The Curious Case of Aurelius Capital v. Puerto Rico

Puerto Rico filed for bankruptcy protection at 11:32 in the morning on May 3, 2017; by 11:33, the magnitude was obvious. No American territory had ever defaulted on so much debt. “A bankruptcy without precedent” ran a morning-after headline in the tabloid El Vocero, in an issue that also quoted leftist politicians warning readers not to be fooled: The filing, they claimed, was a prelude to more austerity. The island owed $72 billion. Already there was out-migration of 60,000 people a year and 10.5 percent unemployment. There were reports that vendors, owed millions of dollars, would no longer deliver food to Puerto Rican prisons.

The following month, an inconspicuous complaint was filed in federal court in San Juan. The plaintiffs were a group of hedge funds that had purchased Puerto Rican bonds around 2015 and were concerned that the bankruptcy would prevent them from recouping the bonds’ full value. According to the complaint, the Puerto Rican Constitution mandated the repayment of certain types of bond debt, but the island’s latest budget was instead pouring money into services that were “nonessential,” leaving the bondholders high and dry. The hedge funds argued that this was illegal and sought to point out some “nonessential” expenses to the court.

The hedge funds scoured the island’s budget. The Department of Sports and Recreation’s allotment of $39.2 million: Nonessential, the lawsuit said. Ditto the $12.6 million for the Institute of Puerto Rican Culture; $7.3 million for the Corporation for Public Broadcasting; $1.8 million for the Boys & Girls Club; and the $88,000 commitment to a nonprofit ballet company. One assertion in particular stood out. Puerto Rico’s budget had set aside $205 million in discretionary money for things like disaster relief. “While a ‘rainy-day fund’ is nice to have,” the hedge funds conceded in Paragraph 159, “it is impossible to see how this is an ‘essential service’ or how it can be justified,” in part because natural disasters were not “likely to occur” in the coming fiscal year. Three months later, Hurricane Maria made landfall. The presiding judge dismissed the complaint.

Among the plaintiffs on that complaint were a few subsidiaries of Aurelius Capital Management, a firm that is well known on Wall Street and obscure beyond it. Its chairman, Mark Brodsky, is one of the shrewdest hedge-fund managers of his generation. He made a fortune in distressed sovereign debt, purchasing bonds from countries that appeared to be in financial trouble, watching as they defaulted, then suing in court for full repayment. Brodsky started buying Puerto Rican bonds in 2015. That year, the financial journalist Michelle Celarier suggested in The New York Post that, of all the holders of debt, Aurelius would be the most intransigent, the least receptive to a forgiveness plan for the island. “The main hurdle for Puerto Rico is Mark Brodsky,” she wrote.

He was not a hurdle to be cleared easily. Brodsky had once spent about seven years suing Argentina for bond payments — and secured a lucrative settlement. (Addressing the United Nations in 2014, the president of Argentina accused hedge funds like Brodsky’s of “financial and economic terrorism.”) So while Brodsky held only a sliver of Puerto Rico’s debt — $379.5 million, according to court filings, or about 0.5 percent — he could, by deploying his skills in the legal system, punch above his weight in bankruptcy proceedings. One prominent lawyer who worked on the Puerto Rican debt crisis described Brodsky to me as “a very skillful adversary” who was also “a prophet of doom.” Jealous of his privacy, Brodsky rarely gives interviews and never releases any photographs of himself. During the Argentina proceedings, multiple news outlets published a head shot of a Captain Ahab-looking man — squinting eyes, white chin-strap beard — whom they identified as Brodsky. It was in fact a picture of the private-equity mogul Sam Zell. It is still the first Google Image result when you search for “Mark Brodsky Aurelius.” (Brodsky’s P.R. agents are aware of the mix-up but apparently see no reason to correct it.)

Though the rainy-day fund complaint was dismissed, Aurelius had another one in the works. Later in 2017, the fund was back in court with a separate clique of bondholders. This time, it plied a totally different method. Instead of firing around the edges, trying to pick off the budgets of the Boys & Girls Club and the ballet company, the firm aimed at the bull’s-eye: It leveled an argument that the bankruptcy process itself violated the U.S. Constitution. For the next two years, with this argument in hand, Aurelius scaled the federal appellate system. The District Court ruled against it, so it appealed; the First Circuit agreed on the merits but withheld a remedy, so it appealed again. Finally the case flopped onto the steps of the U.S. Supreme Court, which heard oral arguments in October and will issue a ruling before next August. If Aurelius wins, it will be one step closer to compelling Puerto Rico — a territory poorer than any state in the union — to pay the full $379.5 million that the firm most likely acquired at a steep discount.

The U.S. solicitor general, Noel J. Francisco, who wrote the federal government’s brief in the proceedings, has claimed that a victory for Aurelius would “undo years of progress toward Puerto Rico’s economic recovery, causing devastating practical consequences for the people of the island”; inflict “grave harm to innocent third parties”; and disrupt “billions of dollars” of financial transactions. Moreover, Francisco claims that the precedent set by a ruling in the firm’s favor could invalidate the election of the mayor of Washington and strip the governors of Guam and the Virgin Islands of their legitimacy. Aurelius holds that these are distractions from the core constitutional issue at hand. “The court should not be dissuaded by the opposing parties’ unfounded claims of ensuing ‘chaos,’ ” the firm said in a reply brief. “These claims boil down to an extraordinary assertion that the constitutional violation here is simply too blatant and too big to remedy.”

That a firm holding a paltry 0.5 percent of the island’s debt could trigger even one of Francisco’s hypothetical scenarios reveals the disproportionate power that this tiny corner of Wall Street has accrued over the past generation. Largely out of view, distressed-debt hedge funds have honed a set of tools for recovering bad foreign debt, turning courts into collection agents. The tools work so well, and with such sophistication, that it was probably a matter of time before they were requisitioned from abroad and applied to a territory of U.S. citizens.

Distressed-debt litigation was unimaginable for most of the history of modern finance. Private players like hedge funds stayed away from sovereign debt because there was no way for them to get their money back if a country defaulted; a hedge fund couldn’t take a country to court. During the twilight of the Cold War, the situation changed. The American government in 1976 passed a law that severely weakened the immunity of sovereign countries in U.S. courts; Britain followed with a similar law two years later. It happened almost entirely by accident: Officials, in trying to solve one problem, accidentally created a new one. What the officials had wanted to address was some trouble with state-owned enterprises like those in the Soviet Union. These enterprises behaved like private companies — maximizing their profits and in some cases expanding internationally — but because they were nominally organs of government, they were immune from litigation in international courts, giving them an unfair advantage over businesses in the West. To address the flaw, the U.S. and Britain passed laws allowing private enterprises to bring lawsuits against foreign governments in courts in, say, New York or London. Forty years later, the U.S.S.R. is long gone, but these laws are still on the books.

In the 1990s, the hedge-fund manager Kenneth Dart figured out that by buying distressed debt and then suing debtor countries in major Western courts, he could make a tremendous amount of money. During the Brazilian debt crisis in 1992, after other creditors had given up and settled, Dart sued Brazil for repayment on over $1.3 billion of debt — and won a better settlement than the others. As Dart’s copycats learned, distressed-debt litigation rewarded patience and creativity. When Paul Singer, the founder of Elliott Management, was owed money from Argentina, for instance — an obligation he pursued throughout a 14-year legal ordeal — Elliott’s subsidiary NML Capital filed a lawsuit in Ghana to take possession of an Argentine Navy frigate temporarily docked near Accra. (Elliot won its case in Ghana, but the decision was overruled by the International Tribunal for the Law of the Sea.) Amazingly, this was not the strangest episode of that crisis: In 2009, Argentina’s National Museum of Fine Arts held back certain paintings from a planned exhibit in Frankfurt because it feared that if the artworks left the country, German bondholders would seize them. This past spring, the hedge fund Contrarian Capital Management — through a shell L.L.C. called Red Tree Investments — filed two claims that are pending in the Southern District of New York against the national oil company of Venezuela for $182 million of debt, which Contrarian purchased on the secondary market. Because they are perceived to swoop down on sick prey, firms like these are sometimes called “vulture funds.”

When Dart and Singer started, fewer than 10 percent of sovereign-debt crises involved litigation. Today that figure is more like 50 percent. Further, according to a working paper from the German monetary-policy think tank CESifo, when there is litigation, there’s now a two-thirds chance that the plaintiff is a hedge fund. Because many hedge funds make use of shell corporations or nested L.L.C.s, it’s impossible to quantify how much government debt around the world they actually hold. But Mark Weidemaier, a professor of law at the University of North Carolina, Chapel Hill, whose research focuses on sovereign-debt litigation, explained that today, when a government or city hits financial turbulence, “it’s unquestioned that a substantial portion of its debt is going to wind up in Wall Street hands.”

How it winds up there is important. When a government issues bonds, the first buyers tend to be vanilla investors like central banks or mutual funds, who willingly pay face value in exchange for the promise of regular interest payments. It’s only when something bad happens (missed payment, military coup, recession), and the bonds start trading significantly under face value on the assumption they will not be fully repaid, that the more creative investors’ ears perk up. Unlike the first wave of bondholders, who care mostly about interest and stability, these distressed-debt investors care mostly about the actual bond paper, which theoretically entitles them to full repayment and furnishes interest along the way as a lagniappe.

In addition to Aurelius, a handful of kindred entities hold Puerto Rican paper: Monarch Capital Master Partners, Pinehurst Partners, Senator Global Opportunity Master Fund. Nearly all the bonds that Aurelius holds are a preferred kind called “general obligations,” or G.O.s, which have traded everywhere from 99 cents to 20 cents on the dollar since they were issued in 2014. According to Matt Fabian, a partner at the bond-research house Municipal Market Analytics, a standard estimate would say that funds like Aurelius acquired G.O.s at an average cost of 50 cents on the dollar, or about $180.3 million in total. (Aurelius does not disclose its holdings or discuss its trading.) If Aurelius purchased those bonds at 50 cents and then sued for the full face value, that difference could yield a profit of 100 percent, before legal costs. Now imagine purchasing the bonds at a steeper discount — 35 cents on the dollar, or 25.

Puerto Rican debt would have looked attractive for two reasons. Having poor credit, the island paid much higher interest than other government borrowers, about 8 percent versus the 4 percent that New York City, for example, paid for bonds issued during the same period. And, Puerto Rican bonds trade on the United States municipal market, but, unlike a city, Puerto Rico could never declare bankruptcy. Federal law forbade it. One way or another, the island would have to find a way to pay its debts. Unless someone changed the law.

Though vulture funds have a reputation as calculating mercenaries who can see 10 steps ahead, they are in fact much closer to trial lawyers who adjust their tactics in real time to accommodate new evidence or parry changes in the opposing team’s strategy. It’s misleading to speak of a singular distressed-debt strategy. The strategy is to outfox and improvise. Accordingly, the best sovereign-debt hedge funds are run by scrappy types with experience in courtrooms, not business-school graduates or management consultants. Paul Singer, the litigant behind the Argentine frigate affair and the man Brodsky considers his mentor on Wall Street, once told an interviewer that his boyhood ambition was becoming “a courtroom lawyer, someone like Perry Mason.” Like Singer, Brodsky practiced law before defecting to finance.

In June 2016, President Obama signed the law that allowed Puerto Rico to declare bankruptcy: The Puerto Rico Oversight, Management and Economic Stability Act, panderingly named to generate an acronym in Spanish. PROMESA was a unique piece of legislation. It passed with bipartisan support during a period when nearly nothing else did. And it is vehemently loathed by nearly everyone it affects. PROMESA let the island restructure its debt, but — critics have suggested — at the cost of its sovereignty. To supervise Puerto Rico’s finances, the law created a panel of seven people, which came to include an insurance executive, a bank chief executive and a private-equity manager. Where before the island’s governor and representatives decided what to spend money on, now an unelected board would have veto power over the budget.

Such unbridled authority required a legal justification, and Congress found it in Article IV of the Constitution: “The Congress shall have power to dispose of and make all needful rules and regulations respecting the territory or other property belonging to the United States.” Put another way, the oversight board derived its authority from Article IV somewhat as a district magistrate in India in 1820 would have derived his power from the Crown. Inside the Treasury, this was considered legally watertight: The oversight board was a territorial entity with territorial power, established under Article IV. It was an obvious application of Congress’s absolute, or “plenary,” power over Puerto Rico.

But not everyone was convinced. When the law was debated on the floor, a handful of senators insisted that invoking Article IV posed a risk. What if the board were so powerful that it could instead be considered an instrument of the federal government? If that were so, then the drafters had gotten their articles crossed: They should have obeyed Article II, the appointments clause, which requires federal officers to receive an up-or-down vote in the Senate. Senator Maria Cantwell, Democrat of Washington, got to the heart of it: “If this bill is enacted, you’re going to have board members that have significant authority over federal law, and they’re not appointed by the president, and they’re not confirmed by the Senate. So it’s going to be challenged constitutionally.” Cantwell even predicted what kind of party would bring the challenge: hedge funds. “Puerto Rico,” she added, “will continue to be bled.”

The oversight board has proposed that general-obligation bondholders be paid back 35 cents of every dollar of debt they hold, which could cost Aurelius tens of millions of dollars (or potentially hundreds of millions if one considers the firm’s claims on full repayment to have merit). But the second part of Cantwell’s prophecy, that the island will bleed while the law is contested, turned out to be equally true. The board’s decision that public pensions over $1,200 a month be reduced by as much as 8.5 percent has made enemies of tens of thousands of retired Puerto Ricans who depend on these already-meager checks. That the cuts were never voted on, and the people wielding the knife weren’t answerable to the people of Puerto Rico, intensifies the sense of outrage.

“It’s a denial of basic democratic principles,” Aníbal Acevedo Vilá, the island’s governor from 2005 to 2009, told me. Rafael Bernabe Riefkohl, a professor at the University of Puerto Rico and a onetime Working People’s Party candidate for governor, told me that the reduction of pension-and-retirement benefits would visit lasting harm on the poor and the elderly. “It’s hitting some of the most vulnerable people and pushing many of them into poverty,” he said. The oversight board is known in Puerto Rico as La Junta, which calls to mind the postcoup military governments of the Latin American 1980s.

Reflecting this near-universal discontent, unexpected travelers have clambered aboard Aurelius’s attack on PROMESA. In a brief supporting Aurelius’s appeal in the First Circuit, 33 Puerto Rican mayors and legislators from the minority Popular Democratic Party urged that court to side with the firm, while explicitly acknowledging that they considered the firm’s reasons for suing to be strictly mercenary.

Brodsky declined an on-record interview but sent me some comments via email. When I initially approached his P.R. agent for an interview, I said — naïvely — that I wanted to learn more about his “strategy.” But Brodsky didn’t concede that he was executing a strategy to begin with: Either he genuinely saw himself as defending the Constitution or he was really, fully committing to a bit. Maybe it’s a little bit of both. “The citizens of Puerto Rico ought to have the same constitutional protections as the citizens of the 50 states,” he wrote. But, he went on, the oversight board’s lawyer had cited “disturbingly racist” legal precedents that treated Puerto Ricans as “second-class citizens.” Brodsky also said: “I care a lot about acting honorably. I care a lot about the court system. I felt very strongly that if we were going to file an appointments-clause challenge, we would do it early in the bankruptcy case. Had we wanted to be disruptive, we would have waited on the sidelines and initiated the lawsuit two years later.”

Aurelius’s co-plaintiff in the Supreme Court appeal is the Union of Puerto Rican Electrical Workers, which argues that the oversight board’s fiscal plan would impair collective-bargaining agreements, stripping them of worker’s rights. Jessica Méndez-Colberg, the lawyer representing the union, told me by phone that she really did hope Aurelius would win. But she added, of her own co-plaintiff, “Nobody could think they’re doing this because of an interest in the well-being of Puerto Rico.”

Aurelius hired Theodore B. Olson, the former solicitor general, to argue at the Supreme Court. Olson is the man who argued successfully for George W. Bush in Bush v. Gore; he’s one of the most expensive lawyers in America. Most people expected him to lose. Kent Barnett, a professor at the University of Georgia School of Law who has written extensively on the appointments clause, told me that he would be deeply surprised if the court didn’t find “unanimously” against the firm. “They’re going to hold that these are officers of Puerto Rico, and that will be the end of the case.” Jacob J. Lew, the secretary of the Treasury who oversaw the drafting of PROMESA, told me that “a great deal of legal effort was invested in designing a provision that could withstand constitutional scrutiny.” Anthony Vitarelli, a former Treasury lawyer who worked under Lew, said he expected the justices to smack down Aurelius. “Hedge funds are not generally constitutional formalists,” he said, dryly.

On the morning of Oct. 15, the only question seemed to be whether the justices would play it straight and stick to the constitutional question or, like Vitarelli, acknowledge what may be ulterior.

Olson started off in the 1780s. James Madison warned in the Federalist Papers that Congress could draw too much power to itself — “into its impetuous vortex,” as Olson put it — and that’s exactly what had happened here, he said. He reminded the court that the appointments clause was “central to the separation of powers.” When it was threatened, he said, private litigants like Aurelius had an obligation to defend it, because they’re the ones who could afford the lengthy court battles. But something went askew in his performance. After an exchange during which Olson and Justice Sonia Sotomayor talked over one another, Justice Samuel A. Alito Jr. piped up with a question. “Mr. Olson,” he said, “are you and your client here just to defend the integrity of the Constitution, or would one be excessively cynical to think that something else is involved here involving money?”

Olson stammered his way through an answer before Alito cut him off.

“Are you and Aurelius here just as amici to defend the Constitution?” Alito asked. “There is no money issue involved here?”

“Of course, there — of course, there — ”

“This is a real case,” Alito said. “I’d just like to know what’s really going on here.”

“Well,” Olson said, “there’s over $100 billion dollars’ of indebtedness being adjudicated.”

“Right, and your client wants more of it,” Alito replied. “So what is it, exactly?”

What exactly was going on there was revealed in the response to Alito’s questions: waves of laughter that rippled softly from the gallery up to the benches. This was funny in the way a slightly-too-real wedding toast was funny. (“Congratulations, Adrian, for marrying rich.”) It was funny because a justice had said out loud what everyone in the room was already thinking: Aurelius, the court, the lawyers, the Treasury officials, the fund managers and the spectators all got it. Almost everyone shared to some extent in the joke — everyone except, perhaps, the 3.2 million people whom the court’s ruling will affect. They were on an island, 1,500 miles south.