The Global Lawyer: Puerto Rico plan creates a hurricane in the world of public debt

Few victims attract more sympathy than the pensioners of Puerto Rico, who have been serially ravaged by tropical and financial storms. The island’s restructuring plan – which boldly gives unfunded pensions priority over bondholders – will test just how much sympathy they attract after it is filed in federal court later in 2019. In different ways, the case will set a precedent for debtors as disparate as New Jersey and Venezuela.

Under the federal overseers’ $124bn plan, pensioners would at worst receive 91.5 cents on the dollar; holders of valid bonds are allotted only 64 cents on the dollar. The bond insurer Assured Guaranty vows to sue; it will argue the island’s constitution gives bondholders first claim on “all available resources”. And the Puerto Rico restructuring law, passed by Congress in 2016, overlays the basic rules of bankruptcy – presumably including absolute priority.

At the same time, the overseers will stress that this bespoke law, known as Promesa, promises “adequate funding” for public pensions. Vulnerable retirees would only impose new burdens on the public if abandoned, and places such as Detroit have set the stage for treating them kindly when the city went bankrupt.

The second audacious move telegraphed by the overseers is to let Puerto Rico off the hook for at least $6bn in bonds it issued from 2012 to 2014 in disregard of the constitutional debt ceiling. Bondholders such as Aurelius Capital – which is virtually certain to challenge this move in court – say it is absurd to let borrowers void their own loans retroactively based on a technicality. Aurelius will likely argue that Promesa incorporates the principle that a plan may not unfairly discriminate against the holders of similar bonds. The overseers will likely urge a broad equitable reading of the precept.

The implications of Puerto Rico’s plan are clear for US states that have massively underfunded pensions, such as Illinois and Connecticut. “If this works,” Puerto Rico overseer and legal scholar David Skeel has remarked, “it may make bankruptcy for states seem like something that lawmakers should be considering a little more seriously.”

The global implications are less obvious, but no less sweeping. North Carolina law professor Mark Weidemaier sees Puerto Rico’s case as part of a trend whereby government debtors question the validity of their own debt. Puerto Rico’s precedent may be especially salient when Venezuela re-enters global markets; by some lights, Venezuela has sold nearly $100bn in bonds without the needed approval of the national assembly.

“Oops, I can’t repay you because I had no right to borrow,” seems a cheeky argument. But as a policy matter, Mr Weidemaier says, it would be healthy for courts to respect such arguments by debtors such as Puerto Rico and Venezuela, in order to give meaning to self-imposed constraints on borrowing, such as debt ceilings or legislative sign-offs. “In theory, these requirements are supposed to stop governments from borrowing too much. But in a moment of crisis, borrowers have an incentive to ignore them. If the judiciary takes these constraints seriously after the fact, they might actually have their intended effect,” he says.

Meanwhile, an absurdly dense legal process must play itself out. Barring a mediation breakthrough, federal judge Laura Swain will entertain Assured Guaranty’s and Aurelius’s objections at an initial hearing in Puerto Rico capital San Juan in late 2019. Both objections will be aired at the plan confirmation hearing, and Aurelius’s may be litigated beyond, subject to appeal.

Amid all this, the US Supreme Court has already accepted a case arguing that president Donald Trump’s appointment of Puerto Rico’s oversight board violated the US Constitution for lack of Senate confirmation. Mind you, Puerto Rico restructuring has historically had bipartisan Senate support, and the Senate can always just confirm the overseers.

Billion-dollar bond crises generate endless fascinating disputes, some of them pointless. The overseers’ bold plan could throw a lifeline to hurricane-hit pensioners, and blaze new legal paths for US states as well as sovereigns in financial distress. But first, the overseers’ jobs must be saved, either by the Supreme Court or by the Senate.

Michael D Goldhaber serves as US correspondent for the International Bar Association. He has been tracking the world’s largest disputes since the turn of the millennium. Email: michael.goldhaber@gmail.com