In a pair of opinions on August 8, the First Circuit gave bondholders a second opportunity to prove they are being improperly denied revenue securing the bonds issued by Puerto Rico’s instrumentalities. Alluding to two hurricanes that devastated the island commonwealth and its economy, the appeals court did not suggest how the district court should rule on remand but said in both opinions that circumstances have changed dramatically since the lower court ruled last year.
The PREPA Receivership Appeal
After the Supreme Court ruled that Puerto Rico was ineligible for chapter 9 municipal bankruptcy, Congress quickly adopted the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA (48 U.S.C. §§ 2161 et. seq.), creating the Financial Oversight and Management Board of Puerto Rico. Exercising its exclusive authority several months later, the Oversight Board initiated court-supervised debt restructuring proceedings in the District of Puerto Rico for Puerto Rico and its instrumentalities, including the Puerto Rico Power Authority, known as PREPA.
The Chief Justice selected District Judge Swain of New York to oversee the PROMESA proceedings in Puerto Rico.
Holders of revenue bonds issued by PREPA alleged that the power authority breached a promise to raise rates enough to cover debt service. Under Section 362(d)(1) of the Bankruptcy Code, incorporated into PROMESA by 48 U.S.C. § 2161(a), they sought modification of the automatic stay so they could petition another court to place PREPA in receivership and seek a rate increase.
Judge Swain denied the motion in September 2017 on three grounds. With regard to two of them, she ruled in substance that Sections 305 and 306 of PROMESA, 48 U.S.C. §§ 2165 and 2166, precluded her from ceding authority or jurisdiction to another court. Alternatively, she concluded there was no “cause” to modify the stay because the balance of harm tipped in favor of Puerto Rico.
First Circuit Judge William J. Kayatta, Jr. reversed and remanded on the first two grounds and remanded on the third.
Section 305 of PROMESA is modeled after Bankruptcy Code Section 904, dealing with municipal bankruptcies. Section 305 precludes the court from interfering with the “governmental powers of the debtor.”
To read Section 305 so broadly as to prohibit lifting the automatic stay, Judge Kayatta said, “would effectively wipe out” the ability to modify the automatic stay. Although Section 305 prohibits the bankruptcy court from interfering with governmental powers, he said it does not preclude the court from lifting “the stay to allow another court to do what the bankruptcy court cannot do.”
Although Judge Kayatta agreed that allowing a “robust receivership” might have a “deleterious impact” on the ability to restructure Puerto Rico’s finances, he said it “might be possible to grant tailored relief [so that] the receiver may only take specific steps to protect the creditor’s collateral.”
Next, he addressed Section 306 of PROMESA, which gives the court exclusive and original jurisdiction. That section, he said, is not unique to PROMESA. “Rather, it is the general rule for bankruptcies.”
According to Judge Kayatta, the grant of exclusive jurisdiction “has to our knowledge never limited the bankruptcy court’s power to allow others to act on the debtor’s property with the permission of the bankruptcy court.” He therefore reversed Judge Swain and held that Section 306 does not prevent the court from finding “cause” to lift the stay and permit the bondholder to petition for a receivership.
In what Judge Kayatta called a “brief section,” Judge Swain had ruled alternatively that she would not modify the stay even if she had power to do so. He said that Judge Swain did not assess “the extent to which” bondholders “might be irreversibly harmed” or whether PREPA was adequately protecting the bondholders’ interests. In sum, Judge Kaytatta wanted Judge Swain to give more detail explaining how she “weighed on each side the balance of the harms.”
Since the “situation on the ground . . . has changed greatly” in the last year, “in the wake of Hurricanes Irma and Maria,” Judge Kayatta said it was “best to allow the bondholders to file a new and updated request for relief from the automatic stay” so that Judge Swain could “focus on the merits of that request free of any thought that the request is categorically precluded.”
The Toll Road Bondholder Appeal
Holders of $65 million in uninsured bonds issued by the Puerto Rico Highways and Transportation Authority mounted an adversary proceeding alleging that the authority was diverting toll revenue that is subject to their statutory lien.
The bondholders asserted a statutory lien evidently to avoid the operation of Section 552(a) of the Bankruptcy Code, which, with exceptions, cuts off security interests from attaching to property acquired after filing.
For the first time in their reply brief in bankruptcy court, the bondholders recognized what may have been a mistake and argued, alternatively, that they held a security interest. Invoking a local rule, Judge Swain barred the new argument and proceeded to rule that the bondholders did not have a statutory lien.
Because the statutory lien was the only basis for asserting lien rights, Judge Swain denied relief from the stay and denied the request for adequate protection. The bondholders appealed.
Writing the opinion for the First Circuit, Judge Kayatta concluded that Judge Swain did not abuse her discretion by disallowing arguments based on a security interest, although he said it was a “close call.” He therefore proceeded to analyze whether the bondholders held a statutory lien.
Judge Kayatta described how the Bankruptcy Code creates three mutually exclusive categories of liens: security interests, judicial liens and statutory liens. Quoting Section 101(37) of the Bankruptcy Code, he said that a statutory lien arises “solely by force of a statute.” He said that Puerto Rico’s enabling statute permits the authority to secure bonds but does not “require that it do so.” In the case of the toll road bonds, the pledge was voluntary and thus was not a statutory lien because the lien did not “attach automatically.”
Since the statutory lien – which he found not to exist – was the only basis for the appeal, Judge Kayatta upheld the denial of a modification of the stay.
However, Judge Kayatta said the bondholders’ waiver of an argument based on a security interest “is not permanent,” as Judge Swain herself had observed. He granted the bondholders permission to file “any updated motions for relief,” presumably to seek a modification of the stay and adequate protection based on the assertion of a security interest.
Judge Kayatta also dealt with Judge Swain’s alternative decision to deny a modification of the stay. Because she had dealt with the issue “briefly,” he said it was necessary for Judge Swain “to revisit these rulings anew” by identifying the “precise nature and extent” of the collateral, the value of the collateral at filing, and the amount required for the operation of the toll roads. As he did in his other Aug. 8 opinion, he said that “much has transpired since September 2017.” He also said the circuit’s opinion should not imply how Judge Swain should rule on remand.