First Circuit PROMESA Opinion Addresses the Automatic Stay and Trust Funds

In an opinion in Puerto Rico’s debt-adjustment proceedings under PROMESA, the First Circuit pointed out how a creditor has a lighter burden in modifying the automatic stay if the creditor is going after funds that the debtor holds in trust.

In its September 25 opinion, the First Circuit decided it was error for the district court to deny a motion to modify the stay without making a preliminary determination about the existence of a trust.

The Reserve Account

The dispute revolved around $76 million held in a reserve account by the Puerto Rican government resulting from duplicate insurance premiums paid by owners of autos between 1998 and 2010. Litigation ensued for years and reached settlement in 2016.

The settlement established a notice and claim-filing process for those who paid duplicate premiums. From the reserve account, the settlement called for paying valid claims for overpayment.

Later in 2016, Congress enacted the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA (48 U.S.C. §§ 2161 et. seq.). In May 2017, the Oversight Board under PROMESA initiated the Title III debt-adjustment proceedings, which invoked the automatic stay under Section 362 of the Bankruptcy Code.

In view of the stay, Puerto Rico halted payments from the reserve fund.

In early 2018, plaintiffs in the duplicate-payment litigation filed a motion to modify the automatic stay in the district court presiding over the PROMESA proceedings. The district judge denied the motion, although she did require the continued submission and review of claims.

In denying the lift-stay motion, the district court evaluated the 12 factors laid out in Sonnax Industries v. Tri Components Products Corp. (In re Sonnax Industries), 907 F.2d 1280 (2d Cir. 1990). The decision to deny a modification of the stay rested in significant part on the district court’s view that disputes over payment from the reserve fund should be resolved in the process of confirming a plan.

In his opinion for the First Circuit, Circuit Judge William J. Kayatta, Jr. said that the district court had declined to decide whether the funds in the reserve account were held in trust. If the funds were in trust, the island’s government would have had no equity interest in the monies.

362(d)(1) vs. 362(d)(2)

On appeal, the plaintiffs argued that they were entitled to stay relief because the money they sought was being held by the commonwealth as trustee. Judge Kayatta pointed out that the plaintiffs made a mistake in litigation strategy.

The plaintiffs sought stay modification “for cause” under Section 362(d)(1), which invokes the Sonnax factors. Instead, Judge Kayatta said the plaintiffs should have sought stay relief under the “more obvious path for relief laid out in subsection 362(d)(2).”

The facts a creditor must prove are more limited under Section 362(d)(2). When the creditor seeks to proceed “against property,” the subsection allows the court to modify the stay if the debtor has no equity in the property and the property is not necessary for an effective reorganization. In footnote 2, Judge Kayatta suggested that the plaintiffs were likely to rely on subsection (d)(2) on remand.

Even under Section 362(d)(1), Judge Kayatta said that the district judge “first needed to make at least a preliminary determination of the parties’ respective property interest[s] in the disputed funds.” He went on to say that several of the Sonnax factors would turn on the parties’ respective interests in the disputed funds.

Judge Kayatta was therefore constrained to reverse the district judge because she “should not have declined to consider” the existence of trust funds. He said that “[m]any courts have decided to grant stay relief ‘for cause’ after first finding that the debtor only had a legal, rather than equitable, interest in the property at issue.”

The Partial Reversal

Addressing the $76 million still held in a reserve fund, Judge Kayatta said that the “members of the plaintiff class who qualify for reimbursement from this subset of funds have made a prima facie showing of traceability and the existence of a trust relationship.”

With regard to creditors with claims against the reserve fund, Judge Kayatta reversed and remanded for the district judge “to consider on remand in preliminarily deciding whether the Commonwealth possesses any equity in the segregated funds.” After making a preliminary determination about Puerto Rico’s interest in the reserve fund, he said the district court should reapply the Sonnax factors.

However, Judge Kayatta did sustain the district court’s denial of a stay modification with regard to creditors who did not have claims against segregated funds. He said they could not show a prima facie case for the existence of trust funds.

Nota Bene

Judge Kayatta’s opinion explains why the automatic stay in a municipal bankruptcy sweeps more broadly than the stay in an ordinary individual or corporate bankruptcy.