Court rules against Puerto Rico Employees Retirement System bondholders

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The United States First Circuit Court of Appeals upheld a ruling against bondholders of the Puerto Rico Employees Retirement System.

The First Circuit released the opinion authored by Associate Judge Sandra Lynch Thursday. Judges Jeffrey Howard and Kermit Lipez concurred with the opinion.

Chapman Strategic Advisors Managing Director James Spiotto said the First Circuit found that the bondholders had gained a security interest prior to the ERS bankruptcy petition but that the petition had terminated it. Lynch said she was using “security interest” and “lien” interchangeably.

The bondholder’s pre-petition lien wasn’t on anything that continued after the petition, Spiotto said.

Spiotto said he thought the judges’ view of the conditions necessary for there to be special revenues was too narrow. They had said that there must be a utility or “physical system.”

The judges’ second-to-last sentence was “We emphasize that we decide each of these three claims narrowly, based on these specific facts.” Spiotto said this might mean the decision will be less of a precedent for other decisions than otherwise would be the case.

The decision was for two cases. In both cases, the Puerto Rico Oversight Board was the plaintiff and more than a dozen investment funds and hedge funds were the defendants.

Robert Gordon, an attorney who represents the Official Committee of Retired Employees of the Commonwealth of Puerto Rico said, “The Official Retiree Committee welcomes the ruling of the First Circuit Court of Appeals, which upholds the district court ruling that Employee Retirement System (ERS) bondholders do not hold a security interest in ERS assets acquired after ERS filed for bankruptcy. This ruling should provide meaningful support to Puerto Rico’s restructuring efforts and to the protection of Puerto Rico’s retirees and their retirement benefits.” Gordon is a partner at Jenner & Block.

The bondholders had made three arguments. First, they said that their security interests fit within exceptions found in section 552 of the U.S. bankruptcy code, a section incorporated into the Puerto Rico Oversight, Management, and Economic Stability Act.

Second, they said they were entitled to the “special revenue” provisions of PROMESA. Third, they said that if the court ruled against them on their first two claims, section 552 could not be retroactively applied to their claims prior to PROMESA without violating the so-called Takings Clause of the U.S. Constitution.

The First Circuit rejected all three arguments.

Regarding the first argument, the bondholders had argued “they have an interest in both the system’s pre-petition right to receive post-petition employers’ contributions and in the employers’ pre-petition obligations to make post-petition contributions to the system on account of any actuarial deficit,” in Lynch’s words.

“We concluded that the system’s statutory authority to receive post-petition employers’ contributions constituted merely an expectancy and not a property ‘right’ as it is clear that the payment and the amounts of the contributions depended on work occurring on and after the petition date,” Lynch wrote.

The bondholders also do not have liens on purported employer obligations to solve any deficiency in the pension system. Lynch said that neither the security agreement nor the bond resolution include language on the collateral and because the employers’ contributions are not “proceeds.”

The First Circuit said that the District Court had properly said that for there to be protected “special revenues,” they have to be involved with a “physical system” like one providing transportation or utilities. The First Circuit also agreed with the lower court on the fact that the ERS didn’t charge any fees that could be the origin of “special revenues” and that this was important.

As for the bondholders’ argument that PROMESA didn’t mean to retroactively address existing bonds and that the Takings Clause of the Constitution would bar a retroactive taking from the bondholders, the First Circuit focused on PROMESA itself. It said that the law itself and its incorporation of other bankruptcy code measures showed that Congress intended the law to apply to bonds created before PROMESA’s passage.
The First Circuit said that it was bound to follow Congress’s intention and uphold the law.

On Friday the taxable ERS bonds were trading around 20 cents on the dollar, down from the 37 cents on the dollar they had traded at on Thursday, according to John Barasch, director of municipal evaluations at ICE Data Services.

As of February 2017, there were $3.2 billion of ERS bonds outstanding.

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