Puerto Rico Retirement System Bondholders Win Their Security Interest Back

Reversing the district court in part, the First Circuit did not decide whether the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA (48 U.S.C. §§ 2161 et. seq.), could be used to avoid security interests granted before the enactment of PROMESA.

Perhaps motivated by the venerable legal principle known as rachmones, the First Circuit reversed District Judge Laura Taylor Swain, who had ruled in August that bondholders did not have a perfected a security interest in collateral securing $2.9 billion in bonds issued by the island commonwealth’s employee retirement system, commonly known as ERS. (Rachmones is a Yiddish term meaning pity or sympathy. It is sometimes spelled rachmunis or rachmanis.)

Significantly, however, the First Circuit did uphold Judge Swain’s ruling under the Uniform Commercial Code that a UCC-1 financing statement cannot describe collateral by reference to a document not found in the filing office.

The Avoidance Litigation

After the Supreme Court ruled that Puerto Rico was ineligible for chapter 9 municipal bankruptcy, Congress quickly adopted PROMESA. Months later, the Financial Oversight and Management Board of Puerto Rico initiated court-supervised debt-restructuring proceedings for Puerto Rico and its instrumentalities in the District of Puerto Rico. The Chief Justice tapped District Judge Swain of New York to oversee the PROMESA proceedings in Puerto Rico.

ERS, Puerto Rico’s retirement system, was authorized by statute to issue secured debt. The retirement system issued bonds in 2008 to be secured by ERS’s revenue, among other things. The UCC-1 financing statement described the collateral as the property shown on the security agreement that was attached.

However, the security agreement described the collateral as having the meaning defined in the statute that authorized issuance of secured bonds. The statute or its definition of collateral was not attached to the financing statement.

In 2015, UCC-3 continuation statements were filed. Unlike the original UCC-1 in 2008, the 2015 UCC-3s contained complete descriptions of the collateral. However, the continuation statements identified the debtor as ERS but did not use a new name, commonly abbreviated as RSE. Allegedly, RSE was the new name officially given to ERS in the English translation of an amendment to the statute governing the retirement system. The amendment was enacted after the bonds were issued but before the UCC-3s were filed.

Acting on behalf of the retirement system in Puerto Rico’s debt-adjustment proceedings, the Oversight Board sought a declaratory judgment that the bondholders’ security interest was unperfected and could be avoided under Section 544(a), incorporated by Section 301 of PROMESA.

In August, Judge Swain granted the Board’s motion for summary judgment and declared the security interest to be unperfected and therefore unenforceable.

Judge Swain said that a financing statement need only “reasonably” identify the collateral under UCC § 9-110. The collateral description by reference, she said, may only refer to a document attached to the UCC filing or to another document on file in the UCC clerk’s office. She therefore held that the original UCC-1s in 2008 failed to perfect the security interest.

The question remained: Was the security interest perfected by the filing of the UCC-3s in 2015, which did include a description of the collateral?

For Judge Swain, the UCC-3s raised a different question: Was the debtor properly identified because the UCC referred to ERS, not RES?

UCC § 9-503(a)(1) requires that the debtor’s name on a financing statement must be the name “on the public organic record most recently filed with or issued or enacted by the registered organization’s jurisdiction.” A trade name is insufficient under UCC § 9-503(c).

Judge Swain ruled that the UCC-3s failed to perfect the security interest because she concluded that ERS was a trade name, which “Article 9 expressly provides is insufficient.” She therefore held that the security interest was also unperfected by the filing of the UCC-3s.

To avoid the loss of secured status, the bondholders contended that the Board could not use Section 544(a) to invalidate a security interest granted before the enactment of PROMESA. However, Judge Swain held that Section 544(a) could be employed retroactively to avoid an unperfected security interest granted before the adoption of PROMESA.

The bondholders appealed.

The First Circuit’s Reversal

The First Circuit reversed in part in an opinion on January 30 by Circuit Judge Sandra L. Lynch, who wrote two notable bankruptcy opinions in 2018 regarding the repeat-filing stay modification and the good faith defense to a discharge violation.

Agreeing with Judge Swain, Judge Lynch ruled that the bondholders were not perfected in 2008 because the collateral description was inadequate. Parting company with Judge Swain, Judge Lynch held that the bondholders did become perfected by the UCC-3s in 2015.

With regard to the 2008 financing statements, Judge Lynch said they were “insufficient to perfect the security interest” because: (1) The collateral was “not described, even by type(s),” (2) the 2008 financing statements “do not tell interested parties where to find the referenced documents,” and (3) the bond resolution laying out the collateral was “not at the UCC filing office.”

Judge Lynch said bondholders were not secured at the outset because the original filings did not give “fair notice to other creditors and the public of a security interest.”

On the other hand, Judge Lynch concluded that the bonds became secured on the filing of the UCC-3s in 2015. The opinion will have little precedential value beyond Puerto Rico, because she said the result turned on “a unique confluence of circumstances involving two languages and a translation.”

Puerto Rico has two official statutory languages, Spanish and English. The 2013 Spanish language statute allegedly changing the retirement system’s official name from ERS to RSE was not officially translated into English until a year later.

Judge Lynch explained that the English language version uses the two terms “seemingly interchangeably.” Indeed, RSE is used only three times in the statute, while ERS appears more than 35 times.

Despite the prevalence in the usage of ERS, the Oversight Board contended that the one subsection in the statute using RES was the only provision that governed the retirement system’s official name. On that basis, Judge Swain believed that ERS was not the proper name for UCC filings.

Interpreting the language of UCC § 9-503(a)(1), Judge Lynch said that the court was not obliged to follow only one clause in a statute to pinpoint the debtor’s name in the “public organic record.” Rather, she said, the “UCC provision directs focus to the entire ‘public organic record.’”

In addition to the prevalence of the use of ERS in the English version of the statute, Judge Lynch pointed out that ERS was the name “consistently used by the [retirement system] itself, including in court filings, before and after the translation of the amended Act in 2014.”

Having concluded that the bondholders were secured after all, Judge Lynch did not reach the question of whether the Bankruptcy Code’s avoiding powers can be employed to set aside a transaction that occurred before the adoption of PROMESA.

The appeals court remanded the case to Judge Swain for further consideration in light of the opinion.