prior probability

In our previous two posts, we reviewed the main details of a proposed private law solution to Puerto Rico’s public debt crisis. (This proposed solution would not require any new legislation, and it appears in this working paper by Aden, et al., 2016.) Here, we will evaluate the feasibility and merits of this solution.

For starters, we really admire the simplicity and elegance of the private law solution in the Aden et al. paper. After all, since a municipal bond is, legally speaking, nothing more than an investment contract, the relevant provisions of the Puerto Rico Civil Code should, in principle, apply to bonds emitted by the government of Puerto Rico. That said, what if the parties to the underlying bond contracts opted out of Puerto Rico law? We would not be surprised if the underlying contracts relating to Puerto Rico’s municipal bonds contained either a choice of law clause or a forum selection clause (or both). But even if Puerto Rico law did apply to these bonds, there are three additional legal barriers the government of Puerto Rico would have to overcome in order to implement the solution in Aden et al.: (1) can a government agency or instrumentality be a debtor under the provisions of the Puerto Rico civil code, (2) are bonds really a “joint obligation” under civil law, and (3) does federal bankruptcy law preempt the provisions of the Civil Code discussed in Aden, et al.? The third issue is currently awaiting resolution by the U.S. Supreme Court, so let’s focus on the first two issues in the remainder of this post.

To begin with, we see no good reason why the relevant debtor/creditor provisions of the P.R. Civil Code shouldn’t apply to a government agency or instrumentality. If anything, the same laws that apply to private persons and business entities should also apply to the government. Nevertheless, Aden et al. might be on shakier ground regarding step two of their proposed solution. We are under the impression that “joint obligations” (oligaciones solidarias) under the civil code refers to joint ownership of an indivisible thing (like a painting or a boat). In the case of bonds, by contrast, each individual bondholder’s ownership interest or credit rights can be easily and separately ascertained, so a strong argument can be made that bonds (or stocks, for that matter) should never be classified a “joint obligation.” Lastly, even if bonds (i.e. investment contracts) could be classified as a “joint obligation” under civil law (thus solving the critical holdout problem identified in Aden et al.), the government of Puerto Rico would still need to offer a restructuring deal that would be attractive enough to obtain the support of a simple majority of the relevant class of bondholders. How likely is that?

In the alternative, then, we would offer a procedural solution to the P.R. debt crisis: what if the Puerto Rico government and its major creditors (see below) were to agree to some form of binding arbitration to settle their differences?

In our previous post, we mentioned that three law students at Duke University (Aden, et al.) figured out a two-step solution to Puerto Rico’s public debt crisis, a simple and elegant solution that is already available to Puerto Rico under existing provisions of the P.R. Civil Code. We also reviewed step one of their proposed solution. Briefly, under Article 1812 of the Puerto Rico Civil Code, “a debtor may judicially ask from his creditors a reduction in the amount and an extension of time in the payment of his debts,” and under Art. 1818 of the Civil Code, a debt restructuring or “haircut” agreed to by a simple majority of creditors is binding on all of them. Although a court cannot compel any creditors to agree to new terms, a court may order the parties to negotiate in good faith with each other. (Put another way, a court can order the creditors to visit the barber shop; it can’t compel them to get a haircut.)

But why would any creditors ever agree to a haircut in the first place, especially when holdouts might still receive payment in full after after the other creditors have agreed to restructure their claims (i.e. the “Argentina problem”). The holdout problem now takes us to the second step of the Duke students’ solution. Specifically, Aden et al. claim that in Puerto Rico’s case the holdout problem can be solved through the civil code concept of the “joint obligation” (obligación solidaria), a legal fiction or default rule set forth in Articles 1090 to 1101 of the Puerto Rico Civil Code (31 L.P.R.A., secs. 3101-3112). The Duke authors rightly note that a joint obligation under the civil code is “not a restructuring per se, but rather a way for Puerto Rico to be able to pay what little funds it has available to all of the creditors pro rata without the fear of holdouts” (Aden, et al., 2016, p. 6).

In summary, when an obligation is classified as a “joint obligation” under the Puerto Rico Civil Code, the debtor of the obligation may elect to make payments to any one of his joint creditors, and as long as one of the creditors is paid, then the other creditors may not recover their share of the debt from the debtor. (See Article 1095 of the P.R. Civil Code, 31 L.P.R.A., sec. 3106.) Instead, the other creditors must seek contribution from the creditor who received payment from the debtor. Moreover, Aden et al. make a strong case that Puerto Rico’s General Obligation Bonds are a “joint obligation” under the Puerto Rico Civil Code. In particular, they point out section 32(b) of the March 7, 2012 Puerto Rico Bond Resolution, which states that “all proceedings shall be instituted only […] for the equal benefit of all beneficial owners of the outstanding […] Bonds” (Aden, et al., 2016, p. 9). Thus, in the words of the Duke authors, “because the General Obligation bonds are classified the same, treated the same, arise from the same Bond Resolutions, then [a joint obligation] exists between them and these creditors may be treated as joint creditors” (ibid.).

(In the alternative, Aden et al. argue that Puerto Rico’s General Obligation Bonds are a “joint obligation” under Article 1093 of the P.R. Civil Code (31 L.P.R.A., sec. 3104) and under Article VI, Section 8 of the Puerto Rico Constitution. Article 1093 of the Civil Code states that a “joint obligation” may exist even when the “creditors and debtors are not bound in the same manner … and under the same conditions,” while Article VI, Section 8 of the P.R. Constitution states: “In case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law.”)

In our next blog post, we will evaluate the merits and feasiblity of this simple and elegant two-part solution to Puerto Rico’s debt crisis.

Image Credit: Yannerys Colmenarez.