Can Section 510(b) wipe out PREPA bondholders’ claims against the commonwealth?
Puerto Rico Electric Power Authority (PREPA) bondholders urged the First Circuit Court of Appeals on Friday to reverse a district court ruling that subordinated their claims against the Commonwealth and effectively wiped out an $8.3 billion recovery tied to PREPA’s revenue bonds.
The hearing, requested last November in a sharply worded appellate brief, centers on whether Section 510(b) of the Bankruptcy Code applies to claims arising from the Commonwealth’s alleged violation of an 85‑year‑old statutory covenant and subsequent constitutional violations. Bondholders argue the district court’s interpretation was legally unsound, economically punitive, and inconsistent with the structure of PROMESA, the Puerto Rico Oversight, Management and Economic Stability Act.
In their November 2025 brief, the PREPA Ad Hoc Group laid out the foundation of their appeal. PREPA’s 1974 Trust Agreement requires the utility to charge rates sufficient to pay operating expenses and bond obligations. The Commonwealth, in turn, codified a statutory covenant—22 L.P.R.A. § 215—promising it would not “limit or alter” PREPA’s rate‑setting powers until all bonds were paid.
The bondholders argued that beginning in 2014, the Commonwealth violated that covenant by stripping PREPA of its rate‑making authority and blocking the utility from collecting revenues, including from government entities that stopped paying their electric bills. Those actions, they say, impaired PREPA’s net revenues—the collateral securing the bonds—and triggered constitutional claims under the Takings and Contracts Clauses.
The Bond Trustee filed a proof of claim in the Commonwealth’s Title III case in 2017, asserting damages limited to the amount owed on the bonds. The Commonwealth’s confirmed plan of adjustment, however, provides that any claim subject to Section 510(b) subordination receives no distribution.
The district court agreed with the Oversight Board that the bondholders’ claim “arises from” the purchase or sale of PREPA bonds and must be subordinated. The bondholders appealed, arguing the ruling misread the statute, ignored constitutional concerns, and contradicted decades of bankruptcy precedent.
At oral argument, Assured Guaranty’s counsel Miguel Estrada told the appeals court panel the district court’s analysis collapsed the distinction between owning a security and the transaction in which it was purchased.
“Our claim is about conduct that began in 2014,” Estrada said. “A claim founded on 1941 statutes that were violated starting decades later could not have arisen out of the purchase or sale in 1974.”
He argued that Section 510(b) was designed to address fraud in securities transactions—not independent statutory or constitutional violations by an affiliate of the issuer.
John Cunningham, representing GoldenTree and Syncora, said the statutory covenant functions like an affiliate guarantee—an assurance by the Commonwealth that it would not undermine PREPA’s ability to pay its bonds.
“It is absolutely mind‑boggling that such a result could have occurred,” Cunningham said. “No case supports expanding 510(b) to claims arising from affiliate obligations to assure repayment of debt owed by another affiliated debtor.”
He stressed that statutory covenants are standard in municipal finance and were intended to protect bondholders, not to be used against them.
Eric Brunstad, arguing for the PREPA Ad Hoc Group, framed the dispute as a constitutional takings case.
“They are using Section 510(b) to zero out a takings claim,” he said. “The Commonwealth impaired the bondholders’ property rights by taking away PREPA’s right to set its own rates and forcing it to provide electricity for free.”
Brunstad said the bondholders did not waive their takings claim and that even if 510(b) applied, the statute would only subordinate the claim to the level of the relevant security—PREPA’s secured bonds—placing the claim in the general unsecured class, not below it.
The Oversight Board, which spoke on behalf of PREPA, urged the First Circuit to affirm, arguing the bondholders already have a claim against PREPA and cannot pursue a second claim against the Commonwealth for the same alleged impairment.
Mark Harris, arguing for the Board, said the statutory covenant was expressly designed as an inducement to purchase PREPA bonds.
“The whole purpose of the statutory covenant is to provide an inducement,” Harris said. “It makes no sense to say that wouldn’t arise from the purchase or sale.”
He warned that allowing the claim would slash recoveries for the Commonwealth’s general unsecured creditors from 20 percent to roughly 5 percent.
Counsel for the Claims Reconciliation Monitors emphasized that the bondholders never appeared in the Commonwealth’s general unsecured creditor class during plan confirmation—and that their late‑asserted $8.4 billion claim would have radically altered recoveries.
“You cannot accept the benefits of being in the class but not the burdens,” counsel said, noting that unsecured claims are impaired and dischargeable under the plan.
Estrada rejected the Oversight Board’s characterization of the bondholders’ litigation posture.
“We did not agree to subordination,” he said. “All tort claims against the Commonwealth were unsecured. That does not mean 510(b) applies.”
Brunstad noted a Ninth Circuit’s decision that supports the bondholders’ position that post‑issuance misconduct cannot be subordinated under 510(b).
The First Circuit’s decision will determine whether bondholders can pursue constitutional and statutory covenant claims against the Commonwealth—or whether those claims must be subordinated and effectively eliminated.
The ruling carries major implications for creditor recoveries, PROMESA jurisprudence, and the scope of Section 510(b) in municipal bankruptcy—especially where statutory covenants and constitutional claims intersect.
