Congress Goofed. Puerto Rico Pays.

Bankruptcy was an option until 1984. That's when a drafting error became law.

Fishing for answers.

Photographer: Christopher Gregory/Bloomberg

This week, Puerto Rico managed to make its latest payment on its crushing debts, but all bets are off as to whether it will eventually default on its many obligations. 

Attempts to restructure more than $100 billion worth of liabilities have run into serious obstacles, as legal challenges mounted by aggrieved bondholders invalidated legislation intended to ease the burden.

QuickTake Puerto Rico's Slide

These legal skirmishes reflect the fact that Puerto Rico is trapped in a no man’s land of bankruptcy law. This wasn’t always the case. At one time, Puerto Rico, along with other territories and all states, could authorize municipalities and public corporations to enter bankruptcy. Yet a little over three decades ago Congress stripped the island of its recourse to municipal bankruptcy law.

How that happened is a strange story indeed, one with implications for today, when Puerto Rico’s staggering debt load threatens both the island's people and the wider municipal bond markets and the retirement funds and investors that rely on them.

For much of American history, the federal government and the individual state governments have shared sovereignty over bankruptcy proceedings of all kinds. The Constitution (Article I, Section 8, Clause 4 ) allowed for a federal law governing bankruptcies. But it was not until 1898 that the country got a permanent federal bankruptcy law, and its scope was limited. Individual states continued to oversee voluntary bankruptcy proceedings of corporations and other actions.

Coincidentally, 1898 was also the year that the United States went to war with Spain and took control of Puerto Rico. And when Congress drafted the Bankruptcy Act of 1898, it made explicit reference to the island, noting in its opening page of definitions that anytime the word “states” was invoked, it “shall include Alaska, Hawaii, Porto Rico , and the District of Columbia.” This didn’t mean that Puerto Rico was a state per se; rather, it merely enjoyed that same access to federal bankruptcy laws that bona fide states did.

The 1898 legislation did not allow states or municipalities to declare bankruptcy. In 1934, Congress passed the Municipal Bankruptcy Act, a new piece of the bankruptcy code that enabled municipalities and public corporations to file for bankruptcy with the approval of the "state" that had jurisdiction. Though soon declared unconstitutional, a watered-down version signed into law in 1937 survived legal challenges. Puerto Rico, along with the District of Columbia, had access to these powers because they fell under the definition of “states” in the language of this law. 

Things more or less remained that way until 1978, when President Jimmy Carter signed a revision of the entire federal Bankruptcy Code. The subset of the code that related to municipalities and public corporations like utilities -- better known as Chapter 9 -- helpfully defined these entities as “a political subdivision or public agency or instrumentality of a State.”

But in a bizarre oversight, the legislation failed to define “state.” Drafting errors like this one prompted Arizona’s Democratic senator, Dennis DeConcini, to introduce S.658, the Bankruptcy Technical Amendments Act, in 1979. Among many tweaks, the bill proposed to “amend the definition of ‘State’ to include the Commonwealth of Puerto Rico, the Panama Canal Zone, the District of Columbia, and any territory or possession of the United States." These "government units,” a report on the bill noted, “were inadvertently left out of the definition of ‘State’ during the passage of the Reform Act.”

The bill passed the Senate and went to the House, where it entered the bowels of the Democrat-controlled Judiciary Committee. When the committee drafted its version of the bill, it declared its desire to deal with the many “errors” in the 1978 revisions.

But it then proceeded to introduce an error of its own, declaring that the word “state” should be taken to include “the District of Columbia and Puerto Rico, except for the purpose of who may be a debtor under Chapter 9 of this title.” This meant that Puerto Rican municipalities and utilities could no longer access federal bankruptcy law, overturning decades of statutory precedent.

Why the change? No one debated or discussed it in Congress. No one seems to have noticed the provision, or if they did, bothered to question why it had been inserted. Was it a rogue committee staffer? A clerical error?

The historical record is silent on these questions. Puerto Rican municipalities were hardly on the verge of bankruptcy at this time. And while it’s tempting to read the change as some kind of veiled attempt to frustrate Puerto Rican demands for statehood, the rest of the bankruptcy law drafted by the House defined “state” to include Puerto Rico and its inhabitants.

Indeed, Kenneth Klee, who served as a bankruptcy consultant to the House Judiciary Committee from 1977 to 1982, recently testified that “there is no legislative history explaining the purpose or rationale” for the language.

Whatever the reason for the change, the bill languished, shoved aside in favor of more pressing legislation. But in 1981, the Senate, now in Republican hands, resurrected it -- retaining the curious exclusion of Puerto Rico from Chapter 9. Over the next three years, the bill moved slowly through Congress.

Throughout this process, the radical alteration in Puerto Rico’s status attracted no debate or discussion. The only person who threw up a red flag was a law professor from the University of Michigan named Frank Kennedy. In a prepared statement before Congress in April 1983, he raised concerns that a bill ostensibly devoted to making some technical fixes to an existing piece of legislation was in fact introducing “substantive and significant changes in the law.” He singled out the Chapter 9 exclusion for particular notice, declaring, “I do not understand why the municipal corporations of Puerto Rico are denied by the proposed definition of ‘State’ the right to seek relief under Chapter 9.”

His query fell on deaf ears. A year later, the clause and all the other “technical” amendments to the 1978 law ended up bundled into a much larger, more controversial piece of legislation known as the Bankruptcy Amendments and Federal Judgeship Act of 1984. In the process, Puerto Rico lost its access to Chapter 9 proceedings.

Thanks to this bizarre turn of events, Puerto Rico has been forced to try to find other ways to deal with its debt burden. Last spring, its legislature approved the Recovery Act, meant to let public corporations like the Puerto Rico Electric Power Authority restructure their debt. The courts ruled parts of it unconstitutional -- demonstrating that Puerto Rico cannot solve its problems alone.

Congress should get involved. It may or may not choose to restore Puerto Rico’s access to Chapter 9. But the least it could do is have the kind of debate on the subject that it should have held three and a half decades ago.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.