Puerto Rico's Precarious Position Isn't So Unusual
No U.S. state has defaulted on its bonds since the Great Depression -- yet Puerto Rico, a commonwealth that operates much like a state without being one, is on the brink. Is there any connection between Puerto Rico’s unique constitutional status and it economic woes? If not, what does that say about the prospect for future default by any of the actual 50 states of the union?
Start with why states haven’t defaulted in the past 80 years. Part of the reason is that states are governed by various forms of budget amendments. Forty-three states require the governor’s proposed budget to be balanced, and 37 state constitutions require the budget to be balanced at the end of every fiscal year (or sometimes two).
Puerto Rico’s constitution contains both of these provisions. In that respect, at least, Puerto Rico is no different from the other states that have balanced-budget amendments.
In reality, many of these states allow accounting tricks to avoid violating their rules -- tricks that arguably violate the spirit of the state amendments. Puerto Rico, like others, allows money borrowed from bonds to count as a form of revenue when balancing the budget. In the short term, this makes sense -- otherwise states might never be able to borrow for large infrastructure projects without producing an unbalanced budget.
But as the example of Puerto Rico shows, over time, a state may build up more and more bond debt -- including debt taken on simply to fund existing budget shortfalls.
There’s a lesson here for the 50 states and, perhaps more important, for their bondholders: A state balanced-budget amendment sounds great in theory, but may not matter very much in practice. In general, constitutional provisions are wondrously flexible things, as the gay-marriage decision, Obergefell v. Hodges, most recently reminded us. Strict constructionists may wish constitutional rules were interpreted narrowly, but more often than not, they aren’t.
Then there’s the U.S. Constitution, which prohibits states from enacting any law impairing the obligation of contracts, including their own. On its face, the contracts clause would seem to be a good measure to protect bondholders against state default -- after all, a bond is a contract. Constitutional scholar Ernest Young, writing with Emily Johnson, argued in 2012 that “repudiation of a state’s bonds is surely unconstitutional under the Contract Clause.”
That might overstate the case a bit. Applying the contracts clause, courts ask whether a given impairment of a state’s contractual obligations was “reasonable and necessary to serve an important government purpose.” Keeping the state running in the face of fiscal disaster might well count as an important government purpose. Put another way, it might serve the interests of the public, not just that of the government.
The contracts clause applies to Puerto Rico, as the U.S. Court of Appeals for the First Circuit held in 2011. In general, the courts treat Puerto Rico as a state for purposes of federal constitutional limitations -- and the contracts clause is no exception.
Yet in the real world, the contracts clause hasn’t always been effective in protecting against state default -- and not just because the contracts clause might actually allow it. A number of states defaulted on their obligations in the 1840s; in the 1870s, several former members of the Confederacy defaulted on the debt they had accrued during Reconstruction, when they were governed indirectly by federal control -- all notwithstanding the contracts clause.
How can it be that states -- and Puerto Rico -- can violate the Constitution with impunity? Well, as interpreted by the Supreme Court, the 11th Amendment bars a suit against a state in federal court by residents of another state, because Justice Anthony Kennedy thought such a suit would be beneath the dignity of a sovereign state. (He really loves dignity -- a lot.) So bondholders couldn’t sue the state in federal court for violating the contracts clause.
Then there’s state court. A state would have to consent to being sued in its own courts, and indeed a bond contract might already include such a waiver. But it seems unlikely that most state courts would hold against their own sovereigns. If pressed, they might even say that the default was “reasonable and necessary to serve an important government interest” -- and therefore constitutional.
The lesson, again, is that even the apparent federal constitutional guarantee that states will honor their contracts isn’t sufficient to protect against default.
Like a state, Puerto Rico can’t go into bankruptcy, at least not in any familiar way. That leaves the question of a federal bailout. Here Puerto Rico seems worse off than the states -- because it isn’t constitutionally represented in Congress, and its residents can’t vote for president. Political support for a bailout would have to come from the bondholders alone.
It’s tempting to speculate that investors in Puerto Rican bonds were a bit like investors in Greek debt. Both in some sense counted on the entity acting like a “normal” member of the confederation to which it belongs. Surely a U.S. commonwealth wouldn’t be allowed to amass so much debt that default became a realistic possibility. And surely a euro zone country wouldn’t come to the brink of default, and beyond.
But as it turns out, the legal and constitutional features that make an entity into part of a broader union don’t always protect bondholders. Debt is a funny thing. It’s a creature of law -- but when default comes, the debt tends to exceed the law’s capacity to cabin it within legal limits.
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Noah Feldman at email@example.com
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