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BANKRUPTCYWestlaw Journal

VOLUME 9, ISSUE 23 / MARCH 14, 2013

Municipal bonds in Chapter 9 adjustment proceedingsBy Walter W. Miller Jr. Boston University

As Gov. Rick Snyder of Michigan considered appointing an emergency financial manager for the city of Detroit as a substitute for a municipal bankruptcy filing, the question arose: How secure are creditors of municipalities?1 This article will address the extent of bondholder rights in municipal bankruptcy and explain that those rights may provide less protection than would initially appear.

Chapter 9 of the Bankruptcy Code, “Adjustment of Debts of a Municipality,” is one of the most, or perhaps the most, controversial chapter in the Bankruptcy Code. Its complexity arises from the unique arrangement of power in the United States between the individual states and the federal government.

In 1936 the U.S. Supreme Court declared such adjustments unconstitutional on the grounds that a state could not surrender its sovereignty over the political subdivisions within it, even voluntarily and partially, to the national government.2 Two years later, after Congress had redrafted the legislation providing for such adjustments, the court declared constitutional a voluntary cooperation between state and nation to restructure finance in municipalities and subdivisions within a state.3

Since that time, Congress has been very cautious to draft legislation that would not in any way deflect sovereign power from the states. As an example, a political subdivision of a state — a town, a city or even a separately organized special project such as a waterworks facility — may seek relief under Chapter 9 only if the state in which it is located expressly permits it by legislation.4

A debtor in a Chapter 11 reorganization must seek court approval for various actions, such as borrowing money outside the ordinary course of business or using cash collateral. By contrast, a municipality need not seek this approval in Chapter 9 because it would interfere with state sovereignty.5 Two of its provisions specifically declare that:

• Nothing in Chapter 9 is intended to “limit or impair the power of a state to control … a municipality … in the exercise of the political or governmental powers of such municipality, including expenditures for such exercise.”

• “[U]nless the debtor consents or the plan so provides, the court may not … interfere with … any of the property or revenues of the debtor.”6

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These two provisions could have far-reaching effects for municipal bondholders.

To illustrate the impact of these provisions on bondholders, it is first necessary to understand the relationship of bondholders to a municipality. Bonds issued by municipalities fall into two major categories, general obligation bonds and special revenue bonds. These two categories are delineated by the first having an unsecured claim against the general revenues of the debtor, and the second having a secured claim against specific revenues of a particular part of the debtor (such as income from a water plant).7

To these two types must be added a third, the double-barreled bond. This is a hybrid, a special revenue bond combined with a general obligation bond. It provides that if for any reason the special revenues are insufficient, the holder may resort to the general revenues of the issuer.8

The general obligation bond traditionally is backed by the full faith and credit of the issuing body, the political subdivision of the state. The state authorizes its subdivisions to raise the money by selling bonds and also dictates the terms on which they will be sold. These bonds do not have recourse against any particular property.

In addition to being unsecured, a general obligation bondholder’s rights may be modified in a municipal bankruptcy. The contracts clause in the U.S. Constitution prohibits any state from passing laws that impair the obligation of contracts.9 The whole purpose of the bankruptcy provision of the Constitution, however, is to give Congress the power to pass laws impairing contractual obligations. Thus, the contractual obligation to pay the general obligation bond is subject to modification by reducing the amount paid or prolonging the time within which it will be paid.

In contrast to the general obligation bond, the special revenue bond is secured by a specific portion of the debtor’s receipts, taxes or revenues. For example, if a municipality creates an irrigation project for the community, it could issue bonds secured by those revenues. A purchaser of such a bond would have a continuing lien on the revenues of the project even after the initiation of a Chapter 9 proceeding.10

Section 928 provides that despite the general provision in bankruptcy that liens created by security interests do not reach or secure property acquired by the debtor after the commencement of the case, the special revenue lien does continue “subject to the necessary operating expenses of such project or system as the case may be.” In essence this is a nonrecourse debt and despite a provision in the Bankruptcy Code that converts nonrecourse debt into recourse, another Chapter 9 provision says this conversion does not apply to special revenue debt: “The holder of a claim payable solely from special revenues of the debtor under applicable nonbankruptcy law [meaning the state legislation that authorized the issuance of such bonds] shall not be treated as having recourse against the debtor on account of such claim pursuant to Section 1111(b) of this title.”11

In short, a special revenue bondholder has no claim against the general revenues of the municipal debtor that issued the bond.

The distinction for the holder between the traditional general revenue and special revenue bonds is that the first will be treated as unsecured debt in a Chapter 9 proceeding and the second as secured. While all actions against the debtor are stayed during the Chapter 9 proceeding, the special revenue bondholder continues to have a property interest in the revenues of the special project whose revenues are

Chapter 9 of the Bankruptcy Code, “Adjustment of Debts of a Municipality,” is one of the most, or perhaps the most, controversial chapter in the Bankruptcy Code.

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dedicated to the payment of this bond. When a plan is proposed, the value of the continuing income stream from the special project must be estimated to determine how much of the bond may continue to be deemed secured. A provision in the plan of adjustment for the municipality’s debts must be made to pay that amount in full with interest, although the time within which it must be paid may be extended for years. If the whole amount of the bond can be estimated to be paid from this income, the holder is fully secured.12

On the other hand, the holder of a general revenue obligation, as an unsecured claimant, can be given almost anything in satisfaction of the claim. This is because the “cramdown” rule of Section 1129(b) states that unsecured claimholders (here, general obligation bondholders) can be paid less than the full amount of their claims so long as no lower class receives or retains any property. There are no shareholders in a municipal context, hence there is no lower class than the unsecured claimholders.13

The priority payment requirements of Section 507 of the Bankruptcy Code do not apply, with the exception of administrative expenses.14 States can determine the priority in which unsecured creditors will be paid. The only requirement is that such a determination be in good faith and that a creditor’s claim may only be placed in a class of similar claims.15 Hence, states, to protect their credit rating, could put general obligation bonds at the top of the payment priority using general revenues (not special, which are dedicated to holders of special revenue bonds) to pay all or a large part of the general obligation debt over an extended period of time. Alternatively, states might not give priority to general obligation bonds, with the result that only a fraction of their face amount would be required to be paid.

One final type of bond structure has emerged. This is the general obligation bond that is secured by a statutory lien on the general revenues of the debtor. This is the type of bond that the Rhode Island Legislature recently adopted in 2011 to address the type of bondholder concerns arising from the Central Falls bankruptcy.16

This structure combines both a promise that the full faith and credit of the issuer is dedicated to its payment and a lien on the general revenues of the issuer. Hence, the bondholder has both a contractual promise (that can be broken in bankruptcy) and a property interest that must be recognized in bankruptcy. Because the lien is statutory, it continues on all revenues collected by the issuer during the Chapter 9 proceeding even after the municipality files its petition.17 Because almost all the valuable property of a municipality is in its revenues, this structure gives the bondholder the strongest possible position.

The general obligation bondholder with a first lien has a first claim to revenues, at least on paper. But how strong is this paper claim in a Chapter 9? First, the provision in the Bankruptcy Code requiring bankruptcy court approval for the use of cash collateral by the debtor does not apply in Chapter 9 because approval would interfere with a sovereign state’s right to control its own subdivisions, as previously described. The court may not “interfere” with a state’s subdivision’s use of its property. As a practical matter, no suit can be brought against the debtor so long as the Chapter 9 is in place. Moreover, only the debtor can propose a plan. This noninterference is intentional.18

The history of municipal adjustment legislation is one of Congress increasing the power of the debtor over its own affairs while decreasing the power of the bankruptcy judge to interfere with the debtor’s finances. Congress’ enactment of municipal

While a debtor in a Chapter 11 must seek court approval to borrow money outside the ordinary course of business or use cash collateral, a munici-pality need not seek approval in Chapter 9 because it would interfere with state sovereignty.

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bankruptcy legislation in 1934 limited bankruptcy court authority over the municipal debtor. The legislation stated that the bankruptcy judge could not interfere with any property or revenues of the taxing district “necessary in the opinion of the judge for essential governmental purposes.”

The second iteration, in 1936, excised the phrase “necessary in the opinion of the judge” and read that the bankruptcy judge could not interfere with “any property or revenues of the petitioner necessary for essential governmental purposes.” When it revised this provision again in 1976, Congress dropped the words “necessary for essential governmental purposes.”

Subsequently, when Congress enacted Chapter 9 of the Bankruptcy Code in 1978, it added the language “notwithstanding any power of the court.” Thus, the current version found in Section 904 reads, “Notwithstanding any power of the court … the court may not … interfere with … any of the property or revenues of the debtor.”19

As the bankruptcy judge in the recent Stockton, Calif., proceeding said, “The deletion of the phrase ‘necessary for essential governmental purposes’ from Section 82(c)(2) [of the 1976 version of the law] aimed to broaden the limitation.” The judge also pointed out: “The 1976 version was reenacted in 1978 as 11 U.S.C. [§] 904 with the addition of the preambular phrase ‘Notwithstanding any power of the court.’ This additional limiting language forbids resort to a federal court’s inherent or equitable powers. It reflects reinvigorated sensitivity in 1978 by Congress to avoid unnecessary intrusions of state sovereignty in order to obviate the risk of invalidation by the Supreme Court. “

The court further quoted a House of Representatives committee report that said Section 904 “makes clear that the court may not interfere with the choices a municipality makes as to what services and benefits it will provide its inhabitants.”

Finally, citing Collier on Bankruptcy as persuasive authority, the court summarized, “In short, the 904 limitation on the court’s authority is absolute, with only two exceptions stated in 904: consent [by the debtor]; and provision in a plan of adjustment (which can only be proposed by the municipality).” The municipal debtor, therefore, maintains greater use of its finances, unlike other types of debtors.20

A further point is that the police powers reserved to the states under the 10th Amendment of the U.S. Constitution may also indicate the right of the state to spend its resources without interference in the protection of its citizens.21 In short, the first lien may not in practice be worth a great deal if the municipality is in very serious financial trouble. Accordingly, if it is a choice between paying the police or the debt of the bondholder, for the sake of the citizenry, the municipality could favor its police obligations.

The relevance of these provisions and their history become more manifest as Chapter 9 proceedings have become more frequent in the past few years as a result of the economic downturn. The city of Stockton, Calif., defaulted on its obligations as a result of the financial crisis of 2008. Some of the creditors repossessed some of its property prior to its filing for Chapter 9. Once a Chapter 9 is in place, however, all creditor suits against the debtor or its property are stayed.22 Although Stockton’s proceeding is just beginning, it may follow the route of Harrisburg, Pa., wherein the mayor said, “To disrupt [services] because we can’t make a bond payment would just be unconscion-able.”23 With such sentiment likely to be common, will the type of lien

In addition to being unse-cured, a general obligation bondholder’s rights may be modified in a municipal bankruptcy.

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provided by Rhode Island be any greater protection to bondholders in light of Section 904 of the Bankruptcy Code?

Although every community wants to keep its high credit rating and where possible work out problems with its bondholders and other creditors, in a real crunch where the choice is between providing the citizenry with necessary services and paying bondholders, the choice for any elected official will be clear: General obligation bondholders can wait. If they have a lien, it will stay on revenues but those revenues can be used by the debtor as it sees fit without any court interference, and payment can be delayed possibly for years while the municipality struggles to get on its feet. Bondholders’ one protection will be the desire of the municipality and the state it is in to protect its credit rating.

Perhaps the best protection would be to require issuers of general obligation bonds secured by a lien on the general revenues of the issuer to indicate on the front of the bond in clear language that although the holder has a first lien on revenues, the issuer has a right to use those very revenues for whatever services it deems necessary for its citizenry and that as a result, payment on the bonds may be delayed and possibly reduced. This is because Section 506 applies to Chapter 9 and Section 506 requires the bankruptcy court to determine the value of the collateral securing the claim at the time the plan of adjustment is confirmed. If the tax base has been permanently eroded by the closing of businesses and the foreclosure of homes, that estimate could be less than the face value of the bond.

The Securities and Exchange Commission, reflecting congressional mandate, has always sought more disclosure and transparency in all areas of securities.24 Transparency in the Chapter 9 setting requires potential investors to realize that a first lien on general revenues to secure payment of a general obligation bond really means a first lien to the extent that the revenues are not needed for purposes determined solely by the debtor to be more necessary than paying a bond. WJ

NOTES1 TomHals,Analysis: Bankruptcy Filing May Be Bad Option for Detroit, ReuteRs,Feb.21,2013,

available athttp://www.reuters.com/article/2013/02/21/us-usa-detroit-bankruptcy-idUS-BRE91K0HT20130221.

2 Ashton v. Cameron County Water Improvement Dist., 298U.S.513,530(1936).3 United States v. Bekins, 304U.S.27,52-53(1938).4 11U.S.C.A.§ 109(c)(2)(West,Westlawthrough2012).5 11U.S.C.A.§§ 103(a),363(c)(2),364(b),901(West,Westlawthrough2012).Congressdiscussed

thisissueatlengthinareporttitled“Reportfor§ 364(c),364(d),364(e)ObtainingCredit.”H.R.Rep.No.95-595,at394-95(1977).

6 11U.S.C.A.§§ 903,904(West,Westlawthrough2012).7 See Judy Wesalo temel, the Fundamentals oF municipal Bonds55-59(JohnWiley&Sons,5thed.

2001);11U.S.C.A.§ 902(2)(West,Westlawthrough2012).8 Temel, supra note7,at33,58.9 U.S.Const.art.1,§ 10,cl.1; see also 11U.S.C.A.§ 365(West,Westlawthrough2012);Ashton,

298U.S.at530.10 Therearethreetypesofliens:asecurityinterest,whichiscreatedconsensuallybytheparties;

ajudiciallien,whichiscreatedasaresultofcourtproceedings;andastatutorylien,createdsolelybystatutewithoutcourtproceedingsortheconsentoftheparties.See11U.S.C.A.§§ 928,101(36)-(37),(51),(53)(West,Westlawthrough2012).

11 11U.S.C.A.§ 927(West,Westlawthrough2012).12 SeeJamesE.Spiotto,Chapman&Cutler,PresentationtotheCaliforniaDebtandInvestmentAdvi-

soryCommission:CreditsunderStress,PoliticalRiskinTimesofAusterity,HowStatesandInvestorsCanDealwiththeWillingnesstoPayv.InabilitytoPayProblem81(Oct.17,2012);11U.S.C.A.§§ 901,362,922,506(a),1129(b)(2)(A)(i)(II)(West,Westlawthrough2012).

13 OmerKimhi,Chapter 9 of the Bankruptcy Code: A Solution, 27yale J. on Reg.351,356-58(2010);11U.S.C.A.§ 1129(b)(2)(B)(ii)(West,Westlawthrough2012).

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14 See11U.S.C.A.§ 901(West,Westlawthrough2012).15 11U.S.C.A.§§ 901,507(West,Westlawthrough2012);Sanitary&ImprovementDist.65ofSarpy

County,Neb.v.FirstNat’lBankofAurora,79B.R.877,880(D.Neb.1987),aff’dsubnom.,873F.2d209(8thCir.1989);see also StocktonTriesaChrysler,Wall st. J.,Dec.31,2012(explainingthatthecityofStocktonissubordinatingitsbonddebttoworkerpensions).

16 MichaelCorkery,Bondholders Win in Rhode Island, Wall st. J.,Aug.4,2011available at http://online.wsj.com/article/SB10001424053111903885604576486610528775994.html;AnActRelatingtoTownsandCities–IndebtednessofTownsandCities,ch.269,§1,2011R.I.Acts&Resolves1495-97(codifiedasamendedatR.I.Gen.Laws§ 45-12-1(2012));AnActRelatingtoTownsandCities–IndebtednessofTownsandCities,ch.277,§1,2011R.I.Acts&Resolves1519-21(codifiedatR.I.Gen.Laws§ 45-12-1(2012));Spiotto, supranote12,at35.

17 Onlyaliencreatedbyagreement,asecurityinterest,doesnotattachtofuturerevenuesunlesstherevenuesarededicatedtopaymentofaspecialrevenuebond.See11U.S.C.A.§§ 552(a),101(51),901,928(West,Westlawthrough2012).

18 11U.S.C.A.§ 941(West,Westlawthrough2012);H.R.Rep.No.95-595, supra note5,at399(“Section941givesthedebtortheexclusiverighttoproposeaplan,anddirectsthatthedebtorproposeoneeitherwiththepetitionorwithinsuchtimeasthecourtdirects.”);In re City of Stock-ton, 478B.R.8,13(Bankr.E.D.Cal.2012).

19 In re City of Stockton, 478B.R.at17-22(emphasisadded).20 Id.at19-20.21 U.S.Const.amend.X.22 PamelaA.Maclean,Sleepless in Stockton,cal. laWyeR,December2012,available at http://www.

callawyer.com/clstory.cfm?eid=926047.23 ClaytonP.Gillette,Fiscal Federalism, 79u. chi. l. Rev.281,282(2012).24 u.s. sec. & exch. comm’n, RepoRt on the municipal secuRities maRket41(July31,2012); see generally

JillianZvolensky, GASB: Making Public Pension Funding Information Clear and Comparable, 32Rev. oF Bank. & Fin. l.81,81(forthcoming2012-2013).

©2013 Thomson Reuters. This publication was created to provide you with accurate and authoritative information concern-ing the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. For subscription information, please visit www.West.Thomson.com.

Walter W. Miller Jr. is a professor of law at Boston University School of Law. The author gratefully acknowledges the contributions of Jenny Small (Class of 2013) and Kevin Frazier (Class of 2014). Both provided excellent research and many helpful suggestions. Special thanks to Jenny for both the quantity and quality of her research, her excellent organization thereof, and her textual comments. Additional thanks go to Maximilian Lee (Class of 2012) for his research on Chapter 9 while he was my research assistant.