First Circuit’s Traditional Approach to Section 552 Cuts Off Bondholders’ Liens

Affirming the district court, the First Circuit held that Section 552 of the Bankruptcy Code cut off the security interest held by bondholders in contributions made to Puerto Rico’s retirement system by employers after filing.

The 41-page opinion on January 30 by Circuit Judge Sandra L. Lynch is a mind-numbing analysis of a web of statutes enacted by the Puerto Rico legislature that were intended to fund the pension system when coffers were running dry. The opinion is a defeat for holders of $2.9 billion in bonds that the retirement system sold in 2008. The bondholders thought they had a security interest for the next 50 years in employer contributions to the pension system.

The opinion is more important for what it does not do. Had Judge Lynch ruled to the contrary, her opinion would have upset longstanding interpretations of Section 552. In subsection (a), Section 552 provides that property acquired after filing is “not subject to” a prepetition security interest, with exceptions described in subsection (b).

Background

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.). The Chief Justice of the Supreme Court tapped District Judge Laura Taylor Swain of New York to sit by designation and preside over the proceedings under PROMESA. Large swaths of chapter 9, governing municipal bankruptcy, are incorporated into PROMESA.

Including the retirement system, Puerto Rico and many of its instrumentalities sought relief under PROMESA in 2017. In the debt-adjustment proceedings, Puerto Rico’s federally appointed Financial Oversight and Management Board effectively represented the retirement system.

The bondholders and the board filed cross motions for summary judgment to determine whether the security interest in favor of retirement system bondholders extended to employer contributions paid into the system after filing. Judge Swain granted summary judgment in favor of the board, ruling that the bondholders’ collateral did not include post-petition contributions to the retirement system. The bondholders appealed.

(The retirement system bonds were before the First Circuit in 2019 when the appeals court overruled Judge Swain by holding that the bondholders had a perfected security interest in whatever had been pledged to them. The appeals court remanded the case for Judge Swain to decide whether the bondholders had an enforceable security interest in employers’ post-petition contributions to the retirement system. Altair Glob. Opportunities Credit Fund, LLC v. Fin. Oversight & Mgmt. Bd. for P.R. (In re Fin. Oversight & Mgmt. Bd. for P.R.), 914 F.3d 694 (1st Cir.), cert. denied, 140 S. Ct. 47 (2019). For ABI’s report on Altair, click here. The First Circuit opinion we report on today is the product of the bondholders’ appeal from the decision by Judge Swain following remand, reported at Fin. Oversight & Mgmt. Bd. for P.R. v. Andalusian Glob. Activity Co. (In re Fin. Oversight & Mgmt. Bd. for P.R.), 385 F. Supp. 3d 138 (D.P.R. 2019).)

The Statutes

Section 552 of the Bankruptcy Code is incorporated into PROMESA by 48 U.S.C. § 2161(a). The bondholders argued that their security interests fell within the exception to Section 552(a) contained in Section 552(b).

Section 552(b)(1) continues a prepetition security interest that extends to “property of the debtor acquired” before bankruptcy if the security interest extends to “proceeds, products, offspring, or profits of such property.” The key concept is “property of the debtor.”

The bondholders also relied on Section 928(a) of the Bankruptcy Code, also incorporated into PROMESA by 48 U.S.C. § 2161(a). Section 928(a) provides that the bar in Section 552(a) does not apply to “special revenues” acquired by the debtor after filing.

Likewise incorporated into PROMESA by 48 U.S.C. § 2161(a), Sections 902(2)(A) and (D) of the Bankruptcy Code define “special revenues.”

Section 902(2)(A) defines “special revenues” to mean (not “include”) “receipts derived from the ownership [or] operation . . . of . . . systems of the debtor . . . to provide transportation, utility or other services . . . .”

Section 902(2)(D) defines “special revenues” to mean “other revenues or receipts derived from particular functions of the debtor . . . .”

In substance, Judge Lynch concluded that employer contributions did not fit within any of the exceptions to Section 552(a).

No Exceptions to Section 522(a) Applied

Judge Lynch concluded that post-petition employer contributions were not “proceeds” under Section 522(b)(1) that would be excluded from the post-petition cutoff in Section 552(a) because future revenues were not “property.” She reasoned that future contributions “depended on work occurring after the petition date.” Therefore, she said, employer contributions in the future “constituted merely an expectancy and not a property ‘right’ . . . .”

Future employer contributions did not qualify as “special revenues” under Section 902(2)(A) because the retirement system “did not provide transportation, utility, or other services.” Thus, she said, “Bondholders did not have special revenue bonds under Section 902(2)(A).”

With regard to Section 902(2)(D), Judge Lynch relied on the “plain language” of the statute to conclude that the bondholders did not have special revenue bonds. The retirement system, she said, “does not charge any fees,” nor does “its ‘ownership’ or ‘operation’ of its system of providing pension services produce[] any revenue.”

Finally, the bondholders argued that Section 522, as incorporated into PROMESA, applied only prospectively. If that were true, the bondholders said that cutting off their security interest would be an unconstitutional taking.

Judge Lynch disagreed. She found no unconstitutional taking because she held that “Congress plainly intended to apply Section 552 to security interests and agreements created before the enactment of PROMESA.”