First Circuit Invalidates Puerto Rico's Debt Enforcement and Recovery Act

On July 6, 2015, the Court of Appeals for the First Circuit held in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico that the federal Bankruptcy Code preempted Puerto Rico's Debt Enforcement and Recovery Act (the "Recovery Act").

Under the Bankruptcy Code, Puerto Rico's municipalities are excluded from chapter 9 relief. Consequently, in June 2014, Puerto Rico passed the Recovery Act to establish "a debt enforcement, recovery, and restructuring regime for the public corporations and other instrumentalities of the Commonwealth of Puerto Rico during an economic emergency." Certain bondholders brought suit challenging the validity of the Recovery Act and on February 6, 2015, the District Court of Puerto Rico held that the Recovery Act was preempted by the Bankruptcy Code.

The First Circuit affirmed the district court's decision because it found that the statutory and legislative history of the Bankruptcy Code indicated that Congress intended to preempt laws similar to the Recovery Act. Specifically, the First Circuit found that Congress passed section 903(1) of the Bankruptcy Code (and its predecessor, section 83(i) of the Bankruptcy Act of 1938) to establish uniform federal bankruptcy laws governing municipal adjustment of debts. Section 903(1) of the Bankruptcy Code provides that no "State" may pass any law "prescribing a method of composition of indebtedness" that binds creditors without their consent. The First Circuit held that although Puerto Rico was not a "State" for purposes of chapter 9 eligibility, Congress intended Puerto Rico to be a "State" for all other purposes of the Bankruptcy Code, including section 903(1). Consequently, the court concluded that the straightforward and plain text of section 903(1) manifested Congress' intent to override laws like the Recovery Act.

In so holding, the First Circuit rejected appellant-defendants' "creative" alternative readings of section 903(1). The appellants argued that because Puerto Rico's municipalities could not be "debtors" under chapter 9, (1) they could have no "creditors" for purposes of section 903(1), and therefore the Recovery Act did not bind "creditors" in violation of section 903(1), and (2) section 903(1), as a part of chapter 9, could not apply to an entity ineligible for chapter 9. The First Circuit found both interpretations "unsound and unsuccessful."

See: Opinion: Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico.