The First Circuit’s recent opinion on the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”, 48 U.S.C §§ 2101-2241) outlines initial guidelines for possible future actions against the Puerto Rican government as a result of the Commonwealth’s ongoing debt crisis. Peaje Investments LLC v. García–Padilla, 845 F.3d 505 (1st Cir. 2017).  Congress enacted PROMESA in June 2016 to create, among other things, a temporary stay of debt-related litigation against the government of Puerto Rico.  The temporary stay was set to expire automatically on February 17, 2017, but has been extended until May 1, 2017.  The First Circuit permitted one creditor to move immediately for relief from the stay, but blocked another creditor’s bid.  The decision serves as a template for how creditors may move against the Commonwealth when the PROMESA stay expires later this spring.

In Peaje Investments LLC v. Garcia-Padilla, the First Circuit considered the appeal of two creditors whose motions for relief from PROMESA’s stay had been denied by the District Court of Puerto Rico without a hearing.  The denied creditor, Peaje Investments LLC (“Peaje”), argued that the stay should be lifted so it could challenge the government’s diversion of toll revenues.  The successful creditors, the Altair movants, similarly sought relief based on their interest in certain employee contributions diverted by the Commonwealth.  The First Circuit applied the Bankruptcy Code’s “lack of adequate protection” standard to determine cause for lifting the stay.

In Peaje’s case, the creditor alleged that a bond resolution required the government to deposit toll revenues with a fiscal agent to serve as collateral for bonds issued by the Puerto Rico Highways and Transportation Authority. The First Circuit affirmed the District Court’s denial of Peaje’s motion because “toll revenues are ‘constantly replenished,’” allowing Peaje’s security interest to continue as a “stable, recurring source of income that will eventually provide funds for the repayment” of the bonds.[1]

The Altair movants similarly alleged that the Commonwealth had suspended transfers of employee retirement contributions, which served as collateral for their bonds, to the required fiscal agent. The Altair movants, crucially, included in their filings a statement by the Commonwealth’s Employees Retirement System that “uncertainty about future employee contributions could affect” repayment of the bonds held by the Altair movants.  The District Court characterized these contributions as “a perpetual revenue stream whose value is not decreased by the Commonwealth’s acts,” much like Peaje’s collateral, but the First Circuit reversed course.  It found that the Altair movants deserved a hearing to demonstrate the “alleged uncertainty” of the Commonwealth’s ability to repay the bonds.[2]

The stay will expire in May, at which point an influx of actions against the government of Puerto Rico relating to the debt crisis is expected. The First Circuit’s decision is limited in scope due to the PROMESA stay’s anticipated expiration, but creditors pursuing litigation against the government after the stay is lifted may choose to heed the opinion’s underlying guidance:  do not hold back in initial pleadings.

[1]       Peaje Investments LLC v. García–Padilla, 845 F.3d 505, 511 (1st Cir. 2017)

[2]       Id.

Earlier this month the Supreme Court granted certiorari to hear the Fifth Circuit case Husky International Electronics, Inc. v. Ritz, which originated in the United States Bankruptcy Court for the Southern District of Texas. The Fifth Circuit’s decision interprets “actual fraud” in the context of an exception to a debtor’s discharge that would require a creditor to prove that the debtor made a false representation. As the decision stands, this interpretation would make it more difficult for creditors to prove actual fraud when debtors transfer assets with the intent of hindering payments to creditors, making it easier for debtors to place assets out of creditors’ reach.

The question presented to the Supreme Court focuses on the “actual fraud” exception to discharge under § 532(a)(2)(A) of the bankruptcy code, and whether this exception applies only when the debtor has made a false representation, or whether the “actual fraud” exception also applies if the debtor deliberately obtained money through a fraudulent transfer scheme that was actually intended to cheat a creditor.

In Husky, Husky International Electronics, Inc. (“Husky”) sold and delivered goods to Chrysalis Manufacturing Corp. (“Chrysalis”), which the debtor, Daniel Lee Ritz, Jr. controlled.[1] Chrysalis failed to pay for the goods purchased from Husky, leaving $163,999.38 as the total amount of Chrysalis’ unpaid debt to Husky.[2] Between November 2006 and May 2007, Ritz transferred millions of dollars from Chrysalis to seven other entities he controlled and owned.[3] Husky sought to hold Ritz personally liable and sued him for the debt of Chrysalis in May 2009.[4] Seven months later, Ritz filed a chapter 7 petition in the United States Bankruptcy Court for the Southern District of Texas.[5] Husky then initiated an adversary proceeding and objected to the discharge of Ritz’s alleged debt.[6] The bankruptcy court held a trial on the matter and found that the transfers Ritz made “were not made for reasonably equivalent value” and that Husky suffered damages in the amount of the debt owed by Ritz.[7] However, the court found that the “actual fraud” exception to discharge did not apply because Husky failed to show that Ritz made a false representation to Husky and therefore Ritz could not have perpetuated an “actual fraud.”[8] On appeal, the district court affirmed the bankruptcy court’s decision, holding that “actual fraud under 11 U.S.C. § 523(a)(2)(A) . . . requires a misrepresentation.”[9]

The Fifth Circuit agreed with the bankruptcy court and district court and held “that a representation is a necessary prerequisite for a showing of ‘actual fraud’” and because there was no evidence of a representation, § 523(a)(2)(A) does not bar the discharge of the debt.[10] The court rejected the Seventh Circuit’s interpretation of § 523(a)(2)(A) in McClellan v. Cantrell,[11] which explained that because § 523(a)(2)(A) covers both actual fraud and false representations, the statute makes clear that the former is broader than the latter, and therefore a misrepresentation is not necessary for § 523(a)(2)(A) to bar the discharge of a debt. The Fifth Circuit explained that this interpretation is in tension with Supreme Court precedent and is inconsistent with previous decisions of the Fifth Circuit.[12] The court explained that both prior to and subsequent to McClellan, the Fifth Circuit has stated that “to prove nondischargeability under an ‘actual fraud’ theory, the objecting creditor must prove” that [] the debtor made misrepresentations.[13]

Husky presents a circuit split for the Supreme Court to review. After the Fifth Circuit issued its decision, the First Circuit issued its decision in Sauer, Inc. v. Lawson.[14] In Sauer, the First Circuit joined the Seventh Circuit in finding that § 523(a)(2)(A) “extends beyond debts incurred through fraudulent misrepresentations to also include debts incurred as a result of accepting a fraudulent conveyance that the transferee knew was intended to hinder the transferor’s creditors.”[15] In its petition for certiorari, Husky argued that the Fifth Circuit’s decision “creates a roadmap for dishonest debtors to cheat creditors through deliberate fraudulent-transfer schemes, and then to escape liability through discharge in bankruptcy.”[16] In opposition to appellant’s petition for certiorari, Ritz argued that the decision does not warrant the Supreme Court’s review at this time, and that even if the Court resolved the question in Husky’s favor, Husky would not get the relief it seeks because under Texas law, “actual fraud” requires a misrepresentation.[17] Oral arguments are expected to be heard during the first half of 2016. Visit HHR’s Bankruptcy Report for future updates on this case.

[1].      Husky International Electronics, Inc. v. Ritz, 787 F.3d 213, 314.

[2].      Id.

[3].      Id.

[4].      Id.

[5].      Id. at 315.

[6].      Id.

[7].      Id. at 315.

[8].      Id.

[9].      Id.

[10].    Id. at 316.

[11].    McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000).

[12].    787 F.3d at 317, 319.

[13].    Id. at 319.

[14].    No. 14-2058, 2015 WL 3982395.

[15].    Id. at *1.

[16].    Petition for Certiorari, Husky International Electronics, Inc. v. Ritz, 15-145 (U.S. July 2015).

[17].    Respondent’s Brief in Opposition to Petition for Certiorari, Husky International Electronics, Inc. v. Ritz, 15-145 (U.S. Sept. 30, 2015).

In a recent decision, the First Circuit used a “flexible” approach to value the collateral claimed by an oversecured creditor, and granted post-petition interest on the creditor’s claim.  In re SW Boston Hotel Venture, LLC, No. 12-9008, 2014 WL 1399418, — F.3d — (1st Cir. Apr. 11, 2014).  Oversecured creditors (i.e., creditors whose collateral is worth more than the value of their secured claim) are exceptions to the general rule that creditors in a bankruptcy cannot receive post-petition interest.  11 U.S.C. § 502(b)(2) (disallowing claims for unmatured interest); 11 U.S.C. § 506(b) (creating exception for oversecured creditors).  Considering the claim of a creditor who became oversecured during the bankruptcy proceeding, the First Circuit highlighted the extent of a court’s discretion to determine how, when, and at what rate post-petition interest accrues.  Choosing between two camps, the First Circuit adopted what is known as the “flexible” approach in establishing when the creditor became oversecured (the “valuation date”) of the creditor’s collateral, though the court noted that this approach might not be appropriate in other circumstances.  The court looked to a pre-petition agreement among the parties to determine the rate at which post-petition interest accrued but found that, even though the parties’ contract called for compounded interest, the creditor forfeited that particular right by not raising it in time.

Determining Secured Status:  Application of the Flexible Approach

The parties in SW Boston did not dispute that the creditor, Prudential Insurance Company of America (“Prudential”), became oversecured at some point during the bankruptcy proceeding, but they disagreed as to when this occurred.  Because Prudential’s claim decreased over the course of the proceeding while the value of its underlying collateral increased, the measuring date made “the difference between a finding of oversecurity or undersecurity.”  In re SW Boston Hotel Venture, LLC, No. 12-9008, 2014 WL 1399418, at *6 (1st Cir. Apr. 11, 2014).

The Bankruptcy Code does not indicate when a court should value secured collateral to determine a creditor’s secured status.  The case law has separated into two camps:  some courts have adopted a strict “single-valuation” approach, where creditors’ secured statuses are categorically determined on the same date, such as the filing date or plan confirmation date.  See, e.g., Orix Credit Alliance, Inc. v. Delta Res., Inc., 54 F.3d 722, 729 (11th Cir. 1995).  Other courts endorse a “flexible” approach, whereby the bankruptcy court chooses the valuation measuring date based on each case’s circumstances. See, e.g.In re T-H New Orleans Ltd. P’ship, 116 F.3d (5th Cir. 1997).

In SW Boston, the First Circuit applied the flexible approach, finding that section 506(b), the bankruptcy rules, and the legislative history’s silence on the matter “[suggest] flexibility.”  SW Boston, 2014 WL 1399418, at *8.  The measuring date expressly provided by Congress in section 506(a) implies that the valuation contemplated by section 506(b) was not limited to a particular date.[1]  The flexible approach also appealed to the Court’s consideration of fairness and equity, avoiding “an all-or-nothing result that hinges more on fortuity than reality” and seeming “more likely to produce fair outcomes.”  Id. at *9.  While under the single-valuation approach, a creditor who becomes oversecured a day after the chosen date is not entitled to receive post-petition interest and a creditor who becomes oversecured a day earlier is.  The court clarified that it did “not suggest that bankruptcy courts must, or even should, adopt the flexible approach whenever collateral values and/or claim amounts fluctuate,” but instead “simply recognize[s]” that a bankruptcy court may look to principles of equity and fairness in determining the best approach.  Id. at *10, n.13.

A Note on the Valuation of Collateral

The bankruptcy court considered several potential valuation dates, including the petition date.  Prudential asserted that it was oversecured on the petition date, pointing solely to the debtors’ asset schedules as proof.[2]  The bankruptcy court instead applied the property’s sale price and closing date to determine oversecurity.  In finding that the bankruptcy court did not err in this determination, the First Circuit held “that a valuation made for one purpose at one point in a bankruptcy proceeding has no binding effect on valuations performed for other purposes at other points in the proceeding.”  Id. at *11.

Simple Interest Accruing at a Contractually Determined Rate

Section 506(b) does not determine at what rate post-petition interest accrues and whether it does so as simple or compounded interest.  Courts generally agree that the appropriate interest rate is within the court’s discretion.  But where an interest rate has been contractually agreed upon by the parties, such terms “presumptively apply” if they are not invalid under state law or inequitable.  Id. at *13.  The First Circuit approved of the lower courts’ use of a default rate specified in the loan agreement between the debtor and Prudential.  It found that the debtor failed to show that the default rate exceeded the threshold established by applicable state law, that the default rate was lawful under state law, and that the rate did not violate federal equitable principles.

The court also considered and rejected Prudential’s argument that its post-petition interest compounded on a monthly basis.  Although the parties’ agreement expressly called for monthly compounding of interest, the Court found that the creditor forfeited its “entitlement to compounding where it . . . did not seek compound interest until after the bankruptcy court granted it post-petition interest . . . .”  Id. at *15.

Practical Implications

In lieu of clear guidelines, the First Circuit’s decision elevates flexibility and fairness over other potential factors.  Under SW Boston, potential creditors cannot anticipate which valuation approach will apply to their circumstances, or how the court will apply its discretion.  But potential creditors can take steps to protect themselves.  Parties should draft clear agreements with a view to potential bankruptcy, keeping in mind that the default rates they choose may be applied to post-petition interest.  Once proceedings have commenced, it is in a creditor’s best interest to seek oversecured status early on, to seek the valuation of underlying property in the proper context, and to support any related claims with ample evidence


[1].      The Court stated that “[t]he fact that Congress mandated particular measuring dates in the exception without mandating a particular measuring date in the general rule suggests that it intended flexibility . . . .”  Id. at *8.

[2].      The Debtors’ schedules of assets “indicated that the value of Prudential’s collateral, in the aggregate, was substantially more than its total pre-petition claim.”  Id. at *10.