(Adds Treasury comment, link to document, more information from sources regarding source of plan)
By Nick Brown and Megan Davies
SAN JUAN/NEW YORK, Feb 25 (Reuters) - The U.S. Treasury worked with Congress on a plan last year which envisioned giving Puerto Rico's pensioners stronger legal protection than holders of its constitutionally backed bonds if it went bankrupt, according to sources and a draft of the proposal obtained by Reuters.
The draft, circulated in Washington late last year but not made public in the run-up to President Barack Obama's Omnibus budget, imagined a broad structure aimed at protecting citizens while providing flexibility to cut debt, an approach consistent with what Puerto Rico's leaders have sought.
For a link to the document: tmsnrt.rs/21kkMg2
One source familiar with the document said it represented what administration officials, including those at Treasury, had proposed to potentially include in the Omnibus bill. A second Congressional source said the plan was the product of talks between Treasury and senators from both parties, although it was unclear who actually wrote it and Republicans ultimately did not use the language.
However, a Treasury spokesman said the administration had not "prescribed a particular approach" but would work with Congress to review legislation that emerges.
Treasury put forward a proposal in October which did not include draft legislation, the spokesman said, without confirming the authenticity or origin of the document seen by Reuters.
"As part of our standard practice, the Treasury Department has also provided technical assistance to congressional staff in the drafting of various forms of potential legislation, ahead of the March deadline for Congressional action," the spokesman said.
The fate of Puerto Rico, facing $70 billion in debt, is a hot topic in Washington. While the draft will likely differ from any formal legislation proposed in a Republican-controlled Congress, it gives insight into the Obama administration's approach.
The island has lobbied for access to a bankruptcy-like mechanism to reduce debt, a view supported by the Obama administration and Congressional Democrats but resisted by Republicans who want to protect creditors' interests.
In the proposal, language protecting pensioners in a bankruptcy setting is stronger than language protecting bondholders.
A debt restructuring plan could be confirmed by a judge if it "does not unduly impair the claims of any class of pensioners." The same protection exists for general obligation (GO) debt, but only "if feasible," the draft said.
The proposal would also require struggling territories to submit fiscal plans that "provide adequate funding for public pensions" but reduce "the debt burden to a level that is sustainable."
Puerto Rico's biggest pensions face a combined funding shortfall of roughly $43.5 billion, or 96 percent, and are projected to run out of assets by about 2019.
"We would not want to put at risk the payments that are due to pensioners," Treasury Counselor Antonio Weiss said during a hearing on Puerto Rico on Thursday in front of the House Natural Resources Committee, when asked whether there should be any "sacred cows" exempt from a restructuring in Puerto Rico.
The language of the draft document "gives a debtor latitude to give better treatment to pensions than to GOs," something that would make it "far more controversial" to creditors, Melissa Jacoby, a bankruptcy expert and professor at UNC-Chapel Hill, told Reuters.
Weiss on Thursday called Puerto Rico's pension shortfall "unheard of." It is the largest deficit of any U.S. public pension since at least 2000, according to publicplansdata.org.
Yet pension debt is not included in Puerto Rico's oft-cited $70 billion debt load, despite the fact that the payments will become the Puerto Rico government's responsibility when the pensions run out of assets around 2019.
Reporting by Nick Brown; Editing by Kim Coghill and Meredith Mazzilli