LEGAL ANALYSIS - Puerto Rico rulings could have broader ramifications for bond markets - Debtwire

LEGAL ANALYSIS – Puerto Rico rulings could have broader ramifications for bond markets

21 February 2018 - 12:00 am

Puerto Rico’s special revenue and general obligation bondholders got some important answers in two separate rulings issued by Judge Laura Taylor Swain in January. Unfortunately, those answers created a whole new set of questions for the larger municipal bond market.
On 30 January, Judge Swain dismissed two lawsuits brought in connection with the Commonwealth of Puerto Rico’s Title III bankruptcy proceedings – one brought by general obligation bondholders against the Commonwealth of Puerto Rico and two others brought by insurers of special revenue bonds against the Puerto Rico Highways and Transportation Authority (PRHTA).
The opinions issued by Judge Swain in connection with the dismissals could have important implications not only for bondholders in the various Title III proceedings, but also for the municipal bond markets at large. The Title III statutes interpreted by Judge Swain were adopted in substantially similar form from Chapter 9 of the Bankruptcy Code and thus have implications for Chapter 9 bankruptcies.
Below, the Debtwire legal analyst team provides an overview of the general obligation bondholder and insurer litigations and analyzes Judge Swain’s decisions and their ramifications for the Title III cases specifically and municipal bondholders generally.
Special revenue bonds vs. GO bonds
In order to more fully understand Judge Swain’s decisions, a short explanation of the differences in general obligation bonds and special revenues bonds is helpful. General obligation (GO) bonds are backed by the “full faith and credit” of the state, municipality or government subdivision (e.g. a school district) that issues them. The issuing municipality in effect pledges to use its taxing power to ensure repayment of the bonds. Although GO bonds are unsecured — no specific property is pledged as collateral — investors have treated them as “secured” because they are backed by the taxing power.[1]
Special revenue bonds, in contrast, are paid from pledged revenues generated from a specific activity of the municipality such as transportation or utility projects. They can also be backed by pledged special tax revenues. Unlike GO bonds, special revenue bonds are limited recourse obligations – they are not backed by the issuer’s full faith and credit. Bondholders can thus only look to the pledged revenue stream for repayment, and the default risk is correlated with the reliability of that revenue stream. The Bankruptcy Code defines “special revenues” to include receipts from transportation, utility or other projects and various specialized taxes such as excise taxes, taxes levied to finance projects and receipts from tax increment financing.[2]
Municipalities have increasingly relied on special revenue bonds for financing. One reason is that special revenue bonds offer a way to circumvent constitutional and statutory limitations on a municipality’s ability debt limits, since special revenue bonds are not counted towards those limits. Pledges of revenue streams are also a way around the municipality’s inability to pledge public assets.
GO bonds were long viewed as the gold standard for municipal bond investors because they are backed by a municipality’s full faith and credit. However, this understanding was upended by the treatment of GO bond claims in Detroit’s Chapter 9 proceedings. There, unlimited tax general obligation (UTGO) bondholders received an approximately 74% recovery. Holders of special revenue sewer bond claims were, in contrast, paid in full.[3]
Special revenue bonds and bankruptcy
In Chapter 9 proceedings, special revenue bonds are indeed “special.” They enjoy unique protections under the Bankruptcy Code. Unlike contractual liens generally, liens on special revenue continue to attach to property acquired by a debtor after a bankruptcy filing. Under Bankruptcy Code section 552(a), liens arising from a pre-petition security agreement do not attach to property acquired by a debtor after the bankruptcy filing,[4] unless and to the extent that the security agreement so provides.[5] However, section 928(a) of the Code provides an exception to section 552(a) for special revenues – pre-petition liens continue to attach after the bankruptcy filing.[6]
The payment of special revenue bonds is also exempted from the section 362 automatic stay. Section 922(d) of the Bankruptcy Code provides that the stay does not apply to the “application of pledged special revenues in a manner consistent with section 927 (sic) [7] of this title to payment of indebtedness secured by such revenues.” Sections 552, 922 and 928 of the Bankruptcy Code were incorporated into PROMESA and therefore apply to Puerto Rico’s Title III proceedings.
The interplay of section 928(a), 922(d) and 552(a) were discussed in a series of rulings in the Jefferson County, Alabama Chapter 9 case. Bankruptcy Judge Thomas Bennett analyzed the interplay of sections 922(d) and 928(a) and concluded that they were intended to ensure payment of the pledged revenues to bondholders during an in-court restructuring. Jefferson County had issued warrants to finance its sewer system. After the system was plagued by cost overruns and mismanagement, a receiver was appointed. Later, the county itself commenced Chapter 9 bankruptcy proceedings. The indenture trustee for the warrant holders then moved the bankruptcy court for a determination that the receiver could continue in his role notwithstanding the Chapter 9 filing.
The court denied the relief, finding that the automatic stay prevented the receiver’s continued operations, with one exception – the receiver could continue to apply the special revenues pledged to pay warrant holders during the case. The court noted that “pledged special revenues would continue to be paid uninterrupted to those to which/whom payment . . . is secured by a lien on special revenues.”[8] In a later ruling, which addressed a dispute over whether certain operating expenses, as defined in Bankruptcy Code section 928(b), could be paid ahead of warrant holders, Judge Bennet ordered that after payment of operating expenses, funds remaining in the revenue account were to be paid to warrant holders in the priority and manner in the indenture.[9]
PRHTA’s special revenue bonds
Notwithstanding the additional protections for special revenue bondholders, a cash-strapped municipality in Chapter 9 will be tempted to look to the revenue streams securing special revenue bonds and devise theories to tap them in order to satisfy unrelated obligations of the municipality. One special revenue stream that is the subject of litigation in Puerto Rico’s Title III proceedings is the revenue of the Puerto Rico Highways and Transportation Authority. PRHTA was created pursuant to a 1965 enabling act as an autonomous public corporation responsible for developing, operating and maintaining Puerto Rico’s toll roads, highways and other mass transportation facilities. PRHTA financed its operations by issuing a series of bonds under resolutions issued in 1968 and 1998. The Resolutions authorized “sinking funds” into which PRHTA makes monthly deposits. A fiscal agent, the Bank of New York Mellon (BNYM), holds the pledged monies in the sinking funds in trust for bondholders.
The PRHTA bonds are insured by various bond insurers, including Assured Guaranty Corp. and Assured Guaranty Municipal Corp. (AGC), Financial Guaranty Insurance Company (FGIC) and National Public Finance Guarantee Corporation (NPFGC). AGC insures approximately USD 1.5bn of PRHTA bonds, FGIC insures approximately USD 447m and National insures USD 706m.
As Puerto Rico’s fiscal situation worsened, in 2015 the Commonwealth began tapping PRHTA’s revenues and applying them to other Commonwealth obligations. PRHTA bondholders were instead paid out of PRHTA’s debt service reserve funds. Afterwards, from January through July 2016, PRHTA failed to make over USD 100m in debt service payments.[10] The insurers paid bondholders on behalf of PRHTA and claimed full subrogation to the rights of the bondholders as a result.[11]
Afterwards, on 20 June 2017, the Puerto Rico Fiscal Agency and Financial Advisory Authority directed BNYM to refrain from making a USD 219m payment to bondholders from the reserve funds due on 3 July 2017. AAFAF asserted that the funds in the reserve accounts were PRHTA’s property and that making the payment would violate the Bankruptcy Code section 362(a) automatic stay incorporated into PROMESA. PRHTA defaulted on the 3 July payment.
Puerto Rico and PRHTA commence Title III proceedings
Notwithstanding its economic woes, Puerto Rico’s status as a commonwealth left it unable to use Chapter 9 of the Bankruptcy Code to restructure its debt. In 2016 U.S. Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), which borrowed heavily from Chapter 9, to provide a mechanism by which Puerto Rico can restructure its debts. PROMESA also established a Financial Oversight and Management Board to approve fiscal plans for the commonwealth and its instrumentalities (such as PRHTA) and to file bankruptcy petitions on behalf of those entities. On 13 March and 28 April 2017, the Oversight Board certified fiscal plans for the commonwealth and for PRHTA, which authorized the commonwealth to apply the pledged PRTHA revenues to non-bondholder obligations. On 3 May 2017, the Oversight Board commenced a debt adjustment proceeding under Title III on behalf of Puerto Rico. The Oversight Board followed on 21 May 2017 by filing a Title III proceeding on behalf of PRHTA.
Case No. 1 – Assured Guaranty Corp., et al. v. Commonwealth of Puerto Rico
Shortly after the Title III filings, AGC, FGIC and NPFGC filed two adversary proceedings in PRHTA’s Title III case on 3 June 2017.[12] The plaintiff insurers asserted standing to bring the claims under various theories – (1) the applicable insurance agreements and bond documents deemed the insurers to be the sole owners of the insured bonds for purposes of bringing bondholder actions, (2) the insurers were third-party beneficiaries of the PRHTA resolutions and (3) the insurers were subrogated to the rights of the bondholders whose claims they had paid. Plaintiffs named as defendants PRHTA, the commonwealth, Financial Oversight and Management Board, AAFAF, Puerto Rico Governor Ricardo Roselló and several other individuals.
The plaintiffs sought declaratory and injunctive relief– a declaration that PRHTA bonds are secured by contractual and statutory liens on special revenues on PRHTA revenues and special excise taxes on crude oil, diesel gasoline and motor vehicle licenses, a declaration that the continued application of special revenues to bondholders post-bankruptcy was not stayed by the filing of Title III proceedings, and a declaration that PRHTA’s failure to remit those revenues during the Title III cases violated sections 922(d) and 928(a) of the Bankruptcy Code as incorporated into Title III. The insurers also sought a declaration that all special revenues held in the reserve accounts are property of, or held in trust for, PRHTA bondholders. Finally, plaintiffs sought an injunction compelling fiscal agent Bank of New York Mellon PRHTA to pay the special revenues to bondholders.
The commonwealth and PRHTA moved to dismiss, arguing that the plaintiffs had failed to state claims for relief because neither section 928(a) nor 922(d) required the continued payment of special revenues to bondholders after the filing for bankruptcy, nor did those statutes create a cause of action for bondholders to sue PRTHA to compel payment. At most, the Bankruptcy Code entitled plaintiffs to adequate protection of their perfected security interest, assuming they had one. However, the defendants disputed that plaintiffs possessed a perfected security interest.
In so arguing, the commonwealth and PRHTA relied upon Judge Swain’s September 2017 decision in a separate adversary proceeding in PRHTA’s Title III case in which she had held that PRTHA bondholders did not possess a statutory lien on the toll revenues pledged to secure the bonds.[13] In that earlier dispute, Peaje Investments, which held PRHTA bonds, had filed an adversary proceeding to enforce its rights to the continued payment of special revenues post-bankruptcy. Peaje sought a preliminary injunction ordering PRHTA to deposit toll revenues with the fiscal agent for payment to bondholders. Peaje argued that the PRHTA enabling act and the 1968 bond resolution gave rise to a statutory lien on PRHTA special revenues which, due to its status as a statutory lien, was exempted from the section 552(a) lien cutoff applicable to liens created by security agreements. Peaje further argued that Bankruptcy Code sections 928(a) and 922(d) required continued payment to bondholders post-bankruptcy filing. Judge Swain denied Peaje’s request for a preliminary injunction, holding that neither the enabling act nor the bond resolution created a statutory lien.[14]
In the current dispute with the insurer plaintiffs, the commonwealth PRHTA also argued that, in any event, the bankruptcy court lacked jurisdiction to determine plaintiffs’ claims. The defendants based this argument Section 305 of PROMESA, which provides that unless the debtor consents or a plan of adjustment so provides, the court may not interfere with any of the debtor’s property or revenues or the use or enjoyment of such property or revenues.[15] Section 305 is substantially similar to section 904 of the Bankruptcy Code, which was enacted to allay concerns that the bankruptcy court’s exercise of the federal judicial power in municipal bankruptcy cases would impinge upon state sovereignty.[16]
The decision
Judge Swain largely rejected defendants’ subject matter jurisdiction argument. She concluded that section 305 is not a jurisdictional statute, but instead addresses the limitations on the “powers and remedies” employable by a court in Title III proceedings.[17] The defendants had misinterpreted section 305 by conflating a bankruptcy court’s subject matter jurisdiction with its power to grant relief. With one exception, plaintiffs’ claims presented a justiciable case or controversy over which the court could exercise its subject matter jurisdiction.[18] The exception was plaintiffs’ claim that they had a lien on the funds in the reserve accounts. The court determined that the insurers had not alleged either facts or a theory that would require PRHTA to refrain from withholding payments to bondholders and that thus “a determination of the lien interest, standing alone, will not resolve conclusively the question of whether, when and from what, if any, funds the PRHTA bondholders are entitled to be paid.”[19] The court’s inability to resolve this last question would make its determination of the lien question an impermissible advisory opinion, which the court lacked subject matter jurisdiction to issue.
Judge Swain then examined the “plain language” of sections 928(a) and 922(d) and dismissed plaintiffs’ remaining claims. For purposes of the motion, the parties did not dispute that the PRHTA revenues were “special revenues” as defined by the Bankruptcy Code. Judge Swain also found it unnecessary to address the question of whether the insurers had a valid security interest in the pledged special revenues.
Judge Swain rejected plaintiffs’ argument that section 928(a) required continued payment to PRTHA bondholders during the Title III case. The statute permitted, but did not require, such payments. Section 928(a), while exempting liens on special revenues from the post-bankruptcy section 552(a) cutoff, does not address lien enforcement or payment “at all.”[20] The statute does not stay the operation of section 362(a)(4), which enjoins creditors post-bankruptcy from engaging in “any act to . . . enforce any lien against property of the estate.”[21] This interpretation was consistent with section 928(a)’s legislative history, which shows that the statute was intended to obviate the risk that the section 552(a) lien cutoff would, post-petition, could result in special revenue bonds being treated as general obligation bonds in a bankruptcy case.[22]
Turning next to section 922(d), Judge Swain held that the statute permits, but does not require, a debtor to continue making payments on special revenue bonds without first seeking court relief from the automatic stay.[23] Also, Judge Swain concluded that “[n]othing in the language of Section 922(d) requires debtors . . . to apply the revenues to outstanding obligations . . . . [n]or does anything in the plain language of section 922(d) demonstrate that Congress intend that the provision give holders of instruments secured by such revenues the power to compel continued application of such revenues to payments during the course of a Chapter 9 bankruptcy proceeding.”[24] She added that “[r]eading Section 922(d) to permit, but not compel, bond payments gives meaning to Section 922(d) while also respecting the Bankruptcy Code and PROMESA prohibitions on judicial interference with a municipality’s governmental functions and revenues.”[25] This conclusion was also consistent with section 922(d)’s legislative history, which demonstrated that section 922(d) was intended to allow either a municipality or third-party to continue to pay special revenues to bondholders post-petition. Judge Swain distinguished the Jefferson County cases on the grounds that “no issue of refusal to pay had been presented to the court,” and that the cases only concerned what funds qualified as special revenues under sections 928(a) and 922(d).[26]
Judge Swain also dismissed the insurers’ request for declarations that bondholders (and the insurance companies to the extent that they were subrogated to the bondholders) either own the reserve account funds directly or that the reserve account funds are held in a constructive trust for their benefit. According to Judge Swain, although the PRTHA statutes and bond resolutions authorized the collection, deposit and pledge of tolls and taxes, they do not confer ownership in the revenues.[27] Finally, although the resolutions stated that the reserve monies are held in trust, section 305’s prohibitions on bankruptcy court interference with PRHTA’s property interests in the funds, whether title or reversionary, prevented the bankruptcy court from granting any relief.
Case No. 2 – ACP Master Ltd., et al. v. the Commonwealth of Puerto Rico
The second case in which Judge Swain issued an important opinion was an adversary proceeding filed by GO bondholders shortly after the commonwealth filed its Title II case.[28] On 29 June 17, Aurelius Capital Master Ltd. and several other funds commenced an action seeking a declaration that their GO bonds were “constitutional debt” backed by the commonwealth’s “good faith, credit and taxing power” and that “constitutional debt” was entitled to “unique protections”— one of which was an “absolute and enforceable first lien and claim on all of the Commonwealth’s available resources.”[29] Plaintiffs also sought a declaration that they held the sole beneficial property interests in two revenue streams – certain taxes earmarked for payment of obligations of the commonwealth’s instrumentalities but subject to clawback when commonwealth resources were insufficient to pay GO bondholders (Clawback Revenues), and certain property tax revenues (Special Property Tax Revenues).
Plaintiffs asserted that since 2016 the commonwealth had retained significant Clawback Revenues and wrongly applied them to commonwealth expenses rather than the GO bondholders’ “constitutional debt.” On November 2015, Puerto Rico Governor Alejandro Garcia Padilla issued an executive order instructing the commonwealth to retain Clawback Revenues that were used to make a USD 164m constitutional debt service payment. In 2016, although, the commonwealth held back an additional USD 289m in Clawback Revenues, it did not use the funds to pay GO bondholders, it defaulted on a USD 817m payment due to bondholders.[30]
The GO bondholders both sought declaratory and injunctive relief. They sought declarations that:
(1) under Puerto Rico law the Clawback and Special Property Tax Revenues are “restricted” revenues that must be segregated and deposited into a separate account and used only to pay the constitutional debt;
(2) plaintiffs have, and the commonwealth lacks, equitable or beneficial property interests in the Clawback and Special Property Tax Revenues;
(3) plaintiffs have statutory liens on the revenues, and that those revenues are “special revenues” under the Bankruptcy Code;
(4) the commonwealth’s use of the Clawback and Special Property Tax Revenues other than to pay GO bondholders would constitute an unlawful taking under the Fifth Amendment of the United States Constitution; and
(5) Puerto Rico law requires the segregation of the Clawback and Special Property Tax Revenues be segregated in a separate account must be used to pay constitutional debt.
Plaintiffs also sought injunctive relief prohibiting the defendants from diverting the Special Property Tax and Clawback Revenues and directing them to segregate and preserve those revenues to pay GO bondholders.
The commonwealth moved to dismiss on the grounds that the court lacked subject matter jurisdiction over the GO bondholders’ claims because the claims did not satisfy the “case or controversy” requirement and because they were barred by Section 305 of PROMESA. It also argued that the GO bondholders’ claims should be dismissed because they failed to allege that the revenues in question were either restricted, were subject to liens or were special revenues.
The decision
Judge Swain dismissed all of the GO bondholders’ claims. Addressing the threshold question of jurisdiction, she found that the majority of the bondholders’ declaratory judgment claims sought a determination of “aspects” of their legal rights rather than a “conclusive determination of ultimate issues in this PROMESA debt adjustment process.”[31] Plaintiffs sought advisory opinions on hypothetical disputes, which were beyond the power of the court to decide.
More particularly, Judge Swain found that the court lacked subject matter jurisdiction over the question of whether the reserve funds were “restricted” because the dispute was too “vague” to present a case or controversy.[32] Judge Swain also held that the court lacked jurisdiction to decide plaintiffs’ claims seeking determinations as to who holds the equitable and beneficial property interests in the revenues, whether the revenues are secured by statutory liens, whether the revenues are special revenues under the Bankruptcy Code and whether the commonwealth can apply the revenues to payments other than constitutional debt payments. She concluded that resolving each of these claims would have required the court to issue “abstract declarations of the parties’ respective relationships to the subject revenues” without resolving any “concrete dispute” such as a claim objection, an adequate protection request, stay relief request or a confirmation hearing.[33]
Judge Swain dismissed the Fifth Amendment takings claim was dismissed because it was hypothetical and unripe. She observed that PROMESA contemplates moving from a fiscal plan to proceedings to confirm a plan of adjustment, yet the Title III case were only “in their early stages.”[34] “[A]ny changes in creditors’ rights” had to be made “through the mechanism of a plan.”[35] She noted that as of the date of her decision the content of the fiscal plan was “in flux,” there was no plan of adjustment and no “final decision” as to the treatment of the revenues or the compensation of claims.[36]
The court did find, however, that it could exercise jurisdiction over claims 9 through 11[37] – i.e. the requests for declarations that the revenues must be deposited into segregated accounts and used only to pay GO bondholders, and for an injunction directing the segregation and preservation of the revenues for such payment. Judge Swain found that those claims sought “sufficiently specific and immediate conclusive relief.” However, Judge Swain concluded that she could not decide these claims because they ran afoul of PROMESA section 305. Granting the requested relief without the commonwealth’s consent would restrict the use of the Commonwealth’s revenues and the exercise of its governmental powers, in violation of section 305. This restriction applied not only to the requested injunctive relief, but the declaratory relief as well. Judge Swain found that “[s]ection 305’s prohibition is not limited to remedies that are directly coercive; a decree that the territorial government or its instrumentality must conduct its affairs in a manner different from the one it has chosen is necessarily one that would interfere within the meaning of the statute.”[38] Given the court’s inability to issue a remedy, Judge Swain dismissed these remaining GO bondholders’ claims for failure to state a claim.
Judge Swain’s January 30 decisions are important for several reasons. First, they reflect a clear intent to resolve bondholder claims in each Title III case through the plan of adjustment process rather than through piecemeal adjudications of bondholder rights in separate adversary proceedings. Judge Swain’s dismissal of the bondholder claims in the GO bondholder action is particularly instructive in this regard, especially in view of her observations that almost all of the claims presented were unconnected to any “concrete dispute,” i.e. a confirmation hearing, a claim objection or requests for adequate assurance or stay relief. Her additional observations that the Title III cases “are in their early stages,” that PROMESA contemplates that creditors’ rights be altered through a plan of adjustment and that the commonwealth had not finalized the contents of its fiscal plan, let alone proposed a plan of adjustment that resolved bondholder claims, also support this conclusion.[39] Furthermore, Judge Swain’s determinations that section 928(a) does not grant bondholders the right to enforce continued payment of special revenues during a Title III case and that section 922(d) provides an exception to the automatic stay reflect an intent to ensure that the Commonwealth receives the full breathing room the automatic stay provides so that the commonwealth may reorganize.
Second, Judge Swain’s decisions reflect a respect for the commonwealth’s status as a sovereign and a sensitivity to the Tenth Amendment issues that are implicated when a sovereign is a debtor. This concern is reflected in Judge Swain’s dismissal of the GO bondholder’s requests to segregate the Special Property Tax and Clawback Revenues for payment solely to GO bondholders. Although Judge Swain concluded that the court had jurisdiction over those claims, she still dismissed them because PROMESA section 305’s prohibition on the bankruptcy court’s interference with the commonwealth’s use and enjoyment of its property prevented her from granting relief.
The third takeaway, and the one with perhaps the broadest implications for municipal bondholders, is Judge Swain’s holding that sections 928(a) and 922(d) of the Bankruptcy Code (as adopted into Title III in PROMESA) do not entitle holders of special revenue bonds the right to continued payment during the pendency of a Title III case, nor do they grant bondholders a right of action to compel payment on the bonds. In a nutshell, Judge Swain has stated that holders of PRHTA bonds can’t get paid during the Title III case unless and until PRHTA consents. PRHTA’s refusal thus far to give that consent indicates that special revenue bondholders may have to wait for a confirmed plan of adjustment to receive payment. Judge Swain’s decision represents a sharp change in course from the treatment of holders of special revenue warrants in Jefferson County, where Judge Bennett ordered that payments be made in the priority and manner provided for in the indentures at issue.
Both the insurers and GO bondholders have appealed Judge Swain’s rulings. If those rulings are upheld by the 1st Circuit, they could result a shift in special revenue bondholder expectations that is analogous to the shift in GO bondholder expectations following GO bondholders’ failure to receive less than a 100% recovery under the City of Detroit’s plan of adjustment. Ratings agencies such as Fitch have already sounded alarm bells about what Judge Swain’s decision may portend for the markets. If the decisions are upheld, how will they affect the demand for special revenue bonds if bond holders can no longer be secure in the belief that they will be able to enforce their liens in bankruptcy? How will that uncertainty be priced into the market? Will other jurisdictions follow the 1st Circuit’s lead? Will this get to the Supreme Court?
These are but some of the questions that will have to be answered in the Puerto Rico saga.
Paul Gunther is a former practicing restructuring and litigation attorney. Prior to joining Debtwire as a Legal Analyst, Paul practiced in the New York offices of Dentons US LLP, Salans LLP and Mayer Brown LLP. He has represented various constituencies in high-profile restructurings.
Any opinion, analysis or information provided in this article is not intended, nor should be construed, as legal advice, including, but not limited to, investment advice as defined by the Investment Company Act of 1940. Debtwire does not provide any legal advice and subscribers should consult with their own legal counsel for matters requiring legal advice.
[1] GO bonds can be further divided into Unlimited Tax General Obligation (UTGO) bonds and Limited Tax General Obligation (LTGO) Bonds. Generally, UTGO bonds are disti