The Impact of PROMESA on Creditors

On June 30, 2016, the United States Senate passed the “Puerto Rico Oversight, Management and Economic Stability Act” (“PROMESA”) and it was quickly signed into law by President Obama.^[1]  PROMESA enables the Commonwealth of Puerto Rico and its public corporations and other instrumentalities in financial distress to restructure their debt.^[2] The goal of PROMESA is to “bring solvency to Puerto Rico, build a foundation for future growth and ensure the island regains access to capital markets”.^[3]  PROMESA, though, is not limited to restructuring and enforcement of debt obligations or securities.  If you lent money or extended other forms of credit, or provided goods or services, to Puerto Rico or any of its instrumentalities, PROMESA may affect you.

GENERAL FRAMEWORK

PROMESA, among other things, provides for the appointment of a financial control board, imposes a stay of creditor enforcement remedies, and provides a framework for restructuring the debt obligations of Puerto Rico and its financially distressed public corporations and other instrumentalities.  The Oversight Board (defined below) will have significant control over the development and enforcement of fiscal plans and balanced budgets for Puerto Rico and its public corporations and instrumentalities.  (For purposes of this article, the author uses the term “instrumentality” broadly to include any political subdivision, public agency, instrumentality [including any instrumentality that is a bank], or public corporation that is designated by the Oversight Board to be a “covered territorial instrumentality” under PROMESA.)

FEDERAL OVERSIGHT BOARD

A financial control board entitled the “Financial Oversight and Management Board” (the “Oversight Board”) will be created.  The Oversight Board will consist of seven members appointed by the President, six of whom will be selected from lists of individuals recommended by the majority and minority leaders of the United States House of Representatives and the United States Senate.  At least one of the appointees must be a resident of Puerto Rico.^[4]  Members of the Oversight Board will not be compensated, but will be entitled to reimbursement for reasonable and necessary expenses.

The members of the Oversight Board must meet the following eligibility requirements, among others:

• must have knowledge and expertise in finance, municipal bond markets, management, law, or operation of business or government;
• must comply with federal conflict of interest requirements; and
• prior to appointment, may not be an officer, elected official, or employee of Puerto Rico, a candidate for elected office of Puerto Rico, or a former elected official of Puerto Rico.

Powers of Oversight Board

• approve appointment of an executive director selected by the chair of the Oversight Board;
• analyze financial and operational condition and establish and implement corrective actions;
• determine the schedule for the Governor and legislature to develop and submit fiscal plans and budgets, and modifications of budgets as necessary;
• develop, review, approve, certify and oversight of a fiscal plan (covering a period of at least 5 years) and annual budget for each fiscal year for Puerto Rico and any covered instrumentality;
• certify compliance or non-compliance of the annual budget adopted by Puerto Rico and each covered instrumentality in connection with the fiscal plan.  If the Oversight Board does not issue a certificate of compliance, it may make recommendations and reductions in nondebt expenditures to the budget necessary to ensure compliance with the fiscal plan;
• certify, in its sole discretion, voluntary agreements with holders of Puerto Rico’s debt obligations with Puerto Rico or its covered instrumentalities;
• review and rescind certain laws enacted between May 4, 2016 and the establishment of the Oversight Board that alter pre-existing priorities of creditors in a manner outside the ordinary course of business or that are inconsistent with Puerto Rico’s constitution or laws;
• approve issuance of debt or guarantees, or the exchange, modification, repurchase, redemption or similar transactions relating to debt of Puerto Rico or its instrumentalities issued prior to the enactment of PROMESA;
• make recommendations relating to the financial stability, economic growth, management responsibility, and service delivery efficiency of Puerto Rico or its instrumentalities, including the privatization and commercialization of entities of Puerto Rico or its instrumentalities;
• review legislative acts, executive orders, regulations, rules and contracts to ensure compliance with an approved fiscal plan;
• monitor and issue notices of non-compliance to the President, the House of Representatives Committee on Natural Resources, the Senate Committee on Energy and Natural Resources, the Governor and the Puerto Rico Legislature that the actual quarterly revenues, expenditures, or cash flows of Puerto Rico or the covered instrumentality are not consistent with the projected revenues, expenditures, or cash flows in an approved budget for such and make appropriate reductions in nondebt expenditures to ensure compliance with the approved budget;
• intervene in any litigation filed against Puerto Rico or its instrumentalities; and
• issue a restructuring certification regarding Puerto Rico or a covered instrumentality authorizing the commencement of an adjustment of debt case under title III of PROMESA.

WHAT IS THE IMMEDIATE IMPACT ON CREDITORS OF PROMESA?

Automatic Stay Precludes Most Creditor Remedies

The initial impact of PROMESA is the “automatic stay” that took effect immediately upon PROMESA’s enactment. Creditors who hold Liability Claims (generally, bonds, notes and other financial debt obligations) are automatically stayed, or prevented, from taking action against Puerto Rico, its instrumentalities, or its property to collect debts that could have been commenced before the date of enactment.  By its terms, the automatic stay operates as a general moratorium and court-ordered injunction, and no court order is necessary as the injunction is automatically triggered by the enactment of PROMESA. The automatic stay can be enforced by court order if necessary, and violators risk the assessment of damages, costs, and attorneys’ fees incurred in defending any action taken in violation of the automatic stay.  Like the automatic stay under the Bankruptcy Code^[5], the automatic stay under PROMESA is intended to give Puerto Rico and its instrumentalities a “breathing spell” from creditors because it automatically stops all collection efforts and all foreclosure actions relating to the debt obligations of the Commonwealth and its instrumentalities. 

Unless modified by the federal district court, the automatic stay remains in effect until the later of February 15, 2017 or six months after the establishment of the Oversight Board for Puerto Rico, subject to extension as provided in section 405(d) of PROMESA.

• The types of actions covered by the automatic stay include, but are not limited to, the following:

• commencing or continuing lawsuits against Puerto Rico, its instrumentalities or its officers;
• obtaining possession of the property of Puerto Rico or its instrumentalities or exercising control over property of Puerto Rico or its instrumentalities;
• creating, perfecting or enforcing most liens against property of Puerto Rico or its instrumentalities; and
• setting off any debt owed to Puerto Rico or its instrumentalities against any liability claim owed to such creditor that arose prior to the enactment of PROMESA.

• Any party in interest may ask the district court to relieve it from the automatic stay “for cause”.  In order to obtain relief, the party in interest likely will need to show that the hardship to the party in interest will significantly outweigh the hardship to Puerto Rico if the stay remains in place.

Creditors May Not Exercise Remedies Under Contracts

• Ipso Facto Clauses are Not Enforceable.  Many if not most contracts include provisions that expressly allow one party to a contract to declare a default or terminate a contract based upon the financial condition of the other party or if the other party becomes bankrupt or insolvent.  Under the Bankruptcy Code, these contractual provisions (sometimes referred to as ipso facto clauses), which purport to modify or terminate the contract solely based upon the debtor’s bankruptcy, insolvency or financial condition, are not enforceable.
• Section 405(j) of PROMESA provides that bondholders and other holders of debt issued by Puerto Rico or its instrumentalities may not exercise any contractual remedy or remedy provided in law based on the financial condition, the commencement of a restructuring, insolvency, bankruptcy or other proceeding.  Section 405(j), however, is more expansive than the provision in the Bankruptcy Code that renders ipso facto clauses unenforceable.  Under section 405(j), contractual provisions that authorize a bondholder to exercise remedies based on the non-payment of principal or interest or based on any contractual or covenant breach by Puerto Rico or an instrumentality also are unenforceable.  Thus, a bondholder may not exercise any right to setoff, apply or appropriate funds, seek the appointment of a custodian, raise interest rates, or exercise control over property of Puerto Rico or its instrumentalities.
• Section 405(j) is not limited to actions by bondholders and other holders of debt obligations, providing that no counter-party under any contract with Puerto Rico or any of its instrumentalities may exercise any contractual remedy based on the financial condition, the commencement of a restructuring, insolvency, bankruptcy or other proceeding involving Puerto Rico or any of its instrumentalities.   
• Section 405(j)(3) of PROMESA also makes unenforceable any contractual provision that authorizes a counterparty to terminate or modify a contract with Puerto Rico or its instrumentalities based on the insolvency or financial condition of Puerto Rico or its instrumentalities, the establishment of the Oversight Board, or a default under a separate contract that is due to, triggered by, or a result of the financial condition or insolvency of Puerto Rico or its instrumentalities or the establishment of the Oversight Board.

How Does PROMESA Purport to Protect Creditors?

• The fiscal plan developed and approved by the Oversight Board must, among other things:

• ensure that assets, funds, or resources of an instrumentality are not loaned to, transferred to, or otherwise used for the benefit of Puerto Rico or another instrumentality, unless permitted by Puerto Rico’s constitution, an approved plan of adjustment, or an approved “Qualifying Modification” (as defined under PROMESA); and
• respect the relative lawful priorities or lawful liens in the constitution, other laws, or agreements of Puerto Rico or a covered instrumentality.

• PROMESA purportedly does not discharge obligations of Puerto Rico or its instrumentalities or release, invalidate or impair any security interest or lien securing such obligations.
• Puerto Rico and its instrumentalities must make interest payments on outstanding debt when such payments become due during the length of the automatic stay, to the extent the Oversight Board determines that making such payments is feasible,.
• PROMESA is not intended to impair or affect the implementation of a restructuring support agreement executed by Puerto Rico or its instrumentalities prior to enactment of PROMESA or to impair or affect the obligations of Puerto Rico or its instrumentalities to proceed in good faith as set forth in such restructuring support agreement. (Section § 405)
• Secured creditors may bring an action to challenge inter-debtor transfers that violate applicable law (PROMESA § 407)
  

RESTRUCTURING DEBT OBLIGATIONS

Consensual Modification^[6] of Bond^[7] Claims^[8]?

Sections 601 and 104(i) of PROMESA provide a process for submission and approval of a voluntary agreement modifying Bond Claims.  The modification may be proposed by the issuer of the Bond or by one or more holders of the right to vote the issuer’s outstanding Bonds.  If proposed by one or more holders of the right to vote, the Oversight Board may accept the proposed modification on behalf of the issuer.

• In connection with each proposed modification, the Oversight Board, in consultation with the issuer of the Bonds, will separate the Bonds into separate pools as follows:

• at least one pool will be established for each issuer of Bonds;
• Bonds that are secured by a lien on property will be classified in a secured pool;
• for issuers who have issued multiple Bonds, separate pools will be established corresponding to the relative priority or security arrangements of each holder of Bonds;
• separate pools will be established for senior and subordinated Bonds corresponding to their relative priority or security arrangements; and
• for each issuer that has issued multiple Bonds, some of which are guaranteed by Puerto Rico, separate pools will be established for guaranteed and non-guaranteed Bonds.

• Proposed modifications to the Bond Claims must be submitted to the holders of the affected debt instruments for acceptance or rejection.  To be approved, the proposed modifications must be consented to or approved by holders of at least 50% of the outstanding principal amount of the affected Bonds in the particular pool entitled to vote, and, of those who actually vote, by 2/3rds of the aggregate outstanding principal amount of Bonds in such pool.
• The proposed modification also must be approved by the Oversight Board, which must determine and certify:

• voluntary agreement complies with the conditions in section 104(i)(1) of PROMESA:

• Certified by the Oversight Board. If an applicable fiscal plan has been certified, the voluntary agreement with holders of the affected Bond Claims provides for a sustainable level of debt for Puerto Rico or the related issuer, as applicable, and is in conformance with the applicable certified fiscal plan;
• Not Certified by the Oversight Board. If an applicable fiscal plan has not been certified by the Oversight Board, the voluntary agreement provides, in the Oversight Board’s sole discretion, for a sustainable level of debt for Puerto Rico or the related issuer, as applicable; or
• The voluntary agreement is limited solely to an extension of applicable principal maturities and interest on Bonds issued by Puerto Rico or the related issuer, as applicable, for a period of up to one year during which no interest will be paid on the Bond Claims affected by the voluntary agreement.

• voting requirements set forth in section 601 of PROMESSA have been satisfied; and
• PROMESA provides for certification by the Oversight Board of a modification of Bond Claims pursuant to a pre-existing voluntary agreement if the modification is consistent with a restructuring support or similar agreement executed prior to May 18, 2016 by the issuer and holders of a majority in amount of Bond Claims that are to be affected by such modification.  

• The proposed modification will not become effective as to holders who did not approve or consent to the modification until an order approving the qualifying modification has been entered by the federal district court.
• Modification is Binding on all Holders.  A qualifying modification will be conclusive and binding on all holders of Bonds whether or not they have given consent, and on all future holders of those bonds if:

• The requisite majorities of Holders of the Bonds in the affected pool of the issuer have consented to or approved the modification;
• Cramdown.  With respect to a Bond Claim that is secured by a lien on property and with respect to which the holder of such Bond Claim has rejected or did not consent to the qualifying modification, the holder of such Bond retains the lien securing such Bond Claims or receives on account of such Bond Claim, through deferred cash payments, substitute collateral, or otherwise, at least the equivalent value of the lesser of the amount of the Bond Claim or of the value of the collateral securing such Bond Claim; and
• The federal district court, on motion of the applicable issuer,, enters an order that the requirements of section 601 have been satisfied.  The voluntary modification may be approved by the federal district court and made binding on all holders only where at least 50% of the principal amount of the affected Bond in the particular pool vote or consent to the voluntary modification and, of those who cast a vote, at least 2/3rds of the aggregate principal amount of the affected Bonds in the particular pool approves the proposed modification.  If so approved by the holders and the federal district court, the modification will bind all affected holders within the applicable pool.

Adjustment of Debts

The second avenue for debt relief (a Title III case) involves the commencement of a adjustment of debt case.  Puerto Rico or the covered instrumentality, with the approval of the Oversight Board, may file a petition with the federal district court seeking to restructure its debts.  A case under Title III is similar but not identical to a case under chapter 9 of the Bankruptcy Code. 

Eligibility Requirements

• the entity is Puerto Rico or one of its covered instrumentalities;
• the Oversight Board has issued a certification for such entity; and
• the entity desires to affect a plan to adjust its debts.

• Prior to permitting an entity to commence a Title III case, the Oversight Board, in its sole discretion, must certify that:

• the entity has made good-faith efforts to reach a consensual restructuring with its creditors;
• the entity has adopted procedures necessary to deliver timely audited financial statements and has delivered draft financial statements and other information sufficient for an interested person to make an informed decision;
• the entity has a fiscal plan in place; and
• no order approving a “qualifying modification” (as provided in section 601 of PROMESA) is in place.

Powers of the Federal District Court are Limited

• Section 305 of PROMESA provides that, absent consent by the Oversight Board or a provision in the entity’s debt adjustment plan, the federal district court may not, by any stay, order, or decree, interfere with:

• any of the political or governmental powers of the debtor;
• any of the property or revenues of the debtor; or
• the debtor’s use or enjoyment of any income-producing property.

• Thus, the debtor, without federal district court supervision or oversight, maintains control of most of its financial affairs and operations in order to operate and to provide services to residents.
• Limitations on Power of Federal District Court.  The federal district court may not do the following, absent consent by the Oversight Board:

• take over debtor’s operations;
• remove members of debtor’s governing board; 
• appoint a trustee or receiver; or
• give the debtor powers it does not have under applicable federal and state law.

• Federal district court powers are generally limited to:

• approving the petition (finding that eligibility criteria have been met);
• permitting the assumption or rejection of executory contracts and unexpired leases, including collective bargaining agreements;
• approving compensation of professionals;
• allowing or disallowing claims;
• confirming a plan of adjustment; and
• monitoring implementation of the plan.

• Actions Not Requiring Court Approval.  Puerto Rico may do the following without court approval (but subject to Oversight Board approval):

• spend money, use, sell or lease property, including cash collateral (Bankruptcy Code section 363 is not incorporated into a Title III debt adjustment case under PROMESA);
• pay debt incurred prior to enactment of PROMESA, if it chooses;
• pay expenses in connection with the operation of the debtor’s affairs; and
• retain professionals.

• Postpetition Financing.  PROMESA incorporates Bankruptcy Code sections 364(c) and (d) into a Title III debt adjustment case to enable Puerto Rico or its covered instrumentality to borrow.

• Such postpetition credit can be incurred on one of three bases:

1. An unsecured "super-priority" basis with priority over all priority claims for administrative expenses;
2. Secured but subject to existing liens; or
3. Secured by a lien equal or senior to existing lien, if the debtor cannot otherwise obtain credit and if the existing lienholder receives "adequate protection.”

• “administrative expenses” that are subordinate to the postpetition financing are those expenses incurred directly in connection with the Title III case itself, such as court costs, attorneys’ fees, costs of distribution of the plan and solicitation of acceptances.

Debt Adjustment Plan: The goal of a Title III debt adjustment case is to restructure the entity’s (Puerto Rico’s or the specific covered instrumentality’s) debt obligations.  In general, the formulation of a debt adjustment plan involves negotiations among the debtor, an official committee of creditors and other interested parties and, under PROMESA, the Oversight Board.

• Exclusivity

• only the Oversight Board (not the debtor) may file a plan for adjustment of the debts of the debtor;
• creditors may not file competing plans; and
• PROMESA does not fix a specific deadline by which the Oversight Board must file a plan.  Section 312 provides that if a plan for adjustment of debts is not filed with the petition, the Oversight Board shall file such plan at such later time as the court fixes.

• Confirmation of a Plan.  The federal district court may confirm a debt adjustment plan if it meets the following requirements:

• complies with the provisions of the Bankruptcy Code made applicable to a Title III case under PROMESA;
• complies with the provisions of PROMESA;
• the debtor is not prohibited by law from taking any action necessary to carry out the plan;
• any legislative, regulatory, or electoral approval necessary under applicable law in order to carry out any provision of the plan has been obtained, or such provision is expressly conditioned on such approval;
• provides that on the effective date, each holder of an administrative claim will receive on account of such claim cash equal to the allowed amount of such claim;
• is in the best interests of creditors and is feasible; and
• is consistent with the applicable fiscal plan certified by the Oversight Board.

• Note:   If the plan is confirmed, it is binding – even on dissenting creditors.
• Plan must be in “best interests of creditors”

• generally interpreted as better than the other non-bankruptcy alternatives available to creditors;
• “alternative” generally is considered dismissal of the case, where every creditor must fend for itself; and
• courts generally require a reasonable effort by the debtor that is a better alternative for its creditors than dismissal of the case.

CONCLUSION

The imposition of a financial control board may be helpful in restoring Puerto Rico’s credibility and may assist in providing Puerto Rico with capital market access.  The Oversight Board, once constituted, will need the full cooperation of Puerto Rico and its public corporations and other instrumentalities in order to succeed. 

Puerto Rico is precluded from adopting its own bankruptcy laws to restructure its debt or the debt of its instrumentalities, and Puerto Rico’s public corporations and other instrumentalities are not eligible to be debtors under chapter 9 of the Bankruptcy Code.  While some concepts and provisions may have been drawn from the Bankruptcy Code, there are significant differences.  Despite bondholders’ familiarity and experience with chapter 9 bankruptcy cases, PROMESA remains uncharted.  As a consequence, over the next weeks and months, bondholders and other creditors will be poring over this novel and unfamiliar act to understand how PROMESA will affect them.  Ultimately, it may be left to the courts to interpret and determine their rights.