens and priorities) and (e) provides for economic stimulus and motivates business development in order to expand business and attract new business activities that create good new jobs for a high percentage of those meaningfully employed.
Benefits of Financial Oversight and Recovery Plan
It cannot seriously be disputed that Puerto Rico has over the recent years struggled to address its financial challenges and find a financially sound path forward with its governmental obligation of essential services and infrastructure, economic stimulus and business development as well as dealing with ever increasing debt and rising costs of borrowing. At the same time, one of the ugly and unfortunate facts of economic distress is that it adversely affects your financial credibility in the market so that access to needed liquidity and cost of borrowing become more expensive exactly when you least can afford the increased cost and burden.
This loss of financial credibility had led to Puerto Rico paying a yield of over 10% while most sovereigns currently are experiencing currently low bond annual yields of 2.27% for U.S.A., 1.52% for Canada, .74% for Germany and 1.03% for France (10 year bond September 2015) (compare to Puerto Rico’s recent ten year G.O. bond with a yield exceeding 10% in February 2014).
The price of a lack of financial credibility and a recovery plan to a sovereign cannot be underestimated. Just 2% more on a 20 year bullet maturity debt financing of $1 billion has a present value cost of approximately $250 million (at a 5% discount) or 25% of the original principal amount. The use of financial oversight and development of a sound recovery plan has a proven record for providing needed financial credibility to citizens and creditors alike.
Government debt restructuring and adjustment does not necessarily mean debt elimination. Of the 600 sovereign restructuring since 1950, there were 186 debt exchanges with private creditors (foreign banks and bondholders) compared to the others done through the Paris Club for bilateral debt restructuring or other resolution mechanisms for debt held by government or government related agencies. About 70% of the debt resolutions were lengthening the maturity and only 30% involved reduction of the face amount. Further, as noted, a refinancing at just 2% per annum lower interest rate on a 20 year bullet maturity debt can be a 25% present value savings of the principal amount. A sound financial oversight and Recovery Plan brings the financial credibility to be able to benefit from such refinancing or restructuring.
Such a Recovery Plan for Puerto Rico will foster financial credibility and create increased revenues due to increased business activity and new, better compensated employees and better services and infrastructure to attract and encourage business activity and a healthier, safer and more prosperous future for its citizens. This needed Recovery Plan can only be developed with financial credibility buy-in and participation by the affected governmental bodies, elected officials, citizens and taxpayers, vendors, bondholders and other creditors as well as the international markets and community. This needed financial credibility has been obtained in the past by the use of financial oversight and recovery assistance provided by a higher governmental or recognized entity. This is well demonstrated by: (a) the use of the Municipal Assistance Corporation for New York City in 1975, (b) the Pennsylvania Intergovernmental Cooperation Authority for Philadelphia in 1991, (c) the District of Columbia Financial Responsibility and Management Assistance Authority for Washington, D.C. in 1995 and (d) the use by the majority of States of various forms of financial oversight, technical assistance aimed at addressing the financial distress of their municipalities to avoid financial meltdown and Chapter 9. In the past, sovereign restructuring have used the Paris Club (for government debt), the London Club (for commercial bank debt) and the International Monetary Fund attempting to achieve the same result. The evolving diversity of financial creditors with differing investment motivations demonstrates the need for financial oversight and recovery assistance from a higher or agreed-upon supervising adult. Congress under the Bankruptcy Clause could provide that if financial oversight is not followed by consensual resolution of debt issues consistent with the recovery plan, the Oversight Authority would be transformed into a quasi judicial body to approve the recovery plan or so modify the recovery plan so that the treatment of creditors is fair and reasonable as well as sustainable and affordable, all of which can be confirmed by a Federal Court under Congress’s bankruptcy power. This could be embodied in a new restructuring and bankruptcy law for Territories enacted under the Territorial and Bankruptcy Clauses of the U.S. Constitution.
Accordingly, for the Commonwealth of Puerto Rico, Congress should consider establishing a Financial Oversight and Recovery Assistance Authority with, if necessary, expanded bankruptcy power as noted above to (a) help Puerto Rico help itself to develop the necessary Recovery Plan, (b) provide necessary oversight of financial information, operation and credibility through transparent financial statements and budgets as approved by the Authority, (c) encourage and foster buy-in and constructive participation by creditors and others through an impartial and fair process that will bring all required parties to the table and provide all the best results possible, (d) if necessary, determine what is sustainable and affordable and resolve issues with the input from all parties, with impartial and fair respect for their respective rights for the best interest of all and (e) if necessary have a Federal Court order the debt restructuring embodied in a recovery plan approved by the Authority.
The U.S. Treasury Department released, on October 21, 2015 a Joint Statement by Treasury Secretary Jacob J. Lew, National Economic Council Director Jeff Zients, and Health and Human Services Secretary Sylvia Mathews Burwell on the Obama Administration’s Legislative Proposal to Address Puerto Rico’s Urgent Fiscal Situation including an analysis of Puerto Rico’s Economic and Fiscal Crisis and Roadways for Congressional Action (“Treasury Report”) that should be helpful to Congress in its consideration of what is the appropriate legislation for Puerto Rico to help itself successfully address its financial distress. The general conclusions in the Treasury Report find support in the discussion herein and in the written statement provided to the U.S. Senate Judiciary Committee as of December 1, 2015 of the issues and the experience of past sovereign debt crises and the best practices to be followed to obtain an effective and expedited resolution that is a permanent fix and not one of the many band-aids.
Congress has recognized the need for prompt action. Senators Hatch, Murkowski and Grassley have introduced a bill on December 9, 2015 named The Puerto Rico Assistance Act of 2015. It provides temporary payroll tax cuts for residents of United States possessions (Territories) from 6.2% to 3.1%. It authorizes a study of Puerto Rico’s pension plans to ensure sustainability and transparency with tools to deal with unfunded and unsustainable pension promises. The legislation establishes the Puerto Rico Financial Responsibility and Management Assistance Authority to develop sustainable budgets and financial plans for Puerto Rico and its governmental entities including public corporations. The Authority can borrow funds but is not a “bailout vehicle” and is not backed by the full faith and credit of the United States. A Chief Financial Officer is appointed as the principal advisor to the Governor in developing a budget. The Authority will clarify information about Puerto Rico’s existing debt obligations and ability to pay but will not have any powers to adjust, modify or approve debt adjustments similar to bankruptcy powers under the Bankruptcy Clause or as recommended by the Treasury Report.
The resulting questions about this legislation include whether there is sufficient oversight, supervision, assistance and transparency with financial discipline and tools to assure sustainability and viability and to significantly improve financial credibility with creditors, financial markets and the international community. Another issue is whether creditors, bondholders, vendors and public employees will perceive this as a final resolution process so they will engage and provide their “best deal” without feeling the need to hold back or not participate because it may be just another Band-Aid and they do not want to suffer the death of a thousand bites. Should the concepts discussed above, in the Written Statement and the Treasury Report with enforceable financial oversight and recovery assistance to obtain final resolution that is sustainable and affordable be approved and ordered for the benefit of all, the need to undertake further studies for another piece of legislation or process can be avoided. The beauty of the legislative process is the benefit of exchange of ideas, discussion and debate that should demonstrate the capacity for growth and change with a resulting evolved legislation that is, as Aristotle said of “virtue” nothing in excess; not too weak and not too strong but just right to accomplish the intended mission of helping Puerto Rico help itself and achieve financial recovery.
For a more detailed analysis, please see the Written Statement of James E. Spiotto to the U.S. Senate Judiciary Committee.