LOS ANGELES — A California charter school bankruptcy and a dispute in Puerto Rico's Title III bankruptcy process raise a question about who should be responsible for perfecting a lien so that bondholders get paid in a liquidation.
Is the issuer ultimately responsible for filing documents that perfect a bondholders’ claim, or is bond counsel required to make sure that occurs?
Orrick Herrington & Sutcliffe
Court documents filed by plaintiff UMB Bank, the trustee, in the case’s pre-trial discovery indicate what occurred in the Tri-Valley Learning Corp. bankruptcy could be an issue for bondholders of other California charter school debt or high-yield revenue bonds should those operators end up in bankruptcy. Incorrect filings of financial documents to perfect a lien under the Uniform Commercial Code also arose as an issue for holders of Puerto Rico pension obligation bonds.
“From my perspective, when a deal is represented as having a degree of security and no one is taking responsibility, investors are left holding the bag,” said a research analyst for an asset management firm that invests in high-yield debt including charter schools. The analyst asked to remain anonymous.
In the Tri-Valley case, he said, a bank lender swept in and took money that would have belonged to the bondholders if the lien had been perfected.
The failure to file the necessary documents meant the lien didn’t come up in UCC searches when Tri-Valley subsequently borrowed more money, so bondholders didn’t get first dibs in the liquidation.
“If it’s not bond counsel’s responsibility, then who is responsible?” the analyst said. “Is it the conduit issuer’s responsibility? Deals are sold every day promising a basket of securities and rights — and the burden should be on those professionals that the deal is delivered as promised.”
Glenn Weinstein, a partner at Pugh, Jones & Johnson, P.C., speaking generally and not to the specifics of the Tri-Valley bankruptcy, said that bond counsel is usually considered responsible for making sure the documents are filed to perfect the lien.
Tri-Valley Learning Corp., the charter school operator, filed for Chapter 11 bankruptcy to reorganize its debts in November 2016 and converted that bankruptcy to Chapter 7 liquidation eight months later.
The bond documents included the provision that TVLC would perfect the bondholders’ security interests in all of its personal property by filing the requisite UCC statements.
UMB Bank, the successor bond trustee to The Bank of New York Mellon Trust Co., filed the lawsuit against Orrick in December 2016 in Orange County Superior Court, for “alleged professional negligence and alleged violations of the California Securities Act” in connection with a 2012 bond issue for Tri-Valley.
UMB claimed it was Orrick’s responsibility to make sure the lien was perfected, while Orrick’s attorneys argued it was the charter school operator’s responsibility.
Because the lien was not perfected in the Tri-Valley case, a bank loan issued to the charter school after the bonds were sold ended up being first in line to be paid in the bankruptcy. If the lien had been perfected, the bank loan would have been subordinate to the bonds.
UMB claimed in its original complaint that Orrick failed “to perfect or confirm the perfection of certain security interests in the charter schools’ assets, including facilities and equipment located in Livermore, within sufficient time to establish a first-priority security interest for the bondholders before the bond’s default.”
John Sullivan, a partner with Long & Levit LLT, who represented Orrick, told the Bond Buyer at the time of the settlement that Orrick believed the UMB suit was without merit, but agreed to a mutually acceptable settlement to avoid the uncertainty and expense of litigation, and to focus entirely on serving its clients.
Neither side would disclose the amount of the settlement. UMB had originally asked for $1.4 million in damages, according to court documents.
Financial statements should be filed under the Uniform Commercial Code perfecting the lien when the bonds are sold, said Weinstein, a former chair of the securities law and disclosure committee of the National Association of Bond Lawyers. He was not speaking on behalf of NABL.
Timing is important to make sure the bond debt does not become subordinate to debt incurred after the bonds are sold, Weinstein said.
“I would say under most circumstances that is usually something that bond counsel is going to do,” Weinstein said. “And it’s usually done for a number of reasons. As a practical matter, if you are bond counsel you are running the show at the closing. You are responsible for keeping tabs on who is responsible for what and getting signatures. And to make sure all of the items on the closing list get done.”
While a traditional bond counsel opinion isn’t a perfection opinion and almost no one gives a perfection opinion, bond counsel is giving an opinion as to what the security for the bonds is, Weinstein said.
NABL has a nine-page compliance checklist to help bond counsel discuss post-issuance compliance matters with issuers and conduit borrowers. The checklist is divided into three parts: tax, securities and state law matters. Under the securities section, the checklist includes proof of filing UCC statements with appropriate authorities as required by state procedures. Under the UCC section, it includes proof of filing recorded mortgages, deeds of trust with appropriate authorities and proof of delivery of originals to trustee or custodian.
Weinstein said the checklist provided by NABL is a guideline of what the organization thinks follow best practices, but following the checklist is not a requirement.
He doesn’t think changes need to be made around current processes to protect bondholders should the issuer end up in bankruptcy.
“I think most bond counsel and most lawyers who represent parties in the transaction know what ought to be done,” Weinstein said. “In Puerto Rico, I am really surprised that someone tried to file the documents that way. Normally, you find the right language and put it in the form. Why it was done the way it was in that case, I don’t know.”
Holders of $2.9 billion of Puerto Rico Employees Retirement System debt were on the wrong side of an
Bondholders “were rendered unsecured due to inadequate financing statements," according to a
“This should be a lesson to secured creditors to ensure that their financing statements conform to the requirements of the Uniform Commercial Code,” the attorneys wrote. “Step one for secured lenders should be to review their collateral package to ensure that all collateral is properly perfected and adequately described according to applicable law.”
In the ERS case, the court found the UCC financing statements “did not contain a sufficient collateral description, the correct debtor name, and other relevant information, and therefore failed to perfect the ERS Bondholders’ security interest," according to Chapman.
“Taken as a whole, the ERS Security Decision serves as a cautionary tale to all secured lenders, and particularly those holding municipal debt, that they should consult counsel and confirm perfection at the first signs of distress,” the Chapman attorneys wrote.
Tri-Valley closed its two Stockton, California, schools, Acacia Elementary and Acacia Middle, in March 2017, then struggled to keep its remaining two schools — Livermore Valley Charter School and Livermore Valley Charter Preparatory School — open through the end of the 2016-2017 school year.
Despite issuing $68 million in tax-exempt bonds to construct school buildings, the charter school company “believes that the furniture and fixtures located at the debtor’s Livermore campus likely represent the only assets that are not subject to liens or avoidable liens,” according to a bankruptcy court document filed when it asked the case to be converted from reorganization to liquidation.
The state’s Fiscal Crisis & Management Fiscal Assistance Team
The 501(c)(3) nonprofit public-benefit corporation issued $27.5 million in tax-exempt bonds through the California School Finance Authority in 2012 as well as an additional $15 million in Qualified School Construction Bonds.
It also issued $25.5 million through another conduit issuer, the California Statewide Communities Development Authority, in 2015.
The bonds issued through the California School Finance Authority were the focus of the UMB lawsuit. The bonds were sold in a private placement using underwriter Westhoff Cone & Holmstedt. CSFA, a conduit issuer under the umbrella of the State Treasurer's Office, primarily facilitates financing for charter schools, according to its website.
The Tri-Valley charter school operator had defaulted on its bonds by the time of the conversion to liquidation. It made an unscheduled draw of more than $324,000 on debt reserves in October 2016 on the 2012 bonds and then missed its June 1, 2017 debt service payments, according to filings on the Municipal Securities Rulemaking Board’s EMMA website.
