MYTH vs FACT:  Why Applying Chapter 9 to Pre-existing Debt is Constitutional and Fair

MYTH:  Retroactively applying Chapter 9 to pre-existing debt is unconstitutional and unfair.

FACT:  Applying Chapter 9 to pre-existing debt is constitutional as a legal matter and fair as a policy matter, and making Chapter 9 prospective-only would not only gut the bill, but would also be unworkable as a practical matter.

Ken Klee is a professor of law at UCLA.  He is considered by many to be the “dean of the bankruptcy bar.”  He was also the Republican staffer who was largely responsible for writing the 1978 Bankruptcy Reform Act, which codified Chapter 9.  He is a strong proponent of HR 870 and submitted written testimony to the Judiciary Committee in his personal capacity (read the testimony).

In his testimony, Professor Klee directly addressed the “retroactivity” issue:

• “Critics might question the constitutionality of retroactive relief. The arguments should fail for many reasons.First, at least since the 1978 Bankruptcy Code enacted chapter 9, Congress has had the power to authorize the filing of a chapter 9 petition for Puerto Rican municipalities. All debts, claims, and liens created on or after October 1, 1979 have always been subject to modification in such event.  All H.R. 870 does is change the body politic that authorizes the municipality to file, not the substance of the applicable bankruptcy law.

• Second, ever since the Supreme Court decided the Bekins case in 1938, there has been no constitutional impediment to the modification of unsecured debts or other contractual rights in chapter 9. The Contracts Clause of the United States Constitution binds only the States, not Congress, and the Supreme Court has made clear that a State’s authorization of its municipalities to file chapter 9 does not transgress the Contracts Clause.

• Third, retroactive application of chapter 9 does not violate the Fifth Amendment as a matter of either due process or takings.Chapter 9 provides sufficient safeguards for a secured creditor’s rights, both in the form of the fair and equitable test and the general best interests of creditors test. To the extent there is any taking, it is justly compensated by giving the secured creditor deferred payments of a present value at least equal to the value of its collateral; there is no constitutional claim of the secured creditor to more than that. As the Court has so aptly observed, “Property rights do not gain any absolute inviolability in the bankruptcy court because created and protected by state law. Most property rights are so created and protected. But if Congress is acting within its bankruptcy power, it may authorize the bankruptcy court to affect these property rights, provided the limits of the due process clause are observed.”

John Pottow is a professor of law at Michigan.  He testified at the hearing in support of HR 870 (read the testimony).

In his testimony, he also directly addressed the “retroactivity” issue:

• “Given my support for HR 870, Members of the Committee may want to know if I perceive infirmities in its drafting.  I do not.  It is cleanly drafted.  Short and sweet, it gets into the exclusion of Puerto Rico from the definition of State, puts it back in, and then ends.  Best of all, the bill contains a clause making explicit the intent to apply to debts incurred prior to its enactment.  This is a good thing.  The point of bankruptcy law is to provide comprehensive, final resolution of general financial default.  Allowing some debts (future debts), but not others (pre-existing debts), to be resolved is pointless.  There is no such thing (or, more precisely, no such useful thing) as a ‘half-restructuring.’”

• “Some might worry that HR 870 applying ‘retroactively to pre-existing debts is somehow unfair or even unconstitutional to the holders of that debt.  This concern is mistaken.  The Nation has had numerous bankruptcy laws throughout its history  . . . .  Those laws generally applied to pre-existing debt when enacted, and the Supreme Court confirmed the permissibility of Congress exercising its power under the Bankruptcy Clause in this manner.  This of course makes sense, because Congress has authority under the Constitution’s Bankruptcy Clause to adjust debts, putting all on notice that their contractual rights are always subject to adjustment by the Congress should a debtor ever avail itself of bankruptcy relief.  (The Constitution’s Contract Clause does not apply to the federal government.)”  [Professor Pottow then goes on to make the same point as Professor Klee regarding the Taking Clause]

Chapter 9 simply empowers state governments to authorize their insolvent municipalities to adjust their debts.  Every state has this power.  Only about half of the states currently authorize their municipalities to file.  The other half currently do not, but those states could provide that authorization for its municipalities at any point in the future and apply it to pre-existing municipal debt (again, otherwise Chapter 9 would be pointless).

• So, let’s take the example of a state that does not currently authorize Chapter 9 filings by its municipalities—Georgia.  If a bondholder purchases Atlanta bonds right now, Atlanta does not currently have the option to file Chapter 9 if it becomes insolvent.  But, if Atlanta encounters financial difficulties, the Georgia legislature can authorize Atlanta to file Chapter 9, and Chapter 9 can and would apply to pre-existing Atlanta debt.  Likewise, a bondholder who purchases a Puerto Rico municipal bond knows only that Chapter 9 does not currently apply.  Likewise, a bondholder who purchases a Puerto Rico municipal bond knows only that Chapter 9 does not currently apply. Congress maintains the authority to extend Chapter 9 to Puerto Rico, and bondholders were never given a guarantee that it would not act to do so should the circumstances permit.

• If a PR municipal bondholder had an expectation that the governing legal regime applying at the time he/she purchased the bond was set in stone, that expectation is completely unreasonable.  The governing legal regime changes all the time, and bondholders—certainly sophisticated ones like the opponents of HR 870—know this and have internalized it.  For example, municipal bonds are exempt from federal taxes.  And that is a major reason investors like municipal bonds.  But every investor who buys municipal bonds knows that Congress, at any point, could decide to repeal the federal tax exemption and that the municipal bonds owned by investors would no longer be tax-exempt.  The Puerto Rico case is no different, and so we respectfully submit that the argument that HR 870 is unfair or violates a contractual obligation owed to investorsin PR’s municipal bonds is both wrong and disingenuous.

• As a practical matter, making the bill prospective-only would be unworkable.  Bond terms can last 10, 20, 30 years, and they are traded on a regular basis in the market, changing hands between investors.  How would making it prospective-only work?  Assume HR 870 became law on July 1, 2015.  Would the rule be that any PR municipal bond purchased before that date, whether in 1990 or on June 30, 2015, would not be subject to adjustment in a Chapter 9 proceeding, but any bond purchased after that date would be subject to adjustment?  What if an investor who bought the PR municipal bond in 2008 (before the date of enactment of HR 870) sells it to a new investor in 2016 (after the date of enactment)?  Does the bond now convert from non-adjustable to adjustable?  As Professor Pottow writes:  “Allowing some debts (future debts), but not others (pre-existing debts), to be resolved is pointless.”  In the real world, it is also infeasible.

Applying Chapter 9 to pre-existing debt is constitutional and fair, and according to market experts, making the bill prospective-only would be virtually impossible as a real-world matter, given the way the bond market functions.

• On February 26, 2015, the Subcommittee on Regulatory Reform, Commercial and Antitrust Law of the House Judiciary Committee held a hearing on HR 870 (click here for more information). Four witnesses testified—three in favor, one in opposition.  The opposition witness was Thomas Mayer, a partner at Kramer Levin Naftalis & Frankel LLP, who testified in his capacity as counsel to funds managed by Franklin Municipal Bond Group and OppenheimerFunds, Inc., who own about $1.6 billion worth of bonds issued by the Puerto Rico Electric Power Authority, or “PREPA.”

• It is critical to note that Mr. Mayer did NOT make any distinction between retroactive and prospective application (read the testimony). For example, he did not argue that prospective application would be fair, while retroactive application would be unfair.  In fact, he said:  “Franklin and Oppenheimer would not oppose the application of Chapter 9 to Puerto Rico if Congress made Chapter 9 a fairer statute, which would take only a few changes.”  This is a critical and damaging admission.  Mr. Mayer testified that Chapter 9, which has been available to every state for many decades, should not be available to Puerto Rico because it is not “fair” in its current form.  In other words, the statute that applies to everyone else (the law of the land) should not apply to the US territory of PR because Franklin and Oppenheimer do not like that statute.