Bondholders of the Puerto Rico Electric Power Authority (PREPA) have a secured claim only up to the amount of certain funds established under their trust indenture, and an unsecured claim for the value of future net revenues of PREPA that would have been payable to them over the remainder of the term of their bonds, according to a March 22 decision by US District Judge Laura Taylor Swain.

The decision is a highly technical reading of the indenture provisions focused on the specific “granting clauses” on the various indenture funds and PREPA’s pledge (or “promise”) of net revenues to the bondholders. As with other decisions coming out of the PROMESA proceedings, it will be of persuasive value for other courts interpreting indenture provisions but will not be binding precedent. Because the reasoning is tailored to the particular language from the PREPA indenture, precedential value will be further limited to indentures with similar pledge language.

Nevertheless, to address the concerns raised by this decision, and mitigate risk in new transactions, we recommend that the granting language in municipal bond transaction documents explicitly grant a security interest and lien in all revenue of the obligor. The security interest can be perfected though a control agreement on the operating account of the obligor.  In any event, bondholders should closely analyze the language of their bond documents in forming any recovery analysis on their stressed or distressed credits, and primary market participants would be wise to pay particular attention to the granting clauses in any new issuance secured by a revenue stream.

Background

PREPA is the Commonwealth of Puerto Rico’s primary electric utility. Between 1974 and 2016, PREPA made several bond issuances totaling approximately $8.3 billion. In 2017, the Financial Oversight and Management Board for Puerto Rico (the Oversight Board) filed a petition under Title III of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) — legislation intended to help address the fiscal crisis in Puerto Rico by, among other things, allowing Puerto Rico to restructure its debt — and commenced a debt adjustment proceeding for PREPA.

In 2019, the Oversight Board sued bond trustee US Bank to, among other things, disallow its secured bond claim to the extent asserted beyond the moneys deposited into certain funds established under the bond indenture.

The March 22 decision came after bondholders and the Oversight Board cross-moved for summary judgment. The Oversight Board requested disallowance of the bondholders’ claim, which would form the basis for bondholder recovery in the pending PREPA plan of adjustment, to the extent it purported to be secured by any PREPA property other than certain moneys currently deposited to certain funds created by the indenture and subjected to a lien in favor of the bond trustee.  The bondholders, on the other hand, argued that they had a claim for the face amount of the bonds secured by all of PREPA’s current and future revenues, to which they could look for payment in perpetuity.

Discussion of Indenture Provisions

Bondholders argued that the PREPA indenture contained a “granting clause” over PREPA’s revenues which entitled them to secured creditor status on such revenues. Specifically, the opening recitals of the indenture said that PREPA “has pledged and does hereby pledge to the Trustee the revenues of the System … and other moneys to the extent provided in this Agreement as security for the payment of the bonds.”

Section 701 of the indenture continued to say that PREPA “covenants that it will promptly pay the principal of and the interest on each and every bond issued under the provisions of this Agreement at the places, on the dates and in the manner specified herein  … [and] such principal, interest and premium will be payable solely from the Revenues and said Revenues are hereby pledged to the payment thereof in the manner and to the extent hereinabove particularly specified.” “Revenues” are defined as all moneys received by PREPA as a result of its ownership and operation of the “System” which is defined, generally, as all properties owned and operated by PREPA.

Critically, there are other provisions of the indenture that create special segregated indenture funds into which revenues net of expenses are deposited, and which are “subject to a lien and charge in favor of the holders of the bonds.” The indenture does not contain provisions subjecting PREPA’s revenues to a lien or charge in favor of bondholders, beyond the “pledge” language in the agreement’s recitals.

The court rejected the bondholders’ argument that pledge language created a security interest, in light of the existence of “more specific operative terms” elsewhere in the indenture. It focused its analysis on the specific language of the PREPA indenture and general principles of contract interpretation, rather than legal constructs that would have broad applicability in municipal bankruptcies.

The court interpreted the pledge language from the PREPA indenture as a mere “promise” to pay the amounts owed on the bonds from net revenues, which is “partially secured” by a lien on the indenture funds which attaches at the time the funds are ultimately deposited. The court emphasized that the recitals contained no reference to any grant of a lien or charge, but instead stated that the pledge is “mutually agreed and covenanted by and between the parties hereto.”

It is a principle of contract interpretation that contracts are to be read in a manner that gives each provision meaning and renders none superfluous. The court reasoned that if the “pledge” language granted a security interest in PREPA’s future revenues, the specific grants of a security interest in funds into which certain revenues were to be deposited would be rendered superfluous.

At bottom, the court interpreted the “pledge” language contained in the recitals as “merely a prefatory clause indicating that the scope of the pledge is mapped by more specific terms to come in subsequent sections.”  Thus, under the indenture, PREPA’s future revenues are a “’mere expectancy’ until they are rendered collateral, i.e., received and deposited into the liened Funds.” And PREPA’s bondholders have no currently enforceable security interest in the future revenues because PREPA has not yet received and deposited them into the pertinent indenture funds.

Chapter 9 Analysis

The court separately analyzed section 928 of the bankruptcy code, the provision that deals with a pledge of special revenues in municipal bankruptcies. Specifically, section 928 states that “special revenues acquired by the debtor” after filing for bankruptcy “shall remain subject to any lien resulting” from a pre-petition security agreement and “any such lien on special revenues … shall be subject to the necessary operating expenses of such project … .”

Bondholders had argued that even if the PREPA trust indenture did not grant a lien on PREPA’s revenues, section 928 would render its perfected lien on indenture funds to cover all future special revenues of PREPA after the confirmation of its plan of adjustment, in perpetuity (until the bonds were paid off).

The court disagreed. It held that the bondholders’ liens persist on special revenues deposited into the indenture funds after the commencement of PREPA’s Title III case, but the lien does not extend to future revenues prior to receipt, based on its close reading of the indenture as described above. The court further held that section 928 does not make PREPA’s obligation to deposit revenues into the liened funds nondischargeable in bankruptcy. Thus, although the bondholders have a security interest in amounts on deposit in the liened funds after the commencement of the case, that lien is cut off when PREPA’s plan of adjustment is confirmed.

Effects on PREPA Bondholder Recovery

At the end of the day, PREPA’s bondholders will have a claim against PREPA, based on PREPA’s promise to pay debt service on the bonds from pledged net revenues of the utility system, that is partially secured by the moneys in the indenture funds and otherwise unsecured.

What is the value of the bondholders’ unsecured claim? The court did not say, other than that it will not be the full amount of the outstanding unpaid bonds. Instead, the bondholders must calculate the amount that they would recover if they were to obtain specific performance under the indenture and a receiver raised rates to satisfy payment from net revenues as more specifically described, and subject to the various restrictions, in the indenture.

The official committee of unsecured creditors in the case articulated one potential measure of such a claim as the net present value of the future net revenues that PREPA may generate, or the amount that someone would pay now for the right to potentially receive net revenue payments from PREPA in the future. Any such claim, however, would be unsecured — receiving pennies on the dollar pursuant to PREPA’s plan of adjustment ― except to the extent secured by indenture funds as described above.