By MAXWELL D. SOLET and CHRISTIE MARTIN

In August, 2016, the IRS issued Revenue Procedure 2016-44, the first comprehensive revision of its management contract safe harbors since Revenue Procedure 97-13.  Rev. Proc. 2016-44 (see our description here) built upon and amplified principles laid out in private letter rulings issued over many years and in Notice 2014-67.  Now, less than six months later, the IRS has published Revenue Procedure 2017-13, which clarifies and supersedes Rev. Proc. 2016-44 but does not materially change the safe harbors described therein.  The clarifications are in response to questions received with respect to certain types of compensation protected under earlier safe harbors, incentive compensation, timing of payments, treatment of land when determining useful life, and approval of rates.

 

 

By LEN WEISER-VARON and BILL KANNEL

Today’s U.S. Supreme Court decision in Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust puts an end to one of Puerto Rico’s multi-pronged efforts to deleverage itself.  Given the comprehensiveness of the First Circuit’s intermediate appellate opinion upholding the district court’s invalidation of Puerto Rico’s Recovery Act, it was surprising that the highest court took the case, a decision apparently prompted by Justice Sotomayor’s interest in obtaining a reversal.  Comments of some other Justices at oral arguments raised the possibility of Sotomayor attracting a majority for the proposition that the preemption provisions of Section 903 of the U.S. Bankruptcy Code were inapplicable to Puerto Rico, but in the end only Justice Ginsburg joined what turned out to be Sotomayor’s dissenting opinion in a 5-2 ruling upholding the relegation of the Recovery Act to the dustbins of history.

As  we have written previously, the Recovery Act was damaged goods from the beginning: even if the fairly clear preemption argument had not prevailed, the Contracts Clause constraints on non-federal bankruptcy legislation would have severely constrained, if not eliminated, the effective use of  the Recovery Act to break bond contracts. In any event, the Recovery Act, and the Supreme Court’s decision, were  a couple weeks away from being moot, as it appears evident that Congress will pass PROMESA, the federal oversight and debt restructuring legislation that has always constituted the logical legal mechanism for those favoring a less chaotic denouement to Puerto Rico’s debt woes.

By LEN WEISER-VARON and BILL KANNEL

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

  • Due to Justice Scalia’s death and Justice Alito’s recusal, only 7 Justices heard the case and only 4 votes are needed for a majority.  Almost all of the questioning at oral argument came from Justices Sotomayor, Kagan and Breyer, plus a couple noteworthy questions from Justice Ginsburg.  With the standard disclaimer that questions at oral argument are not necessarily predictive of a Justice’s votes, it seems clear from the questioning that Justice Sotomayor will vote to reinstate the Recovery Act and is the most passionate of the Justices about the issue, and, even if the relatively silent Chief Justice Roberts and the silent Justice Kennedy and Justice Thomas vote to affirm,  the questions and musings of Justices Kagan, Breyer and Ginsburg suggest that Justice Sotomayor could sway them to her position and thereby obtain the 4 votes necessary for reversal of the First Circuit’s holding and reinstatement of the legislation.
  • All that can be said about the actual statutory language that the Supreme Court will interpret is that the drafting does not represent Congress’s finest work.  (Justice Breyer provided the only moment of merriment on the Scalia-less panel when, after a suggestion that the opaque statutory language requires a contextual reading, he responded, “That may be, but I can’t say that an ‘airplane’ means a horse.”) There is no relevant legislative history, so it is not clear that Congress, when it amended the Bankruptcy Code to exclude Puerto Rico’s (and the District of Columbia’s) government instrumentalities from Chapter 9 eligibility, thought about the question of how that would or should impact Puerto Rico’s and D.C.’s right to enact their own insolvency statutes.  So while nominally a statutory interpretation case, this is, on a technical level, almost purely a “what makes the most sense” case.
  • The First Circuit was persuaded that it would make no sense for Congress to act affirmatively to withhold from Puerto Rico the right to authorize its insolvent instrumentalities to file for bankruptcy under Chapter 9, while intending that Puerto Rico have the right to authorize such filings under some insolvency statute of its own creation.  That seems almost unassailably correct; basic common sense suggests that whatever distrust of Puerto Rico must have motivated Congress to close the door to Puerto Rico’s ability to authorize its instrumentalities to file under Chapter 9 cannot be reconciled with Congressional intent that Puerto Rico be allowed to authorize such filings under its own version of an insolvency statute that might be identical to, or differ in unpredictable ways from, Chapter 9.
  • However, Puerto Rico seems to have gotten some traction before the Supreme Court with the proposition (which the First Circuit correctly rejected) that Congress cannot have intended to leave Puerto Rico’s instrumentalities in a “no man’s land” where they had no access to Chapter 9 and no access to an alternative insolvency regime. The short answer is that there is a high likelihood that Congress, if it had an intent on the matter when it eliminated Puerto Rico instrumentalities from Chapter 9 eligibility, precisely intended that Puerto Rico instrumentalities would not have access to an insolvency process unless and until Congress specifically authorized the applicable process (as it is currently being pressed to do by Puerto Rico and the U.S. Treasury.)  Such federal control would be and is consistent with Puerto Rico’s status as a U.S. territory, however it is labeled in the Bankruptcy Code.
  • Justice Sotomayor also raised the issue of whether the principles of federalism and state sovereignty that make the federal Chapter 9 available only to instrumentalities of states that have elected into the Chapter 9 regime would be violated if Chapter 9 were the only insolvency regime available to a state, i.e. whether interpreting Section 903 of the Bankruptcy Code as applicable to states that have not exercised such option (as well as to Puerto Rico and D.C., which have no such option to exercise) would be unduly coercive and raise Tenth Amendment issues.  The First Circuit left that question unaddressed on the grounds that Puerto Rico is not protected by the Tenth Amendment.  But as Section 903 applies to any “State”, if the Supreme Court interprets it, and its restriction on a “State’s” ability to enact insolvency legislation for its instrumentalities, as applying to Puerto Rico, it also will be interpreting it as applying to the 50 states, including those that have not opted to authorize their instrumentalities to use Chapter 9.  Whether or not any of the other Justices would view such an interpretation as presenting a substantial Tenth Amendment concern cannot be discerned from the oral argument, but the Court often interprets ambiguous statutes in a manner that avoids a potential constitutional concern, and Sotomayor’s apparent invocation of that principle may be targeted at her fellow Justices as a counterweight to the proposition that Congress, in eliminating Chapter 9 access for Puerto Rico’s instrumentalities,  must have intended to preclude any access to bankruptcy by such  instrumentalities absent direct authorization by Congress.  In divining what Congress intended by Section 903, Sotomayor appears to be suggesting, the Supreme Court cannot focus myopically on what Congress would have intended for Puerto Rico.
  •  As we have previously discussed, even if the Court revives the Recovery Act, the Recovery Act is, from Puerto Rico’s perspective, a problematic, and possibly ineffective, insolvency process.  A principal purpose of bankruptcy is to adjust, restructure and impair contracts.  The federal government is not subject to the constitutional restriction on impairment of contracts, and therefore the federally-enacted Chapter 9 process can impair debts and contracts.  Puerto Rico, and therefore its Recovery Act, have been held to be subject to the constitutional restriction on impairment of contracts.  A couple of the Justices noted this constraint, both in questioning what benefit Puerto Rico would derive from a reinstatement of the statute and as a potential protection that Congress might have taken into account if it did not intend to preclude non-federal insolvency law.  If the Recovery Act is reinstated and used by Puerto Rico, one can expect years of litigation on the question of whether any debt adjustment (or other contract adjustment) effected thereunder does or doesn’t meet the high bar of public necessity and unavailability of reasonable alternatives required for such adjustment not to constitute an unconstitutional “impairment.”
  • Puerto Rico’s persistence in seeking reinstatement of the Recovery Act reflects a calculus that an insolvency process that produces a legally questionable and potentially unenforceable result is better than no process, and provides creditors more incentive for consensual resolutions than no process.  Chapter 9 eligibility for Puerto Rico’s instrumentalities, and, if Congress were to grant it, “super Chapter 9“ eligibility for Puerto Rico itself,  would clearly, in Puerto Rico’s view, constitute a far more advantageous and conclusive process.  However, there is some risk to Puerto Rico that if the Supreme Court reinstates the Recovery Act before Congress acts on federal legislation to address Puerto Rico’s financial woes, the revival of the Recovery Act would undercut any Chapter 9 momentum, leaving Puerto Rico with its legally wobbly Recovery Act.  But Puerto Rico appears willing to gamble that the Supreme Court will issue its decision after Congress has done whatever it will do, and, in any event, to believe that a constitutionally vulnerable local bankruptcy statute in the hand is worth a constitutionally bulletproof federal bankruptcy statute in the bush.

 

By LEN WEISER-VARON and BILL KANNEL

 

A draft of the U.S. Treasury’s proposed debt restructuring legislation began circulating earlier today.  The draft legislation would give Puerto Rico, as well as other U.S. territories, and their municipalities access to U.S. bankruptcy court under a new chapter of the U.S. Bankruptcy Code (so-called “Super Chapter 9”) as well as making Puerto Rico’s instrumentalities (but not Puerto Rico itself) potentially eligible to file for bankruptcy under existing Chapter 9. The prospects for bipartisan cooperation on some form of such legislation appear somewhat more promising than those for the confirmation of a new Supreme Court justice, but whether this trial balloon will fly remains uncertain.

Some initial observations:

  • The legislation would provide access to bankruptcy to Puerto Rico and other U.S. territories (Guam, American Samoa, Northern Mariana Islands and U.S. Virgin Islands) and their municipalities.
  • The availability of bankruptcy to a territory and/or any “municipality” (i.e. political subdivision, public agency, instrumentality or public corporation of a territory) would be conditioned on the establishment of a Fiscal Reform Assistance Council (Council) at the request of the applicable territory’s Governor.  The Council would consist of 5 members appointed by the President of the United States and would have to approve any such bankruptcy filing.  The Council would have a variety of oversight powers including budget and debt issuance approval powers.
  • The legislation preserves the concept of “special revenue” bonds that benefit from more protective provisions under Chapter 9, such as the continued application of a lien on special revenues to such revenues arising after the filing of the bankruptcy petition, and the inapplicability of the bankruptcy stay to the application of special revenues to payment of debt service on special revenue bonds.  However, the definition of “special revenues” is narrower under the draft legislation than it is under Chapter 9.  As under Chapter 9, “special revenues” include “receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems.”  However, for Puerto Rico and other territories, the draft legislation would not include as “special revenues” “special excise taxes imposed on particular activities or transactions,”  “incremental tax receipts from the benefited area in the case of tax-increment financing,” “other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions” or “taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax-increment financing) levied to finance the general purposes of the debtor.”  Accordingly, debtors that under the legislation could file under either Chapter 9 or this new chapter would have an incentive to file under this new chapter if their revenues would constitute “special revenues” under Chapter 9 but not under the new chapter.
  • The legislation creates a one-year stay (from the date of establishment of a Council) on (i) the commencement or continuation of any action or proceeding that seeks to enforce a claim against the territory and (ii) the enforcement of a lien on “or arising out of” taxes or assessments owed the territory.  Note that the stay becomes effective without regard to whether a bankruptcy petition is filed.
  • A territory may be a debtor upon the establishment of a Council and approval of the filing by the Council.  A municipality of a territory must, in addition, be specifically authorized by territory law to be a debtor.
  • In contrast to Chapter 9, a debtor need not be insolvent in order to be eligible to file for bankruptcy under the proposed new chapter.
  • A territory and its municipalities may file bankruptcy petitions and plans of adjustment jointly.
  • If the debtor is a territory, the presiding judge in the bankruptcy is appointed by the Chief Justice of the U.S. Supreme Court.  If the debtor is a municipality filing separately from a territory, the presiding judge is appointed by the chief judge of the applicable federal circuit court of appeals (the 1st Circuit, in the case of Puerto Rico).
  • Among the various conditions for confirmation of a plan, noteworthy conditions include that “the plan does not unduly impair the claims of any class of pensioners.”  The draft legislation does not define what is meant by “unduly.”
  • The legislation provides a limited degree of protection for Puerto Rico’s general obligation bonds, including as a plan approval condition that “if feasible, the plan does not unduly impair” the claims of holders of the territory’s general obligation bonds that are “identified in applicable nonbankruptcy law as having a first claim on available territory resources.”   Notably, this protection is provided “if feasible” whereas there is no feasibility requirement on the protection of pensioner claims.  Again, the protection of general obligation bonds, “if feasible” is against being “unduly” impaired, without clarity as to what constitutes undue impairment.  Oddly, the implication is that general obligation bonds can be “unduly impaired” if it is not feasible to “duly” impair them.
  • The draft legislation makes many but not all of the general provisions of the Bankruptcy Code, many but not all of the provisions of Chapter 9, and some of the provisions of Chapter 11, particularly those relating to plan confirmation,  applicable to a bankruptcy involving a territory or a territorial municipality.

By LEN WEISER-VARON, BILL KANNEL and ERIC BLYTHE

It is said that muddy water is best cleared by leaving it be.  The Supreme Court’s December 4 decision to review the legality of Puerto Rico’s local bankruptcy law, the Recovery Act, despite a well-reasoned First Circuit Court of Appeals opinion affirming the U.S. District Court in San Juan’s decision voiding the Recovery Act on the grounds that it conflicts with Section 903 of the U.S. Bankruptcy Code, suggests, at a minimum, that at least four of the Justices deemed the questions raised too interesting to let the First Circuit have the last word. This discretionary granting of Puerto Rico’s certiorari petition further muddies the already roiling Puerto Rican waters.

As a result of the Supreme Court’s granting of the Commonwealth’s petition for a writ of certiorari, eight Justices will hear the case (Justice Alito has recused himself), with oral arguments likely in March, 2016.  A decision would then be expected in June, 2016, coinciding with the Commonwealth’s fiscal year end.  At first glance, the decision to grant “cert” appears to be a victory for the Commonwealth (according to SCOTUSblog, over the past three terms the Supreme Court has reversed approximately 72% of cases it has accepted for review).  Of course, the Supreme Court could weigh-in in a manner or on a topic that does not fully resolve the status of the Recovery Act.  At the very least, the review may hinder creditor negotiations and the chances of a consensual resolution.  And a consensual resolution may be Puerto Rico’s best hope.

Even as Puerto Rico legislators laud the Supreme Court’s decision, their pleas for alternate solutions—namely, Chapter 9 eligibility and/or a voluntary debt exchange—continue.  They argue that, absent these solutions, the territory will reach its breaking point before the Supreme Court rules.  The reappearance of the Recovery Act as an arguable solution to Puerto Rico’s quest for a debt restructuring process will likely only contribute to the gridlock in Congress regarding Puerto Rico’s campaign for Chapter 9 eligibility or for “Super Chapter 9” legislation that would enable it to restructure its general obligation debt.  Consensual creditor resolutions may be the Commonwealth’s most realistic option; indeed, the Commonwealth was hopeful it could implement a voluntary debt exchange by May, 2016.  But that was before cert was granted.

Creditors may now be even more wary of negotiating given the greater uncertainty the Supreme Court’s review engenders.  Parties striking deals with the Commonwealth and its entities are going to want to make sure the arrangements reached are “Recovery Act remote”, “Chapter 9 remote”, “Super Chapter 9 remote” and “Whatever the heck Congress, the courts or the Puerto Rico legislators do remote”.  Given the uncertainties regarding Recovery Act implementation (if/when/how), creditors may be unwilling to bear these risks and may choose to leave the muddy water be, for now.  That could be disastrous for Puerto Rico.

Finally, even if the Supreme Court reinstates the Recovery Act, the Recovery Act may still be an ineffectual vehicle for debt restructuring.  Because it is not enacted by the federal government, any plan confirmed under its provisions will be subject to a variety of constitutional challenges under the contracts clause and the takings clause of the U.S. Constitution.

The future’s not ours to see.

By LEN WEISER-VARON and BILL KANNEL

Last week, the Working Group for the Fiscal and Economic Recovery of Puerto Rico gave the broadest hint yet of the next tactic in Puerto Rico’s ongoing quest to deleverage itself.  Although the details have not yet been articulated, Puerto Rico apparently proposes to blend into a single pot several types of distinct taxes currently earmarked to pay or support different types of bonds issued by a number of its legally separate municipal bond issuers, with the hope that the resulting concoction will meet the tastes of a sufficient number of its differing bond creditors to induce them to voluntarily exchange their various types of bonds for a single type of new debt presumably supported by the new blended tax revenue stream.

According to the “Restructuring Process and Principles” slides released by the Working Group on September 24, “the Working Group is working with the Commonwealth’s advisors to structure a debt-relief transaction that will permit the Commonwealth’s available surplus to be used to make payments on its indebtedness while the initiatives and reforms undertaken as part of the Fiscal and Economic Growth Plan take hold.”  Per the release, “[t]he consensual negotiation and ultimate transaction will seek to involve not just creditors of one governmental entity, but instead the creditors of many entities, as part of a single, comprehensive exchange transaction. The  goal of this approach is to avoid a piecemeal strategy that may result in uncoordinated and inconsistent agreements with creditors, litigation among creditor groups, and a lower chance of success.”

As the saying goes, good luck with that.

The Working Group’s trial balloon is short on details as to which existing debt would be involved in the contemplated “single, comprehensive exchange transaction.”  Given the magnitude of the Working Group’s projected funding gap,  after other proposed corrective measures are undertaken, of $14 billion from FY 2016 to FY 2020, and given that direct and guaranteed general obligation bonds and COFINA sales tax bonds  constitute approximately $34 billion out of Puerto Rico’s approximately $71 billion in outstanding public sector bonds, it seems virtually certain that, at a minimum, the contemplated “super-exchange” would involve the g.o. bonds and the COFINA bonds.  Other types of bonds supported, directly or on a contingent basis, by Commonwealth tax revenues are of substantially lesser magnitude and, in many instances, also are payable from independent revenue streams. Some or, depending on the Working Group’s appetite for complexity, all of those other types of bonds also are likely to be targeted for the to-be-negotiated “super-exchange”; as listed in the Working Group‘s September 9 report, they include bonds issued by HTA, GDB, PBA, PFC, PRIFA, UPR, PRCCDA, PRIDCO, GSA and ERS.

In evaluating the feasibility of a negotiated exchange that stirs together this alphabet soup of issuers and creditors, we start from the following premises:

  •  Debt service on the g.o. debt has top priority, under the Puerto Rico constitution,  on the Commonwealth’s “available resources.”  Although enforcement of this legal priority would raise some thorny issues, and although much of the g.o. debt may now be held by holders with a basis well below par, there is no clear incentive for many g.o. bondholders to give up  any portion of their legal entitlement to full debt service payment from “available resources” for what the Working Group’s slides characterize as reduced payment from the Commonwealth’s “available surplus.”
  • Debt service on COFINA bonds is payable from a statutorily assigned portion of the sales tax or of any substitute tax such as the VAT.   The statutorily assigned taxes should be sufficient to pay full debt service on the COFINA bonds for the foreseeable future.  Puerto Rico case law as well as a series of Puerto Rico Attorney General opinions support the validity of such an assignment.  Much of the outstanding g.o. debt has been issued and/or purchased with full awareness by the g.o. bondholders that the relevant portion of the sales tax has been assigned to COFINA and its bondholders.  Similar assignments of specified tax revenues to independent bond-issuing authorities have been upheld in other jurisdictions.  The complaint allegedly ready on someone’s shelf seeking an adjudication that the COFINA structure is a legal sham or that the assigned sales tax revenues remain “available resources” for the payment of g.o. debt service may be filed some day, but from our perspective COFINA holders should like their chances in any such litigation.  Absent disproportionate fear of an adverse result in any such litigation, there is no clear incentive for many COFINA bondholders to give up  any portion of their legal entitlement to full debt service payment from the statutorily assigned and pledged sales tax revenues for reduced payment from any other source.
  • What, if anything, could be achieved by Puerto Rico in consensual debt reduction negotiations with holders of other types of debt with more tenuous claims on Commonwealth taxes (due to express clawback provisions, appropriation requirements, lack of a constitutional payment priority or security interest or other factors) is an interesting question, but may be moot in the event of substantial nonparticipation in a “super-exchange” by g.o. and COFINA bondholders, as Puerto Rico cannot achieve the debt service reductions it asserts it needs without substantial buy-in from the g.o. and/or COFINA bondholders.
  • Although the “Restructuring Process and Principles” slides state that “[t]he transaction will be structured to take into account the priorities of the debt that creditors hold”, it is difficult to derive much meaning from that statement.  Any restructuring that reduces debt service payable on the g.o. bonds in order to pay other Commonwealth expenses will disregard the constitutional priority of debt service in application of available resources.  Any restructuring that reduces debt service payable on COFINA bonds in order to apply some of the sales tax/VAT pledged as security to COFINA bonds to instead pay Commonwealth expenses will violate the statutory priority of COFINA bond debt service.  To the extent that the restructuring would be consensual, it may be tautological that there will be no dishonoring of any constitutional or statutory priority, as the participating bondholders will have agreed to any deviation from such priorities.  If one assumes that Puerto Rico intends to seek concessions from the g.o. bondholders and/or COFINA bondholders, the statement that priorities will be “taken into account” in the proposed “super-exchange” can best be read as a statement that other types of tax-supported debt to be included in the proposed “super-exchange” may be offered less favorable exchange ratios than the g.o.’s and/or COFINAs.
  • The difficulties and uncertain outcome of consensual debt reduction negotiations involving PREPA, a single credit payable solely from electricity revenues widely deemed insufficient to cover the associated revenue bonds, do not bode well for the outcome of consensual debt reduction negotiations involving homogenization of numerous separate credits, including some with strong legal claims for full payment of their debt.
  • Negotiated exchanges involving some degree of municipal debt reduction or bondholder concessions have succeeded in certain other contexts, but few that we are aware of in which the issuer did not have access to a bankruptcy option as an alternative. Successful exchanges involving issuers that did not have access to a bankruptcy process (e.g., certain tribal casino bonds) involved debt that did not benefit from strong legal claims on tax revenues of the type held by Puerto Rico’s g.o. and COFINA holders.

Puerto Rico’s announced strategy for dealing with its debt has evolved from ring-fencing its tax-supported debt and attempting to address its public corporation debt with a Puerto Rico bankruptcy statute to targeting its tax-supported debt in a consensual negotiation process.  The Working Group and its advisors may sincerely believe that a “debt lite” consommé can emerge from such pot-stirring, but may also believe that a failed process will provide additional ammunition for what Puerto Rico really wants to address its unwieldy debt structure: enactment of federal “super Chapter 9” legislation that would give it access to a federal bankruptcy process encompassing its g.o. bonds as well as its public corporation debt.

By JOHN REGIER and BRETON LEONE-QUICK

Last week, the National Association of Bond Lawyers held its 13th Annual Tax and Securities Law Institute.  Some of the panels included current and former employees of the SEC who spoke on several of the more notable recent developments with respect to enforcement actions in the Municipal Securities space:

1)  The SEC is policing negligence.  Peter Chan, a former staff member of the SEC’s Enforcement Division, acknowledged that suspicion of recklessness is no longer seen by the Staff as a prerequisite for opening an SEC investigation of an issuer – negligence is sufficient.  He noted how “people walking in a fog can cause as much harm as people conspiring to do wrong.” Chan also cited SEC Chairman White’s “broken windows” strategy in support of this practice, and said that the MCDC Initiative is a prime example. However, Chan also acknowledged that the SEC is not likely to bring a case if an issuer has followed sound disclosure policies and procedures and engaged in thoughtful deliberations, even if the SEC questions the accuracy of statements made in the Official Statement.

2)  Exploration of Allen Park and control person liability.  During one of the panels, Mark Zehner, Deputy Chief of the Enforcement Division’s Municipal Securities and Public Pension Division Unit, spoke at some length about the Allen Park, Michigan case in which the SEC, for the first time, charged a municipal official (the mayor of the city) as a “controlling person” under Section 20(a) of the Exchange Act.  Mr. Zehner noted that the SEC has a lot of experience with control person liability, and has brought more than one thousand such cases in the private sector. From his presentation, it appeared as if one of the reasons why the SEC chose to assert a Section 20(a) claim in the Allen Park case was the somewhat more flexible standard for proving control person liability that exists in the Sixth Circuit.  Mr. Zehner noted that the SEC has a lot of ways to hold someone liable (e.g., aiding and abetting) without having to resort to Section 20(a) liability and that there is a good faith exception to control person liability written right into the statute. Reading between the lines, it appears as if the SEC believed they had proof that Allen Park’s mayor was complicit in the alleged fraud and they had an opportunity to use control person liability in a way that would make headlines and create a deterrent for other municipal officials around the country.

3)  Update on the MCDC initiative.  LeeAnn Gaunt, Chief of the Enforcement Division’s Municipal Securities and Public Pensions Unit, spoke at some length about the MCDC Initiative. She did not disclose the number of reports the SEC received, but from her comments it appears as if the SEC received a substantial number of them.  She explained that the Staff is dealing with the broker-dealer submissions first, but are cross-checking to see if issuers reported the same transactions. Settlement orders will be released in batches so as not to stigmatize individual broker-dealers. The orders will identify two or three types of material failures but will not identify issuers or transactions. The broker-dealers will be given two weeks to sign the papers and return them. Ms. Gaunt did not commit to a timetable as to when this would occur, but implied that there would likely be several waves of orders during this calendar year. Every party that self-reported will receive a response from the SEC at some point. Issuers who were reported by broker-dealers but did not self-report will not necessarily hear from the SEC.

By LEN WEISER-VARON and BILL KANNEL

At the end of “The Candidate”, Robert Redford’s title character, having won, famously asks, “What do we do now?”

A similar question can be asked now that the federal district court in Puerto Rico has struck down the Puerto Rico Public Corporation Debt Enforcement and Recovery Act.

In a February 6, 2015 opinion, Judge Besosa rejected enough of Puerto Rico’s ripeness and standing arguments to reach the merits of the plaintiffs’  challenges to the validity of the Recovery Act.  As we had anticipated, Judge Besosa held that the Recovery Act is preempted by Section 903(1) of the federal Bankruptcy Code, which provides that “a State law prescribing a method of composition of indebtedness of [a] municipality may not bind any creditor that does not consent to such composition.”  The Recovery Act contains provisions that purport to permit changes to the debt obligations of eligible Puerto Rico public corporations without the consent of all affected debtholders. The court held that Section 903(1) applies to Puerto Rico, and that it not only invalidates those provisions of the Recovery Act that purport to bind non-consenting creditors, but preempts the Recovery Act entirely.

Puerto Rico enacted the Recovery Act because the federal Bankruptcy Code precludes Puerto Rico’s public corporations from availing themselves of Chapter 9 of the federal Bankruptcy Code to restructure their debts. Puerto Rico’s public officers are now asking themselves the Spanish version of Redford’s question: “Y ahora que hacemos?” Certain creditors of PREPA and other overleveraged Puerto Rico issuers may be asking variations of that question.

Some potential answers:

1)      The Recovery Act may yet recover. In addition to the ripeness and standing issues, Judge Besosa’s opinion rests on a textual analysis of Section 903(1), including the definition of the word “creditor” as used therein and elsewhere in the Bankruptcy Code and its applicability to creditors of an entity that is not a debtor in a federal proceeding. Puerto Rico is likely to appeal the federal district court’s ruling, both as to the ripeness and standing analysis and as to the applicability of Section 903 to Puerto Rico and the Recovery Act. The ruling is certainly a victory for the plaintiff bondholders and takes the Recovery Act off the table for the near future. In addition, Judge Besosa’s discussions of the contract clause and taking clause issues with the Recovery Act highlight the obstacles the Recovery Act has faced from the beginning as legislation that does not benefit from the federal bankruptcy power’s override of the contracts clause. Accordingly, a resurrected version of the Recovery Act, if any, would continue to face substantial legal challenges. But the Recovery Act, or something like it, will remain hovering in the background of any restructuring discussions during the pendency of the likely appeal.

2)      The invalidation of the Recovery Act, whether or not it proves permanent, eliminates the only existing process under which those public entities that would have been eligible to restructure under that legislation could do so over the objections of holdouts.  Both for Puerto Rico and for those creditors who believe that PREPA and/or certain other Puerto Rico issuers are incapable of sustaining their existing debt and must restructure, the invalidation of the Recovery Act may provide additional impetus to try to persuade the U.S. Congress to amend the Bankruptcy Code to authorize Puerto Rico to authorize its public corporations, or certain of its public corporations, to file for bankruptcy under Chapter 9. Such legislation was filed in the prior session of Congress and its viability may be somewhat enhanced by Judge Besosa’s ruling.

3)      While any Recovery Act appeal wends its way through the higher courts, and while any  legislation to amend the federal Bankruptcy Code seeks to wend its way through Congress, PREPA and PREPA’s creditors, and any other Puerto Rico issuers who seek debt relief and their creditors, will need to negotiate without a forum, without a final arbiter, and without the ability to impose a majority or supermajority consensus on holdouts. That process can be a messy and difficult one, but not necessarily an impossible one. In contrast to Robert Redford’s most recent movie, the working title for the as-yet-unfinished movie about Puerto Rico and its creditors remains All Is Not Lost.

 

 

 

By Len Weiser-Varon

The U.S. Securities and Exchange Commission recently settled the first securities fraud charges brought against a municipal official alleging “control person” status under the federal securities laws.  The SEC’s settlement with the former mayor of the city of Allen Park, Michigan bars him from participating in future securities offerings and imposes a $10,000 penalty. A city administrator also was charged and barred from participation in future securities offerings

The SEC’s enforcement actions, brought against the city and the two city officials, alleged that the offering documents for a “double-barreled” general obligation bond issue contained false and misleading statements.  In particular, the SEC alleged that the offering documents failed to disclose adverse developments relating to a proposed public-private transaction for a film studio project to be located on land purchased with the bond proceeds; the project was not consummated, leading to financial difficulties that caused the state of Michigan to appoint an emergency manager for the city.  The bonds issued for the project were rated A by S&P and subsequently downgraded to BB+, and recent audited financial statements for the city have carried a going concern qualification.

The enforcement action against the city was brought under  Section 17(a)(2) of the Securities Act of 1933, which permits administrative action by the SEC for negligent conduct, and under SEC Rule 10b-5, which permits administrative action by the SEC as well as a private right of action by affected investors, but requires proof of “scienter”, or an intent to deceive (which has been interpreted to include highly unreasonable conduct or recklessness.)

More notably, the SEC charged the mayor as a “control person” under Section 20(a) of the Securities Exchange Act, under which any person who directly or indirectly “controls” another person found liable for a violation of the Securities Exchange Act or any regulation thereunder is jointly and severally liable, to the same extent as the controlled person, to any person to whom the controlled person is liable.  Liability as a “control person” can be avoided if the “control person” establishes that he or she acted in good faith and did not directly or indirectly induce the act or acts constituting the violation.

Liability under Section 20(a) generally requires two elements: a primary violation of the federal securities laws by the “controlled person”, and proof that the person charged with the Section 20(a) “controlled” the primary violator.  It is unclear whether there are any circumstances under which a municipal official sitting on a multi-person board or council could be held to “control” an issuer, or issuer personnel, found to be a primary violator responsible for fraudulent statements in an offering document for municipal securities.  But in the Allen Park enforcement action the SEC appears to have alleged that the mayor controlled the city, the alleged primary violator.

If a primary violation and “control” of the person or entity that made the misleading statement is established, the burden shifts to the “control person” to establish good faith, which, unsurprisingly, means the absence of bad faith, which is akin to the absence of scienter.  In theory, even if an accused official does not establish good faith, he or she can avoid liability upon proof that he or she did not “induce” the primary violation.  The courts have not conclusively adjudicated whether to “induce” requires active encouragement, or whether in some circumstances the failure to exercise efforts to prevent a violation can be deemed to induce the violation.

The Allen Park enforcement action was settled by the issuer and the officials without admitting or denying liability, and sets no precedent on what type of conduct by an issuer official constitutes “control” over a primary violator of the securities laws or induces the violation.  But it suggests that in the aftermath of U.S. Supreme Court decisions that have eliminated aiding and abetting liability in private actions under Section 10(b) of the Securities Exchange Act and narrowed the circle of potential primary violators that the SEC can allege “make”, within the meaning of Section 10(b), a fraudulent statement in a securities offering document, the SEC intends, when feasible, to use a “control person” theory to go after actors it deems culpable for securities fraud in municipal offerings but cannot reach as primary violators.

Initial reaction to the SEC’s introduction of “control person” charges to municipal securities enforcement actions has included concern that public officials involved with municipal entities that issue bonds or other securities may now face charges and potential vicarious liability for disclosure malfeasance by other issuer officers or employees.  However, the SEC will face an uphill battle proving allegations of “control”, bad faith and “inducement” of a primary violation by an issuer board member or official who may have approved the distribution of an official statement but was not actively involved in its preparation, did not sign the official statement, and did not urge another official to exclude or include particular disclosure. The extent to which the SEC will include “control person” charges in future enforcement actions alleging primary securities law violations by an issuer or another issuer official remains to be seen, but such charges are most likely to be brought where there is evidence of active complicity in deceptive disclosure.