WASHINGTON – Congress’ narrow tailoring of the PROMESA law to Puerto Rico prevents states from using the law as a template for their own restructurings, and ensures states’ path to restructuring would still be a hard one, according to bankruptcy experts and others.
Puerto Rico is using Title III of the Puerto Rico Oversight, Management and Economic Stability Act for its record-setting restructuring process. The title outlines a territory-specific process modeled after Chapter 9 bankruptcy, which applies to municipal entity restructurings. States themselves cannot restructure under Chapter 9 and Puerto Rico’s need for its own restructuring process stemmed from Chapter 9’s exclusion of both the territory and its entities. PROMESA paired the restructuring authority with the imposition of a seven-member oversight board that is acting as debtor for the territory.
The fear that Congress’ solution for Puerto Rico would lead to something similar for states was a factor in the congressional process that created PROMESA. The House Natural Resources Committee, which spearheaded the legislation, tried to alleviate those concerns in part by grounding its actions in the Constitution’s Territorial Clause. The clause, which does not apply to states, gives Congress the power to “dispose of and make all needful rules and regulations respecting the territory or other property belonging to the United States.” The committee made the point at the time it was working to write PROMESA that a state could only use the new law if it took the unlikely steps of revoking its status as a state, becoming a U.S. territory and petitioning the U.S. government for an oversight board.
NewOak Fundamental Credit made note of the difference between states and Puerto Rico in a May 5 MuniCredit Insights column, saying “it will be tempting to draw generalizations from this historic debt restructuring to the municipal market at large” but that “at the end of the day, Puerto Rico is not a full sovereign credit like any of the 50 states.”
“Indeed, its territorial status is the very reason the island got its own unique ‘bankruptcy-like’ process, Title III,” NewOak said.
Bankruptcy experts said a state would have to ask Congress to take action to allow statewide restructuring, both because such broad restructuring isn't currently allowed under the law and because states and the federal government are dual sovereigns under the U.S. Constitution. The co-sovereign nature of the state and federal government relationship means Congress can’t unilaterally subject a state to the federal bankruptcy laws. Congress would be reluctant to take constitutionally granted sovereignty away from a state, observers said.
Allowing statewide restructuring would “be a drastic change in the perception of the public markets and the perception of the financial credibility of states,” said bankruptcy specialist James Spiotto of Chapman Strategic Advisors. “I don’t know if Congress wants to take on that significant of a change.”
Joseph Krist, a partner with Court Street Group and a long-time analyst, said the debate in Congress could also have political elements, depending on whether Republican “red states” or Democratic “blue states” are the ones feeling fiscal pressure. While the current states with fiscal problems, like Illinois and New Jersey, are “blue states,” there “are also red states that could easily be in a position to have these problems,” Krist said.
“The red state side of this would be really strongly opposed to the idea of a federal answer for everything,” Krist said, adding he doesn’t think Republicans, given their leanings toward states’ rights, would want to start running states. “As circumstances emerge, I totally admit anything is subject to change, but I do believe there is a strong enough philosophical opposition to it that would be very difficult to overcome.”
Additionally, the need for state consent for congressional action raises the question of whether states would even want to ask for a statewide bankruptcy solution, according to Spiotto. Given the risks to states and past comments from state groups, he said he thinks the answer is no.
The National Governors Association and National Council of State Legislatures have opposed such an idea in the past, telling Congress in a 2011 letter that “allowing states to declare bankruptcy is not an authority any state leader has asked for nor would they likely use.” An NGA spokesperson said the group no longer has a formal stance on the issue, while confirming that it opposed statewide bankruptcy in 2011. NCSL similarly did not have an updated stance.
Spiotto said states would have to consider how restructuring would affect their access to the muni market, where a statewide restructuring would be seen as a serious “stigma” and damage the chance for future market access.
“States are supposed to be responsible, like the federal government, they’re supposed to be the supervising responsible adult,” Spiotto said. “While local governments can be more like children and territories can be like the children, the supervising adult has certain responsibilities.”
Krist said states considering restructuring would also have to consider what strings would be attached to congressional help.
“I find it hard to believe that a procedure would be established that would allow states to walk away from their obligations without requiring them to give up a significant level of independent decision-making,” Krist said. “I think that on a practical basis, that has obvious negatives for the states and on a philosophical basis, I think there would be significant opposition [in Congress] to such an arrangement.”
Other market observers said that the focus on whether statewide bankruptcy could flow from Puerto Rico’s actions may be overlooking possible smaller restructurings states could use instead or be looking at the wrong PROMESA precedent.
Melissa Jacoby, a University of North Carolina law professor specializing in bankruptcy, noted that Chapter 9’s definition of municipality, which designates an entity that could apply for relief under the code, is broad and still not as fleshed out as it could be.
“While it remains true that states have a very long path and an uphill battle to get the right to bankruptcy, and it’s rightly controversial for both sovereignty reasons and otherwise, there are other ways states, depending on the ways they set up their instrumentalities” could address their debt, Jacoby said.
For example, the state may understand it cannot restructure all of its debt but could have some of its entities, like sewer and water authorities, take advantage of Chapter 9, she said. Jacoby added she is not necessarily advocating for that course of action.
Matt Fabian, a partner with Municipal Market Analytics, said people who are concerned that PROMESA will lead to statewide bankrupcties may be misreading the situation.
“The real precedent from PROMESA is that the federal government created one-off legislation that was very specific and customized to Puerto Rico and Puerto Rico’s situation,” Fabian said. That precedent should have people looking at what issues with fiscally troubled states Congress may be able to hone in on and fix instead of looking more broadly at just bankruptcy, he said.
For example, Illinois’ problem is not as much debt but instead its unfunded pensions, according to Fabian. The state currently has $126.5 billion in unfunded pension liabilities.
“The precedent of PROMESA would make me think that a federal one-off solution would be aimed at finding a way for them to fund pensions or find a way to reduce pensions,” Fabian said. “The precedent is not the mechanics of [PROMESA] itself. The precedent is to go there and make life more difficult for bondholders.”
But he did warn, like others, that it is “easy to conflate credit situations between Illinois and Puerto Rico” when in reality Illinois “is a vastly better credit” and isn’t in the need Puerto Rico was at the time PROMESA passed.
That still-substantial gulf between Puerto Rico’s severe fiscal distress and states’ financial problems is another reason large-scale restructuring talks or congressional help will be kept on the sidelines, sources said. States would have a much easier time raising taxes to cover serious shortfalls than Puerto Rico would have and that possible solution would make it much harder for the state to show it is truly insolvent and in need of restructuring, they said.
Yvette Shields contributed to this article