Twenty-five years before the failures of the United States Congress and the Commonwealth's government caused a debt crisis in Puerto Rico, a philosopher painted on a cliff side over a slum in Mexico City: "The national debt is not the debt of the people." The bite of that truth is now being felt in Puerto Rico. For the past decade, Puerto Rico's creditors have forced austerity in an effort to make the Puerto Rican people pay for the governments' failures. Many Puerto Ricans -- who didn't sign the promissory notes, can't be held liable for the debt, and have the legal right to move to the mainland -- are simply leaving the island and the austerity behind.
At $72 billion, the debt far exceeds Puerto Rico's ability to pay. Everyone knows that the creditors must accept massive losses, and everyone knows pretty much what the total amount of those losses must be. What remains to be determined are the proportions in which the various creditors will share the losses. In short, Puerto Rico is descending into chaos for lack of a legal process that can force the greediest of the creditors to accept their fair share.
Such a process is available to every state or territory of the United States except Puerto Rico and the District of Columbia. That process -- recently used in the rescue of Detroit - is debt adjustment under Chapter 9 of the United States Bankruptcy Code. Congress excluded Puerto Rico and its instrumentalities from Chapter 9 by legislation adopted in 1984. Neither the legislative history nor any other source provides a reason for the exclusion. Congress could correct its mistake even at this late date, but the Republicans won't go along. They argue that the lenders relied on Puerto Rico's inability to file bankruptcy, so it is unfair to change the rules now. The lenders, they say, should have their full, non-bankruptcy remedies. On Friday, the Supreme Court accepted a case that may validate a Puerto Rican law that substitutes for Chapter 9, but the decision in that case is not expected until June -- too late for the current crisis.
Fortunately, a legal strategy exists by which Puerto Rico and its creditors can have the benefits of Chapter 9 now, without denying any creditor its full, non-bankruptcy remedies. The Puerto Rico government can create a virtual Chapter 9 for itself by granting a security interest - essentially a mortgage -- in all of the assets creditors could seize to all creditors who agree to suspend their collection efforts and be bound by the virtual Chapter 9 outcome. Technically, the virtual Chapter 9 would be an arbitration, the arbitrator probably a retired United States Bankruptcy Judge, and the governing rules the provisions of Chapter 9.
Creditors who prefer their legal remedies would have full access to them. They could sue in the courts, obtain judgments, and enforce those judgments against the debtor's assets to the full extent of the law. Enforcement is by physical seizure and sale of the assets. If such seizures actually occurred, they would certainly generate chaos. But the law gives secured creditors priority over the rights of judgment creditors and the right to block such seizures. That right would continue for the duration of the virtual Chapter 9 and probably for many years afterwards. Even when the crisis was over, the judgment creditors' collection rights would remain subordinate to those of the secured creditors. For these reasons, few or no creditors would actually prefer their legal remedies over participation in the virtual Chapter 9.
To my knowledge, this strategy has never been employed by a government. But a less-virulent strain of it has been used successfully by insolvent Silicon Valley companies as far back as the dot-com bubble. Palo Alto attorney Lincoln Brooks used it in about fifty cases. Companies granted security interests to the local Creditor Managers' Association as trustee for all of the companies' unsecured creditors. Dissident unsecured creditors were free to obtain judgments and try to seize assets. But they tried in only about five cases and they succeeded in none of them.
The virtual Chapter 9 strategy would generate enough leverage over creditors for Puerto Rico to deal with its debt crisis. The risk is that it would generate too much. Without an actual Chapter 9 to limit the Puerto Rican government, that government could design a procedure even more to its benefit. The creditors would still have to participate for exactly the same reasons. The government might even find in this strategy a way to continue outspending their revenues indefinitely. For the benefit of Puerto Rico's creditors as well as its people, Congress needs to fix the Puerto Rico Chapter 9 loophole before it is too late.