Chapter 9 for Puerto Rico:  Momentum and Myths

While the U.S. Treasury Department and the administration of Gov. Alejandro Garcia Padilla are actively engaged in conversations over possible federal administrative reforms to improve Puerto Rico’s fiscal situation, momentum has similarly increased on Capitol Hill to push forward legislative solutions.

On September 30, 2015, the Senate’s third-ranking Democrat and future Democratic leader, Sen. Chuck Schumer (D-NY) sent a letter to Senate Judiciary Committee Chairman Charles Grassley (R-IA) along with eleven of his Democratic colleagues  calling for a congressional hearing on S. 1774, the Puerto Rico Chapter 9 Uniformity Act, to consider the extension of chapter 9 bankruptcy protection to Puerto Rico’s municipalities and public corporations.

The senators emphasize that “Puerto Rico is in the midst of a severe financial crisis, which has the potential to become a humanitarian disaster” that “also threatens the U.S. economy at large.”  The senators further describe the legislative anomaly that occurred in 1984 when Congress excluded Puerto Rico’s municipalities from filing for relief under chapter 9 and note that the statutory remedy—S.1774, the Puerto Rico Chapter 9 Uniformity Act—would provide an efficient and fair path to recovery for Puerto Rico and, ultimately, American taxpayers.

As “[b]ankruptcy issues are squarely within the jurisdiction of the Senate Judiciary Committee,” the senators urge Senator Grassley to “protect [the committee’s] jurisdiction and provide a forum for a hearing about the bankruptcy implications of the Puerto Rican debt crisis, and in particular S.1774.”  Democratic Leader Harry Reid of Nevada has also indicated his support for S.1774.

The Democratic senators’ public support for S.1774 comes at the same time as Resident Commissioner Pedro Pierluisi announced that he had added more than a dozen prominent Democratic co-sponsors to H.R. 870, his legislation to open chapter 9 of the Bankruptcy Code to Puerto Rico.

In February 2015 when Pierluisi proposed H.R. 870, he made a tactical decision not to add co-sponsors in order to avoid the suggestion that the proposal—and the relief it would facilitate—was partisan in nature.  Nevertheless, both H.R. 870 and S.1774 quickly became mired in politics, and the party lines effectively were cemented after Senator Schumer endorsed H.R. 870 and introduced S.1774 with Senator Richard Blumenthal (D-CT).

The partisan divide found on Capitol Hill, however, does not extend to Repbulican thought leaders and bankruptcy legal experts, who argue that:

• Chapter 9 is not a bailout.

A “bailout” is when taxpayer funds are used to satisfy the claims of creditors of an insolvent institution.  Instead, chapter 9 would enable Puerto Rico’s municipalities and public corporations to reduce those same creditors’ claims, facilitate a comprehensive resolution of a significant portion of Puerto Rico’s debt and avoid the possibility of a real bailout.  It has been suggested that Congress would indeed spend the money rather than let PREPA, provider of the island’s electric supply, “go dark” due to its debts.

On the other hand, extending chapter 9 to Puerto Rico would not cost the federal government a dime.  As explained by Ike Brannon, a former a U.S. Treasury official and now a Growth Fellow of the George W. Bush Institute, “The notion that it would cost the federal government money if Puerto Rico’s municipal corporations were permitted to restructure their debts under Chapter 9 woefully misconstrues both Puerto Rico’s current situation as well as how a Chapter 9 proceeding actually works.”  He rejects the idea that chapter 9 is incompatible with fiscal conservatism, writing, “There is no reason to think that an orderly restructuring would cost the federal government any money: The reality is that the longer we allow the island’s debt situation to metastasize, the more likely it is that the feds will end up on the hook.”  He joins at least 90 organizations and individuals, including other conservative individuals like Gov. Jeb Bush and former Sen. Bob Dole and organizations like Americans for Tax Reform and the Council for Citizens Against Government Waste, that support extending chapter 9 to Puerto Rico’s municipalities and public corporations.

• Chapter 9 alone is not an intended panacea to fix all of Puerto Rico’s financial difficulties, but it is a critical component of recovery.

Some conservative critics of chapter 9 argue that it is useless because it does not go far enough to solve Puerto Rico’s debt crisis.  As noted by respected conservative commentator Ramesh Ponnuru, that is not a reason to refrain from extending Chapter 9 protections, it is a reason to supplement the proposed reforms.  Chapter 9 availability for municipalities would be part of a broader solution to adjust all of Puerto Rico’s indebtedness.  The solution to Puerto Rico’s troubles will be multi-faceted and will include financial, social and political measures. Innovative measures, such as Pierluisi’s proposal to enable the U.S. Treasury and the New York Federal Reserve Bank to provide low-cost financing to the Puerto Rican government, have become part of the debate.

• Chapter 9 will not make it more difficult for Puerto Rico to obtain financing in the capital markets.

In recent testimony before the Senate Finance Committee, Dr. Douglas Holtz-Eakin, President of the conservative American Action Forum, suggested that Congress should not entertain chapter 9 for Puerto Rico’s municipal corporations because it would lead to “higher borrowing costs” and make it more difficult for Puerto Rico to secure financing.

As an initial matter, Puerto Rico’s access to the financial markets is already limited.  Chapter 9 provides a recognized and predictable insolvency mechanism that is familiar to investors.  Sophisticated municipal bond investors price the risk of non-payment into their investments.  Even if existing bondholders expected U.S. bankruptcy law not to apply in Puerto Rico, they still had to factor in the risk that the borrower would not pay back the money.  As Ponnuru noted, that risk has come to pass.

Dr. Holtz-Eakin offered no evidence that the cost of capital is higher in the 50 states because their municipalities have chapter 9 available to them.  In fact, chapter 9 historically has yielded successful results for bondholders, including in cases that appeared hopeless at filing.

For example, after Detroit defaulted on its pension bonds in June 2013, it filed for chapter 9 relief.  The initial plan of adjustment proposed by the city would have provided low recoveries for many creditors.  After court-mandated negotiations, however, the city was able to settle with all of its major constituents, and many of its municipal bondholders received complete or substantial recoveries under the bankruptcy plan.  Other cases involving successful municipal bondholders include Orange County, Valley Health System of Hemet, City of Vallejo and Sierra Kings Health Care District of Reedley, California; Jefferson County, Alabama; and Central Falls, Rhode Island.

Contrary to Dr. Holtz-Eakin’s assertion that the availability of chapter 9 would lead to “perpetually higher borrowing costs” that would burden “future generations,” chapter 9 is fundamentally rehabilitative.  The U.S. Bankruptcy Code incorporates the quintessentially American concepts of encouraging entrepreneurial risk and providing a “fresh start” to entities that have failed.  Post-chapter 9, Puerto Rico’s access to the capital markets potentially would be unfettered.

Chapter 9 need not be partisan issue; it is part of a practical solution to a financial, social and political quagmire that bedevils Puerto Rico and could eventually burden U.S. taxpayers.  As explained by Brannon, “Absent some sort of restructuring under Chapter 9, Puerto Rico’s situation may keep deteriorating until a federal role—along with a potential federal bailout—becomes necessary.”  Ponnuru agrees:  “[E]xtending Chapter 9 would give Puerto Rico some relief and provide taxpayers some protection . . . Creditors, not taxpayers, should take the hit for unwise loans.”