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Puerto Rico: The Multiple Issuer Problem

posted by Adam Levitin

One problem complicating any resolution of Puerto Rico's financial distress is that there are a multiplicity of issuers. There are separate claims on separate issuers, and it won't work to resolve just some of them, as they are all ultimately drawing on the same set of economic resources.  While there are claims on different assets, they value of those assets derive from Puerto Rico's overall economic production.  This multiple debtor problem makes Puerto Rico materially different from, say Detroit, where there was one primary debtor (the City of Detroit). (I don't know the legal status of Detroit Public Schools--is it separate from the City, the way the Chicago Public Schools are?) As far as I'm aware, Chapter 9 filings have almost always been single entity filings, rather than filings of multiple associated cases, as occurs with Chapter 11. 

So what can be done to deal with the multiple issuer problem? Even if Puerto Rico were allowed to file for bankruptcy (or its various sub-territorial entities were allowed to file), it doesn't solve the problem. While there can be multiple bankruptcy filings and the different cases can be administratively consolidated, that is a very different thing that actual consolidation of debtors, and the inability to resolve claims on one debtor can hold the other cases hostage.  It doesn't do any good to resolve the general obligation debt if creditors can force the electric utility to raise prices through the roof.  With this sort of multiple entity case, the hostage value held by creditors increases significantly.

Puerto Rico's division of governmental authority into various government units is a form of asset partitioning.  This asset partitioning might have helped Puerto Rico get more credit than it should have on cheaper terms ex ante (for a model, see here), but ex post this sort of asset partitioning can blow up in a debtor's face if there is no way to reconsolidate in order to restructure. (Consider, for example, the value of the LA Dodgers without their stadium and without the parking lots by the stadium.) Partitioning via devolution of authority to multiple local government units and authorities is a more permanently binding form of asset partitioning than corporate subsidiaries or even than some securitization arrangements.

Below I present three ideas for how to resolve the multiple issuer problem: consolidation via exchange offer; consolidation via merger; and consolidation via the creation of a common co-issuer entity that is bankruptcy eligible.  

The first is to consolidate via an exchange offer.  That could be a voluntary or involuntary exchange (as detailed in my first post on Puerto Rico). I don't think a voluntary exchange offer is going to work, and the politics of an involuntary exchange using eminent domain are problematic (and there's some measure of legal risk involved too). 

The second possibility would be a merger of the various issuers.  That won't work for several reasons. First, there are likely merger restrictions in the various debt covenants, and second, it would involve a total restructuring of Puerto Rican government, which would lead to a lot of internal governance confusion. 

The third possibility would be to add a co-issuer to all of the debt obligations.  I suspect that would fly under the various covenants involved, as a co-issuer by itself does not diminish creditors' rights--it actually expands them.  (This was the move done in Codere's restructuring in order to get UK jurisdiction for a Scheme of Arrangement.) Now let's imagine that the co-issuer were not another Puerto Rican entity, but say, a Delaware LLC.  That Delaware LLC co-issuer would be eligible to file for bankruptcy, unlike the Puerto Rican original issuers.  So let's say that the Delaware LLC co-issuer were to file in, well, Delaware.  The automatic stay would obviously apply to the Delaware LLC co-issuer. And there's a pretty good chance the court would extend the automatic stay to the Puerto Rican issuers, whether under section 362(a), 105(a), or some general equity powers argument (see, e.g., A.H. Robins v. Piccinin; but contrast In re Lyondell Chemical (granting only a temporary stay under section 105(a))).

Now even if the automatic stay can be extended to the Puerto Rican issuers, that's not enough to do the trick, as that automatic stay will be lifted at the end of the case. To make this method work, the court would have to enter a third-party release of the Puerto Rican entities. If they make a substantial contribution to the plan (and they would), I think there would be grounds for their release. But this just puts the question of the legal authority for third-party releases front and center. We've seen courts grant them generally in two situations: mass torts (e.g., Johns Manville for asbestos, before the adoption of section 524(g)) and when there is a high degree of overlapping identity between the debtor and the third parties (e.g., officers and directors of closely held companies, when the company is sort of an alter ego). The legality of these third-party releases is still somewhat up in the air. Five circuit courts of appeals have blessed them in some situations (Metromedia (2d); Continental (3d); A.H. Robins (4th); Dow Corning (6th); Airdigm (7th)), but there's no statutory hook for them outside of the asbestos context, and the existence of the third party release provision for asbestos under section 524(g) argues against authority for third-party releases in other contexts.

Bottom line is that it's anyone's guess what the Supreme Court would do with a third-party release.  (Travelers Indemnity Co. v. Bailey doesn't resolve the question of the bankruptcy court's authority to enter a third party release:  "whether the Bankruptcy Court had jurisdiction and authority to enter the injunction in 1986 was not properly before the Court of Appeals in 2008 and is not properly before us". Instead, the case dealt with the authority of the bankruptcy court to interpret its injunction (which was assumed valid).). Thus, the co-issuer route, while possible, has real legal risk, more so, in my view, than the eminent domain route. 

The fact that there's legal risk, however, does not end the story. Legal risk cuts both ways. The fact that there's even a plausible route forward gives Puerto Rico some bargaining power if it can credibly threaten to proceed with a consolidation, whether it is a formal buyout (at whatever price) or the insertion of a common co-issuer that is eligible to file for bankruptcy. 

Irrespective of the tools used, the problem of multiple issuers is a real one that is complicating any attempts to resolve Puerto Rico's financial distress. 





Using a Delaware LLC as co-issuer sounds like a good idea to solve several of Puerto Rico's problems. However, I am curious to know if you think Section 548 of the Bankruptcy Code could pose a potential problem, particularly the notion of constructive fraud?

Although it primarily comes up in the context of parent-sub guarantees, it seems potentially applicable in this context: the LLC would essentially step in and incur an obligation on behalf of Puerto Rico, which can easily be characterized as transferring an interest. Moreover, the LLC would not be receiving much value in return, nd because the entire point of the set up is for the LLC to file for bankruptcy, the remaining requirements of 548 seem to be met. Of course, the 'trustee' is usually the debtor, but a creditor could petition the court to actually appoint a trustee, and the usual reasons for not doing so (as they apply to operating companies) does not apply in this case.

Do you think this would pose a problem? Or is 548 not applicable?

Third party releases don't merely require a substantial contribution in at least some circuits. In Dow Corning, the Sixth Circuit adopted a seven factor test; all seven factors are required: (1) identity of interest; (2) substantial contribution from non-debtor; (3) injunction is essential to reorganization of debtor; (4) the impacted voters overwhelmingly voted to accept the plan; (5) the plan provides a mechanism to pay for all or substantially all of the classes effected by the injunction; (6) the plan provides an opportunity for those claimants who chose not to settle to recover in full; and (7) the bankruptcy court made a record of specific factual findings that support its conclusions in favor of an injunction. In re Dow Corning Corp., 280 F.3d 648, 658 (6th Cir. 2002). In Detroit's plan confirmation, Judge Rhodes applied Dow Corning to a third party release of city employees that were indemnified by the city. In re City of Detroit, Mich., 524 B.R. 147, 262-265 (Bankr. E.D. Mich. Dec. 31, 2014). He did not specifically address all the factors, but he did denied the third party release.He found that the debtor had failed to prove that the release was essential or crucial to the reorganization of the debtor, the City of Detroit. In your proposal, its not clear to me how the release of a co-debtor (Puerto Rico) would be essential to the reorganization of the Delaware LLC. Its essential to Puerto Rico's organization but that is not the factor a court considers. I am less familiar with other circuits' test for a third party release, but I wanted to point out that even a third party release, if legal, wouldn't be easy.

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