The Inducement Trap: The First Circuit Subordinates PREPA Bondholders’ $8.5 Billion Claim Against the Commonwealth Under Section 510(b)

Wednesday, October 7, 2026

Bondholders tend to think of Section 510(b) of the Bankruptcy Code, 11 U.S.C. § 510(b), as someone else’s problem. The provision subordinates claims “for damages arising from the purchase or sale” of a security of the debtor or its affiliate, and the typical claimant is a disappointed shareholder trying to recover as a creditor, not a holder of fixed debt.

The First Circuit’s September 23, 2026 decision in the PREPA revenue bond litigation is a reminder that the statute says “security,” not “stock,” and that the words a claimant uses to describe its own claim can decide whether it is paid. The trustee for PREPA’s bondholders filed an $8.5 billion proof of claim in the Commonwealth of Puerto Rico’s Title III case, alleging that the Commonwealth had impaired statutory and constitutional protections it granted as a “material inducement for investors to purchase” the bonds. In re Fin. Oversight & Mgmt. Bd. for P.R., Nos. 25-1745, 25-1748, 25-1749, 25-1750, 25-1751, slip op. at 8 (1st Cir. Sept. 23, 2026), https://www.ca1.uscourts.gov/sites/ca1/files/opnfiles/25-1745P-01A.pdf [hereinafter PREPA Bondholders]. The court held that a claim so described seeks damages arising from the purchase of securities of a Commonwealth affiliate and affirmed its placement in a plan class that receives nothing. Id. at 9, 27–28. The opinion joins five other circuits on post-purchase conduct; its more useful parts are the limits the court drew, the argument it found waived, and the alternative classification the bondholders never asked for.

PREPA’s revenue bonds are payable solely from its net revenues; the Authority Act provides that they “shall not be a debt of the Commonwealth” and that the Commonwealth shall not “be liable thereon.” P.R. Laws Ann. tit. 22, § 210 (2026). What the Commonwealth did provide, to make the bonds marketable, was a covenant not to “limit or alter the rights or powers” vested in PREPA until the bonds were repaid (the “Statutory Covenant”). Id. § 215. The Commonwealth and PREPA filed separate Title III cases in 2017. PREPA Bondholders, slip op. at 6–7.

The bond trustee filed two proofs of claim: one in PREPA’s case for principal and interest, and one in the Commonwealth’s case, for $8.5 billion, alleging that the Commonwealth had interfered with PREPA’s ability to repay the bonds, including by rate-setting legislation. The Commonwealth claim pleaded breach of the Statutory Covenant and violations of the Takings and Contracts Clauses, and it alleged that the Commonwealth had granted the Statutory Covenant as a “material inducement for investors to purchase” the bonds. Id. at 7–8.

The Commonwealth’s plan, confirmed in 2022 without objection from the trustee, placed “Section 510(b) Subordinated Claims” in Class 64 with no distribution, under a definition that tracked the statute and extended it to claims “relating to” the “purchase, sale or retention” of a security. General unsecured claims in Class 58 stood to recover roughly 20% if the trustee’s claim was excluded and roughly 5% if it was included. Id. at 8–9.

The Oversight Board objected to the claim on time; the trustee’s response again described the Statutory Covenant as “induc[ing] the purchase of PREPA’s bonds”; and the court stayed the dispute. Id. at 9–10. In 2025 the Board moved to enforce the plan, and Judge Swain, sitting as the Title III court, held that the claim belonged in Class 64, treating the motion in the alternative as a request for leave to amend the Board’s timely objection under Federal Rule of Civil Procedure 15(a). Id. at 10–11; see Fed. R. Civ. P. 15(a)(2); Fed. R. Bankr. P. 7015. Two features of the record mattered on appeal: the bondholders litigated classification as a binary choice between Class 58 and Class 64, and, despite the district court’s “repeated inquiries,” they never sought an alternative class for their constitutional causes of action, even though the plan contained a class for claims of “constitutional character” entitled to “full payment.” PREPA Bondholders, slip op. at 11 n.5, 30 n.18.

Judge Rikelman wrote for the panel, joined by Judges Howard and Dunlap. The court affirmed the classification order while expressly reserving several questions it did not need to reach.

A. The objection bar date was not a safe harbor.

Applying Rule 15(a)(2), whose applicability the bondholders did not contest, the court affirmed the leave to amend under abuse-of-discretion review: the undue-delay inquiry is not a matter of counting days, the district court had stayed the classification dispute almost as soon as it surfaced, and the prospect of additional litigation did not establish undue prejudice on this record. Id. at 13–15. The court did not decide whether a plan-enforcement motion is itself a proper vehicle for a post-deadline classification challenge. Id. at 13 n.7.

B. “Arising from” has no time stamp.

The bondholders’ lead argument was that Section 510(b) reaches only misconduct at the time of the securities transaction. The court found no such limit in the text or in the contemporaneous dictionary meaning of “arise,” which supports a causal requirement but not a temporal one, and it joined the Second, Third, Fifth, Ninth, and Tenth Circuits: “Like our sister circuits, we hold that § 510(b) does not categorically exclude claims based on post-purchase misconduct.” Id. at 18–20 (collecting cases).

C. The label on the claim does not matter.

Nor is the statute “restricted to certain causes of action.” Relying on the Second Circuit’s Lehman Brothers Holdings decision, the court held that “a claimant cannot avoid subordination under § 510(b) simply by pleading a different legal theory or redefining the claim’s character,” and it saw no reason to exclude statutory and constitutional theories. Id. at 21–22 (citing Adler v. Lehman Bros. Holdings Inc. (In re Lehman Bros. Holdings Inc.), 855 F.3d 459, 478–80 & n.29 (2d Cir. 2017)).

D. Affiliate securities count.

The statute “expressly extends to securities issued by ‘an affiliate of the debtor,’” and nothing in it requires duplicative claims against the same debtor. PREPA Bondholders, slip op. at 22–23 & n.12. PREPA’s affiliate status was conceded. Id. at 16.

E. This was not an ordinary bond repayment claim.

The bondholders’ best argument was that the claim sought no “damages” at all, because it equaled the unpaid principal and interest. The court agreed with the premise: Section 510(b) “does not subordinate ordinary bond-repayment claims,” which “seek payment for the securities themselves, not ‘damages arising from’ their purchase.” Id. at 23. But only PREPA owed the bonds, the trustee had already filed a repayment claim in PREPA’s case, and both the Authority Act and the Trust Agreement disclaim Commonwealth liability. What the trustee sought was “compensation for the Commonwealth’s alleged impairment of separate statutory protections that the Bondholders allege induced them to purchase the bonds,” and measuring that loss by unpaid principal and interest “does not render § 510(b) inapplicable.” Id. at 23–24. Fixed debt is no defense, because the Code’s definition of “security” includes bonds, id. at 24 n.14, and the court reserved “whether § 510(b) could ever apply to a guaranty claim,” because the Commonwealth “expressly did not accept any obligation to repay” the bonds. Id. at 23–24 n.13. The reservation matters: the Fifth Circuit has subordinated an investor’s claims where the debtor’s guaranties induced the investment, and the First Circuit relied on that decision for the causal nexus here. See Templeton v. O’Cheskey (In re Am. Hous. Found.), 785 F.3d 143, 155, 157 (5th Cir. 2015), as revised (June 8, 2015); PREPA Bondholders, slip op. at 26.

F. The constitutional label does not matter either.

The bondholders invoked the canon of constitutional avoidance. The court held that the canon has no role absent ambiguity, that the text and the circuit consensus foreclose the bondholders’ reading as applied here, and that Section 510(b) “does not establish any carve-out for claims asserting constitutional causes of action.” PREPA Bondholders, slip op. at 28–30. It did “not reach the merits of the Bondholders’ constitutional claims, including whether the Commonwealth effected a taking and, if so, what compensation the Constitution would require.” Id. at 31.

G. The level-of-subordination argument was waived.

Finally, the bondholders argued that even if Section 510(b) applies, it subordinates a claim only to claims “senior to or equal the claim or interest represented by such security,” and because that security was a secured bond of PREPA rather than of the Commonwealth, the claim should not be “demoted” below the Commonwealth’s general unsecured claims. The court held the argument forfeited (never raised below) and waived (no plain-error showing in the opening briefs), because whether Section 510(b) applies “is analytically distinct from any question about the level of subordination that § 510(b) requires.” Id. at 31–33.

The courts that have confronted the question split on the mechanics while agreeing on the result for unsecured affiliate securities. In the Lehman Brothers SIPA liquidation, Judge Peck subordinated claims against Lehman Brothers Inc. based on unsecured bonds of its parent to LBI’s general unsecured claims. In re Lehman Bros. Inc., 503 B.R. 778, 784–85 (Bankr. S.D.N.Y. 2014), aff’d on other grounds, 519 B.R. 434 (S.D.N.Y. 2014), aff’d sub nom. ANZ Sec., Inc. v. Giddens (In re Lehman Bros. Inc.), 808 F.3d 942 (2d Cir. 2015). The Second Circuit, adopting the district court’s analysis, held that “in the affiliate securities context, ‘the claim or interest represented by such security’ means a claim or interest of the same type as the affiliate security,” so that the claim is subordinated to claims senior to or equal to claims “of the same type as the underlying securities,” whether secured debt, unsecured debt, or common stock. ANZ Sec., 808 F.3d at 946; see also id. at 950 (describing the approach as superimposing the affiliate’s capital structure onto the debtor’s). The Ninth Circuit called that reading “likely the best interpretation” but did not have to choose, because an equity investment in the debtor’s affiliate was subordinated below general unsecured creditors under any approach. Liquidating Tr. Comm. of Del Biaggio Liquidating Tr. v. Freeman (In re Del Biaggio), 834 F.3d 1003, 1012–15 (9th Cir. 2016).

That is why the waiver matters. The affiliate securities in Lehman Brothers and Del Biaggio were unsecured notes and equity, which land at or below the general unsecured level when superimposed on the debtor’s capital structure. The PREPA bonds are secured by a lien on PREPA’s net revenues. In re Fin. Oversight & Mgmt. Bd. for P.R., 121 F.4th 280, 301 (1st Cir. 2024). The Second Circuit’s “same type” reading therefore supplies an argument, which the First Circuit did not reach, that a claim represented by secured affiliate debt should be subordinated only to claims senior to or equal to secured debt; it is close to the argument the bondholders raised for the first time on appeal. See PREPA Bondholders, slip op. at 31–33. It is an argument, not a holding. The lien runs against PREPA’s revenues, not Commonwealth assets, so how that “type” would be superimposed on the Commonwealth’s priority scheme is itself unresolved, and whether the First Circuit would adopt the Second Circuit’s reading at all is open.

Decisions that subordinate $8.5 billion claims invite overreading, and the court anticipated it. “Section 510(b) does not subordinate all claims raised by purchasers or owners of securities,” nor does “arising from” reach “every possible claim that bears any incidental connection to an earlier securities transaction.” The court acknowledged ambiguity at the statute’s “outer reaches” and declined to define them; this claim, “based on its own allegations,” fit “comfortably” within the core. PREPA Bondholders, slip op. at 24–25; see also id. at 20 n.10.

Two passages will do most of the work in future cases. The first is a footnote disagreeing with the district court: to the extent the Title III court read Section 510(b) to reach any claim that “ultimately relate[s]” to a securities transaction “regardless of the nature of the claim or degree of causal relation, we do not agree.” Id. at 24 n.15. Relative to the decision below, the First Circuit’s standard is narrower.

The second is the court’s treatment of Khan v. Barton (In re Khan), 846 F.3d 1058, 1064–65 (9th Cir. 2017), where the debtor converted stock the claimant had bought years earlier and the Ninth Circuit held that the injury arose from the conversion, not the purchase. The First Circuit read Khan to hold that Section 510(b) “ceases to apply when a later and independent wrong displaces the securities transaction as the source of the claimed damages.” There, the purchase “explained merely how he came into possession of the property that the debtor later stole”; here, “the very protections the Commonwealth allegedly impaired induced that purchase,” making it “central to the Trustee’s asserted claim for damages” rather than “merely part of the historical background.” PREPA Bondholders, slip op. at 26–27.

That is the line the court drew, and on this record it turned on the trustee’s own allegations. A claim can fall outside Section 510(b) when its source is a wrong independent of the securities transaction. Here, the allegedly impaired protections had induced the purchase, making that purchase central to the trustee’s damages claim.

Affiliate structures are the norm. Conduit issuers, holdco and opco structures, parent guarantees, and public authorities backed by state covenants all pair a security issued by one entity with a claim against another, and the First Circuit has now applied Section 510(b) to a non-issuer affiliate that expressly disclaimed liability on the bonds. In municipal financing, a claimant may allege that an investor protection both supplied a contract or property right and induced the securities purchase. In PREPA, that combination supplied the causal link on the trustee’s allegations. Claimants should examine the source of their injury and preserve classification arguments from the first filing.

The alternative class was never requested. The plan contained a class for claims of “constitutional character” entitled to full payment, and the bondholders, pressed repeatedly by the district court, never asked for it. Id. at 11 n.5, 30 n.18. Whether the claim would have qualified is a question the record leaves unanswered. Put every plausible alternative classification on the record, and raise the level-of-subordination question below.

Plan definitions and bar dates. The plan’s Class 64 definition reached claims “relating to” the purchase, sale, or “retention” of a security, broader than the statute; the court did not reach whether that definition independently controlled, id. at 28 n.16, and the trustee had not objected to confirmation. The Board, meanwhile, obtained leave under Rule 15(a)(2), in a framework the bondholders did not contest, to amend its timely objection roughly a year after the deadline, and it prevailed. Id. at 13–15. Creditors should contest subordination-class definitions at confirmation and should not assume a passed objection deadline forecloses reclassification of a claim that drew a timely objection; plan proponents whose definitions are broader than the statute hold an independent argument the court did not reach.

Price two claims, not one. The PREPA bonds carry a repayment claim against PREPA, which this decision does not touch, and a damages claim against the Commonwealth, which now sits in a class receiving nothing. See id. at 7, 9, 23. The face amount says nothing about the second claim. Read the proof of claim as the objector will, ask whether the pleaded theory rests on a protection that induced the purchase or on an independent wrong, and allocate reclassification risk in the trade documents.

Six Takeaways

1. Read your proof of claim as the objector will. If it says the debtor's promise induced the purchase, Section 510(b) is in play.

2. Plead the independent wrong, if there is one. Khan requires a different source of damages, not a different label.

3. Keep the claims analytically distinct. Plead and price an issuer repayment claim, any guaranty claim, and an affiliate damages claim separately. The First Circuit reserved whether Section 510(b) can reach a guaranty claim, and the Fifth Circuit has subordinated claims where guaranties induced the investment. 

4. Never litigate classification as a binary. Footnote 18 is the cautionary example.

5. Preserve the level-of-subordination argument. For secured affiliate securities, the Second Circuit's "same type" reading supplies an argument about the level of subordination that the First Circuit has not decided. Raise it below. 

6. Fight plan definitions at confirmation, not when the classification motion is filed. 

The PREPA bondholders did not lose because Section 510(b) grew. They lost because their claim, as they themselves described it, was a claim about why they bought the bonds. In the First Circuit, that description was enough.