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Puerto Rico Supreme Court’s Deference to Legislature’s Determinations: A Double-Edged Sword for Puerto Rico Bondholders?


The Government Development Bank for Puerto Rico (GDB) hosted an unusual public conference call on October 31 to respond to legal questions raised by investors in bonds issued by the Puerto Rico Sales Tax Financing Corporation, better known by its Spanish acronym, COFINA.  During the one-hour call (which is available for replay on the GDB website), bond counsel and underwriters’ counsel made presentations explaining the rationales for legal opinions they delivered in connection with COFINA’s most recent bond issues, and responded to several written questions submitted by investors in advance of the call.

The legal opinions and the investor questions focused on the validity of the statutory transfer by the Commonwealth of Puerto Rico to COFINA of 2.75% (recently increased to 3.50% by statutory amendment) of Puerto Rico’s annual sales and use tax revenues (or, if greater, stated minimum annual amounts), and of the legislature’s statutory declaration that such transferred tax revenues do not constitute “available resources” which, under Puerto Rico’s constitution, are dedicated on a first priority basis to the payment of Puerto Rico’s “public debt”, such as Puerto Rico’s general obligation bonds.  Puerto Rico is reported to have over $50 billion in tax-supported debt outstanding.

The legal opinions noted, and counsel reasserted in their presentations, the absence of judicial precedent in Puerto Rico construing the validity of the legislature’s carve-out of a portion of the sales and use tax revenue to secure COFINA bonds.  Given such circumstances, the opinions and presentations focused on decisions by various state courts upholding similar financing structures in New York and certain other states, as well as on the Puerto Rico judicial system’s history of deference to the legislature’s determinations as to the necessity and validity of legislation.   One of the lawyers on the conference call, in response to an investor question, stated that he could recall only two instances in recent memory in which the Puerto Rico courts had invalidated legislation, and one of those involved restrictions on Puerto Rico’s judicial branch.

Puerto Rico’s tradition of judicial deference to its legislature’s acts was emphasized on the call as a source of comfort to bondholders vis-à-vis any potential court challenges to the existing statutes establishing COFINA’s revenue stream and its pledge to COFINA bondholders.  We note, however, that a case decided earlier this year by the Puerto Rico Supreme Court suggests that such deference may be a double-edged sword in situations where the legislature decides it is in Puerto Rico’s interests to impair rights granted by a prior legislature.  The case in question, Hernandez v. Estado Libro Associado, 2013 WL 3586616 (June 24, 2013) upheld legislative reforms to Puerto Rico’s public pension system against claims that such reforms violated the U.S. Constitution’s “contracts clause” restricting states from impairing contractual rights, as well as the Puerto Rico constitution’s analogous provision.  (Courts that have considered the matter have held that though Puerto Rico is not a “state” it is equally subject to the U.S. Constitution’s “contracts clause.”)

Hernandez was decided on June 24, 2013, and an official translation of the Spanish text is not yet available.  (Official translations into English of Puerto Rico Supreme Court cases generally lag the opinion release date by a substantial period. )   The unattributed “per curiam” majority opinion and the unusually candid attacks and counterattacks on fellow justices in the concurring and dissenting opinions testify to the political heat generated by the legislative cutbacks on public employee pension rights and brought to bear on the Puerto Rico judiciary in reviewing the constitutionality of cutbacks designed to address the island’s troubled balance sheet.  Though Hernandez only directly affects Puerto Rico’s state employee pensions, the court’s approach to the case may have substantial relevance to Puerto Rico’s bondholders should the Puerto Rico legislature deem it necessary to revisit bond-related legislation in order to reduce Puerto Rico’s liabilities or reprioritize application of revenues.

Puerto Rico is likely to remain dependent on the good will of the bond market in most conceivable scenarios, and therefore is unlikely to resort to a unilateral  legislative restructuring of its bond debt unless it has no other options.  The Hernandez decision was greeted in some quarters as a positive sign for Puerto Rico's bondholders in that it demonstrates the Puerto Rico judiciary's willingness to uphold politically contentious legislation designed to put Puerto Rico's economic house in order. However, the Hernandez decision, summarized below, suggests that, should Puerto Rico feel compelled to effect a unilateral debt restructuring, the Puerto Rico judiciary may be no more protective of Puerto Rico’s contractual obligations to mutual funds and other bond investors than it has been to Puerto Rican public employees.

Hernandez Majority Opinion

The short majority opinion in the 5-4 decision summarizes the challenged legislation as freezing benefits under defined benefit plans for employees in the public pension system who have not yet retired; increasing retirement age, with a phase-in for those near retirement; increasing required employee contributions to the system; and moving current plan participants to a defined contribution plan.  The opinion states:

“{W]e are aware of the effect this reform will have on the retirement plans of the plaintiffs and other public employees. All of us in public service have family members, colleagues and friends who will be affected by this legislation.  On the other hand, we know the importance of the resolution of these cases to Puerto Rico’s economic situation, particularly to government debt which permits access to funds for development and maintenance of infrastructure and of other programs of singular importance to those of us who live in Puerto Rico.  This Court has the obligation to adjudicate the cases before us and to delicately balance some conflicting interests of extreme importance in our life as a people.”

The majority opinion references the U.S. Constitution’s contracts clause and its counterpart in Puerto Rico’s constitution, but notes that they do not absolutely prohibit contract impairment.  Citing precedents, the opinion states that if there is a substantial or severe impairment, the court must evaluate whether the impairment promotes a legitimate governmental objective and is rationally related to the attainment of that objective.

The majority opinion acknowledges that when the law under review impairs the government’s own obligation, heightened scrutiny is warranted, because the government’s self-interest is involved.  But it also states that the court must give deference to legislative findings regarding the necessity and importance of the legislation.

The opinion references a prior case, Bayron Torro v. Serra, as establishing that the state can alter the terms of the public pension system for employees who are not yet retired as long as the alterations are reasonable and promote the retirement system’s solvency.  The current opinion then quotes some legislative history from the pension reform legislation in which legislators referenced the dire status of the pension system.

The majority opinion also acknowledges that an impairment of contract will not be upheld if there are less drastic or severe means of addressing the government’s objectives than those set forth in the legislation.  It references the plaintiffs’ argument that the legislature could have increased the sales and use tax or other contributions to the pension system.  But, in a single sentence, it summarily states that the plaintiffs failed to proffer evidence sufficient to convince the court that the alternatives were viable or less onerous, and reiterates that legislative determinations are entitled to deference.

The majority opinion concludes that the pension reform legislation is constitutional because, though it substantially impairs contract rights, the measures are reasonable and necessary to salvage the actuarial soundness of the pension system and there are no less onerous measures to achieve that objective.

Hernandez Concurrence

There is a short concurrence by two of the justices stating that they agree with the majority opinion “for Puerto Rico and because it is legally correct, not because of blackmail, pressure or unjust, insulting and regrettable public comments by members of the other two branches of government…”  The concurrence asserts that “for better or for worse, the needs and collective well-being of the approximately 3.5 million inhabitants of Puerto Rico prevail over the individual interests of the thousands of public employees affected.”  The concurrence ends with a sentence in bold-faced letters stating: ”Those who presumed the existence of a hidden agenda on the part of the members of the Court are shown today to be untruthful.”  

Hernandez Dissents

The four dissenting justices produced three dissenting opinions, the first of which starts with the following quotation in English:  “Emergency does not create power.”  The first dissent goes on to state that “in a stark per curiam opinion – orphaned of any identified author – the majority plays a final dirty trick on thousands of public employees using a judicial methodology that constitutionalizes the rubber stamp.”   The dissent accuses the majority of misreading precedent, and states (quoting another case) that the test is that “alterations of employees’ pension rights must bear some material relation to the theory of a pension system and its successful operation, and changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages.”  Because the pension reform legislation impaired contractual rights without substituting comparable new ones, the dissent’s view is that it is unconstitutional.

The first dissent takes to task three members of the majority who apparently flipped their position from a recent prior case; the dissent forecasts that the turnaround by the three justices has created a “new” Supreme Court.  The dissent characterizes the majority as holding that the legislation “is reasonable because … why because the government says it is.”  The dissent ends with the following advice: “Swim, as this inconsistency can only be understood – perhaps – when, from the shore, we observe the ebb and flow of the sea.”

The second dissenting opinion continues the nautical theme of the first dissent, stating that “if the ship is taking on water and there is a real threat of sinking, the first thing one throws over is the knick-knacks,” not the most precious objects (such as, in the justice’s view, workers’ pension rights.)  The second dissent focuses on distinctions between the cases relied on by the majority and the applicable facts and law in Hernandez.  It also asserts that Puerto Rico’s public pension system has had an actuarial deficit since its inception, and  references case law from  other states holding that if a state is aware of problems when it enters into a contract, it cannot later impair those contracts just because the problems have changed in degree.  Finally it asserts that while it is likely that many of the pension reforms in the challenged legislation could have survived constitutional scrutiny, the reduction in future annuity payments does not pass constitutional muster because of the existence of less drastic options that could achieve the same objective.

The lengthy third dissenting opinion states that “given the pusillanimous posture assumed by 5 members of this court, I have no choice but to dissent.”  The dissent argues that the affected pension rights are contract rights; that the pension reform legislation substantially impairs such contract rights, that contract rights can only be impaired if the impairment is necessary and reasonable; that a substantial impairment is not reasonable if it addresses a problem that the state was aware of when the contractual rights were established, that less deference is due to the state when its legislation impairs its own contractual obligations, that the existence of less onerous alternatives must be taken into account in determining reasonableness of legislation, as must whether any new benefits are granted in substitution for the rights taken away, and that under these standards some of the challenged legislation’s provisions are unreasonable and presumptively unconstitutional, and that the plaintiffs’ challenge should have been allowed to proceed.

Concluding Observations

The Hernandez case showcases the Puerto Rico judiciary’s current deference to legislative determinations, particularly on matters relating to addressing Puerto Rico’s economic and financial crisis.  The extent to which such deference should be a source of comfort to bondholders may depend on assessments of the likelihood that the Puerto Rico legislature will view it necessary to accord greater respect to its contractual commitments to bondholders than to its public employees in addressing its financial imbalances.  Should Puerto Rico feel compelled at some future point to enact “bond reform” legislation that impairs existing bondholder rights, the Puerto Rico courts may be no more receptive to a constitutional challenge than they were to the pension reform challenge in Hernandez.  In the event of any such hypothetical legislation, therefore, whether bondholders or bond  trustees can establish a right to bring challenges in federal, rather than Puerto Rican, courts may turn out to be outcome-determinative.

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William W. Kannel is a bankruptcy attorney at Mintz. Bill has experience in corporate reorganizations and municipal Chapter 9 and debt restructurings. He represents both creditors and debtors in all phases of distressed debt negotiations, bankruptcy litigation, and distressed asset acquisitions.