Special revenues may not be as special as many bondholders have historically expected. Two recent rulings from District Court Judge Laura Taylor Swain in the Puerto Rico PROMESA proceeding have held that bond issuers are not required to make post-petition special revenue bond payments during a pending Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) Title III bankruptcy proceeding. Judge Swain also held that unless the Oversight Board authorizes special revenue payments, the court lacks authority to compel the payment. The rulings are at odds with existing precedent, legislative history, and market expectations and have alarmed the municipal finance industry.
In this blog post, we look at the immediate impact of Judge Swain’s interpretation of the Bankruptcy Code—pending appeal—and consider how to mitigate bondholder risk for new special revenue secured bond issuances.
What does the Bankruptcy Code say about special revenues?
Special revenues are revenues derived from a project or system, for example toll revenue generated by a highway or bridge project. Under section 928 of the Bankruptcy Code, special revenues acquired after the commencement of the case remain subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.
Section 922 of the Bankruptcy Code expressly provides that the filing of a petition does not operate as a stay of application of pledged revenues to payment of indebtedness secured by such revenue. The marketplace has commonly understood that section 922 of the Bankruptcy Code protects special revenues and directs their payments to issuers notwithstanding a pending bankruptcy.
What did Judge Swain say about the automatic stay and special revenues?
Despite market expectations, Judge Swain held in the Assured Adversary Proceeding that the holders of special revenue bonds cannot compel the debtor to apply special revenues to debt service post-petition. Specifically, the Court held that the exception to the automatic stay found in section 922(d) did not authorize actions to compel the debtor to apply net special revenues to debt service—it merely allows debtors to voluntarily make such payments if they so choose.
Judge Swain cited legal commentary, noting that nothing in the plain language of section 922(d) demonstrates congressional intent to give the holders of special revenue secured bonds the power to compel continued application of such revenues to payments during the course of a Chapter 9 proceeding.
Is this ruling consistent with the Bankruptcy Code and prior precedent?
Legislative history suggests that section 922(d) was intended to avoid the impairment of special revenue bonds in bankruptcy by excluding such payments from the automatic stay. Indeed, the market has long viewed the continuation of payments on special revenue debt as a certainty.
Consistent with that expectation is Judge Thomas Bennett’s decision in the Jefferson County Chapter 9 proceeding. In Jefferson County, Judge Bennett analyzed a pledge of special revenues pursuant to the definition contained in section 902(2)(A) to find that specifically pledged sewer revenues were not subject to the automatic stay. Judge Bennett held that the automatic stay does not bar application of pledged special revenues to indebtedness, regardless of whether the special revenues are generated pre- or post-petition or whether they have been paid over to the trustee. The Jefferson County opinion does not address whether such payments were voluntary or compulsory, but the ruling is consistent with perception that Congress intended to protect special revenues in an effort to ensure a stable municipal finance market.
What is the Basis for Judge Swain’s Opinions?
Judge Swain dismissed the bondholder’s claims in the Assured Adversary Proceeding, holding that section 922(d) only grants a municipality “permission” to continue paying special revenue obligations in its discretion during a bankruptcy and does not compel a debtor to make such payments. The Court narrowly read the plain language of section 922(d), finding no express payment obligation, and concluded that section 922(d) does not sanction non-consensual interference with governmental properties or revenues under section 305 of PROMESA. Section 305 of PROMESA is similar to section 904 of the Bankruptcy Code—they both protect debtor property from court interference. Section 904 generally prevents a court from issuing any stay, order, or decree that might interfere with any of the property or revenues of the debtor. Under section 304 of PROMESA, the consent of the Oversight Board is required or the enforcement must be in connection with a plan of adjustment if property rights or revenues are to be implicated.
While the ACP Adversary Proceeding merely touches on the authority of the court under section 305 of PROMESA, the Assured Adversary Proceeding takes a deeper dive. In the Assured Adversary Proceeding, Judge Swain dismissed a complaint by bondholders regarding the payment of special property tax and clawback revenues, ruling that section 305 of PROMESA restricted the court’s ability (notwithstanding its subject matter jurisdiction) to enforce the payment of special revenues post-petition because the Oversight Board did not consent to such payments. Judge Swain read section 305 of PROMESA broadly. Taking these two opinions together, Judge Swain has held that where the debtor is in possession of the special revenue proceeds and they have some property interest in those funds (be it a small reversionary interest or something else) or the funds are the debtor’s revenues, the Bankruptcy Code does not compel that the payments be made and section 305 of PROMESA prevents the court from ordering the Debtor to pay.
How Safe Are Special Revenues?
Not as safe as they were prior to Judge Swain’s rulings, but safe enough if a bondholder is able to establish as a matter of law that they hold an enforceable security interest and lien on special revenues. Bondholders with liens are still able to prove their lien and seek payment and/or adequate protection once a Chapter 9 proceeding is filed.
The market’s reliance on the assumption that the Bankruptcy Code protects special revenues and mandates their application to debt service in a Chapter 9 proceeding must adjust to reflect the new reality—that the payment of special revenue bonds post-petition is not mandatory, but permissive. Both rulings are on appeal to the First Circuit Court of Appeals and, until those appeals are determined, parties structuring special revenue bond issuances should consider the difference between permissive and mandatory turnover of special revenues post-petition in pricing and in accessing risk in the event of an issuer Chapter 9 filing.
If a special revenue issuance is protected by a state statutory lien, there may be broader protection in the event of a Chapter 9 filing. This is particularly true if the state statute requires the special revenues to be received by a third party, never be in the possession, custody or control of the issuer, and state or other applicable law requires that the funds received be applied to debt service.
Bond documents should clearly identify the statutory lien and be consistent with state statutory requirements regarding the flow of funds. There is greater protection when a statute prohibits the issuer from ever receiving the special revenues because under this scenario, to allow a debtor to receive and perhaps reallocate special revenues would be a violation of state law. It is important when issuing special revenue secured debt pursuant to a state statute that the offering statement, indenture, issuer’s resolution, and payment agent agreement are consistent and comply with the statute.
What Does the Future Hold?
It depends on what the First Circuit determines on appeal. If the First Circuit accepts Judge Taylor’s statutory interpretation, then the certainty previously enjoyed with regard to turnover of special revenues post-petition must be reconsidered in terms of deal structure and pricing and risk to enforceability during a bankruptcy proceeding. Market access for some issuers will be limited unless state law provides for a statutory lien and payment through a third party intermediary and not the debtor. Should the First Circuit uphold Judge Swain’s ruling, we expect that there will be pressure on Congress from all parties within the municipal finance industry, including issuers, to revise section 922(d) to require or mandate turnover of special revenues after a Chapter 9 filing.
 Assured Guaranty Corp. et al. v. Commonwealth of Puerto Rico et al. Adv. Proc. No. 17-155-LT and 17-155-LTS (Bankr. D.P.R., January 30, 2018) (“Assured Adversary Proceeding”); ACP Master, LTD., et al. v. The Financial Oversight and Management Board for Puerto Rico as representative of Commonwealth of Puerto Rico, et. al., Adv. Proc. No. 17-189-LTS (Bankr. D.P.R., Jan. 30, 2018) (“ACP Adversary Proceeding”). The Assured Adversary Proceeding and the ACP Adversary Proceeding were filed in In re The Financial Oversight and Management Board For Puerto Rico, as representative of Commonwealth of Puerto Rico, No. 17BK 3283-LTS (Bankr. D.P.R.). The Puerto Rico Highways and Transportation Authority (“PRHTA”) is one of several Title III debtors.
 PROMESA was enacted by the U.S. Congress and signed into law in 2016. PROMESA is codified at 48 U.S.C. §§2101, et seq.
 In re Jefferson Cnty., Ala., 47 B.R. 228, 262-74 (Bankr. N.D. Ala. 2012).
 See appellate case numbers 18-1165/18-1166 (Assured) and 18-1108 (ACP Master Fund).
 Note that in the Assured case, the Puerto Rico Fiscal and Advisory Authority, on behalf of PRHTA, delivered instructions to the fiscal agent directing the agent not to make scheduled payments to bondholders and that any such payment, if made, would violate the automatic stay under PROMESA. Accordingly, the fiscal agent did not make the payments.