Puerto Rico’s colonial status hinges on a New York hedge fund’s greed

While the drama in Venezuela currently has center stage in sovereign debt circles, a lawsuit in San Juan has the potential to be one of the most significant in sovereign debt history. This lawsuit could not only derail Puerto Rico’s current debt restructuring attempts, but it could also call into question the constitutionality of its status as an “unincorporated” U.S. territory. Rarely does a case that is nominally about debt so squarely involve the question of what it means to be sovereign.

In 2016, Congress passed the Puerto Rico Oversight, Management and Economic Stability Act, or Promesa, which among other things established a control board with broad powers to run Puerto Rico’s finances until it can be returned to fiscal stability. To quote the title of one of the academic articles that inspired the control board idea, it is a “dictatorship for democracy” in the form of a temporary, undemocratic institution designed to restore order.

{mosads}Unsurprisingly, the board has faced strong opposition. Critics allege that it fails to address the island’s underlying economic problems, and also that it fails even the most basic tests of democratic accountability. Some union leaders, environmental groups, and left-wing political parties see the board as a tool of vulture capitalists working in cahoots with the federal government to reimpose colonial rule.

This makes it all the more striking that their most powerful ally against the board might well be an infamous New York hedge fund, whose lawsuit could bring the control board crashing down, and perhaps even alter Puerto Rico’s territorial status. The hedge fund, Aurelius, has a straightforward claim: The members of the Promesa board were unconstitutionally appointed, and therefore the steps toward a debt restructuring that the control board has taken and plans to take (which would likely force Aurelius to take a haircut on the nearly half a billion dollars of Puerto Rican debt it holds) are invalid.

The basis for this claim lies in the appointments clause of the Constitution, which specifies that principal federal officers must be appointed by the president, with the advice and consent of the Senate. Although the case law is not crystal clear, principal federal officers tend to be those who exercise significant authority pursuant to federal law and who have the president as their only boss. If the appointment of a seven-member control board with carte blanche to run the finances of the country’s biggest territory is not the appointment of primary federal officers, what is?

But the board members have an answer. Puerto Rico is, according to century-old Supreme Court precedents, an “unincorporated territory.” That means that the board members are territorial officers under the territorial clause of the Constitution, not federal officers subject to the appointments clause. The former clause gives Congress the power to “make all needful rules and regulations respecting the territory or other property belonging to the United States.” A plenary authority is not subject to the usual constraints of the separation of powers.

That those Supreme Court precedents, the much-reviled Insular Cases, are still part of American law is an embarrassment. They were written by the same basic lineup of justices who penned Plessy v. Ferguson, and are tainted by a stunningly racist and colonial mindset. Plessy v. Ferguson is the infamous case that held that “separate but equal” was constitutional, and it was explicitly overturned by Brown v. Board of Education. The Insular Cases, by contrast, remain good law and are still the basis of Puerto Rico’s form of sovereign limbo.

The federal district court in San Juan is therefore presented not simply with an aggrieved creditor, but with a claim that goes right to the heart of Puerto Rico’s legal status. The core question, in a way, is whether Puerto Rico, more than a century after it was acquired through conquest, remains still a distant colony, as the Insular Cases held, or has truly become part of the United States. For the millions of American citizens in Puerto Rico, the island’s legal status has been of paramount importance long before the debt crisis or the impact of Hurricane Maria.

For decades now, Puerto Ricans have debated whether and how to become the 51st state, become an independent nation, or remain a territory with no voting representation in Congress. Many have concluded that their preferences will be ignored on the mainland, which might help explain why only a quarter of eligible voters showed up for a June referendum on the island’s status. In the words of one U.S. congressman of Puerto Rican descent, “Congress won’t do anything.” Maybe. But Aurelius is not going away, and it has a war chest, a brilliant legal team, and a tenacity that will force the federal government to take note.

This is, after all, one of the same hedge funds that, in the infamous “pari passu” litigation, brought the Argentine government to its knees just a few years ago. The Aurelius managers did not set out to lead a constitutional crusade from their Fifth Avenue penthouses. They simply want to avoid having to take pennies on the dollar for their bonds (which is what the board will probably do in order to get Puerto Rico back to sustainability). But in fighting against the board, Aurelius has already proven willing to smash away at the foundations of Puerto Rico’s legal status.

A century ago, economic disputes over things like sugar tariffs led to the Insular Cases, which established Puerto Rico’s status as an “unincorporated territory.” The financial dispute currently playing out in that quiet federal district court in San Juan might just unwind it.

Joseph Blocher and Mitu Gulati are law professors at Duke University and authors of “Puerto Rico and the Right of Accession.”