Congress has scheduled yet another hearing on the debt crisis slowly destroying the lives of millions of American citizens living in Puerto Rico. If this results in prompt legislative action, we should applaud the exercise of strong, even if belated, leadership. If this results only in more platitudes on a vague need for “structural reform,” then we should notch another failure of our congressional representatives to solve actual problems where real people suffer. Nor will the Obama administration escape unscathed if nothing happens; it is not helpless, so “Blame Congress” won’t work.
Congress’s inability to act on this burgeoning crisis is especially surprising given the near- unanimous and bipartisan chorus of scholars, disinterested investment professionals, and politicians who have advocated such simple changes as amending the Bankruptcy Code. Heavy hitters ranging from Sen. Bernie Sanders (I-Vt.) to Grover Norquist and Newt Gingrich all agree that bankruptcy reform, such as the Puerto Rico Chapter 9 Uniformity Act currently pending, needs swift passage.
One bizarre exception to this emerging consensus is former Sen. Judd Gregg (R-N.H.), who in this very journal opposed bankruptcy reform. Admitting that Puerto Rico’s problems have been long in the making, his contrary proposal appears to be, literally, a “time machine.” More earthly technology, such as the bankruptcy reforms already pending in Congress or jointly proposed by the Treasury Department, HHS and the NEC, are more compelling.
Gregg’s opposition boils down to three assumptions, each flawed. First, he claims retirees and pension investors would be hurt by allowing Puerto Rican entities chapter 9 relief. Leaving aside the premise that tax-exempt retirement accounts would be invested in tax-exempt municipal bonds, there is no reason to assume investors, let alone the sophisticated hedge funds who are truly driving bankruptcy reform opposition, were mistaken into thinking the bankruptcy laws are un-amendable. Any risk of legislative change is already well priced into the market.
Second, Gregg claims making chapter 9 available for the territory of Puerto Rico will “domino” to other states, and that contagion will bring about the end of the bond markets. He references Detroit as the beginning of this “catastrophe[e].” The simple error is not recognizing the administration’s proposal would draw the line at federal territories, over which the Congress has special control, so the dominos stop there. The second error is the unsubstantiated hysteria of market collapse. In fact, the available data on Detroit suggest a post-bankruptcy ability to borrow on market terms beyond its credit manager’s wildest dreams. If Detroit’s credit access was “destroyed” by debt restructuring, it sure recovered quickly.
The final objection is that bankruptcy would leave bondholders “wholly unprotected” while a court somehow “slashed” debt. This is the most important mistake because it fundamentally misunderstands bankruptcy law. What bankruptcy does is allow a majority of creditors who support a sensible debt restructuring plan to bind holdouts who try to block a voluntary workout. And if there is no consensual solution, when Puerto Rico eventually defaults, the inevitable consequence will be service failure and humanitarian crisis. Make no mistake: Puerto Rico is on the path to Greece. And guess what? Eventually Greece had to be bailed out. This is the reason true conservatives like Grover Norquist and Newt Gingrich are so intent on bankruptcy reform: it is wishful thinking to think the financial problem will go away, so the pressure on a public bailout in the absence of a deal will only increase inexorably with time.
So what can be done as a truly bipartisan solution to Puerto Rico? The key with any workout is to force stakeholders to come to the table. As long as bondholders think they have a Get-Out-of- Bankruptcy-Free card, they will not negotiate seriously. This is not a liberal-conservative issue, this is a bankruptcy issue. Indeed, in Detroit, the labor unions were forced to come to the table and negotiate concessions, and a deal – painful, but necessary – was eventually worked out. The hedge funds holding Puerto Rican debt should be subjected to no less sacrifice.
Getting these investors to negotiate a realistic repayment plan will require two things. First, Congress should amend the Bankruptcy Code to cover Puerto Rico (administration proposal) or even just the municipalities (pending legislation). Second, the executive branch should step in forcefully. Right now, Treasury appears to be patting itself on the back for having written a strongly worded letter to Congress to amend the bankruptcy laws. That’s not good enough. Treasury should be using its powers to force parties to the table. For example, it could use the Exchange Stability Fund to underwrite new bonds that result from a voluntary exchange in a workout, but denying such backstopping to holdouts. It could use its stature to investigate the allegations that some of the bond debt is illegally issued and hence not entitled to full payment. In other words, it needs to make creditors fear congressional inaction, not aspire toward it. That will only happen with a credibly frothy Treasury demonstrating that the only thing worse than bankruptcy reform will be no bankruptcy reform and a furious administration stepping in to use all its powers to prevent looming crisis for millions of U.S. citizens.
But bringing parties to the table is only one part of the puzzle. The other part is to restore confidence in the borrower. And on that point, Gregg is dead right: there needs to be meaningful financial oversight and transparency. With a debtor with such a sorry financial track record as Puerto Rico, that probably requires an “external” component, the same way an external oversight board was part of the so-far-successful Detroit restructuring. The board need not be a permanent fixture; it can sunset itself out of existence with certain benchmarks, but it needs to assure that the past practices of budgetary disaster will never recur.
Yes, there’s more: Medicaid, EITC, and so on. But a bipartisan solution’s foundation is bankruptcy reform (tough for hedge funds) and external oversight (tough for local politicians). Let’s hope our leaders figure that out in time to prevent needless suffering.
Pottow is John Philip Dawson Collegiate Professor of Law, University of Michigan Law School.
By John A. E. Pottow
The pitfalls of no Puerto Rico bankruptcy
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