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Executive Summary

  • On June 12, 2024, the U.S. Court of Appeals for the First Circuit held that bondholders of the Puerto Rico Electric Power Authority (PREPA) have a lien on its present and future Net Revenues, and that the amount of the bondholders’ claim is the face amount of the outstanding debt, which is roughly $8.5 bn.
  • The First Circuit’s decision reversed key aspects of the lower court’s decision and will likely be viewed as a win for revenue bondholders more generally.
  • We expect that the municipal bond market will take a collective sigh of relief because many had thought the lower court’s decision was contrary to generally understood market principles that collateral pledges in revenue bonds are not cut off by the filing of a municipal bankruptcy case.
  • This note provides a discussion of the case, the lower court’s rulings, the First Circuit’s decision, and our initial thoughts and impressions.

Introductory Comment

On June 12, 2024, the U.S. Court of Appeals for the First Circuit (the “First Circuit”) issued its decision in a pending appeal addressing how revenues bonds issued by the Puerto Rico Electric Power Authority (“PREPA”) should be treated in its Title III bankruptcy proceeding. In broad strokes, the First Circuit reversed the lower court and held that bondholders have a lien on present and future Net Revenues at PREPA, and that the amount of the bondholders’ bankruptcy claim is the face amount of its debt, which is roughly $8.5 bn. This decision will likely be viewed as a win for revenue bondholders more generally, and we expect that the municipal bond market will breathe a collective sigh of relief because many had thought the lower court’s decision was contrary to generally understood market principles that collateral pledges in revenue bonds are not cut off by the filing of a municipal bankruptcy case.

This note provides a comprehensive discussion of the case, the lower court’s rulings, the First Circuit’s decision, and our thoughts and impressions. We caution that the following discussion is complex. For example, the First Circuit confronted novel and difficult legal questions like: are the PREPA revenue bonds secured, and if so, does the lien securing those bonds survive PREPA’s bankruptcy case and to what extent? If they’re not secured, what claims and/or rights do bondholders otherwise have? We discussed this appeal and the parties’ arguments at length in a prior note entitled PREPA: Are Revenue Bonds Really Secured?

For the purposes of this note, however, we have done our best to limit the discussion and omit issues that are technical and not central to the key takeaways. On that score, we also emphasize that a discussion of the history of PREPA and its Title III case, including recent hearings in connection with confirmation, is beyond the scope of this note. For more information on PREPA’s case, its docket can be found here.

What is PROMESA, the FOMB, and PREPA’s Title III Case?

In 2016, Congress enacted the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) to address the fiscal challenges faced by Puerto Rico and its instrumentalities, including PREPA. PROMESA established the Financial Oversight and Management Board for Puerto Rico (the “FOMB”), which has many powers, including the power to commence a bankruptcy-like restructuring proceeding for Puerto Rico and its governmental instrumentalities—like PREPA—under so-called “Title III” of PROMESA. Title III is like Chapter 9 of the U.S. Bankruptcy Code—the chapter allowing for the adjustment of municipal debts like in the case of Detroit. PROMESA incorporates many provisions of Chapter 9, so legal rulings coming out of PROMESA can set precedent in future chapter 9 cases.

The FOMB is comprised of individuals appointed by the President of the United States and certain leaders in Congress, and PROMESA empowers the FOMB to act as the legal representative of a debtor in a Title III bankruptcy proceeding. One of the powers enjoyed by the FOMB is the power to commence litigation on behalf of the debtor.

In 2017, the FOMB commenced a Title III restructuring process (read: bankruptcy process) for PREPA in the U.S. District Court for the District of Puerto Rico (the “Title III Court”). The Title III process was necessary, in part, to address PREPA’s approximately $8.5 bn in revenue bonds (the “Bonds”) that it had issued to pursuant to a 1974 trust agreement (as amended and supplemented, the “Trust Agreement”). PREPA, which supplies substantially all of the electricity in Puerto Rico, had been engaged in prepetition restructuring negotiations with its bondholders, but those discussions failed, necessitating the Title III filing.

Litigation Commences Over the Trustee’s Proof of Claim

Following protracted and unsuccessful negotiations with bondholders, the FOMB opted to press its objection to the proof of claim (“POC”) filed by U.S. Bank N.A., in its capacity as the successor trustee, fiscal agent, and secured party for the Bonds (the “Trustee”). On October 3, 2022, the FOMB, acting on behalf of PREPA, filed a complaint objecting to the POC (see the Complaint here), which asserted a $8.5 bn claim secured by “(i) all moneys and investments held by PREPA including moneys held or required to be held in trust for the benefit of holders of PREPA Bonds; (ii) present and future revenues of PREPA; and (iii) certain covenants, obligations and undertakings of PREPA.” See Complaint at 3. In the broadest sense, the Trustee asserted that it had a lien on all future revenues collected by PREPA.

The FOMB argued, among other things, that the Trust Agreement’s grant of a security interest (another name of a lien) was expressly limited and did not cover all future revenues collected by PREPA. Rather, the FOMB asserted that the security provided to the Trustee was limited to certain demand deposit accounts (i.e., a “Sinking Fund” and certain other “Subordinate Funds”) that only receive cash after gross revenues received by PREPA run through a prescribed and detailed waterfall of uses, including for the payment of PREPA’s current expenses (referred to as a “Net Revenue” pledge). The FOMB also argued that the Trustee had no security interest in PREPA’s covenant and remedies set forth in the Trust Agreement. Finally, the FOMB argued that the terms of the Trust Agreement disclaim any recourse claim to PREPA (i.e., these were non-recourse revenue bonds), meaning that the Trustee’s claim against PREPA is “payable solely” from its collateral at the time of the Title III filing – that is, from the Sinking Fund and Subordinate Funds, which contained approximately $20 mn.

The Trustee and certain other parties-in-interest counterclaimed (the “Counterclaims”) (we collectively refer to the Trustee and the other parties as the “Trustee” because their legal positions are substantially similar). The Counterclaims sought declaratory relief that: (i) the Trustee has recourse not only to the particular demand deposit accounts, but that it also has recourse to all of PREPA’s revenues and other monies; (ii) the Trustee has a valid lien against all of PREPA’s revenues (not just in the demand deposit accounts); (iii) PREPA breached its statutory obligations to raise rates to pay on the Bonds; and (iv) the Trust Agreement created an express trust and PREPA holds all money it receives in trust for the benefit of the Trustee.

The Title III Court Issues Three Rulings

In 2023, the Title III Court issued three rulings addressing the bondholders’ POC, which are summarized as follows:

  • First, the Title III Court held (click here) that (1) the Trust Agreement only granted the Trustee a security interest in monies deposited in certain limited bank accounts (i.e., the Sinking Fund, Self-insurance Fund, Capital Improvement Fund, Reserve Maintenance Fund, and Construction Fund (each as defined in the Trust Agreement)) and not in PREPA’s revenues more generally; (2) the liens in some of these accounts are perfected; and (3) the Trustee has no security interest in the covenants contained in the Trust Agreement. The Title III Court reasoned that future revenues in which the Trustee seeks a security interest are nothing more than a “mere expectancy” that is not collateral unless and until such funds are deposited in the specific deposit accounts over which the Trustee has a lien. In addition, the Title III Court held that (4) the Trustee does have an unsecured recourse claim against PREPA, but that recourse claim is not the face amount of the Bonds. Instead, the claim is limited under the terms of the Trust Agreement to an amount that the Trustee could collect if the Trustee commenced litigation outside bankruptcy. That equitable calculation is roughly what could be received by obtaining the appointment of a receiver, having the receiver raise rates to satisfy the Bonds, and reducing that amount by PREPA’s reasonable expenses over the relevant period. The Title III Court referred to this as the “Unsecured Net Revenue Claim.”
  • Second, following the completion of a subsequent evidentiary hearing, the Title III Court held that the Trustee’s Unsecured Net Revenue Claim is estimated at $2.388 bn (click here).
  • Third, the Title III Court dismissed each of the Counterclaims largely based on the reasoning from its prior decision (click here). The Title III Court also concluded that the Trust Agreement does not create an express trust such that PREPA must hold all of its collected revenues in trust for the benefit of the Trustee if PREPA defaults on the Bonds.

Each of the parties found something in the Title III Court’s rulings that they did not like, so they all appealed to the First Circuit.

The First Circuit Reverses the Title III Court on Several Crucial Holdings

On June 12, 2024, the First Circuit issued a lengthy, thoughtful, and technical decision (click here) that reversed several critical holdings. We highlight the First Circuit’s key holdings as follows:

  • First, bondholders have a lien on PREPA’s “Revenues,” even if the funds are not physically in the various funds in certain bank accounts (e.g., the Sinking Fund).
  • Second, the scope of the pledge is limited to PREPA’s “Net Revenues.” The court looked at the Trust Agreement language but was particularly persuaded by the opinion of counsel accompanying the debt issuance, which stated that the lien was limited to “Net Revenues.” The court outright rejected the FOMB’s argument that the liens were limited to certain bank accounts, notably articulating that: “We are loath to read ambiguous language in the Trust Agreement in a manner suggesting that the Agreement calls for investors to be misled, as would be the case if we were to hold that the Bondholders’ collateral was limited to moneys in the Sinking and Subordinate Funds.”
  • Third, bondholders have a lien on future Net Revenues, not just historical revenues. The court relied on Puerto Rico law and § 928 of the Bankruptcy Code, which provides that liens on certain types of future municipal revenue pledges known as “special revenues” are not cut off by a municipal bankruptcy filing. See, e.g., 11 U.S.C. § 552(a)§ 928.
  • Fourth, the court declined to establish a general rule regarding “the extent to which a lien on Net Revenues received post-confirmation is dischargeable in a plan of adjustment.” The First Circuit noted that this issue was not addressed by the Title III Court and there was insufficient briefing on appeal.
  • Fifth, the First Circuit rejected the Title III Court’s creation of an “Unsecured Net Revenue Claim,” which was estimated at $2.388 bn. Instead, the First Circuit determined that the total value of the bondholders’ claim should be based on the face value of the Bonds, which amounts to approximately $8.5 bn. Critically, the First Circuit emphasized that this claim does not mean bondholders are entitled to receive a payment of $8.5 bn; rather, bondholders simply have a bankruptcy claim worth $8.5 bn. The bondholders are therefore secured creditors only to the extent of the value of the collateral and are unsecured for any deficiency.
  • Sixth, the First Circuit held that the bondholders are non-recourse creditors, meaning that their recovery is limited to their specific collateral. In other words, the bondholders cannot assert an unsecured, non-recourse deficiency claim against PREPA’s other assets. This is because the Trust Agreement explicitly states that bondholders are to be compensated solely from their collateral without recourse to PREPA’s other assets.

Thoughts and Takeaways

We are still digesting the First Circuit’s decision and what it means for the municipal market. We nonetheless offer our initial thoughts and takeaways.

As a threshold matter, and as we discussed in our prior note, the Title III Court’s ruling seemed novel and at odds with generally understood principles governing how revenue bonds in debt adjustment proceedings like Chapter 9 and PROMESA should be treated. But while we shared that view, we also recognized that Title III Court was careful to adhere its analysis and conclusions to the specifics of the PREPA Trust Agreement and did not speak about revenue bonds in the municipal market more generally.

Now that the First Circuit has reversed the Title III Court’s key holdings, we expect there to be fewer concerns in the municipal market that revenue bonds must necessarily lose their revenue pledge in municipal debt adjustment proceedings. That being said, however, we also observe that the First Circuit was careful not to tread into unchartered waters and speak too broadly. Indeed, the First Circuit declined to establish a general rule regarding the treatment of a bondholder’s lien in Chapter 9 or PROMESA, including “the extent to which a lien on Net Revenues received post-confirmation is dischargeable in a plan of adjustment.” The court was also quick to note that bondholders are not entitled to payment of the full amount of their $8.5 bn claim. In other words, bondholders are only entitled to a $8.5 bn claim, and may only recover to the extent of the value of their Net Revenue pledge without any claim to PREPA’s other assets. So, in the end, the First Circuit corrects several errors that it saw in the Title III Court’s analysis, but it was careful not to paint with a broad brush and address legal issues not properly before it, such as the treatment of claims on revenue pledges in plans of adjustment, or what the value of those revenue streams actually are. Those legal issues will be left for future appellate courts to resolve.

Mark Lightner, Esq.
Head of Special Situations Legal Research | LinkedIn

Pat Luby
Head of Municipal Strategy | LinkedIn



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