… federal bankruptcy legislation did not include a means of handling municipal insolvency and debt adjustment prior to 1934. During the Great Depression, however, there was widespread nonpayment of property taxes, which municipalities depended upon to fund government services. (It would probably be useful here to describe how different mortgage products were back then from what they are now, but I’ll spare you.) From 1929 to 1937, there were over 4,700 municipal defaults. Bondholders did exactly what I described in my prior post: they obtained writs of mandamus from the courts for levies of further taxes. Given the magnitude of defaults, it is not difficult to imagine the chaos that ensued.
Emergency legislation was introduced to protect municipalities from protracted disputes with creditors that could interfere with the provision of essential government services. This legislation was intended to be temporary and would have expired in 1940. It did not survive that long. In 1936, the US Supreme Court ruled that the legislation was unconstitutional because it gave the federal court some control over an insolvent municipality’s administration and revenues (Ashton v. Cameron County Water Improvement District No. 1). The10th Amendment grants states sovereign powers, which extend to their political subdivisions. Predictably, things returned to chaos in the wake of the court’s decision.
New legislation was introduced in 1937 that addressed the court’s concerns with respect to state sovereignty. In its new form, the legislation provided “(1) no interference with the fiscal or governmental affairs of political subdivisions; (2) a limitation on the protection of bankruptcy to the taxing agency itself; (3) no involuntary proceedings; (4) no judicial control or jurisdiction over property and revenues of the petitioning agency necessary for governmental purposes; and (5) no impairment of contractual obligations by states” (Spiotto). The revised legislation was similarly challenged and upheld by the US Supreme Court (United States v. Bekins). This legislation also included a sunset provision, which was repealed in 1946. The Chapter 9 process that is in place today is this legislation with some subsequent amendments.
It is necessary to start with the legislative history of Chapter 9 in order to make the point that municipal bankruptcy is quite different in both form and substance from corporate bankruptcy. Many people mistakenly assume that Chapter 9 is akin to Chapter 11, and this assumption leads them to believe that filing for bankruptcy is a far more convenient option for a distressed municipality than it is in reality. There are very good reasons why Chapter 9 filings are extraordinarily rare, but you do have to understand what you are talking about in order to recognize them.
Why even bother?
John Knox and Marc Levinson (Orrick, Herrington & Sutcliffe) published a paper last year that discusses under what circumstances municipalities might consider filing for bankruptcy and the eligibility criteria. There are three main reasons municipalities file for bankruptcy. First, “filing a bankruptcy petition invokes an automatic stay – basically a federal court injunction – against any action that could otherwise be taken against the municipality … or its officers and employees.” The automatic stay gives officials some breathing room from creditors and other stakeholders in the municipality’s fiscal situation, thereby allowing officials to address the municipality’s policy and cash flow problems in a comprehensive way, not piece-by-piece in court. Second, although the judge has limited powers in the Chapter 9 process, federal bankruptcy judges are experienced arbiters and may be able to broker an agreement that would not come about absent adult supervision. Third (and most importantly), Chapter 9 provides municipalities a means for adjusting their obligations by reducing, extending, or restructuring their debts.
Knox and Levinson also mention several disadvantages to filing for Chapter 9. The first disadvantage is that the credit markets will have an immediate negative reaction (obviously). The municipality’s credit ratings will be downgraded or suspended. (This is also a material event that requires disclosure.) Vendors may cut off credit (e.g., delayed billing arrangements) or demand prepayment for services, making regular operations challenging. The municipality’s perceived creditworthiness is likely to suffer for a number of years, with some notable exceptions (like Orange County, CA).
The second disadvantage is that Chapter 9 bankruptcy filings come with steep real and opportunity costs. The City of Vallejo, CA, for example, has been stuck in bankruptcy since May 2008. According to the Bond Buyer,the city has spent $9 million responding to 825 court filings (so far), mainly because the unions have contested nearly every aspect of the proceedings (which are hopefully near some sort of resolution at this point). To put this amount into perspective, the city currently has an $82 million budget deficit. Furthermore, “the distraction of dealing with a bankruptcy case – preparing for and attending hearings and depositions, responding to endless requests for information and documents from creditors, rating agencies, collective bargaining units, elected officials and the public – can be a major distraction from the core work the staff must do to keep the organization functioning” (Orrick). (This is one reason many states have their own processes for dealing with distressed municipalities. As with Harrisburg entering into Pennsylvania’s Act 47 program last week, municipalities can receive help from state officials and specially-appointed financial advisors in working through these issues. This also brings higher political influences to bear on the problems, which could potentially expedite a resolution.)
A third disadvantage is that there is a stigma on the community for years. Businesses do not want to relocate to politically dysfunctional communities. Residents tend to vote with their feet. Real estate values may decrease. To the extent that these affect tax revenues going forward, the bankruptcy filing may only draw out the municipality’s financial woes.
Eligibility
To be eligible to file for Chapter 9, the municipality must meet several criteria. First, the entity must meet the definition of a municipality, which includes cities, counties, and other instrumentalities of the state, but excludes the state itself. There has been something of a trend (for want of a better word) of financing projects that address a public concern (e.g., transportation infrastructure or sports facilities) through what are theoretically bankruptcy-remote entities, and this appears (to me, at least) to be testing the legal definition of a municipality. The number and scale of these projects and the associated risks is difficult to quantify (although it can certainly be said that such projects comprise a relatively small fraction of the overall market), the latter especially since the projects tend to be politically loaded once they become financially distressed. The instances where these projects have tested the bankruptcy process involved state or local government officials orphaning what one might characterize as political boondoggles (made possible largely because of lax standards with feasibility studies). Thus far, these legal structures do seem to have served their purpose – which is to give the government the opportunity to decide the nature of its involvement in an independently financed project’s fate.
Ambac, for example, unsuccessfully challenged the Las Vegas Monorail Company’s Chapter 11 filing on the grounds that the LVMC was actually a municipality. The LVMC bonds were issued by the state on a conduit basis, and Ambac saw this challenge as an opportunity to limit the insurer’s billion-dollar-or-so exposure to defaulted LVMC bonds.
South Carolina challenged the Connector 2000 Association’s Chapter 9 filing, arguing that the toll road operator could not be considered a municipality. State transportation officials did not want taxpayers to be stuck with the toll road’s maintenance costs just so bondholders could recoup a larger fraction of their investment (or derive a higher profit from speculating on a distressed credit). So far, this case has not been resolved. In an attempt to appease the state, the association’s proposed debt exchange gives the state a higher place in the waterfall of toll revenues, so some funds will go to the Department of Transportation to offset maintenance costs before they flow to bondholders. A hearing on the state’s challenge to the case has been stayed on account of the proposed debt restructuring, to which bondholders and the bankruptcy court would have to agree.
Second, state law must specifically authorize the municipality to file for bankruptcy under Chapter 9. Currently, 23 states do not provide the requisite statutory authorization for municipalities to file for bankruptcy. (I can list them for anyone who is keeping score.) Municipalities in these states would need to seek legislative action before they could file, which is a considerable hurdle. Georgia specifically prohibits its municipalities from filing. Furthermore, according to Vinson & Elkins, “some other states have such rigid requirements with respect to public debt that filing for bankruptcy under Chapter 9 is effectively impossible. Kansas, for example, requires its political subdivisions to operate on a cash-only basis, so filing for bankruptcy is a virtual impossibility. [I’ll explain this momentarily.] Massachusetts requires that if a municipality is unable to pay its debts, the municipality must notify the Commissioner of Revenue to investigate the situation, and then the State Treasurer will pay the debt, to be reimbursed with money that would otherwise be payable from the state to the municipality. [This is generally referred to as an “intercept” program.]” Many other states have their own programs or provisions for dealing with distressed municipalities independently of Chapter 9. (Basically, if you are waiting for a wave of municipal bankruptcies, I would not hold your breath.)
Third, the municipality must meet the definition of insolvency, which means “the municipality either must not be paying its undisputed debts as they come due at the time of the filing, or must be unable to pay such debts when they become due in the future. The latter test is a prospective, but must be based on a projection of the current or immediately ensuing fiscal year. A projection that the municipality will not be able to meet its obligations in subsequent years is not sufficient to establish insolvency” (Orrick). The definition of insolvency as it relates to governments seems to be a significant source of confusion as people have started to care more (or at all) about public finance. For example, I have seen many people (even government officials) argue that a government is insolvent because it has a relatively low pension funding ratio. This is incorrect; there is not a balance sheet test for solvency under Chapter 9.
Fourth, the municipality has to “desire to effect a plan to adjust its debts,” which is another way of saying that the municipality has to file for bankruptcy voluntarily (as demonstrated by a resolution or ordinance that is adopted by the governing body). (It is worth noting that a municipality can be involuntarily compelled to address its financial obligations by the state or bondholders in a state court – i.e., outside the Chapter 9 process. For example, in September, an Alabama judge placed the Jefferson County sewer system into receivership at the request of the Bank of New York Mellon, the trustee on the bonds, who represents bondholders – mainly JP Morgan, which got the county into financial trouble in the first place, Bank of America, and several other banks. The receiver has the authority to raise sewer rates, although that might not be especially useful seeing as how the county’s rates are already higher than those in most major US cities.)
Finally, the municipality has to be able to demonstrate that it has attempted to negotiate in good faith with creditors, or that such negotiations are impractical (e.g., there are too many different creditors involved, or the creditors cannot be identified).
How Chapter 9 is different than Chapter 11 in practice
According to Knox and Levinson, “in Chapter 11 cases (which municipalities are ineligible to file), the bankruptcy judge wields significant power to control what the debtor may and may not do during the course of the case. For example, without court approval, any proposed action by the debtor outside the ordinary course of business must be approved by the court after creditors and other parties in interest have been provided with the opportunity to object. Nor may the debtor borrow funds outside the ordinary course of business, grant collateral for a new loan or settle a significant claim against it absent court approval.” This does not apply in Chapter 9. Oddly enough, a municipality in Chapter 9 may borrow additional funds for administrative expenses, and the loans made to a Chapter 9 municipality will be given a higher priority than the funds borrowed before the Chapter 9 petition was filed (with the exception of special revenues, which are discussed later). This provision allows an insolvent municipality to continue to function as a municipality. The court also cannot throw out elected officials or override voter limitations on new taxation.
The primary difference between public and private bankruptcies, however, is that a municipality cannot be forcefully liquidated: “if a private firm files for bankruptcy under Chapter 11 seeking to reorganize and thus continue to operate, but it fails to achieve that objective, the case will likely be converted to a liquidation case under Chapter 7 … a trustee is appointed, and is charged with liquidating all assets for the benefit of creditors, who go away with whatever share they can receive. Assets are sold or foreclosed upon, the entity no longer operates, and it ceases to conduct business” (Orrick). Governments, on the other hand, exist in perpetuity, and their assets serve a purpose pursuant to a social contract (i.e., there is more to this situation than a financial relationship).
Because there is no imminent threat of liquidation, Chapter 9 bankruptcy cases can drag on and on forever and even ultimately remain unresolved. This is a major incentive for the municipality to strive for a negotiated agreement with creditors outside the courts (or for state officials to step in to assist a distressed municipality).
Claim type and creditor treatment
Muni bondholders are treated differently in a Chapter 9 bankruptcy according to the source of repayment on the bonds. General obligation (GO) bonds “are treated as general unsecured debt under Chapter 9, which means that the municipality is not required to make payments of principal and interest during a Chapter 9 case. GOs are also subject to restructuring under the plan of adjustment” (Vinson & Elkins). This is not the case for revenue bonds, which “continue to be secured by such revenues during a Chapter 9 case, requiring the continued application of such revenues to the repayment of the secured debt” (Vinson & Elkins). (Even at the state level, where Chapter 9 does not apply, there are examples of a preference for a specific revenue pledge over a GO pledge. For example, Bloomberg recently reported that Massachusetts was able to cut the spread on its last issue by 10 bps, during a week with considerable supply pressure, because investors liked the pledge of motor-vehicle fuel and registration fees. This has not been the case with GO bonds in the market – note that Massachusetts itself has a high Aa1 credit rating. An institutional investor interviewed for the article seemed to be surprised by this development and attributed it to headline risk, but it does mesh with my discussion of pledges in the previous post.)
A commenter on the previous post mentioned that there are many muni market issuers that are isolated from state and local government fiscal stress. This observation is true even through the bankruptcy process because Chapter 9 protects “special revenues.” Many governments have separate units (such as public utility systems) that are funded by users through service fees and finance capital projects through debt supported by those fees. According to Orrick, “the Bankruptcy Code … provides that those special revenues may not be diverted to pay the debts of the municipality that are unrelated to the system or enterprise that generated them … in many jurisdictions, this also is the result under state law, which restricts the use of such revenues to the enterprise itself.” (Tax increment financing agreements are also treated as special revenues and cannot be diverted in a bankruptcy case. TIF bonds can still be very risky transactions, however.)
Chapter 9 allows a municipality to assume its favorable contracts and real and personal property leases and reject unfavorable ones. According to Orrick, however, “neither is automatic … to assume a contract or lease, absent consent by the nondebtor party, the municipality must cure all monetary defaults and provide adequate assurance that it will be able to perform on the contract in the future.”
Collective bargaining agreements are also subject to assumption / rejection, but they are more difficult to address than other financial commitments. According to Orrick, the US Supreme Court has placed extra burdens on the rejection of collective bargaining agreements, which include “mandating that the bankruptcy court balance the hardships employees would suffer as a result of rejection of the agreements against the benefits to the municipality for rejecting those agreements. The court must also conclude that the municipality employed reasonable efforts to resolve contract issues short of rejection, and that a prompt resolution would not be forthcoming.”
Some final thoughts…
I hope that providing this background information has been a productive exercise for everyone involved. If you take anything away from reading this series, I hope it is an appreciation that default and bankruptcy are far more subtle matters than most mainstream commentary (e.g., the NYT and 60 Minutes) have made them out to be. Commentary that fails to distinguish between public and private debt, types of bonds, types of security, debt structure and management, etc. is not going to be particularly useful to an investor. (I also think it is reckless and irresponsible that no one in the media asks people making inflammatory remarks to defend their claims quantitatively, rather than treating them like the Oracle of Delphi, especially when scores of extremely well-informed market participants hold the opposite position, but I digress.) Beyond that, I hope people come to recognize that government borrowers have absolutely no economic or political incentive to repudiate their debts and that most of the commentary on this topic has confused actual default risk with policy issues and the attendant political posturing. It has been nice to see some sanity surface in the financial media on this topic (column by Joe Mysak, for example). I hope it catches on.
Self-Evident.org – byBONDGIRL