On May 3, 2017, after years of speculation and legal and political challenges, the Commonwealth of Puerto Rico, by and through its seven-member Financial Oversight and Management Board, filed for bankruptcy protection under the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”). By order of the Chief Justice of the Supreme Court of the United States, Judge Laura Taylor Swain of the Southern District of New York has been designated presiding judge in this and certain related Puerto Rican bankruptcy cases.
As we would expect in any case involving application of a brand new legal framework to a body that was previously ineligible for bankruptcy protection, the Puerto Rico restructuring has featured a number of thorny questions. At first blush, many seem to be questions of legal interpretation. But most will never be answered through pure statutory and doctrinal analysis.
This is because bankruptcy, like most litigation, is a game of strategy played against a backdrop of scarcity. Laws governing payment priority are extremely important in setting the stage, but not all claims are fully litigated and at some point any last-standing holdouts will be pressured to accept a deal that has reached almost full consensus. When these deals are struck, whatever the debtor agrees to pay to one group of creditors will impact what other creditors receive. All of this means it is incredibly important for parties to secure an early, prominent, and, ideally, well-funded seat at the bankruptcy negotiation table.
This article examines a recent disagreement involving whether and to what extent certain bondholders will have such a seat at Puerto Rico’s bankruptcy negotiation table.
II. The U.S. Trustee's Formation of an Unsecured Creditors' Committee
The dispute began on May 19th, when the U.S. Trustee announced that it would appoint an official retiree committee and an official unsecured creditors’ committee in the Commonwealth’s bankruptcy case. The U.S. Trustee derived its appointment power from PROMESA’s integration of Chapter 11 of the U.S. Bankruptcy Code. Similar to Chapter 9, which governs municipal bankruptcies, PROMESA makes applicable certain provisions of Chapter 11. Both Chapter 9 and PROMESA borrow heavily from Chapter 11 because that is the portion of the Bankruptcy Code that was explicitly drafted with the most complex restructurings in mind. As a result, many of its provisions are suitable not only for business debtors, but for any debtors with large groups of creditors battling for better treatment under a plan of restructuring.
One of Chapter 11’s provisions that PROMESA makes applicable to the Commonwealth is Section 1102, which authorizes one or more committees to represent groups of stakeholders. In Chapter 11 business bankruptcies, the U.S. Trustee typically appoints an unsecured creditors’ committee and, if circumstances warrant, an official equity committee. Secured creditors generally advocate directly in their own right, or they form ad hoc groups to negotiate as a collective body. In Chapter 9 municipal bankruptcies, the U.S. Trustee typically appoints only a retirees’ committee, and may decline to appoint an unsecured creditors’ committee on the grounds that such a committee is unnecessary (usually because the largest unsecured creditors are already represented on the retirees’ committee or advocating directly in their own right, or because the municipality has indicated its intent to pay them in full).
But while there are many similarities between PROMESA and Chapter 9, there is at least one important distinction: PROMESA provides, in Section 2176(a), that the court may award legal and other professional fees incurred by official committees, while Chapter 9 contains no such provision. This has an obvious incentive effect. Creditors that might otherwise prefer to advocate directly in their own right may, under PROMESA, prefer to have an official committee so that the bills are paid by the debtor.
An official committee also offers other benefits, such as investigatory powers and a clear and recognized seat at the bankruptcy negotiation table. This is because the debtor, the other parties, and the court may pay particular attention to arguments made by an official committee, and the debtor may be more inclined to negotiate and reach settlements with an official committee. Those settlements, in turn, can be the basis for pressuring holdouts to accept the plan or risk a judicial cramdown.
Of course, the attractiveness of an official committee to any given creditor ultimately comes down to how good the creditor feels about its payment priority, and, if it isn’t entirely confident of its legal rights, whether that creditor feels like the committee will represent its interests when it presses for better treatment. Otherwise, an official committee - at least in that particular creditor’s eyes - can do more harm than good by using its powers and its seat at the negotiation table to extract value that might otherwise flow to the creditor that believes it occupies a superior position. This is where things become especially murky in Puerto Rico.
III. The Ad Hoc Committee of General Obligation Bondholders
A group of creditors holding approximately $3 billion of full faith and credit general obligation bonds issued or guaranteed by the Commonwealth has come together, calling itself the Ad Hoc Group of General Obligation Bondholders (the “GO Group”). The GO Group believes that its members - and other holders of the Commonwealth’s approximately $19.6 billion in general obligation claims - are actually secured creditors, meaning that they would be among the first in line for repayment. But the Commonwealth’s Financial Oversight Board argues that the general obligation bondholders are unsecured, meaning that they are on equal footing with most of Puerto Rico’s other creditors.
This deeper rift, which has to do with the way bankruptcy and non-bankruptcy laws perceive promises to use all of a government’s available resources to pay certain creditors, is likely to be the subject of extensive litigation that could take months or even years to resolve.
In the meantime, there is the more immediate matter of official committee formation. But nothing is simple in bankruptcy, and even this seemingly administrative committee-appointment matter reflects the same broader strategic considerations. If the general obligation bondholders are secured, then their interests would not be represented by an unsecured creditors’ committee. If, on the other hand, they are unsecured, then they would be among the Commonwealth’s largest unsecured creditors and one or more of them should be appointed to serve on any such committee.
The GO Group thus found itself between the proverbial rock and a hard place. Should it resist the formation of an unsecured creditors’ committee as an unnecessary drain on the Commonwealth’s resources and proceed as an ad hoc group the way that most prominent clusters of senior secured creditors proceed in Chapter 11 cases? Or should it demand to be part of the official committee?
Again, the problem is that the GO Group presently faces a high degree of legal uncertainty regarding the secured nature of its claims. And, while an ad hoc group of clearly senior secured creditors has an undeniably important seat at the negotiation table even without an official committee, an ad hoc group with questionable or unrecognizable liens may fare the poorest of them all. This is because, to the extent it is relegated to unsecured status, its members would have no assurance that their unique interests are represented by the official committee.
IV. The Ad Hoc Committee's Challenges Regarding the Official Committee
Likely motivated by these and other concerns, the GO Group contacted the U.S. Trustee in June to challenge its decision to appoint an official unsecured creditors’ committee. (This and other correspondence can be found in exhibits to this motion.) The GO Group argued that such a committee should not be formed at all; however, so long as a committee was formed, then “it should be primarily, if not entirely, composed of” members of the GO Group.
But the U.S. Trustee proceeded to form an official unsecured creditors' committee and did not include any general obligation bondholders. In July, the GO Group again contacted the U.S. Trustee, requesting that the official committee be reconstituted to include general obligation bondholders. When the U.S. Trustee declined this request in mid-July, the GO Group filed a July 21st motion asking the court to reconstitute the official committee.
In an unavoidably circular argument, the GO Group maintained that its members are secured, but reasoned that general obligation bondholders should nonetheless serve on the unsecured creditors’ committee because any such committee should be fully representative of the Commonwealth’s diverse creditor body.
In an August 11th memorandum opinion, Judge Swain dealt a strategic blow to the GO Group, denying the motion on the grounds that creditors holding only secured claims are not entitled to serve on an official unsecured creditors’ committee, and that the GO Group has failed to demonstrate that its interests are not “adequately represented” in the case. Highlighting the inherently circular nature of the GO Group’s argument, she explained, “the GO Group itself has never conceded that it is unsecured. To the contrary, it argues that the Constitutional Debt is protected by a statutory lien….The GO Group cannot have it both ways. Its legal stance is fundamentally at odds with that of the general unsecured creditors, rendering it entirely unsuitable as a representative of those creditors’ interests.”
For now, it looks like general obligation bondholders will have to rely on the GO Group or on their own individual efforts to advocate for their interests. Assuming broader legal challenges to the Commonwealth’s bankruptcy case are unsuccessful, the GO Group’s most important task will be to build a convincing argument that the bondholders' claims are considered secured under federal bankruptcy law.
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