UPDATE 1-Puerto Rico seeks dismissal of U.S. bond funds' lawsuit

Mon Jul 21, 2014 5:16pm EDT

(Adds details from filing, background about restructuring efforts, bylines)

By Tom Hals and Nick Brown

July 21 (Reuters) - The U.S. commonwealth of Puerto Rico asked a federal court to dismiss as premature a lawsuit filed by U.S. mutual funds that sought to strike down a recently enacted Puerto Rican law that the funds said posed a threat to American investors.

The law, known as the Public Corporation Debt Enforcement and Recovery Act, allows certain public corporations to modify their debts.

The passage of the law in June spooked the $3.7 trillion U.S. municipal bond market and weighed on prices of bonds issued by Puerto Rico's electric authority, known as PREPA.

Puerto Rico said the lawsuit, brought by bond funds run by Franklin Templeton and OppenheimerFunds, was untimely because PREPA had not sought to restructure its debt.

The lawsuit "should be dismissed on ripeness grounds unless and until PREPA files for relief under the act," the commonwealth said in Monday's filing in federal court in San Juan.

Puerto Rico has about $73 billion of debt, of which roughly $19 billion is in its public corporations, according to an estimate by Barclays.

By allowing its public corporations - but not the government itself - to restructure under the Recovery Act, the government hopes to reassure bondholders that it will not get tied down in bailing out its public agencies.

The Franklin Templeton-led plaintiffs said the law violated the U.S. Constitution by effectively allowing Puerto Rico to impair certain contracts. They also alleged that the power to make bankruptcy law rests solely with the U.S. federal government.

Puerto Rico countered both arguments, saying the impairment of contracts is allowed when "necessary to achieve an important government purpose," and that the restriction on states to make bankruptcy law exists only when such a law would conflict with federal law.

But that is not the case here, it argues, because bankruptcy laws currently in place do not apply to Puerto Rico.

Regardless of whether the law survives the constitutional challenge, PREPA's debt is likely to be restructured through a negotiation resembling a U.S. bankruptcy, thanks in large part to the advisers running the talks, which specialize in large-scale turnarounds.

Monday's filing revealed that restructuring experts from law firm Kirkland & Ellis are now among the army of lawyers representing Puerto Rico, joining a slew of bankruptcy professionals including Proskauer Rose attorney Martin Bienenstock and financial adviser Jim Millstein, who oversaw the government rescue of American International Group. (Reporting by Tom Hals in Wilmington, Delaware, and Nick Brown in New York; editing by G Crosse)

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