U.S. District Court Holds that Puerto Rico’s Recovery Act is Unconstitutional

posted in: Municipal Bankruptcy | 0

By Mark Ellenberg, Howard Hawkins, Lary Stromfeld, Ivan Loncar, and Thomas Curtin of Cadwalader Wickersham & Taft LLP

On February 6, 2015, in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico, the U.S. District Court for the District of Puerto Rico held that the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) is expressly preempted by section 903 of the Bankruptcy Code. Section 903 of the Bankruptcy Code expressly prohibits all states, including Puerto Rico, from enacting laws that prescribe a “method of composition” that discharges debts. The Recovery Act, which was loosely based on chapter 9 of the Bankruptcy Code, would have permitted Puerto Rico’s power authority (PREPA), highway authority (HTA) and water authority (PRASA) to adjust their debts without the consent of all creditors. The court concluded that this scheme ran afoul of section 903, even though municipal entities in Puerto Rico are expressly excluded from the coverage of Chapter 9. The decision is among the first to explicitly hold that section 903 expressly preempts the states, including Puerto Rico, from enacting any debt adjustment scheme that results in the discharge of indebtedness, even if the affected entities have no remedy under the Bankruptcy Code. The court also denied the Commonwealth’s motion to dismiss the plaintiffs’ claims under the Contracts Clause and certain of the plaintiffs’ claims under the Takings Clause.

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Puerto Rico Public Corporation Debt Enforcement and Recovery Act

posted in: Municipal Bankruptcy | 0

Puerto Rico is facing the most critical fiscal situation in its history. Its public corporations are especially compromised, overwhelmed by growing deficits and unsustainable debt loads but barred from reorganizing under federal law. Last June, Puerto Rico enacted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act, which allows eligible public corporations to restructure their debt burdens.

The Recovery Act is likely preempted by federal bankruptcy law. Although the Recovery Act was justified as a valid exercise of the Commonwealth’s police power, the statute is likely unconstitutional under the Supremacy Clause. Where state law conflicts with federal law — as does the Recovery Act with section 903 of the Bankruptcy Code — the state law is preempted. On February 6, 2015 Judge Francisco Besosa of the U.S. District Court for the District of Puerto Rico held this was the case in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico and Blue Mountain Capital Management v. Governor Alejandro Garcia-Padilla.

Yet despite the Recovery Act’s probable constitutional infirmity, the threat of potential public corporation default nonetheless exerted sufficient pressure to motivate temporary consensual relief. In choosing this approach, Puerto Rico risks weakening outside investor interest in future securities offerings. But perhaps such high-stakes federalism will prompt Congress to reconsider the basis for and desirability of Puerto Rico’s idiosyncratic treatment under Chapter 9 of the Bankruptcy Code, and elsewhere in federal law.

This article was published in the Harvard Law Review, February 2015. To read the full article, click here.

This post comes from Robert Niles (J.D./M.B.A. ’16), a member of the Bankruptcy Roundtable team

The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy

By Charles J. Tabb, University of Illinois College of Law

2005-tabb The received wisdom in bankruptcy jurisprudence is that the Fifth Amendment Takings Clause independently limits the exercise of the bankruptcy power under the Bankruptcy Clause. Accordingly, secured creditors in bankruptcy are assumed to enjoy a constitutional right to receive the full value of their collateral in the bankruptcy case.

The thesis of this article is that the received wisdom is wrong. Professor Tabb argues that the Takings Clause of the Fifth Amendment does not and should not constrain the powers of Congress to modify the substantive rights of secured creditors under the Bankruptcy Clause. Instead, the only meaningful limits on the modification of substantive rights of stakeholders pursuant to the bankruptcy power are those that inhere in the Bankruptcy Clause itself.

The Bankruptcy Clause has only two limitations, both of which are extremely easy to satisfy regarding the treatment of secured creditors: that the law be “uniform,” and “on the subject of bankruptcies.”

The article first explains why it matters whether we continue to subscribe to the received wisdom that the Takings Clause limits what can be done to secured creditors in bankruptcy. Then it examines in considerable detail the historical evolution of bankruptcy jurisprudence in this area. Finally, the article assesses how we might best strike a prudential and meaningful constitutional balance.

To read the full article, click here.

ISDA Resolution Stay Protocol: A Brief Overview

On November 12, 2014, the International Swaps and Derivatives Association (“ISDA”) officially released the ISDA 2014 Resolution Stay Protocol (the “Protocol”), a mechanism that contractually imposes a stay on certain default rights in ISDA contracts between adhering parties during the resolution of a significantly important financial institution (SIFI) counterparty or one of its affiliates.

The first section of the Protocol—addressing default rights under Special Resolution Regimes (“SRRs”) (e.g., the U.S.’s OLA and FDIA)—is relatively uncontroversial. It merely ensures that adhering cross-border counterparties will be bound by the preexisting stay provisions of a foreign SRR, even if the jurisdictional limitations of the SRR would normally exempt such cross-border counterparties. This section went into affect for the 18 adhering banks on January 1, 2015.

The second section of the Protocol—addressing default rights under the U.S. Bankruptcy Code—has been met with significantly more contention. This section confines, to a limited extent, the use of currently existing “safe harbors” in the Code, by contractually limiting certain cross-default rights in ISDA contracts in the case of a counterparty’s affiliate’s bankruptcy, so that the affiliate is not also forced into bankruptcy, where close-out rights are safe-harbored. Significantly, this section will not go into effect until further regulations are promulgated by the Federal Reserve and other U.S. regulators. The concept behind the Protocol’s second section is that a failure of one part of a SIFI should not necessarily lead to defaults and close-outs of derivatives and repos sitting in affiliates of the SIFI, if the affiliate is still performing on its obligations.

The HLS Bankruptcy Roundtable has focused on the Code’s safe harbors previously. Click here for an analysis of the effect of the safe harbors on systemic risk; click here for an argument for narrowing the safe harbors for repos.

Congress is also currently considering the issue of the safe harbors in the case of a SIFI failure. Click here and here for previous coverage of currently pending legislation, the Financial Institution Bankruptcy Act, which would impose a short stay on financial contracts in the case of a SIFI resolution under the Bankruptcy Code.

For a full discussion of the Protocol, please see Mayer Brown’s Legal Update, here.

(This post was drafted by Stephanie Massman, J.D. ’15.)

Fixing the Trust Indenture Act to Allow Restructuring Votes

posted in: Workouts and Pre-Packs | 0

By Mark J. Roe, Harvard Law School

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The Trust Indenture Act of 1939 bars binding bondholder votes on core payment terms. The inability of deal proponents to get a binding vote can lead the debtor to file for an otherwise unnecessary bankruptcy. To get a deal done when there are economically-important holdouts, deal proponents often seek exit consents to induce enough holdout bondholders to reluctantly tender into a deal they don’t otherwise like, by stripping the bond indenture of those covenants on which bondholders can vote.
Exit consent transactions have generally been upheld, despite that in analogous corporate settings such distortions induce doctrinal and deal structure issues. Recent decisions indicate that exit consents that oust the bondholders from an effective individual choice ran afoul of the Trust Indenture Act, which may well have been the intent of the 1930’s drafters of the law.
Regardless, the anti-voting provision is anachronistic. It was passed when bankruptcy law did not respect bondholder votes without a judge’s substantive approval of the deal, but the Code was updated in 1978 to allow binding votes. Bondholders should also be free to agree in advance to a binding vote in an out-of-court workout. More restructurings will succeed and avoid bankruptcy. And proponents will have less reason to resort to arm-twisting with exit consents. Similar individualized consent difficulties and holdout issues have hobbled sovereign debt restructurings, with sovereign debt issues moving in recent years to include majority vote provisions.
For my analysis of the incentives and structure of bond restructurings in light of the TIA, see 97 Yale L.J. 232 (1987).

SDNY Issues Novel Opinion Holding that Out-of-Court Restructurings May Violate Noteholder Rights Under the Trust Indenture Act

posted in: Workouts and Pre-Packs | 0

By Alan F. Denenberg, Joseph A. Hall, Michael Kaplan, Jeffrey M. Oakes, Richard D. Truesdell, Jr., and Sarah Ashfaq of Davis Polk & Wardwell LLP

Companies have long relied upon out-of-court restructurings to keep them afloat during times of financial distress. In Marblegate Asset Management v. Education Management Corp. (S.D.N.Y. 2014), the Southern District of New York found that a proposed out-of-court restructuring, objected to byminority creditors, likely violated provisions of the Trust Indenture Act of 1939 (TIA), a Depression-era federal statute intended to protect rights to payment under a TIA-qualified indenture, which governs debt securities offered in any U.S. public offering. Unlike earlier TIA cases, a critical element of the proposed restructuring in Marblegate was explicitly permitted by the governing indenture, and no consent of the objecting creditors was required by the indenture. Nonetheless, the Court read the TIA to give creditors a substantive right to protection against out-of-court restructurings that they did not consent to on an individual basis, although it ultimately did not grant the plaintiffs’ motion for a preliminary injunction. But the potential for a minority creditor to obstruct a company’s ability to restructure, especially in light of indenture provisions the creditor knowingly accepted at the time it purchased its securities, could have serious consequences. While the debtor company’s actions in Marblegate were certainly aggressive, the Court’s view, if adopted by other courts, could have the potential to create an overriding ability for any creditor to block a restructuring — even when permitted by the indenture — directly leading to more court-administered bankruptcies. If followed to that conclusion, the opinion would be a potentially material and unwelcome change to the legal landscape.

To read more, click here.