A recent wave of high profile Chapter 9 bankruptcy filings by municipalities in California and elsewhere has heightened the concern of many bondholders and other parties involved in municipal credit markets about the potential negative impact of such filings on an issuer's municipal bond obligations. This year, the cities of Stockton and San Bernardino, Calif., have filed for bankruptcy, and several other large U.S. cities and counties are currently in bankruptcy or have recently emerged, including Jefferson County, Ala., and Vallejo, Calif. While a high level of municipal bond debt was a motivating factor in the bankruptcy filing by certain of these municipalities, a variety of other factors contributed to the financial woes of some, including a significant reduction in tax revenues, lower real estate values, underfunded pension plans, increased operating costs and fraud. Municipalities facing these problems routinely search for ways to restore financial stability, and Chapter 9 is increasingly being considered as a viable option. Whether it is the best option remains, in many cases, to be seen. For better or worse, however, the filing of bankruptcy by some very large cities and counties in the past few years may only help to embolden some municipalities to view the often significant political and public debt market implications of such a filing as risks they are willing to take.
Municipal bonds historically have been considered safe investments, but a municipality's payment obligations to bondholders can (in certain cases) be altered under a Chapter 9 plan of adjustment, even over the bondholders' dissent. The ability to reduce debt obligations or extend maturities is one reason why certain municipalities choose to seek relief under Chapter 9. Prior to filing, however, any prudent municipality will want to carefully consider all available alternatives and the potential ramifications of a filing, as bankruptcy will carry a stigma that can negatively impact the municipality and its surrounding communities even long after the entity emerges from Chapter 9.
There have been more than 250 municipal bankruptcy filings since 1980; however, many of these Chapter 9 filings were by smaller special districts and authorities. Municipal bankruptcy is still relatively unchartered waters for mid- to large-sized cities, counties, and towns, and many municipal officials and professionals are unfamiliar with its provisions and mechanics. Therefore, other financially-distressed municipalities are closely watching the several large recent Chapter 9 cases around the countryboth municipalities with currently pending cases, such as Jefferson County, Ala., and Stockton, Calif., and municipalities that have recently emerged from bankruptcy, such as Vallejo, Calif.in order to gauge whether Chapter 9 is a viable option for restoring financial stability and what effect Chapter 9 will have on the ability of the municipality to access the public debt markets (and obtain funding) in the future.
Points to Consider
One of the first considerations for a struggling municipality is whether a Chapter 9 filing is even possible. A municipality must satisfy certain statutory eligibility requirements to be a debtor under Chapter 9 of the Bankruptcy Code, including a requirement that it be specifically authorized to be a Chapter 9 debtor by state law or by a governmental officer or organization empowered by state law to authorize it to be a debtor under Chapter 9. Approximately half of the U.S. states expressly authorize municipalities within that state to be Chapter 9 debtors. Bankruptcy is not a viable option for municipalities in states that do not authorize such filings, and any petition filed by such municipalities likely will be dismissed by the bankruptcy court. This lesson was recently learned by the City of Harrisburg, Pa., whose Chapter 9 petition was dismissed by the bankruptcy court because the Commonwealth of Pennsylvania had previously enacted legislation prohibiting the city of Harrisburg and other financially distressed "cities of the third class" from filing for bankruptcy.1
If a municipality is eligible, there are certain characteristics of Chapter 9 that may make it appear to be an attractive option, including, as noted above, the ability to confirm a plan that adjusts debts. In addition, in contrast to Chapter 11, the limitation provided by the Tenth Amendment to the U.S. Constitution restricting the power of the federal government to, among other things, create and govern municipalities, means that, in a Chapter 9 case, the bankruptcy court has very little (if any) involvement with, or control over, the operation of a municipality, its political or governmental powers or its property or revenues. This freedom to operate in Chapter 9 without much bankruptcy court oversight may also make Chapter 9 an attractive option for some struggling municipalities. Eligible municipalities would be able to file and continue operating in the ordinary course while working towards a plan of adjustment of its debts that may seek to impair the rights of bondholders and other creditors.
The two primary types of bonds issued by municipalities are general obligation bonds and special revenue bonds. General obligation bonds are typically considered safe investments because they are backed by the full faith and credit of the issuer and are payable from general tax revenues and other income of the debtor. These bonds typically are not secured by a pledge of any specific revenue stream or other assets and, consequently, general obligation bondholders are generally treated as unsecured creditors in a Chapter 9 case. As unsecured creditors, such bondholders may be at risk in a municipal bankruptcy as a bankruptcy court can approve a Chapter 9 plan of adjustment that impairs the rights of general obligation bondholders.2 The city of Stockton, Calif., for example, has indicated publicly that debt reduction for its general obligation bondholders may be necessary as part of its Chapter 9 reorganization, and even proposed to bondholders during prepetition mediation more than $350 million in debt reductions. In addition, while secured bondholders in Vallejo, Calif.'s bankruptcy case were paid in full, holders of certain unsecured certificates of participation recovered only 65 percent of principal amounts owed to them.
Special revenue bonds are another form of debt issued by municipalities. The payment of such bonds often is secured by a pledge of a specific stream of incometypically a dedicated tax or revenues generated by a specific utility or projectand are typically nonrecourse in nature. Special revenue bonds also are considered very safe investments because, among other reasons, the underlying bond documents usually will contain a covenant by the issuer that the pledged revenues will be sufficient to meet debt service and a requirement that the issuer raise the applicable rates as necessary if actual revenues ultimately prove to be insufficient.
Chapter 9 preserves the protections that special revenue bonds provide to both bondholders and issuers. Chapter 9 specifically preserves (i) the bondholders' lien on and right to payment from special revenues, and (ii) the nonrecourse nature of the debt. A provision of the Bankruptcy Code applicable in Chapter 9 cases provides that special revenues acquired by the debtor after the commencement of the bankruptcy case remain subject to a prepetition pledge of such revenues, subject to the necessary operating expenses of the relevant project or system.3 This is in contrast to Chapter 11, where property acquired by the debtor post-petition generally is not subject to a prepetition lien.4 In addition, the automatic stay that goes into effect upon a bankruptcy filing does not apply in Chapter 9 to the application of pledged special revenues. Therefore, the revenues pledged as security can continue to be paid to bondholders during the bankruptcy case.
Despite these protections, holders of special revenue bonds are not immune to a municipality's attempts to modify or reduce debt service payments. The November 2011 Chapter 9 filing by Jefferson County, Ala., was driven, in large part, by the county's more than $3 billion in special revenue bonds issued in connection with its sewer system. During its Chapter 9 case, the county has sought to deduct and set aside funds from the gross revenues of the sewer system to provide for payment of professional fees and capital expenditures, as well as for depreciation and amortization. These deductions would have had the effect of reducing the amount of net revenues that are pledged to and available to pay bondholders. The county based its arguments on §928(b) of the Bankruptcy Code, which provides that a lien on special revenues derived from a project or system "shall be subject to the necessary operating expenses of such project or system, as the case may be."5 The bankruptcy court, however, ruled against the county, finding that the applicable bond documents did not permit the county to withhold such amounts from sewer revenues and that §928 does not provide for a different result.
Costs and Credit Ratings
A municipality in bankruptcy may face financial pressure to propose a Chapter 9 plan that involves modifications to its bond obligations. However, such modifications, if achievedand, potentially, even a public acknowledgement that a municipality is considering debt reductionsmay have significant adverse consequences for that municipality's credit ratings and ability to access the credit markets and borrow funds in the future. There also may be negative consequences for surrounding municipalities as credit agencies and borrowers may impute an unwillingness to pay by some municipalities onto others.
In October 2012, Standard & Poor's Rating Services (S&P) published an article expressing its views that a Chapter 9 filing will carry a long-lasting stigma that likely will impair the municipality's ability to access credit markets even after emerging from bankruptcy. S&P stated:
In our view, there are few actions that should carry greater stigma in the municipal credit markets than a bankruptcy filing. We believe any potential weakening of an obligor's willingness to pay its obligations may reflect degraded credit quality. Moreover, once a bankruptcy occurs, we anticipate the credit implications will remain after the municipality technically emerges from bankruptcy. Restoration of market access could be many years into the future.6