Municipal Bankruptcy

Chapter 9 and Alternatives – Part Three: Competing Interests in Chapter 9 and Bondholders’ Rights


Chapter 9 and Alternatives – Part Three: Competing Interests in Chapter 9 and Bondholders’ Rights ( Depositphoto_-Justice-–-©-Taurus )

by James Spiotto

Chapter 9 is generally viewed as the remedy of last resort for troubled municipalities. If permitted by its state law, a municipality typically does not seek Chapter 9 relief unless it is in extreme financial distress with no obvious solution. Among the factors that can lead to such serious financial distress include the decline of urban areas, the decline of industry and related shrinking of the tax base, unaffordable and unsustainable personnel costs and large debt obligations in excess of the ability to pay. Chapter 9, however, is a vehicle not for elimination of debt, but for debt adjustment. (See Appendix 5 for Charts regarding the differences between Chapter 9 and Chapter 11 of the Bankruptcy Code.) The primary purpose of Chapter 9 is to allow the municipal unit to continue operating while it adjusts or refinances creditor claims. Faced with the necessity to adjust debt, cities who recently have filed for Chapter 9 have been faced with heated battles between creditors including public employees and representatives of public debt with respect to the conduct of the case and the plan of adjustment to be confirmed. Accordingly, a brief discussion of the provisions in Chapter 9 governing the rights of creditors is instructive.

The following chart summarizes the priorities of creditor payments in Chapter 9.

Summary of Chapter 9 Priorities
Type of ClaimExplanation
1.Obligations secured by a statutory lien to the extent of the value of the collateral.abDebt (bonds, tax anticipation notes, revenue anticipation notes) issued pursuant to statute that itself imposes a pledge. (There may be delay in payments due to automatic stay – unless stay is lifted – but ultimately will be paid.) One may expect the bondholders secured by a state statutory lien to argue that the municipality must pay on time the pledged revenues since to do otherwise is contrary to state law and §§ 903 and 904 of the Bankruptcy Code.
2.Obligations secured by special revenues (subject to necessary operating expenses of such project or system) to the extent of the value of the collateral.ab

These obligations are often non-recourse and, in the event of default, the bondholders have no claim against non-pledged assets.

Special revenue bonds secured by any of the following:

(A) receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are used primarily or intended to be used primarily to provide transportation, utility or other services, including the proceeds of borrowings to finance the projects or systems; (B) special excise taxes imposed on particular activities or transactions; (C) incremental tax receipts from the benefited area in the case of tax increment financing; (D) other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or (E) taxes specially levied to finance one or more projects or systems, excluding receipts from general property, sales or income taxes (other than tax increment financing) levied to finance the general purposes of the debtor.c

There should be no delay in payment since automatic stay is lifted under § 922(d).

3.Secured lien based on bond resolution or contractual provisions that does not meet test of statutory lien or special revenues to the extent perfected propitiation, subject to the value of propitiation property or proceeds thereof.cUnder the language of §§ 522 and 928, liens on such collateral would not continue post-petition. After giving value to the propitiation lien on property or proceeds, there is an unsecured claim to the extent there is recourse to the municipality or debtor.  One may expect the creditor to argue that pursuant to §§ 903 and 904, the court cannot interfere with the power of a State to control a municipality in exercise of political or governmental powers with the property or revenues of the debtor, and that includes the grant of security to such secured creditor, priority of payment, mandatory set aside or mandatory appropriation required by state statute or constitution.
4.Obligations secured by a municipal facility lease financing.Under § 929 of the Bankruptcy Code, even if the transaction is styled as a municipal lease, a financing lease will be treated as long-term debt and secured to the extent of the value of the facility.
5.Administrative expenses (which would include expenses incurred in connection with the Chapter 9 case itself).d Chapter 9 incorporates § 507(a)(2) which, by its terms, provides a priority for administrative expenses allowed under § 503(b). These would include the expenses of a committee or indenture trustee making a substantial contribution in a Chapter 9 case.Pursuant to § 943, all amounts must be disclosed and be reasonable for a Plan of Adjustment to be confirmed.
6.Unsecured debt includes:
A. Senior unsecured claims with benefit of subordination paid to the extent of available funds (without any obligation to raise taxes) which include any of B, C, D or E below.
B. General obligation bonds.Secured by the “full faith and credit” of the issuing municipality. Post-petition, a court may treat general obligation bonds without a statutory lien or special revenues pledge as unsecured debt and order a restructuring of the bonds subject to state statute and constitutional provisions as to security interests lien, priority of payment, mandatory appropriation or set aside. Payment on the bonds during the bankruptcy proceeding likely will cease.
C. Trade.Vendors, suppliers, contracting parties for goods or services. Payment will likely cease for propitiation goods or services.e
D. Obligations for accrued but unpaid propitiation wages and pensions and other employee benefits.These do not enjoy any priority, unlike in a Chapter 11.f
E. Unsecured portion of secured indebtedness.
F.  Subordinated unsecured claims.Any debt subordinated by statute or by contract to other debt would be appropriately subordinated and paid only to the extent senior claims are paid in full.  Senior debt would receive pro ratadistribution (taking unsecured claim and subordinated claim in aggregate) attributable to subordinated debt until paid.
  • Chapter 9 incorporates § 506(c) of the Bankruptcy Code which imposes a surcharge for preserving or disposing of collateral. Since the municipality cannot mortgage city hall or the police headquarters, municipal securities tend to be secured by a pledge of a revenue stream. Hence, it is seldom a surcharge will be imposed. But see numbers 3 and 4.
  • Chapter 9 incorporates § 364(d) of the Bankruptcy Code, which permits a debtor to obtain post-petition credit secured by a senior or equal lien on property of the estate that is subject to a lien if the prior lien holder is adequately protected.
  • A pledge of revenues that is not a Statutory Lien or Special Revenue Pledge may be attacked as not being a valid continuing Post-Petition Lien under § 552 of the Bankruptcy Code.
  • These expenses strictly relate to the costs of the bankruptcy. Because the bankruptcy court cannot interfere with the government and affairs of the municipality, general operating expenses of the municipality are not within the control of the court, are not discharged and will remain liabilities of the municipality after the confirmation of a plan or dismissal of the case.
  • Section 503(b)(9) provides for a priority claim to be paid on confirmation of a plan for the value of goods provided propitiation within 20 days of the petition date.
  • Chapter 9 does not incorporate § 1113 of the Bankruptcy Code, which imposes special provisions for the rejection of collative bargaining agreements (making the standard less restrictive, i.e., “impairs ability to rehabilitate”) or §§ 507(a)(4) and (5), which give a priority (before payment of unsecured claims) to wages, salaries, commissions, vacation, severance, sick leave or contribution to pension plans of currently $12,475 per employee.
Municipal Operations and Creditor Protections

While in a Chapter 9 proceeding, the municipality will still have to function as a municipality. Depending upon the statutory mission of the municipality, there are certain necessary and basic municipal services that must be provided, such as public safety (police and fire), public health and welfare (education and health, transportation, building and zoning and, under certain instances, sewer, water and electrical services). History has shown that municipalities in financial distress need a recovery plan that stimulates economic activity in the municipality and encourages business to locate or expand there. This business expansion typically creates new, good jobs that increase tax revenues that lead to the recovery and the solution of financial distress. Also, in order to effectuate a recovery plan, which is necessary for a turnaround, and to prevent future financial distress, there must be funding of essential government services. This will produce a stimulation of the economy and encourage growth of the municipality which will attract new businesses and new citizens. This economic growth will create needed jobs, especially for younger workers who will in turn become taxpayers and which will result in increased tax revenues. In order to accomplish the recovery plan, improved infrastructure is required in order to ensure the required movement of goods, services and workers. In addition, enhanced education programs are important to train young workers for the specific jobs created. Further, improved public safety and welfare programs that will lead to a constructive environment fostering economic growth and recovery.

Defining these necessary municipal services is a question of state law and local choice and may by itself be a complex issue. A bankruptcy court and creditors will not be able to successfully interfere with such service. Section 904 of the Bankruptcy Code recognizes this reality. Accordingly, certain revenues and activities of the municipal body that may be the cause of the “insolvency” may not be able to be restrained, curtailed or modified without a compelling reason. Even municipal debt secured by “special revenues,” which pledge is preserved by reason of § 928 of the Bankruptcy Code, is subject to the payment of necessary operating expenses.

“Special Revenues” Pledged to Bondholders

Many municipal bonds are revenue bonds secured by a pledge of revenues derived from a specific project or a special tax levy. In fact, all states recognize some form of a revenue bond. As background, in a corporate bankruptcy context, § 552 of the Bankruptcy Code provides that property acquired by the estate or the debtor after commencement of a case is not subject to any lien resulting from a security agreement entered into by the debtor before the commencement of the case.  Thus, in a corporate bankruptcy, if a revenue pledge were to exist, such as a lien on inventory or accounts receivable, the pledge likely would not survive the filing of a bankruptcy petition (namely any property or revenue created post petition, such as inventory manufactured or accounts receivable received from sales of inventory after the filing of the case). In a municipal bankruptcy, however, this is not the case.  Specifically, § 928 of the Bankruptcy Code provides that in the case of “special revenues,” the security interest in “special revenues” remains valid and enforceable even though such revenues are received after a Chapter 9 filing. Subsection (B) of § 928 provides that in the case of project or system financing, the bondholders’ lien on “special revenues” is subject to necessary operating expenses of the project or system. Thus, subject to the payment of operating expenses, holders of special revenue bonds would continue to receive payment on those bonds, regardless of the bankruptcy filing.[i]

Section 928 was incorporated into the Bankruptcy Code by the Municipal Bankruptcy Amendments, which were adopted in 1988, as part of an Act to Amend the Bankruptcy Law to Provide for Special Revenue Bonds, and for Other Purposes, Pub. L. No. 100-597 (1988) (“1988 Amendments”). As noted by the Bankruptcy Court in theJefferson County, Alabama Chapter 9 bankruptcy proceeding, the 1988 Amendments became necessary because at the time the 1988 Amendments were adopted, there was great concern in the municipal bond market that the application of general commercial finance concepts rendered the extension of credit to a troubled municipality fraught with risk.[ii] In fact, “[a] major purpose was to change from using corporate debt principles in the municipal financing context when their application would be at odds with how municipal financing has evolved. This was and remains especially apt for revenue based municipal financing transactions.”[iii] As is clearly set forth not only in the specific provisions added to Chapter 9 by the 1988 Amendments but also in the legislative history for the 1988 Amendments, Congress concluded that, without the 1988 Amendments, the uncertainty of the effect of Chapter 9 as it then existed on municipal debt could have dire effects. This was especially true with respect to concerns regarding the continuation of a lien on revenues in a Chapter 9 proceeding.[iv] The Senate Report for the 1988 Amendments, Senate Report No. 100-506, 100th Cong., 2d Session (1988) (the“Senate Report”), made it clear that the intention of the 1988 Amendments was to address the real worry in the marketplace that revenues dedicated to the repayment of municipal revenue obligations would be diverted to other purposes once a local government entered bankruptcy; that this worry rendered clarification of the law a necessity; and that revenue debt could not be impaired in a Chapter 9.[v] The same concern was reflected in the House Report for the 1988 Amendments, which noted that the bill “remedies the inconsistencies between bankruptcy law and principles of municipal finance to remove the potential for problems that now exist.”[vi] As noted by the Jefferson County Bankruptcy Court, “[i]f nothing more is evident from … the legislative history, it is that Congress intended that certain of the corporate finance principles be modified including changing how the automatic stay applies to revenue based financing for municipalities.”[vii]

In fact, the Bankruptcy Court in Jefferson County found that it was clear from the legislative history accompanying the 1988 Amendments that the elimination of the potential loss of a municipal creditor’s lien on special revenues was critical to Congress.[viii] Indeed, the 1988 Amendments were enacted, in part, to protect the municipal bond market from the uncertainty common in other commercial credit markets, provide for readily available inexpensive financing for municipalities and municipal projects and ensure that municipal revenue bondholders receive the benefit of their bargain without the uncertainty typical in non-government financing. In enacting the 1988 Amendments, Congress specifically recognized that “the proposed amendments reflected the principles that have long been the premise for municipal finance but have not been expressly stated in the Bankruptcy Code.”[ix] The Senate Report stated:

The problems created by the incorporation of general commercial finance concepts into municipal bankruptcy provisions first came to light as a result of the financial crisis confronting the City of Cleveland, Ohio in 1979. Cleveland needed additional financing but lenders were unwilling to lend for a variety of reasons, including the incorporation into Chapter 9 of the general bankruptcy concepts of Section 552 of the Code… Thus lenders who contemplated providing financing during financial troubles of the City were discouraged given the concern that their security interest might terminate upon a Chapter 9 filing of the city… Such uncertainty may have dire effects in the future ….

Thus, § 928 provides that special revenues acquired by the debtor after the commencement of a bankruptcy case are subject to any lien granted on special revenues prior to the bankruptcy filing. Section 928 is intended to ensure that revenue bonds do not become transformed into general obligation bonds with a call against all the assets of the municipality upon the filing of bankruptcy petition.[x] The Bankruptcy Court in Jefferson County explains:

The bigger picture of what was to be accomplished by the 1988 Amendments comes from knowing that the post-bankruptcy loss of a security interest in pledged special revenues via § 552(a) or the § 547 avoidance of a payment to a bond or warrant holder pursuant to a special revenue financing could have made the obligation or avoided transfer unsecured. As an unsecured indebtedness, it was then potentially repayable from the general revenues of the municipal entity. Under this scenario, it might have been changed by the pre-1988 version of the Bankruptcy Code from an obligation repayable solely from the revenues of the system or project or a specified tax into one repayable from the general revenues of the municipality. Essentially, it may have been turned from a non recourse into a recourse obligation of the municipal government.[xi]

As background, prior to the addition of § 928 to the Bankruptcy Code, § 552(a) of the Bankruptcy Code was applicable to revenue debt in a Chapter 9. That section provides that property acquired by a debtor after the commencement of the bankruptcy case is not subject to a lien created prior to the bankruptcy filing unless the acquired property constituted proceeds of the property pledged prior to the bankruptcy filing. The result of the application of § 552(a) in the municipal context generally was to strip the lien of revenue bondholders. Therefore, the revenue bondholders would become unsecured creditors with a claim against the post-petition revenues that had previously secured the revenue bonds and their claims would become part of the general obligations of the municipality. The general funds would then be used to pay all creditors including the revenue bondholders. As a result, rather than taking the risk that a specific revenue stream would be sufficient to pay debt service on their bonds, revenue bondholders were, in fact, taking the risk that the general fund of the municipality would not be sufficient to repay all debts of the municipality. Section 928 resolved this problem by providing that revenue bondholders continue to have a lien on special revenues generated after the bankruptcy case. As the legislative history makes clear, the addition of § 928 was motivated by the desire to make it easier for municipalities to obtain needed financing for public projects.

In addition to providing that the lien on special revenues continues after a Chapter 9 filing, the 1988 Amendments also dealt with the problem of timely payment. In order to avoid the delay in payment caused by the automatic stay of § 362, the 1988 Amendments added a new subsection to § 922 of the Bankruptcy Code that makes the automatic stay provision inapplicable to the payment of pledged special revenues to the holders of municipal indebtedness.[xii]

The Senate Report observed that the payment of the net revenues, after payment of operation and expenses of the income producing property, should be paid to the holders of secured bonds without the application of the automatic stay, which is the derivation of § 922(d) in the Code, as the Senate Report states:

This provision [362] is overly broad in Chapter 9, requiring the delay and expense arising from a request for relief from automatic stay to accomplish what many state statutes mandate: the application of pledged revenues after the payment of operating expenses to the payment of secured bonds. The automatic stay should specifically be inapplicable to application of such revenues.[xiii]

In fact, as the Senate Report noted at page 21,

Reasonable assurance of timely payment is essential to the orderly marketing of municipal bonds and notes and continued municipal finance.

The clear intent of Congress in enacting the 1988 Amendments was to provide assurances to the capital markets that special revenues essential to municipal financing remain unimpaired in the event of a Chapter 9 filing. “[T]he amendments insure that revenue bondholders receive the benefit of their bargain with the municipal issuer, namely, they will have unimpaired rights to the project revenue pledged to them.”[xiv]

New Section 927 [928] along with the definition of Special Revenues in Section 902(3) protect the lien on revenues.[xv]

In sum, Congress made clear that revenue bondholders are entitled to receive the revenues pledged to them without any interference and on a timely basis.

Particular attention should be directed to the definition of “special revenues,” the pledge of which survives bankruptcy.[xvi]  “Special revenues” are defined as:

  • receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems;
  • special excise taxes imposed on particular activities or transactions;
  • incremental tax receipts from the benefited area in the case of tax’ increment financing;
  • other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or
  • taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax’ increment financing) levied to finance the general purpose of the debtor…[xvii]

Examples of the “special revenues” mentioned in clause

  1. (A) include receipts derived from or received in connection with the ownership, financing, operation or disposition of a municipal water, electric or transportation system. An excise tax on hotel and motel rooms or the sale of alcoholic beverages would be a special excise tax under clause
  2. (B) “Special excise taxes” are taxes specifically identified and pledged in the bond financing documents and are not generally available to all creditors under state law. General state sales, general income or general property taxes would not be special excise taxes without specific language deemed levied to finance a specific project or system.
  3. In a typical tax increment financing referred to in clause (C), public improvements are financed by bonds payable solely from and secured by a lien on incremental tax receipts resulting from increased valuations in the benefited area.  Although these receipts may be part of the general tax levy, they are considered to be attributable to the improvements so financed and are not part of the preexisting tax base of the community.
  4. Examples of revenues from particular functions under clause (D) would include regulatory fees and stamp taxes imposed for the recording of deeds or any identified function and related revenues identified in the municipality’s financing documents, such as tolls or fees related to a particular service or benefit.
  5. Under clause (E), an incremental sales or property tax specifically levied to pay indebtedness incurred for a capital improvement and not for the operating expenses or general purposes of the debtor would be considered “special revenues.” Likewise, any special tax or portion of a general tax specifically levied to pay for a municipal financing should be treated as “special revenues.”[xviii]
Statutory Liens Protect Bondholders

In certain situations, even if holding general obligation bonds for which the contractual pledge of a municipality’s taxes or revenues generally would terminate on the filing of a municipal bankruptcy petition, a bondholder may continue to receive payment in the wake of a Chapter 9 filing if the underlying statute authorizing the issuance contains a statutory lien, which lien comes into existence by virtue of the statute and arises by force of the statute on specific circumstances or conditions and not requiring further action by the municipality.[xix] A statutory lien cannot be canceled on the filing of a bankruptcy petition or by the bankruptcy court. This approach was recognized by the district court on appeal in the Orange County bankruptcy. There, the court found that the lien securing tax and revenue anticipation notes pursuant to a California statute authorizing the county to pledge assets to secure notes was a statutory lien. Since the statute imposed the pledge, not a security agreement, it survived the filing of a Chapter 9 petition.[xx] At least thirty-two States recognize some form of a statutory lien in relation to their bond obligations.[xxi]

In 2011, the State of Rhode Island was faced with issues of financial distress of its municipalities and, in particular, the City of Central Falls, an old manufacturing town of 19,000, which that had lost its industrial base and had fallen on hard times. The bond rating agencies had reacted to efforts of Central Falls to have a court appointed receiver placed as new management of the City. The state adopted a new law in 2010 that provided that with state supervision, depending on the degree of distress, there could be use of a state appointed overseer, a budget commission of state and local appointed members to approve budgets going forward or a receiver who would replace local government with the power to file Chapter 9. The governor and others had fears that the new law that allowed Chapter 9 filings might cause a restriction in access to the financial market or increase in borrowing costs by all municipalities in Rhode Island as a contagion of a municipal bankruptcy filing. Accordingly, Rhode Island passed a law granting a first statutory lien on all ad valorem taxes and general funds assessments for payment of all public debt (bonds and notes). This was well received by rating agencies and the municipal market so that, when Central Falls filed a Chapter 9 bankruptcy later in 2011, there was no real contagion to other Rhode Island municipalities as to restriction of access to or increase in the cost of borrowing. This is unlike the experience in Michigan where other municipalities claimed as much as 100 basis points or more (1% or more per annum) increase in borrowing costs for unlimited ad valorem tax general obligation bonds (“ULTGOs”) due to Detroit’s filing in 2013 and the emergency manager’s unfounded claim they were unsecured. Even though ultimately, the ULTGOs bondholders were to receive 100% recovery under Detroit Plan of Debt Adjustment the contagion and cloud on ULTGOs continues. After confirmation of Detroit’s Plan of Debt Adjustment last year, there was proposed in Michigan (MI HB5650) to confirm a “statutory lien” being provided on ULTGOs in Michigan for the same reasons as Rhode Island, reduction in the borrowing costs to municipalities in the state. Also, Nebraska has introduced similar legislation to Rhode Island providing a first statutory lien on revenues to assure and secure the payment of bonds and notes (NE LB67).  In fact the State of California complained its school districts were paying 50 to 100 basis points (.5% to 1% per annum) more because of the Michigan ULTGO issue, and a bill in the senate has been introduced to provide a statutory lien to reduce the cost of borrowing by its schools.  (CA SB222)

The statutory language creating a statutory lien is exemplified by California Senate Bill 222 relating to school bonds.[xxii]  The bill provides:

  • When collected, all taxes levied shall be paid into the county treasury of the county whose superintendent of schools has jurisdiction over the school district on behalf of which the tax was levied, to the credit of the interest and sinking fund of the school district, or community college district as designated by the California Community Colleges Budget and Account Manual, and shall be used for the payment of the principal and interest of the bonds and for no other purpose.
  • Bonds issued and sold pursuant to this chapter shall be secured by a statutory lien on all revenues received pursuant to the levy and collection of the tax. The lien shall automatically attach without further action or authorization by the governing board of the school district or community college district. The lien shall be valid and binding from the time the bonds are executed and delivered. The revenues received pursuant to the levy and collection of the tax shall be immediately subject to the line, and the line shall automatically attach to the revenues and be effective, binding, and enforceable against the school district or community college district, its successors, transferees, and creditors, and all other asserting rights therein, irrespective of whether those parties have notice of the lien and without the need for any physical delivery, recordation, filing, or further act.

Historically, municipal markets and analysts have raised the question for states as to whether there should be confirmed that there are statutory liens on general obligation bonds and that the rights of revenue bonds are consistent with the 1988 Amendments under that state’s law.

The significance of special revenues and statutory liens was illustrated recently by the case of Sierra Kings Health Care District, in which a court order reaffirmed the fact that a Chapter 9 proceeding and any order or Plan of Debt Adjustment cannot interfere with notes, bonds or municipal obligations that are paid from the pledge of taxes or revenues that are special revenues or subject to a statutory lien.[xxiii]  Of special significance is the fact that the Sierra Kings court confirmed, for the first time, the post petition effectiveness of a municipality’s pledge of ad valorem taxes which qualified as both a special revenue pledge and a statutory lien. The Chapter 9 proceeding, orders and plan would not affect the timely payment on these bonds according to their terms. Bankruptcy courts in the confirmed Plans for Detroit and Stockton respected statutory liens and special revenues.

The following chart summarizes the intended treatment of bonds and notes, depending on how they are secured, in a Chapter 9 proceeding.

Summary of Basic Treatment of Bonds and Notes in Chapter 9
Type of Bonds/NotesBankruptcy Effects
General Obligation BondsPost-petition, a court may treat general obligation bonds as unsecured debt absent a statutory lien or a pledge of revenues that classifies as special revenues or a statutory lien, priority mandatory appropriation or set aside for payment arising out of state statute or constitution “statutory or constitutional provision as to payment.”  Payment on the bonds during the bankruptcy proceeding likely will cease including payments subject to state statutory or constitutional provisions as to payment as noted above.
General Obligation Bonds plus Pledged RevenuesAssuming that the general obligation pledge is an actual pledge of revenue and to the extent that it may be classified as a statutory lien or special revenues, or subject to state statutory or constitutional provisions as to payment as noted above this secured, statutory or constitutional requirement of the state issuance should be respected to the degree it is consistent and authorized under state law.  A pledge of revenues that is not a statutory lien or special revenues may be attacked as not being a valid continuing Post-Petition Lien under § 552 of the Bankruptcy Code.  This position may be questioned under §§ 903 and 904 of the Bankruptcy Code given the prohibition that the court not interfere with the power of a State to control a municipality in exercise of political or governmental powers the government affairs or revenues of the municipality including payments subject to state statutory or constitutional provisions as to payment as noted above.
Special Revenue
Bonds
A pledge on special revenue bonds will survive a bankruptcy filing.  Pre-petition, a special revenue bond is an obligation to repay solely and only from revenues of a municipal enterprise (net of operations and maintenance costs) that are pledged to bondholders.  The contemplated remedy for default often focuses on a covenant to charge rates sufficient to amortize the debt.  Defaulted bondholders are expected to seek mandamus in court to require the municipal borrower to raise its rates.
Revenues Subject to Statutory
Lien
Assuming the pledge is authorized under state law through a statutory lien, the bankruptcy court should respect that statutory lien.  Thus, as long as the revenues are subject to a statutory lien, payments to the bondholders should be protected post-petition.

General obligation bonds without any pledge of revenue or special statutory or constitutional priority mandated set aside or mandated appropriation can be treated like any other unsecured claim of vendors, workers or pension; however, in Medley, Florida, in 1968, there was a distinction made to pay bond indebtedness on schedule and stretch out the payments to other unsecured creditors over a 10-year period since failure to make payment on the bonds might cause the municipality to lose access to the market or to pay a significantly higher price for access that would justify a better treatment for bond indebtedness for the benefit of all.

As noted in Faitoute Iron & Steel Co., et al. v. City of Asbury Park, N.J., 316 U.S. 502 (1942), discretion must be exercised in dealing with secured claims. While the court recognized that New Jersey’s Depression-era Municipal Finance Commission Act of 1931 could impair municipal debt, there was recognition that secured claims and tax anticipation and revenue notes stand on an entirely different footing from other municipal obligations and, in relation to them, no claim is affected by the Municipal Finance Commission Act of New Jersey. The plan adopted by Asbury Park paid general obligation bondholders a compromise payment (less in amount and a delay in payment).

Payments to Bondholders Are Not Preferences

The Bankruptcy Code also provides assurance to holders of all municipal bond or note obligations that payments received within 90 days of the commencement of a municipal bankruptcy petition are not preferences that may be clawed back.[xxiv]  Specifically, § 926(b) of the Bankruptcy Code provides that a transfer of property of the debtor to or for the benefit of any holder of a bond or note on account of such bond or note may not be avoided under § 547. While this section refers to “bonds or notes,” there is nothing in the legislative history to support the view that this provision is limited only to instruments bearing such titles. The intent appears to be that § 926(b) should be applicable to all forms of municipal debt and allow such holders to keep such payments where the Bankruptcy Code would otherwise require any payments made within 90 days of a bankruptcy filing to be returned to the estate.  Special revenues and statutory liens are designed to provide a municipality experiencing financial distress with additional available sources of financing through various options of refinancing or refunding old debt or obtaining additional liquidity with the use of special revenues or statutory liens that are intended to continue to pay and have a continuing lien on taxes collected even if the municipality should authorize filing a Chapter 9 proceeding.

Lengthy Litigation on the Competing Rights of Creditors May Not Be in Their Best Interest

Municipalities cannot pay that which they have no revenues to fund. Further, when obligations become so overwhelming to a municipality as to crowd out necessary expenses for essential governmental services and infrastructure, the consequences can be devastating and can lead to the meltdown of the local government.

Without a successful recovery plan, there will not be enough funds to employ workers, provide essential services or pay pensions, impaired or unimpaired. In reality, the future of paying creditors including pension funding, workers continued employment and a recovery plan is dependent upon determining what costs and expenses are sustainable and affordable. This would include determining what amount of current expense can be paid that is reasonable, prudent and feasible. Such determination must take into account the necessity of sufficient funding for a recovery plan whereby essential governmental services can be raised to an acceptable level and infrastructure provided to encourage, stimulate and insure business growth and expansion with its accompanying creature of good new jobs, especially for the young citizens. This will insure not only short-term recovery, but long-term success.

The second look and oversight mechanism described herein would help the municipality and all concerned parties develop an effective recovery plan rather than litigate over payment issues which will not be efficient or cost effective.

Fortunately, the answer to all of this is simple. Rather than positioning and fighting as to what can be paid, what cannot be paid and what must be paid, it is in the best interests of all parties striving for the recovery and success of the municipality to recognize and determine what is sustainable and affordable acknowledging the resulting increase in the revenues or adjustments are simply a recognition of reality which through a consensual process prior to Chapter 9 or in a Chapter 9 proceeding. In the long term, this will pay more than the best litigation strategy.

Obligations of the municipality can be appropriately adjusted to what is sustainable and affordable, allowing the municipality to invest in that which will help it recover and grow. There would be the determined affordable fixed payments and contingent payments that would only be paid if there are increased revenues from the success of the recovery. If the municipality does better, there will be more funding. Obligations are not impaired or diminished because realistically all that can be paid is being paid. Creditors have improved expectations that the municipality operating under a realistic recovery plan will make future payments to fund their obligations based on anticipated recovery and success of the municipality. Also, there could be periodic adjustments to the fixed and contingent payments based on actual results of the recovery and what is affordable.

There should be a periodic review of the progress in the recovery plan. If there is a need to adjust available revenues or payment obligations so that what is paid is sustainable and affordable, those adjustments should be made.

Conclusion

As discussed above, Chapter 9 is not a solution to the problems of a financially-troubled municipality. Rather, Chapter 9 is a process. As a result, debt adjustment without a recovery plan does not create an economic turnaround and raises the question of the futility of the process of not addressing the systemic cause of the problem. Essential governmental services must be funded. A recovery plan that stimulates the economy while providing adequate funds for the payment of essential governmental services will lead to economic opportunities and resulting job opportunities for the citizens of a financially distressed city, especially for the young workers. This recovery plan can only be accomplished by assuring participants that essential governmental services will be provided, including improved infrastructure and essential services so the blighted areas are transformed into areas where businesses and citizens will desire to reside and flourish and good jobs are available for all. Such a process will lead to new and expanded business and job opportunities, which result is in the best interest of all creditors. The recovery plan necessarily must be based upon the payment of what is sustainable and affordable. The increased revenues that flow from the creation of new jobs and new taxpayers under the recovery plan should permit the additional funds to ensure payment of these obligations that should be paid, including continued employment of public workers and appropriate funding of pensions. Without a successful recovery plan, the repayment of obligations will not only be difficult but practically impossible. However, restructuring of the obligations in a manner that pays what is feasible is in the best interest of all. Chapter 9 has been and should continue to be used as a last resort when all other alternatives fail.  Consideration of interim processes and procedures to encourage prompt and effective resolution of the causes of the financial distress should be considered such as the Local Government Protection Authority as developed by the Civic Federation. In the long run, we all are benefitted by effective laws and procedures to address and detect as early as possible the existence of municipal financial distress so that the governmental services provided to citizens of local government and the infrastructure are at a level that will allow both citizens and the local government to best assure the bright future of all.

James Spiotto is Managing Director of Chapman Strategic Advisors, LLC and Co-Publisher of MuniNet Guide.

NOTE: If you would like a copy of the full report, including all charts and appendices, please contact Mardee Handler.

 

[i]           In re Jefferson Cnty., Alabama, 474 B.R. 228 (Bankr. N.D. Ala. 2012) (discussion of nature of special revenues); Bank of N.Y. Mellon v. Jefferson Cnty., Ala. (In re Jefferson Cnty., Ala.), 482 B.R. 404 (Bankr. N.D. Ala. 2012) (analysis of necessary operating expenses); In re Sierra Kings Health Care Dist., Case No. 09-19728 (Bankr. E.D. Ca. Sept. 13, 2010).

[ii]          In re Jefferson Cnty., 474 B.R. 228, 267 (Bankr. N.D. Ala. 2012).

[iii]        Id. at 271.

[iv]         Id.

[v]          For further discussion on the importance of the 1988 Amendments, see In re Jefferson Cnty., Ala., 474 B.R. 228 (Bankr. N.D. Ala. 2012); Bank of N.Y. Mellon v. Jefferson Cnty., Ala. (In re Jefferson Cnty., Ala.), 482 B.R. 404 (Bankr. N.D. Ala. 2012) (analysis of necessary operating expenses).

[vi]         H.R. Rep. No. 100-1011 (1988) at 3.

[vii]        Jefferson Cnty., 474 B.R. at 268.

[viii]      Id. at 268-69.

[ix]         Jefferson Cnty., 474 B.R. at 753 (quoting Senate Report, p.1).

[x]          Id. at 754.

[xi]         Id.

[xii]        See generally Jefferson Cnty., 474 B.R. at 268 (“It is clear from both the House and Senate Reports accompanying the 1988 amendments that eliminating the potential loss of a creditor’s lien on revenues was a critical purpose behind the enactment of § 928 and § 922(d).”)

[xiii]      Id. at 271 (quoting Senate Report at 11).

[xiv]       Id. at 270 (emphasis in original) (quoting Senate Report at 12).

[xv]        Senate Report, at 12 (emphasis added).

[xvi]       11 U.S.C. § 902(2).

[xvii]      11 U.S.C. § 902.

[xviii]    See Heffernan Memorial Hospital District, 202 B.R. 147 (Bankr. S.D. Cal. 1996).

[xix]       In re County of Orange, 189 BR. 499 (C.D. Cal. 1995).

[xx]        Id.

[xxi]       The states include: Alabama, Alaska, Arkansas, California Colorado, Connecticut, Florida, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, Nevada, New Jersey, New York, North Carolina, North Dakota, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Vermont, Virginia and West Virginia.

[xxii]      S.B. 222, 1015-2016 Reg. Sess. (Cal. 2015).

[xxiii]    In re Sierra Kings Health Care District, Case No. 09-19728 (Bankr. E.D. Ca. Sept. 13, 2010).

[xxiv]     11 U.S.C. § 926.

 

Article Summary:

Chapter 9 is generally viewed as the remedy of last resort for troubled municipalities. It is a vehicle not for elimination of debt, but for debt adjustment. Accordingly, cities who recently have filed for Chapter 9 have been faced with heated battles between creditors, including bondholders, public employees and other representatives of public debt

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