Puerto Rico bankruptcy Judge Laura Taylor Swain has ruled that holders of Employees Retirement System bonds are not entitled to continued payment in bankruptcy, saying among other things that the bonds’ revenues weren’t protected “special revenues.”
Swain issued her ruling in an adversary proceeding on Thursday. It affects $3.2 billion of ERS bonds in default since July 2017.
The Puerto Rico Oversight Board, as a representative of ERS, was the plaintiff and about 30 investment funds holding the ERS bonds were the defendants.
The plaintiff had asked Swain to find that Bankruptcy Code 552(a) had prevented the bondholders’ claim to ERS revenue during the post-bankruptcy petition period, since July 2017. The bondholders had argued that Swain should say their liens were still valid on ERS property collected since July 2017 and that the bondholders’ claims were “special revenues,” not subject to diversion in a bankruptcy.
With regards to special revenues, the bondholders claimed that section 928 of the Bankruptcy Code, which defines special revenues, and which preempts the part of the code that allows for the diversion of pledged revenue, is relevant to their bonds’ revenue.
Swain rejected the bondholders’ argument, saying that one of the code’s definitions of special revenue describes them as associated with transportation or utility entities and the ERS was not one of these.
Another of the code’s definitions said the special revenues must be from a “particular function of the debtor.” Swain said the employer contributions to ERS “are a means of collection and delivery of deferred compensation to commonwealth employees, and ERS therefore functions as a conduit for distribution of employers’ contributions rather than as a provider of a ‘particular function’ or service that itself produces revenue.”
Commenting on the decision, municipal bankruptcy expert James Spiotto said that Swain had taken a very narrow view of the functions of the ERS.
Spiotto noted that the ERS holders earlier successfully challenged Swain’s rulings in the Court of Appeals for the First Circuit. He said he expected they would challenge this decision in that court.
The bondholders say that Bankruptcy Code 552(b)(1) provides an exception to Bankruptcy Code 552(a)’s statement that the debtor’s property wasn’t subject to pre-bankruptcy liens.
Swain said 552(b)(1) is relevant only to property the debtor gained before the bankruptcy. Since the employer contributions are calculated each year and change according to various conditions, they are property received after the bankruptcy, she argued. Therefore, they are liable to being impaired as part of 552(a).
Spiotto, managing director at Chapman Strategic Advisors, said he found Swain’s reasoning somewhat narrow.
Spiotto said there haven’t been legal cases that can serve as precedent for cases of municipal pension systems that owe bond payments in bankruptcy. Past cases of pension obligation bonds have involved bonds issued by the central government and not retirement systems. There are “unique” and “esoteric” issues in this case that may be appealed, he said.
Finally, Swain rejected the bondholders’ appeal to the U.S. Constitution as preventing the bondholders’ liens. The bondholders said the takings clause of the Fifth Amendment prevented ending the liens without just compensation.
Swain said that the U.S. Congress clearly created the Puerto Rico Oversight, Management, and Economic Stability Act to end liens like those the bondholders claim related to the ERS bonds. She said she couldn’t go against Congress’ will in PROMESA.
In August 2018 Swain ruled that the ERS bondholders didn’t have a perfected security lien on ERS property. The bondholders appealed this decision to the First Circuit and in January that court rejected it, saying that the lien had been perfected. The higher court sent the issue of what to do with ERS bonds back to Swain, who operates in the U.S. District Court for Puerto Rico.