Puerto Rico Bankruptcy Clash Hits Pivotal Point at Supreme Court

(Bloomberg) -- The U.S. Supreme Court is poised to consider a challenge to the oversight board responsible for pulling Puerto Rico out of its record bankruptcy, hearing a case that could mean a new phase of uncertainty for an island still recovering from a devastating 2017 hurricane.

The high court will hear arguments Tuesday from bondholders who say the seven members of the Financial Oversight and Management Board were appointed in violation of the Constitution because they weren’t confirmed by the U.S. Senate. The bondholders, led by Aurelius Investment LLC, are seeking to unravel much of the board’s work and eventually get more for their stakes than the oversight panel is offering.

The argument takes place less than three weeks after the board filed its plan with a federal bankruptcy court for restructuring $35 billion in debt and other liabilities. The proposal would cut that sum, which includes $17.8 billion in commonwealth-guaranteed debt, by 65% to $12 billion. It would also address a pension system that owes current and future retirees $50 billion.

The case offers the Supreme Court a menu of possible outcomes, ranging from a full victory for the oversight board to a ruling that voids the appointments and throws out at least some of the work the board has done over the past two-plus years.

In between is an approach adopted by an federal appeals court in February. That court said the board members were unconstitutionally appointed, but it refused to apply the decision retroactively or toss out any of the five bankruptcy cases the board filed starting in May 2017.

Hurricane Aftermath

“I think there is some sympathy for not undoing everything,” said James Spiotto, managing director of Chapman Strategic Advisers and an expert on municipal bankruptcies. “To say after almost three years that all this is for naught and you just wipe it out like it didn’t happen, that’s a form of sort of judicial amnesia that I don’t think can easily be done, but that is a possible consequence.”

Puerto Rico is still coping with the aftermath of Hurricane Maria, which slammed into the island in September 2017, destroying its electrical grid and killing thousands of people.

Puerto Rico Bankruptcy Clash Hits Pivotal Point at Supreme Court

Resolving the commonwealth’s bankruptcy and debt load could help clear the way for more investment and economic growth. Puerto Rico’s economy grew in the fiscal year that ended June 30 with the help of federal disaster aid money after more than a decade of economic contraction.

Congress created the board in 2016 as part of federal legislation aimed at solving Puerto Rico’s debt crisis. President Barack Obama selected the members, three Democrats and four Republicans, from a list provided by congressional leaders of both parties.

Aurelius says that process violated the Constitution’s appointments clause, which requires Senate confirmation for “officers of the United States.”

The board and the Trump administration say a different part of the Constitution, the one governing U.S. territories, overrides the appointments clause when it comes to Puerto Rico. They also contend that the board members don’t qualify as “officers of the United States” because their authority covers only local matters.

The appeals court agreed with Aurelius on that issue but undercut the impact by saying the ruling wouldn’t apply retroactively. The panel pointed to a legal principle known as the “de facto officer doctrine,” under which courts won’t nullify actions taken in good faith by someone whose appointment is later declared invalid.

“We fear that awarding to appellants the full extent of their requested relief will have negative consequences for the many, if not thousands, of innocent third parties who have relied on the board’s actions until now,” Judge Juan Torruella wrote for the Boston-based court.

Aurelius is asking the Supreme Court to reject that reasoning and order dismissal of two of the bankruptcy cases, including the one centering on debt directly owned by the commonwealth. The bondholders say the de facto officer doctrine doesn’t apply to constitutional violations.

“Such violations demand a meaningful remedy for the aggrieved party,” the bondholders argued.

Decision Delay Sought

The board said the appeals court was right to apply the doctrine and avoid the “severe disruption” of tossing out the bankruptcy cases. Such a move could send creditors racing to the courthouse to collect their debts and ultimately add months of delay to the process.

The Trump administration said dismissal of the bankruptcy cases after more than two years of work “would have dire practical consequences.”

Aurelius called those predictions overblown. The bondholders say that, should the high court side with them, it should grant a delay to provide time for a new board to be appointed and decide how to proceed.

The oversight board manages the island’s finances and its bankruptcy process. The board helped craft and approved a deal that restructured $17.6 billion of sales-tax debt and another agreement that reduced Government Development Bank debt. Terms for all seven board members expired at the end of August, although the entire panel continues to serve, as is allowed under law.

Aurelius Capital Management, which oversees Aurelius Investments, held about $360 million of Puerto Rico general obligations as of March 6, according to court documents. The firm has a history of litigating to achieve better recoveries. It was among a band of holdout investors who refused to accept a plan to resolve Argentina’s debt crisis, in a battle that lasted 15 years.

The board’s appointment process is also being challenged by a labor union that represents employees of the government-owned Puerto Rico Electric Power Authority.

The Supreme Court has put the case on a fast track, something that was urged by both sides. That could mean a ruling by late this year or early next year. The court’s term runs through late June or early July.

The lead case is Financial Oversight and Management Board v. Aurelius, 18-1334.

©2019 Bloomberg L.P.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.