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

United States Court of Appeals, First Circuit

July 6, 2015

FRANKLIN CALIFORNIA TAX-FREE TRUST, et al., Plaintiffs, Appellees,


Christopher Landau, with whom Margarita Mercado-Echegaray, Solicitor General for the Commonwealth of Puerto Rico, Beth A. Williams, Michael A. Glick, Claire M. Murray, and Kirkland & Ellis LLP were on brief, for the Commonwealth of Puerto Rico, Governor Alejandro García-Padilla, and César R. Miranda-Rodríguez, appellants.

Martin J. Bienenstock, with whom John E. Roberts, Andrea G. Miller, Proskauer Rose LLP, Mark D. Harris, Sigal P. Mandelker, Philip M. Abelson, and Ehud Barak were on brief, for Melba Acosta-Febo and John Doe, appellants.

Lewis J. Liman, with whom Jorge R. Roig, Joanne A. Tomasini-Muñiz, González, Machado & Roig, LLC, Lawrence B. Friedman, Richard J. Cooper, Sean A. O'Neal, and Cleary Gottlieb Steen & Hamilton LLP were on brief, for the Puerto Rico Electric Power Authority (PREPA), amicus curiae.

Gabriel R. Avilés-Aponte and Tapia & Avilés on brief for Clayton P. Gillette and David A. Skeel, Jr., amici curiae.

Edilberto Berríos-Pérez and Berríos & Longo Law Office, P.S.C. on brief for Edilberto Berríos-Pérez, amicus curiae.

Matthew D. McGill, with whom David C. Indiano, Jeffrey M. Williams, Leticia Casalduc-Rabell, Indiano & Williams, PSC, Theodore B. Olson, Scott G. Stewart, Matthew J. Williams, and Gibson, Dunn & Crutcher LLP were on brief, for BlueMountain Capital Management, LLC, appellee.

Thomas Moers Mayer, with whom Kramer Levin Naftalis & Frankel LLP, Philip Bentley, David E. Blabey, Jr., Toro, Colón, Mullet, Rivera & Sifre, P.S.C., Manuel Fernández-Bared, and Linette Figueroa-Torres were on brief, for Franklin California Tax-Free Trust et al., appellees.

Marc E. Kasowitz, with whom Daniel R. Benson, Hon. Joseph I. Lieberman (ret.), Hon. Clarine Nardi Riddle (ret.), Andrew K. Glenn, and Kasowitz, Benson, Torres & Friedman LLP were on brief, for the Association of Financial Guaranty Insurers, amicus curiae.

Kate Comerford Todd, Steven P. Lehotsky, U.S. Chamber Litigation Center, Inc., William S. Consovoy, Thomas R. McCarthy, J. Michael Connolly, and Consovoy McCarthy PLLC on brief for the Chamber of Commerce of the United States of America, amicus curiae.

Before Howard, Chief Judge, Torruella and Lynch, Circuit Judges.


The defendants, the Commonwealth of Puerto Rico, its Governor, its Secretary of Justice, and the Government Development Bank ("GDB"), assert that Puerto Rico is facing the most serious fiscal crisis in its history, and that its public utilities risk becoming insolvent. Puerto Rico, unlike states, may not authorize its municipalities, including these utilities, to seek federal bankruptcy relief under Chapter 9 of the U.S. Bankruptcy Code. 11 U.S.C. §§ 101(40), 101(52), 109(c). In June 2014, the Commonwealth attempted to allow its utilities to restructure their debt by enacting its own municipal bankruptcy law, the Puerto Rico Public Corporation Debt Enforcement and Recovery Act ("Recovery Act"), which expressly provides different protections for creditors than does the federal Chapter 9.

Plaintiffs are investors who collectively hold nearly two billion dollars of bonds issued by one of the distressed public utilities, the Puerto Rico Electric Power Authority ("PREPA"). Fearing that a PREPA filing under the Recovery Act was imminent, they brought suit in summer 2014 to challenge the Recovery Act's validity and enjoin its implementation. The district court found in their favor and permanently enjoined the Recovery Act on the ground that it is preempted under 11 U.S.C. § 903(1). See Franklin Cal. Tax-Free Trust v. Puerto Rico, F.Supp. 3d, Nos. 14-1518, 14-1569, 2015 WL 522183, at *1, *12-18, *29 (D.P.R. Feb. 6, 2015); Franklin Cal. Tax-Free Trust v. Puerto Rico, No. 14-1518, 2015 WL 574008, at *1 (D.P.R. Feb. 10, 2015). That provision, § 903(1), ensures the uniformity of federal bankruptcy laws by prohibiting state municipal debt restructuring laws that bind creditors without their consent. 11 U.S.C. § 903(1); see S. Rep. No. 95-989, at 110 (1978).

The primary legal issue on appeal is whether § 903(1) preempts Puerto Rico's Recovery Act. That question turns on whether the definition of "State" in the federal Bankruptcy Code --as amended in 1984 -- renders § 903(1)'s preemptive effect inapplicable to Puerto Rico. Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353, sec. 421(j)(6), § 101(44), 98 Stat. 333, 368-39 (codified as amended at 11 U.S.C. § 101(52)). The post-1984 definition of "State" includes Puerto Rico, "except" for the purpose of "defining" a municipal debtor under § 109(c). 11 U.S.C. §§ 101(52), 109(c) (emphasis added). All parties agree that Puerto Rico now lacks the power it once had been granted by Congress to authorize its municipalities to file for Chapter 9 relief.

We hold that § 903(1) preempts the Recovery Act. The prohibition now codified at § 903(1) has applied to Puerto Rico since the predecessor of that section's enactment in 1946. The statute does not currently read, nor does anything about the 1984 amendment suggest, that Puerto Rico is outside the reach of § 903(1)'s prohibitions. See Cohen v. de la Cruz, 523 U.S. 213, 221 (1998) ("We . . . 'will not read the Bankruptcy Code to erode past bankruptcy practice absent a clear indication that Congress intended such a departure.'" (citation omitted)); cf. Kellogg Brown & Root Servs. Inc. v. United States ex rel. Carter, 135 S.Ct. 1970, 1977 (2015) ("Fundamental changes in the scope of a statute are not typically accomplished with so subtle a move."). Indeed, the Recovery Act would frustrate the precise purpose underlying the enactment of § 903(1). Accordingly, we affirm.

Defendants argue that this leaves Puerto Rico without relief. Although § 101(52) denies to Puerto Rico the power to authorize its municipalities to pursue federal Chapter 9 relief, Puerto Rico may turn to Congress for recourse. Indeed, Congress preserved to itself that power to authorize Puerto Rican municipalities to seek Chapter 9 relief. Puerto Rico is presently seeking authorization or other relief directly from Congress. See Puerto Rico Chapter 9 Uniformity Act of 2015, H.R. 870, 114th Cong. (2015).

I. Procedural History

Two groups of PREPA bondholders sued almost immediately following the Recovery Act's passage to prevent its enforcement. PREPA had issued their bonds pursuant to a trust agreement with the U.S. Bank National Association. The bondholders allege that the very enactment of the Recovery Act impaired these contractual obligations by abrogating certain protections that were promised in the event of default.[1] The first group, the Franklin plaintiffs, [2] filed on June 28, 2014, and cross-motioned for summary judgment on August 11, 2014. The second group, BlueMountain Capital Management, LLC ("BlueMountain"), for itself and on behalf of the funds it manages, filed on July 22, 2014. Together, the Franklin plaintiffs and BlueMountain hold nearly two billion dollars in PREPA bonds.

Both the Franklin plaintiffs and BlueMountain sought declaratory relief under 28 U.S.C. §§ 2201-02 that the Recovery Act is preempted by the federal Bankruptcy Code, violates the Contracts Clause, violates the Bankruptcy Clause, and unconstitutionally authorizes a stay of federal court proceedings. The Franklin plaintiffs (but not BlueMountain) also brought a Takings Claim under the Fifth and Fourteenth Amendments. And BlueMountain (but not the Franklin plaintiffs) brought a claim under the contracts clause of the Puerto Rico constitution. These claims were brought against the Commonwealth of Puerto Rico, Governor Alejandro García-Padilla, and various Commonwealth officials, including GDB agents.[3]The district court consolidated the cases and aligned the briefing on August 20, 2014, but did not merge the suits.

The district court issued an order and opinion in both cases on February 6, 2015, resolving the motions to dismiss and the Franklin plaintiffs' outstanding cross-motion for summary judgment. Franklin Cal. Tax-Free Trust, F.Supp. 3d, 2015 WL 522183, at *1. It entered judgment in the Franklin case on February 10, 2015. Franklin Cal. Tax-Free Trust, 2015 WL 574008, at *1. As relevant here, the district court held that the Recovery Act was preempted by federal law and permanently enjoined its enforcement. It also denied the motion to dismiss the Contracts Clause claim and one of the Franklin plaintiffs' Takings claims.[4]

The Commonwealth defendants appeal from the permanent injunction, the grant of summary judgment to the Franklin plaintiffs, and further argue that the district court erred by reaching the Contracts Clause and Takings Claims in its February 6 order.


Because the appeal presents a narrow legal issue, we summarize only those facts as are necessary. We do not address in any detail the extent of the fiscal crisis facing the Commonwealth, PREPA, or other Commonwealth entities. We begin with the considerations shaping the state-authorization requirement of § 109(c)(2), the provision that presently, in combination with § 101(52), bars Puerto Rico from authorizing its municipalities to bring claims for federal Chapter 9 relief.

A. The History of Federal Municipal Bankruptcy Relief, and the State-Authorization Requirement

Modern municipal bankruptcy relief is shaped by two features: the difficulties inherent in enforcing payment of municipal debt, and the historic understanding of constitutional limits on fashioning relief. M.W. McConnell & R.C. Picker, When Cities Go Broke: A Conceptual Introduction to Municipal Bankruptcy, 60 U. Chi. L. Rev. 425, 426-28 (1993). The difficulties arise because municipalities are government entities, and so the methods for addressing their insolvency are limited in ways that the methods for addressing individual or corporate insolvency are not.[5] Id. at 426-50; see also 11 U.S.C. § 101(40) (defining "municipality" as "political subdivision[s], " "public agenc[ies], " and other "instrumentalit[ies] of a State"). Navigating these difficulties is further complicated, for state municipalities, by a two-prong dilemma created by the Contracts Clause and the Tenth Amendment. See McConnell & Picker, 60 U. Chi. L. Rev. at 427-28.

For these reasons, municipalities remained completely outside any bankruptcy regime for much of the nation's history. See id. at 427-28. Indeed, the prevailing assumption was that the constitutional limitations precluded either level of government, state or federal, from enacting a municipal bankruptcy regime. See id. States could not provide an effective solution to the "holdout problem" presented by insolvency because doing so "would [require] impair[ing] the obligation of contracts" in violation of the Contracts Clause.[6] See id. at 426-28. Federal intervention, on the other hand, might interfere with states' rights under the Tenth Amendment in controlling their own municipalities. Id. at 427-28; see also Ashton v. Cameron Cnty. Water Improvement Dist. No. 1, 298 U.S. 513, 530-32 (1936) (striking down the first federal municipal bankruptcy law on federalism grounds).

The problems created by this absence of municipal bankruptcy relief became acute during the Great Depression. And so, in 1933, Congress enacted Chapter 9's predecessor to provide to states a mechanism for addressing municipal insolvency that they could not create themselves. See McConnell & Picker, 60 U. Chi. L. Rev. at 427-29, 450-54 (summarizing the history).

Although it had a rocky start, see, e.g., Ashton, 298 U.S. at 530-32 (invalidating the initial act), Congress eventually succeeded in avoiding a Tenth Amendment problem. It did so in part by requiring a state's consent in the federal municipal bankruptcy regime before permitting municipalities of that state to seek relief under it, and in part by emphasizing that the statute did not effect "'any restriction on the powers of the States or their arms of government in the exercise of their sovereign rights and duties.'" See, e.g., United States v. Bekins, 304 U.S. 27, 49-54 (1938) (quoting H.R. Rep. No. 75-517, at 2 (1937); S. Rep. No. 75-911, at 2 (1937)) (recognizing that this created a "cooperati[ve]" scheme); cf. McConnell & Picker, 60 U. Chi. L. Rev. at 452-53. This is the origin of the state-authorization requirement of § 109(c).[7] That provision of the Code provides that a municipality may be a debtor under Chapter 9 only if it "is specifically authorized . . . to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to [so] authorize." 11 U.S.C. § 109(c)(2).

This requirement of state consent is based on reason: a state might instead decide to bail out an ailing municipality, if its own fiscal situation permits, to avoid the negative impact that a municipal bankruptcy would have on that state's economy and other municipalities. See C.P. Gillette, Fiscal Federalism, Political Will, and Strategic Use of Municipal Bankruptcy, 79 U. Chi. L. Rev. 281, 302-08 (2012) (explaining the problem of "debt contagion"). But allowing state municipalities to bypass the state and seek federal Chapter 9 relief would undermine a state's ability to do so. See id. at 285-86. In this way, the state-authorization requirement not only addresses constitutional difficulties by making Chapter 9 a "cooperati[ve]" state-federal scheme, Bekins, 304 U.S. at 49-54, it also promotes state sovereignty by preventing municipalities from strategically seeking (or threatening to seek) federal municipal relief to "reduce the conditions that states place on a proposed bailout, " Gillette, 79 U. Chi. L. Rev. at 285-86.

B. Puerto Rico Municipalities Under the Code: 1938-1984

Puerto Rico was granted the authority to issue bonds, and to authorize its municipalities to issue bonds, in 1917.[8] See Act of Mar. 2, 1917, ch. 145, § 3, 39 Stat. 951, 953 (codified as amended at 48 U.S.C. § 741). Like municipalities of a state, a municipality in Puerto Rico is excluded from bankruptcy relief under the Code's other chapters if it becomes unable to meet these bond obligations. See, e.g., 11 U.S.C. § 109; cf. McConnell & Picker, 60 U. Chi. L. Rev. at 426-50 (explaining the obstacles to treating municipal insolvency like corporate insolvency). And, at least from 1938 until the modern Bankruptcy Code was introduced in 1978, Puerto Rico, like the states, could authorize its municipalities to obtain federal municipal bankruptcy relief.[9]See 11 U.S.C. §§ 1(29), 403(e)(6) (1938); 48 U.S.C. § 734 (1934); Bekins, 304 U.S. at 49; accord 11 U.S.C. §§ 1(29), 404 (1976); 48 U.S.C. § 734 (1976); see also S.J. Lubben, Puerto Rico and the Bankruptcy Clause, 88 Am. Bankr. L.J. 553, 572 (2014). And although the modern Code omitted a definition of the term "State" from its enactment in 1978 until it was re-introduced in 1984, most commentators agree that this did not affect Puerto Rico's ability during that time to provide its municipalities authorization.[10]See, e.g., Lubben, 88 Am. Bankr. L.J. at 572-73 & n.125; An Act to Establish a Uniform Law on the Subject of Bankruptcies ("Bankruptcy Reform Act of 1978"), Pub. L. No. 95-598, 92 Stat. 2549 (1978) (codified as amended at 11 U.S.C. §§ 101 et seq.); see also Cohen, 523 U.S. at 221-22; In re Segarra, 14 B.R. 870, 872-73 (D.P.R. 1981).

This changed in 1984, when Congress re-introduced a definition of "State" to the Code.[11] Bankruptcy Amendments and Federal Judgeship Act of 1984, sec. 421(j)(6), § 101(44), 98 Stat. at 368-69 (codified as amended at 11 U.S.C. § 101(52)). This 1984 amendment is key to this case. Like previous definitions, § 101(52) defines "State" to "include[] . . . Puerto Rico." But importantly, and unlike previous versions of the definition, the re-introduced definition of "State" includes Puerto Rico "except for the purpose of defining who may be a debtor under chapter 9 of [the Bankruptcy Code]."[12] 11 U.S.C. § 101(52) (emphasis added). Compare id., with Act of June 22, 1938, Pub. L. No. 696, ch. 575, § 1(29), 52 Stat. 840, 842. As a result of this exception, Puerto Rico municipalities became expressly (though indirectly) forbidden from filing under Chapter 9 absent further congressional action: the change deprived Puerto Rico of the power to grant its municipalities the authorization required by § 109(c)(2) to file for Chapter 9 relief. See 11 U.S.C. § 109(c) (defining who may be a Chapter 9 debtor). The two sides to this controversy dispute whether this change was also meant to transform the preemption provision of § 903(1) without Congress expressly saying so.

C. The Recovery Act: Puerto Rico's Stated Attempt to "Fill the Gap"

Facing a fiscal crisis and lacking the power to authorize its municipalities to seek Chapter 9 relief, the Commonwealth enacted the Recovery Act in June 2014, to take effect immediately. Somewhat modeled after Chapter 9, but with significant differences, the Recovery Act "establish[ed] a debt enforcement, recovery, and restructuring regime for the public corporations and other instrumentalities of the Commonwealth of Puerto Rico during an economic emergency." Recovery Act, Preamble (translation provided by the parties); id., Stmt. of Motives, § E. In particular, the Act was intended to ameliorate the fiscal situations of several distressed Puerto Rican public corporations whose combined deficit in 2013 totaled $800 million, and whose combined debt reaches $20 billion: PREPA, the Aqueduct and Sewer Authority ("PRASA"), and the Highways and Transportation Authority ("PRHTA"). Id., Stmt. of Motives, § A.

The Recovery Act provides two methods for restructuring debt: Chapter 2 "Consensual Debt Relief, " and Chapter 3 "Debt Enforcement." Id., Preamble. Although defendants say these serve as a substitute for Chapter 9, both Chapter 2 and Chapter 3 relief under the Recovery Act appear to provide less protection for creditors than the federal Chapter 9 counterpart. See L.S. McGowen, Puerto Rico Adopts a Debt Recovery Act for Its Public Corporations, 10 Pratt's J. Bankr. L. 453, 460-62 (2014). This is one form of harm that plaintiffs say the Recovery Act has caused them.

For example, Chapter 2 relief under the Recovery Act purports to offer a "consensual debt modification procedure" leading to a recovery plan that would only become binding "with the consent of a supermajority" of creditors. Recovery Act, Stmt. of Motives, § E. But this is belied by the provisions: Chapter 2 permits a binding modification, including debt reduction, to a class of debt instruments with the assent of creditors holding just over one-third of the affected debt.[13] Id. § 202(d)(2); see also id., Stmt. of Motives, § E. There is no analogous "consensual procedure" under federal law.

Chapter 3 relief, on the other hand, is a court-supervised process designed to mirror, in some ways, Chapter 9 and Chapter 11 of the federal Code. Id., Stmt. of Motives, § E. But while Chapter 3 debtors, like federal Chapter 9 debtors, may avoid certain contractual claims, protections for creditors are again reduced. Compare, e.g., id. §§ 325, 326, with 11 U.S.C. §§ 365(e), 901(a); see also McGowen, 10 Pratt's J. Bankr. L. at 461. For example, unlike in the federal Code, the Recovery Act does not provide a "safe harbor" for derivative contracts. Compare Recovery Act, § 325(a), with 11 U.S.C. § 365(e); see also Recovery Act, § 205(c); McGowen, 10 Pratt's J. Bankr. L. at 461.

Municipalities that the Commonwealth may not authorize for federal Chapter 9 relief are nonetheless purportedly made eligible by the Recovery Act to seek both Chapter 2 and 3 relief, either simultaneously or sequentially, with approval from the GDB. Recovery Act, §§ 112, 201(b), 301(a). Unlike the federal Code, the Recovery Act also expressly permits the Governor to institute an involuntary proceeding if the GDB determines that doing so is in the best interest of both the distressed entity and the Commonwealth.[14] Recovery Act, §§ 201(b)(2), 301(a)(2).

Plaintiffs argue that the very enactment of these and other provisions cause them harm in several ways: by denying them the protection for which they bargained under the Trust Agreement, by denying them the protection to which they would be entitled under federal relief, and by injecting uncertainty into the bond market that reduces their bargaining position to address pending default. See McGowen, 10 Pratt's J. Bankr. L. at 460-61 (discussing other examples, including the ...

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