Court of Claims Rebuffs Puerto Rico Bondholders’ Claims of Unconstitutional Takings

Holders of secured Puerto Rico retirement system bonds lost in their latest effort at squeezing blood out of a rock.

Building on decisions by the Supreme Court and the First Circuit, Judge Richard A. Hertling of the U.S. Court of Claims ruled on November 23 that the federal government was not liable for a Takings Clause violation when bondholders lost their security interest in employer contributions as a consequence of the enactment of the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA (48 U.S.C. §§ 2161 et. seq.).

Bondholders Lose Their Post-Petition Liens

After the Supreme Court ruled that Puerto Rico was ineligible for chapter 9 municipal bankruptcy, Congress quickly adopted PROMESA. Large swaths of chapter 9, governing municipal bankruptcy, are incorporated into PROMESA, including Section 552. With the exception in Section 552(b), Section 552(a) cuts off a prepetition security interest in property acquired after filing.

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.

At the Oversight Board’s behest, the Puerto Rico legislature passed legislation requiring the retirement system to transfer its assets to the commonwealth’s general fund. In return, Puerto Rico’s government assumed responsibility for paying retirement benefits. The transfer meant that employer contributions went to the general fund, not to bondholders. The Oversight Board took the position that Section 552 cut off the retirement system bondholders’ security interest in employer contributions made after filing.

The retirement system bondholders mounted several lawsuits, so far unsuccessfully. At the end of January, the First Circuit upheld the district court and ruled that Section 552 cut off the security interest held by bondholders in contributions made to Puerto Rico’s retirement system by employers after filing. In re Fin. Oversight & Mgmt. Bd. for P.R., 948 F.3d 457, 462 (1st Cir. 2020) (“Section 552 Decision”), cert. denied sub nom. Andalusian Glob. Designated Activity Co. v. Fin. Oversight & Mgmt. Bd. for P.R., No. 20-126 (Nov. 16, 2020).  To read ABI’s report on the January opinion, click here.

In the lawsuit before Judge Hertling, the bondholders raised three claims under the Takings Clause of the Fifth Amendment. They contended there had been unconstitutional takings of (1) their liens and their contractual right to timely payment on the bonds; (2) their liens on post-petition employer contributions, and (3) their contractual right to timely payment from post-petition employer contributions.

In addition to the January First Circuit opinion, Judge Hertling’s decision was informed by the Supreme Court’s holding on June 1 that the appointment of the Oversight Board did not violate the Appointments Clause of the Constitution because the members were exercising “primarily local duties.” Fin. Oversight & Mgmt. Bd. for P.R. v. Aurelius Inv., LLC, 140 S. Ct. 1649 (2020). To read ABI’s report, click here.

The opinion by Judge Hertling is a tour de force on the law of takings. Had he not dismissed the bondholders’ claims, federal legislation would often hit a tripwire making the government liable for the impairment of contracts.

The First Claim Fails

The Supreme Court’s decision in June led to the demise of the bondholders’ first claim, based on the notion that PROMESA effected an unconstitutional taking of their liens. The result turned on whether the Oversight Board was a federal entity.

If the Oversight Board was not a federal entity, the Court of Claims would lack subject matter jurisdiction under the Tucker Act, 28 U.S.C. § 149.

In Aurelius, the Supreme Court held that the Oversight Board exercised primarily local duties. Judge Hertling said that “Aurelius is dispositive; it speaks to the precise issue the Court needs to address in order to determine its jurisdiction.”

The Oversight Board “is an instrumentality of Puerto Rico, not the federal government,” Judge Hertling said. Consequently, the bondholders’ “first claim therefore is not against the United States as required under the Tucker Act.”

Judge Hertling dismissed the first claim after also ruling that the Oversight Board’s actions could not be attributed to the U.S.

The Second and Third Claims Fail

The second and third claims were doomed by the First Circuit’s decision this year that the bondholders had no enforceable security interest in post-petition contributions. On both claims, the bondholders argued that Section 552 effected a taking of their security interests in post-petition employer contributions.

Unlike the First Circuit, Judge Hertling was looking at the question in terms of an unconstitutional taking, not the operation of Section 552 alone. He reached the same result as the First Circuit because he ruled that the bondholders only held an “expectancy” in post-petition contributions. In a constitutional sense, there could be no taking of property, because the property did not exist on the filing date.

Judge Hertling said that the First Circuit opinion collaterally estopped those bondholders who were parties to the appeal in Boston.

For bondholders not parties to the Boston appeal as to whom collateral estoppel did not apply, Judge Hertling agreed with the First Circuit. He dismissed the second claim, holding that the bondholders “did not have a property interest in their purported liens on post-petition employer contributions. Accordingly, the plaintiffs cannot establish a taking and have failed to state a claim upon which relief can be granted.”  

The bondholders’ third claim likewise failed. He ruled that “Section 552 impaired the plaintiffs’ contractual right to post-petition employer contributions, but this impairment does not constitute a taking under the Fifth Amendment. Accordingly, the plaintiffs fail to state a claim upon which relief can be granted.”

Judge Hertling explained that the bonds themselves were not “taken.” Rather, he said, they were “impaired,” and an impairment “is insufficient to support a claim for a taking.”