Experts are confounded by Puerto Rico bankruptcy Judge Laura Taylor Swain’s debtor-centric interpretation of the Puerto Rico Oversight, Management, and Economic Stability Act.

The Puerto Rico Oversight Board’s latest proposed Puerto Rico Electric Power Authority plan of adjustment would give bondholders a payout as little as 0.21%, and a ruling Swain made last week could lead to payouts that low.

Much has yet to be decided. Bondholders may appeal the decision. The Puerto Rico Oversight Board plan of adjustment could again be revised. All of this will impact what Swain approves.

However, Swain’s PROMESA interpretation is also likely to influence PREPA bondholder recovery.

PROMESA is the 2016 law governing the Puerto Rico bankruptcies. Its Title III sets the process by which the parties are expected to reach a plan of adjustment.

At a late February PREPA disclosure statement hearing, Swain pointed to her July 2021 interpretation of PROMESA to explain why she ruled for the board on a key topic.

“As both this court and the court of appeals [for the First Circuit] have recognized, PROMESA is more akin to Chapter 9 of the Bankruptcy Code than it is to Chapter 11,” Swain said in July 2021. Chapter 9 is the bankruptcy code for municipal bankruptcies, while Chapter 11 is used in commercial bankruptcies.

“Unlike a commercial bankruptcy, which attempts to balance the rights of creditors and debtors, the principal purpose of, and, by analogy, PROMESA, is to allow municipal debtors the opportunity to continue operations while adjusting or refinancing their creditor obligations,” according to a 2020 First Circuit Court decision Swain quoted.

An attorney experienced in municipal bankruptcy, who requested anonymity, was “surprised” Swain thinks Chapter 9 is less focused on creditors than is Chapter 11 bankruptcy and said he disagrees.

The attorney said he never heard Chapter 9 bankruptcy described as more favorable to debtors than Chapter 11.

Chapter 9 gives debtors more freedom, the attorney said. However, the differences should not be interpreted as allowing judges to be more sympathetic to debtors, he added.

Creditors can propose plans of adjustment in Chapter 11, but not in Chapter 9. A trustee can be appointed on behalf of the creditors in Chapter 11, but not in Chapter 9. While this may seem to be Chapter 9’s bias to the debtor, these clauses stem from the Constitution’s restriction on federal power over the states, the attorney said.

While Swain used her interpretation of Chapter 9 to justify different treatment of bondholders holding the same securities, the attorney said equal treatment of creditors holding the same security is a basic principle of Chapter 9.

Swain is right that PROMESA’s Title III section on bankruptcy is “built on the foundation of Chapter 9,” said David Schleicher, professor at Yale Law School. She is also right that PROMESA and Chapter 9 are “pretty distinct” from the Chapter 11 corporate bankruptcy, he said.

However, Chapter 9 offers “creditor-protecting rules like the ‘best interests’ test and the ‘fair and equitable’ test for plans of adjustment (which itself turns on what creditors can ‘reasonably expect’),” Schleicher said.

Governments in Chapter 9 were forced “to make pretty substantial cuts to their budgets,” Schleicher said. “It is not a get out of jail free card. But it is also very different from corporate bankruptcy.”

Creditors’ role in Chapter 9 bankruptcy “is more limited… than in other cases,” according to a Judicial Conference of the United States web page. However, the site says, a plan of adjustment must be in “the best interests of creditors” in order to win confirmation.

PROMESA proscribes that at least one impaired class of creditors must vote to accept the plan.

“The modern application of Chapter 9 has been specifically to restore the debtor to fiscal health, with the requirement that the solution be in the best interests of creditors being a potential conflict that the judge needs to reconcile in each case,” said Matt Fabian, partner at Municipal Market Analytics. “This is why only the debtor gets to create plan of adjustments, and why the debtor usually decides which of its stakeholders are best recovered in the bankruptcy. The litigation and arguments and judicial oversight are the process by which this doesn’t go too far, at least in theory.”

One distinction with PROMESA, said Kent Hiteshew, who helped create the law when he was part of the Obama administration, is that it sets the Puerto Rico Oversight Board as the debtor and puts it in control of the bankruptcy process.

“Congress created numerous provisions of PROMESA that are intended to protect creditor rights more explicitly than Chapter 9,” Puerto Rico Clearinghouse Principal Cate Long noted.

“For example, the best interest test in PROMESA is a much higher bar than in Chapter 9 and the requirement that a fiscal plan ‘respect’ liens and priority of debts is much more explicit than in Chapter 9.”

“The court has used the poor drafting and ambiguity of PROMESA in favor of the debtor,” an institutional investor with a background in the Puerto Rico bankruptcy said.

Swain, her assisting judge Magistrate Judith Dein, and the court mediation team, the investor said, “have ignored two previously agreed to Restructuring Support Agreements [layout out deals between the Oversight Board and bondholders and] disallowed challenges to revisions of the fiscal plan.”

The court, the investor said, “has been unduly influenced by the whole political nature of the matter, where they were led a misleading narrative of over-indebtedness,” adding ”the debt was really never the problem and reducing [it] hasn’t solved any fundamental structural issues.”

The Oversight Board is trying to use a Swain ruling in an Employees Retirement System case “as a basis to cause future PREPA revenues to be unsecured,” Long said. She called the rationale used in the earlier case “a stretch.”

In Swain’s 70-page ruling Wednesday against PREPA bondholders having a lien on revenue, she emphasized the bankruptcy’s importance for the creditor rather than the debtor.

“The resolution of this issue is of utmost importance to PREPA’s prospects of emerging from Title III [bankruptcy] and to Puerto Rico’s financial stability,” she said.

In late February, Swain pointed to what she sees as the debtor-focused nature of PROMESA as an explanation for her willingness to deviate from equal of treatment of creditor claims in the PREPA bankruptcy.

This issue arose because creditors said the board offered National Public Finance Guarantee vastly better treatment than it is offering other PREPA bondholders. National has agreed to be a supporting impaired class, some say, as a result of the preferential treatment.

Creditors had pointed to a 1984 First Circuit decision to justify their claims that all securities of the same type must be treated the same way in a bankruptcy. But Swain argued the 1984 decision, Granada Wines, was in the context of a Chapter 11 corporate bankruptcy and since PROMESA was like Chapter 9, which focuses on the creditor, the 1984 decision was not relevant to the either the Puerto Rico central government or PREPA bankruptcy.

In the February hearing Swain said she would not reject the proposed disclosure statement because of the Oversight Board’s proposed plan of adjustment classes but would consider objections to the classes in the confirmation hearings, which are now scheduled for July.

Long said the argument in the precedent for differing treatment of similar claims was mainly for unsecured claims and not for bonds. Since the latter are “secured claims,” it will be much more difficult for the Oversight Board to argue National should be treated differently than other bondholders, Long said. Swain has since ruled the PREPA bonds are not secured claims.

Long also said PROMESA’s Title VI is explicit how bonds should be classified: “The administrative supervisor shall not place into separate pools bonds of the same issuer that have identical rights in security or priority.”