Yes, says the First Circuit. The First Circuit recently affirmed the District Court’s decision to deny a group of bondholders’ (the “Bondholders”) motion to have a trustee appointed for the Employees Retirement System of the Government of the Commonwealth of Puerto Rico (the “System”) under section 926 of the Bankruptcy Code. Section 926 of the Bankruptcy Code allows a court to appoint a trustee to pursue avoidance actions in Chapter 9 cases. In 2016, Congress enacted the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) to address Puerto Rico’s financial crisis, which incorporated and made section 926, among other federal bankruptcy provisions, applicable to Puerto Rico. After examining the District Court’s ruling, the Circuit Court concluded that there was no legal error and accordingly the lower court did not abuse its discretion in denying the motion.
Background
The Bondholders own bonds issued in 2008 by the System and claim a security interest in certain assets of the System. Before 2017, the System paid pensions and retirement benefits to government and public corporation employees in Puerto Rico (the “Commonwealth”), was independent from other Commonwealth agencies, and was funded through contributions from employers and employees, investments, and a 2008 bond issuance.
In 2017, the Commonwealth passed Joint Resolution 188 and enacted 2017 P.R. Laws 106 (together, the “2017 Amendment”), which required the System to liquidate its assets and transfer the proceeds to the Commonwealth General Fund. The Commonwealth General Fund would then be required to pay individual pensions, thereby eliminating the employers’ requirement to contribute to the System.
In 2019, the Bondholders demanded that the Financial Oversight and Management Board (the “Board”) bring two avoidance actions to have the 2017 Amendment invalidated, but the Board refused. As a result, the Bondholders sought the appointment of a trustee for the System to bring said avoidance actions under section 926. The District Court denied the Bondholders’ motion, and the Bondholders appealed.
Discussion
Under section 926 of the Bankruptcy Code, the court may appoint a trustee to pursue an avoidance action if the debtor refuses to bring such action. As noted by the First Circuit, the statute states the court may appoint a trustee indicating that Congress intended to give the court discretion. When determining whether to appoint a trustee, a court will examine a debtor’s reluctance to bring the avoidance action and "should be very hesitant to appoint a trustee.” As in any case where creditors seek a trustee’s appointment, the Bondholders had the burden to demonstrate that the Board unjustifiably refused to bring the avoidance actions against the Commonwealth on behalf of the System. The District Court considered the Bondholders’ case and found that they failed to meet the burden, thereby denying the motion to appoint the trustee.
In their primary argument, the Bondholders argued that the District Court erred as a matter of law because it did not confine its analysis of the motion to the two factors commonly used in evaluating motions for derivative creditor standing in commercial reorganization bankruptcies -- (1) the costs and benefits to the individual debtor, and (2) whether the avoidance claims are colorable -- but rather incorrectly considered the fact that the System is a governmental entity, not a commercial one. The First Circuit rejected the argument and explained that the text of section 926 does not limit or discuss the factors a court may consider when evaluating whether to appoint a trustee. Accordingly, the District Court did not err when it considered all of the facts and approached the appointment of a trustee in this case differently than in a commercial insolvency case.
The First Circuit emphasized the differences between governmental and commercial bankruptcies, explaining that unlike in a commercial bankruptcy that aims to balance creditors' and debtors’ interests, the principal purpose of a governmental bankruptcy is to allow the debtor the opportunity to maintain operations while altering or refinancing its creditor obligations.
The First Circuit found support for its conclusion that the District Court did not abuse its discretion -- finding that the District Court appropriately considered special governmental concerns raised in sections 303 and 305 of PROMESA when weighing the trusteeship issue -- because the appointment of a trustee to avoid a transfer could constitute a prohibited interference with the execution of the debtor’s political or governmental functions.
Aside from the unique considerations raised by this being a Chapter 9 case, the First Circuit found that the District Court did not abuse its discretion when it weighed and analyzed the Commonwealth’s potential defenses to the Bondholders’ avoidance actions rather than simply determined whether they were colorable. The appellate court found that the strength of the Commonwealth’s potential defenses was particularly relevant in this case because the Bondholders have other actions pending that seek the same relief as would be sought if the motion to appoint a trustee had been granted. In addition, the pendency of these other actions made it appropriate for the District Court to seek to “avoid a proliferation of actions seeking essentially the same remedy,” each of which could potentially and unnecessarily drain the debtor’s assets.
Conclusion
As both courts’ opinions establish, the fact that a debtor is a governmental entity requires the courts to consider elements that are unique to the functioning of these entities. Creditors who seek certain types of relief should be mindful to tailor their arguments such that these unique concerns are properly addressed.
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