NEW YORK, Jan 11 (Reuters) - A U.S. federal appeals court has decided creditors of Puerto Rico's pension bonds are entitled to a hearing on whether they can proceed with a lawsuit against the island's government over a fiscal emergency law it passed last year.
The First U.S. Circuit Court of Appeals on Wednesday ruled holders of bonds issued by Puerto Rico's Employee Retirement System, its biggest public pension, are entitled to a hearing, overturning a November ruling by a federal judge in Puerto Rico.
The appeals court said the lower court was correct, however, in blocking a similar lawsuit by bondholders of Puerto Rico's highway authority.
The lawsuits were two of many filed last year against the ailing U.S. territory, after former Governor Alejandro Garcia Padilla instituted an emergency law allowing him to maintain public services by diverting revenue streams that had been earmarked as collateral for bondholders.
Under a federal Puerto Rico rescue law known as PROMESA, passed in 2016, lawsuits over debt payments are frozen while the island tries to reach consensual restructuring deals with holders of $70 billion in debt issued by myriad public entities.
But many creditors sued anyway, arguing the fiscal emergency law was unconstitutional, and saying the so-called "stay" of litigation did not apply to them.
Puerto Rico's courts have largely denied these efforts, keeping the stay in place. In November, a San Juan federal judge blocked a handful of these creditors from pursuing their lawsuits without holding a hearing on the issue.
Wednesday's appeals court ruling vacates that decision with respect only to the pension bondholders. It does not allow their lawsuit to proceed, but says the bondholders at least deserve a hearing before a court can decide whether it should proceed.
The pension bondholders have said the government's diversion of funds is harmful to them because it may not leave enough money in the coffers to pay them back.
Puerto Rico's main employee pension faces a shortfall of more than $45 billion, and is less than 1 percent funded, which experts say is among the lowest in the history of U.S. public pensions.
The appeals court also disagreed with the lower court's decision not to allow Puerto Rico's federal oversight board to participate in any litigation.
The board, created under PROMESA to manage Puerto Rico's finances, had sought to intervene in the lawsuits, to oppose the creditors' efforts to lift the stay. PROMESA "appears to grant the board such a right," the appeals court said. (Reporting by Nick Brown; Editing by Alan Crosby)