What happens when private creditor rights in bankruptcy proceedings pose an existential threat to the operation of a public utility? We may soon find out. The Puerto Rico Electrical Authority (PREPA), a public utility and the only electric utility in Puerto Rico, has been in bankruptcy proceedings since Hurricane María devastated the island seven years ago. And this past June, PREPA’s bondholders won a major victory in the First Circuit.
According to the decision, the bondholders’ $8.5 billion claim against the utility was secured by all of the utility’s past, present, and future net revenues, rather than the mere $16 million fund that was separated out for repaying creditors. In other words, PREPA’s creditors now have the ability to look to the entire utility system’s output for repayment, which could be worth billions. If the decision stands, creditors will have significant leverage in their attempts to squeeze even higher electrical rates out of a low-income and aging population.
In the following post, I explain the underlying bankruptcy principles that have brought about this disastrous outcome and call for reforms that mediate between property rights and public goods.
Private Rights in Public Utilities
To understand the First Circuit’s decision, we need to begin with Congress’s enactment of the Puerto Rico Oversight, Management, and Economic Stabilization Act (PROMESA). This “bespoke bankruptcy” law, adopted in 2016, established a process for restructuring Puerto Rico’s debt, and created an unelected management board—known colloquially as “la junta”—to control the territory’s fiscal affairs. Before Congress enacted PROMESA, the utility provider entered into an agreement that reduced the amount they owed to creditors by only 15%. The agreement also included a “transition charge” that required PREPA to raise its electrical rates on many of Puerto Rico’s residents by 10% to ensure repayment.
As the PROMESA bankruptcy proceedings continued, the Board began to indicate that this deal was not sustainable. Indeed, one only needs to consider that Puerto Rico’s median income is less than half of the poorest state—yet citizens pay the fourth highest electrical rates in the country—to see that extracting more wealth in the form of electrical rate increases is untenable. The Board and other parties argued that PREPA’s creditors only had a property right to $16 million (the amount held in a fund established under the bonds), out of the $8.5 billion legal claim (the principal amount of the bonds plus matured interest). The creditors, however, maintained that they had a property interest in “all net revenues” that PREPA produced.
Initially, in March of 2023, the District Court overseeing the proceedings agreed with the Board. However, as noted above, earlier this year the First Circuit reversed. The Court’s decision focused on Section 928(a) of the Bankruptcy Code, which essentially provides lenders who have property rights attached to their loans the right to continue receiving payment. (Creditors without property rights, by contrast, are barred from continuing to receive payment once an entity seeks bankruptcy protection.) This provision is a feature of bankruptcy law grounded in the 5th Amendment’s prohibition against government takings, since extinguishing the creditor’s property claim through bankruptcy law would amount to the taking of their property without just compensation.
According to the First Circuit’s interpretation of the relevant bond documents, the property rights of PREPA’s lenders extend to all of PREPA’s “net revenues” since the organization filed for bankruptcy in 2017. While a dispute remains about whether PREPA actually has any “net revenues,” especially after receiving federal money to repair the grid in the aftermath of hurricane María, the Court’s decision gave PREPA’s creditors leverage. And creditors are wielding this leverage to demand that the utility raise rates on the island to pay their $8.5 billion debt, despite warnings that doing so will lead to a “doom loop” in which people will abandon the grid, and the financial burden will fall on a smaller population of marginalized citizens. In this instance, property rights were upheld at a high cost: the public good.
Balancing & Public Bankruptcy Law
The First Circuit’s decision—which recognizes a bondholder’s property rights in revenue from public utilities—creates a dynamic in which property rights endanger public goods and create a moral hazard in favor of creditors. Discussion of this dynamic in bankruptcy rarely arises because municipal bankruptcies are so rare. However, what’s not rare is the downstream harms that bankruptcy can spur. For example, as bankruptcy scholar Diane Lourdes Dick has pointed out, bankruptcy proceedings often pit bondholders and pensioners against one another. This is a fair characterization of what happened when Puerto Rico’s central government attempted to restructure its debt. As I have described elsewhere, retirees in Puerto Rico who faced the prospect of having their pension income slashed organized to fight back. They did so against incredible odds by using the political process and bankruptcy law to their advantage.
In this case, however, the question is whether bankruptcy law should protect private property at the cost of the decimation of a public good. Using Lourdes Dick’s framing, this case is a battle between thousands of private creditors and the millions who are reliant on public electrical power. Interestingly, the bankruptcy code creates this tension because it requires all plans for the repayment of past debts to be in the best interest of creditors and be “feasible.” While the Code does not define the term feasible, courts have generally interpreted it to mean that the debtor’s financial projections are reasonable and that it will meet its obligations. There is also a political element to it. The people who must implement the agreement should demonstrate that they will not undermine its implementation.
There is no explicit accommodation of these goals to public ends, except to protect government property from being sold off. But what if, as appears to be happening in Puerto Rico, the protection of property rights leads to an onerous result that is akin to selling off the public good? The idea of balancing property rights against the public good (beyond the protection of government property) is new to bankruptcy law. However, potential solutions can be found in labor law. For example, the Supreme Court’s decision in Republic Aviation balanced an employee’s right to organize against an employer’s property rights and found that in some cases labor organizers can use employer property. That is, there are circumstances under which the employer’s property rights must cede to the purposes of the National Labor Relations Act.
Applying the Republic Aviation framework to the domain of bankruptcy is far from straightforward. Labor statutes differ from bankruptcy law, and labor boards are required to balance federal labor law and an employer’s property rights. However, the idea of balancing is not alien to the field of bankruptcy: bankruptcy courts must balance what creditors are owed and what the debtor can pay. While property rights are sacrosanct in bankruptcy, there should be limits to these rights when a sufficiently compelling good is undermined by a private interest. To do otherwise could create a moral hazard by incentivizing creditors to lend knowing that they will receive special protection in which their property rights are elevated over the public good.
To date, bankruptcy scholarship has not considered when property rights must accede to the public good. Current discourse in private sector bankruptcy is centered on Douglas Baird and Thomas Jackson’s “Creditors Bargain Theory.” This theory holds that bankruptcy courts exist to solve creditor coordination problems. David Skeel and Kenneth Ayotte expand on this framework, calling for bankruptcy to think about liquidity problems. Unfortunately, these frameworks are insufficient for managing the political economy problems that cause public bankruptcies, as they are mainly rooted in resolving creditor coordination problems affecting corporations in the first place.
Similarly, public bankruptcy discourse leaves much to be desired. Some scholars have called for “Dictatorships for Democracies”—supervisory institutions that exercise approval authority over local budgets and displace locally elected officials—as a way of controlling for the moral hazard caused by politicians who make financially irresponsible decisions. This proposal calls for states to install unelected financial managers to manage the finances of cities and make decisions concerning them, even if local elected officials dissent. There is no doubt that political decisions plagued the operations of PREPA over the years, but the focus on supervisory boards ignores how other factors like political decisions by state and federal officials distort market incentives to lend and foster political economies that create publicly bankrupt entities.
Additional protections against creditors are necessary for municipal debt for another reason: in the private sector, a company’s creditors can liquidate a company that fails to successfully restructure its debts. In public bankruptcy, however, the creditors cannot simply liquidate the municipality—a fact Congress recognizes by refusing to grant bankruptcy courts the power to attach local government assets or let creditors access government money.
We need a new test for balancing the interests at stake in bankruptcy—one that protects private property, but not at the expense of constructively undermining major public goods. One such balancing test could examine whether the assertion of property rights over a public good essentially acts as a “constructive taking” of public property. For example, if a public utility will foreseeably lose a significant percent of its customers due to rate increases, causing them to forgo desperately needed upgrades, a court might refrain from approving this bankruptcy plan because it amounts to a “constructive taking” of public property by way of the collapse of the public utility. The concept of a “constructive taking” of public property is flexible enough that courts could apply it in situations where related governmental entities are in bankruptcy and have a synergistic financial relationship with one another (such as a public utility and the city or state it’s located in). Under these circumstances, a court could examine whether onerous debt repayment conditions amount to the “constructive taking” of a public good by causing significant deterioration of the relied upon utility.
This suggestion is, however, merely meant as one possible a starting point. Public bankruptcy theory should adopt creative approaches that protect creditors and prevent the degradation of important public utilities in the name of property rights.
This post represents the personal views and comments of the author, and should not be attributed to his employer or the Unsecured Creditors Committee for the Title III PROMESA proceedings.
