Puerto Rico’s history may hold answer to $70bn debt conundrum

The island’s longstanding Civil Code may encourage collective co-operation in $70bn debt battle

High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/0/3759f79e-0078-11e6-99cb-83242733f755.html#ixzz45bujIvf8 T he US Congress has told Puerto Rico that the price of obtaining some relief from the island’s colossal debt is a near total surrender of fiscal sovereignty. Before paying that price, Puerto Rico should explore other options.

The US Congress has told Puerto Rico that the price of obtaining some relief from the island’s colossal debt is a near total surrender of fiscal sovereignty. Before paying that price, Puerto Rico should explore other options.

Puerto Rico owes more than $70bn to bondholders, and no one thinks it can grow its way out of trouble. Many believe that a solution requires Congress to pass legislation creating a debt restructuring mechanism for the island. But Congress is acting slowly, and many in Puerto Rico are sceptical of current legislative proposals.

One reason for scepticism is that Congress wants to condition relief on intrusive federal oversight; the island only gets help if it cedes its right to democratic governance. No government would welcome that trade or expect its citizens to approve — just ask Greece.
That’s especially true here, for Puerto Ricans already lack meaningful rights to participate in US democratic politics. Complicating matters further, some of its creditors have influence in Congress and are working to deny Puerto Rico the right to bind dissenting creditors to a majority-approved restructuring plan. (This is a standard feature of bankruptcy law.)
But is there a way for the Commonwealth to restructure its debt without the blessing of Congress? We posed this question in a class we taught at the University of North Carolina and Duke. The most intriguing student proposals addressed two key uncertainties underlying the debt crisis: the apparent super-priority of some creditors, and the matter of constraining potential holdout creditors.
Much of Puerto Rico’s debt is owed by its municipalities (including public utilities), and the Commonwealth has focused its attention on these borrowers.
However, a significant part of the island’s debt — roughly $17bn — is owed by the Commonwealth itself. So far, it has made little effort to restructure this debt, ostensibly because the island’s constitution gives these creditors priority. In theory, they must be paid even before citizens receive basic services.
We say “in theory” because readers should recognise that such a promise has little meaning in times of crisis. If the Governor of Puerto Rico had to choose whether to use tax revenues to keep the electricity running in hospitals or to enrich a hedge fund manager in Connecticut, what do you think would happen?

What if Puerto Rico amended its constitution to remove the priority extended to certain of its creditors? Though seemingly lawless, and certainly more difficult than other kinds of legal change, such a move would be unsurprising in a time of crisis. Those who think constitutional protections ensure repayment of public debt might want to revisit the treatment of US debt during the Depression.
Investors would likely cry foul, perhaps insisting that such a change would violate the US Constitution. But most Puerto Rican bonds contain no explicit promise of priority and are governed by Puerto Rican law. Sophisticated creditors understand that the borrower may change its law in a crisis.
Those who do not want to assume that risk write explicit protections into the contract and insist that another jurisdiction’s law govern the debt. Indeed, Puerto Rico’s last bond issue, in 2014, contained precisely these protections.
Once the constitutional priority is changed so that bond investors no longer outrank citizens — that is, once legal priority matches the actual priority that any democratically elected government would follow in a time of crisis — it is not clear why Puerto Rico would treat this debt as immune from restructuring.
It could do something akin to what Greece did in 2012, enacting legislation making debt relief approved by a majority of creditors binding on all. Again, some creditors would object, perhaps alleging a violation of the US Constitution.
But in an economic emergency, a narrowly-tailored law allowing creditors to collectively respond to debt crisis should pass constitutional muster. Indeed, Puerto Rico has long had such a law. Because of this, litigious investors may find their constitutional claims weaker than they suppose.
Most discussions of Puerto Rico’s debt invoke the Contracts Clause of the US Constitution, which prevents states (and, most assume, Puerto Rico) from retroactively impairing contracts.
But Puerto Rico may not need to act retroactively. As several of our students discovered, Commonwealth law, like that of other civil law jurisdictions, recognises that creditors in a debt crisis must act collectively. This includes the duty to co-operate in negotiating a workout when a debtor cannot pay.
For instance, some of our students discovered a longstanding provision of Puerto Rico’s Civil Code, §5178, which envisions a judicially-supervised restructuring vote that binds all creditors if a majority approve.
Other provisions, like §3105, recognise that creditors sometimes have a duty not to enforce debt in ways that prejudice other creditors.
Whether or not these sections apply directly to Commonwealth debt, they imply that Puerto Rican law has long recognised the need for collectively-binding restructuring outcomes and that creditors have some obligation to maximise joint welfare rather than seeking the best possible outcome for themselves.
If individual creditors can’t line their pockets with funds made available by others’ sacrifices, this diminishes their incentives to hold out from a restructuring. Protection against holdouts is one of the most important aspects of any restructuring mechanism, yet many in Congress seem hesitant to grant Puerto Rico this key aspect of bankruptcy protection.
But maybe, just maybe, Puerto Rico need not wait for Congress to act. At the very least, the Commonwealth may have options that do not require it to give up democratic self-governance in exchange for flawed Congressional relief.
Mitu Gulati and Mark Weidemaier are on the law faculties at Duke University and the University of North Carolina, respectively

Mitu Gulati & Mark Weidemaier

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