The latest swerve in the rollercoaster that is Puerto Rico public finance occurred on April 11 with the release of the Puerto Rico Supreme Court’s ruling striking down as unconstitutional the bulk of the territory’s teacher pension reform legislation.  The outcome of the case creates some disarray in the executive and legislative branches’ efforts to stabilize Puerto Rico’s finances, as well as in the Puerto Rico Supreme Court’s contracts clause jurisprudence.

We have previously discussed both the teacher pension reform litigation and the Puerto Rico Supreme Court’s prior ruling in the Hernandez case upholding the territory’s public employee pension reform legislation.  In the 5-4 Hernandez case, the dissents included strongly worded accusations that the majority had rubber-stamped the legislature’s conclusion that there were no less onerous alternatives to the  challenged impairments of the employee’s pension rights.   In the 5-3 teacher pension case, the majority went to the other extreme and concluded that the legislature and governor had acted unreasonably in enacting the legislation, because (according to the majority) the legislation failed to take into account the high number of accelerated teacher retirements the legislation would provoke, which (according to the majority) would further strain, rather than improving, the teacher pension system’s finances.

In other words, the court majority concluded that the teacher pension reform legislation did not promote the public purpose to which it was addressed.  As we have previously discussed, the “contracts clause” in the U.S. and Puerto Rico constitutions has been interpreted as permitting state action that impairs contracts if such action promotes a necessary public purpose and there are no less onerous means of achieving that public purpose.  Because the Puerto Rico Supreme Court concluded that the teacher pension reform legislation did not serve its stated public purpose of preserving the viability of the teacher pension system, it did not have to address whether there were less onerous means of achieving that purpose than the legislation’s benefit cutbacks and contribution increases.

In particular, the court referenced certain provisions of the legislation that preserved certain benefits for teachers retiring prior to a near-term cutoff date, economic studies presented by the teachers’ union regarding the impact of the early retirement of 7000 teachers, and an actuarial study forecasting the consequences of the early retirement of 5,000, 7000, 10,000 and 15,000 teachers, respectively.  The court also referenced testimony to the effect that approximately 4,100 teachers had contacted the pension system about early retirement since the legislation was enacted, and that 10,000 or more teachers would be eligible for early retirement.  The court interpreted the actuarial studies as showing that if such large-scale early retirements occurred, the pension fund would be depleted at an earlier date than if no legislation were enacted.  The court noted that the legislation had been enacted during a 6-day period and that the legislature had commissioned no studies about the early retirements the legislation might trigger or the impact of such early retirements on the system’s solvency.  The majority concluded that the teachers’ union had met its burden of proof that the challenged legislation, instead of increasing the system’s solvency, would leave it in a more precarious position.

The court upheld the legislation as applicable to teachers who began or begin service subsequent to its enactment, and also upheld certain cutbacks on system contributions to teacher’s health plans and annual Christmas bonuses to retired teachers, which the court concluded were not pension rights or contract rights.

It is unusual for a court, in a situation of fiscal crisis,  to hold that the other branches of government are effectively wrong about the financial effect of legislation being positive rather than negative.  There no doubt are genuine distinctions between the evidence presented in the Hernandez case and in the teachers’ pension case; it is also clear that there was a change in the receptiveness of certain of the court’s members to the government’s arguments regarding the necessity of the applicable pension reform.  To understand the difference in analysis and result, one may need to go no further than the majority opinion’s second paragraph, which states that “Teachers are the ones that mold the knowledge of the members of our society.  They are a fundamental piece of the educational system.”   A majority of the court appears to have credited the teachers’ presentation on this difficult public policy matter over the government’s.

Puerto Rico bondholders have been following this case for its credit implications as well as its legal implications.  The result may be a mixed bag from both perspectives.  From a credit perspective, the decision invalidates teacher pension reform that the Puerto Rico government has touted as an important component of its financial stabilization plan; on the other hand, the court invalidated the legislation on the stated grounds that the reform would make things worse, not better.  From a legal perspective, the court’s closer scrutiny of contract impairment may be somewhat heartening to bondholders concerned that Puerto Rico’s debt may be next on the impairment list.  Whether any comfort is warranted remains to be seen, but it seems less likely that the Puerto Rico Supreme Court would second-guess the financial efficacy of any future attempts to legislate debt restructuring.