CHICAGO — The stark political divisions around the idea of allowing Chapter 9 bankruptcy in Illinois were highlighted at a recent legislative hearing.
Illinois lacks a general Chapter 9 municipal bankruptcy statute but Gov. Bruce Rauner has proposed adding such a provision to state law as part of a sweeping local government and state pension overhaul bill unveiled in July.
The debate in a Springfield committee room was polarized, with advocates saying Chapter 9 would offer distressed local governments a lifeline back to fiscal health and skeptics calling it an end run around labor contracts.
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In what is viewed as a favorable provision for bondholders, the Local Government Bankruptcy Neutral Evaluation Act would offer them a statutory lien for general obligation and revenue bonds on property taxes collected, or the debt's pledged revenues. The lien would automatically attach from the time of the pledge with no further action needed and is "valid and binding" from the time of issuance, the proposed legislation says.
With such a statutory lien provision in place "you are making the purpose of the Chapter 9 for one singular purpose…to visit it upon labor," said William Brandt, the former board chairman of the Illinois Finance Authority and the longtime owner of corporate and municipal restructuring advisory businesses. The sole purpose is the "rejection of labor contracts," he said.
Brandt likes the idea of a statutory lien protection offered outside Chapter 9 but made clear at a hearing late last month his general distaste for municipal bankruptcy.
"Its bad public policy — horrible public policy and it defeats the purpose of the relationship of government to its citizen when there are so many other vehicles we can use," Brandt told lawmakers. "I'm a great believer in alternatives to Chapter 9."
Brandt's testimony came during an Aug. 25 hearing of the House Pension and Personnel Committee called by chairwoman Elaine Nekritz, D-Northbrook, to dissect the various pieces of Rauner's pension proposal.
While the Chapter 9 bill has been the subject of sometimes spirited hearings, it has gained little traction as the General Assembly's Democratic majority views it as one in a series of Rauner initiatives aimed at harming labor. The Republican governor also wants to allow local governments to curb collective bargaining requirements, arguing both measures would give local governments the tools needed to better manage their finances.
In addition to Brandt's testimony, the committee heard from Brad Erens, a partner in the Chicago office of Jones Day, the firm that handled Detroit's historic Chapter 9.
"It's critically important that it be very seriously considered today, not tomorrow, whether the bankruptcy option should be available," Erens told lawmakers.
Erens said the discussion is especially pertinent given the state's own fiscal difficulties. The state is locked in a budget impasse driven by political divisions between the freshman governor and legislative Democrats.
Insolvent local governments are left to cut critical services or raise taxes if bankruptcy is not an option and "the state is really in no position to help out these municipalities," Erens said. Their problems will only worsen if a recession strikes, he said.
Citing Detroit's experience, Erens called Chapter 9 a "godsend" as it trimmed $7 billion of the city's obligations and freed up funds for reinvestment. He also highlighted Detroit's recent return to the bond market, its first since exiting Chapter 9 late last year, saying it showed that Chapter 9 doesn't prevent future access. The deal, however, was floated with the help of new state-approved bondholder protections that included new statutory lien and trust provisions to elevate the deal above the city's deep speculative grade ratings.
"The idea of this bill is to get people talking about resolution to real financial problems" providing municipalities "a tool in the toolbox," state Rep. Ron Sandack, R-Downers Grove, said in defense of the proposal. Sandack has introduced a Chapter 9 bill and it was the subject of a legislative hearing earlier this year. He later amended it to include a similar statutory lien provision.
Debate during the hearing also turned to the already higher interest costs being paid by local governments due to the state's fiscal troubles and whether giving bondholders a statutory lien could bring down that penalty.
The market has long assessed what's known as the "Illinois effect" or "Illinois penalty" that can range from 25 to 100 basis points for even high-grade paper from local governments with little exposure to the state's struggles.
"We're paying a penalty for the public crisis that we have in finances" at the state level, said State Rep. Jeanne Ives, R-Wheaton, adding she's been advised that the addition of a statutory lien to state books could cut local government borrowing penalties in half.
Erens told Ives he thinks putting such a lien provision in state law could help. "Bondholders would know if there were a bankruptcy they would be paid in full," so they would demand lower interest costs, he said.
The debate adds to the attention statutory liens have received across the country following Chapter 9 bankruptcies in California and Detroit and legislative efforts to protect bondholders. Fitch Ratings recently warned that despite its growing use in U.S. municipal debt, the presence of a statutory lien will not enhance a municipality's debt rating.
"While the presence of the statutory lien will enhance a creditor's post-default recovery prospects, it doesn't avoid the interruption of payment upon a bankruptcy filing by a municipality," said analyst Thomas McCormick. "The simple reason is that in a bankruptcy scenario, the pledged tax revenue could be subject to interruption and default would be likely."
Brandt suggested Chapter 9 is little more than a cop-out in the absence of political will.
"If you can't make the tough decisions, you file a Chapter 9," he said, endorsing intervention efforts that aid a struggling local government with an "active strategy long before you get to a reactive strategy of a Chapter 9."
Erens said local governments won't rush into Chapter 9 given the pains it inflicts and, while supporting a some neutral evaluation process, cautioned against adding too many "layers to bureaucracy" in the process.
During the previous hearing on the Sandack bill, the Civic Federation of Chicago pressed for a model developed by municipal restructuring expert James Spiotto to create an authority to intervene before a government's fiscal strains reach crisis stage.
The quasi-judicial authority would help local governments deal with pension-related and other fiscal burdens threatening their solvency in an attempt to put the government on a sustainable path that avoids default or bankruptcy.
Several existing laws on the state books including the Financial Distressed City Act allow state intervention but it must be sought by the municipality. Ives suggested that existing laws fall short, citing impoverished East St. Louis which has emerged from two decades of state oversight but continues to struggle with deficits.
Illinois law only permits a Chapter 9 filing for the Illinois Power Agency. Currently, 12 states with Chapter 9 statutes require a second look by a governing body like the state. Another 12 states don't require an additional layer of review, according to research by Spiotto.
Two states prohibit local governments from filing bankruptcy and 21 states are either unclear or do not have a specific law, while three states allow it under very limited circumstances, as Illinois does.
While the use of Chapter 9 and the quality of securities and pledges have come under heightened attention from investors, municipal bankruptcy filings remain rare with fewer than 500 filings occurring since its inception in 1934, Nuveen Asset Management LLC said in an August report on Chapter 9. In 2014, 10 municipalities filed for Chapter 9 and so far this year two special districts and one city have filed.
Recent bankruptcies highlight the importance of understanding security pledges, says the report authored by research analysts Kristen DeJong and Beth Dougherty, noting that not all GOs are equal.
"In some states, general obligation bonds are secured by a statutory lien on a dedicated property tax, which could survive a bankruptcy unimpaired," the authors write. "However, ultimately creditor recoveries vary from case to case and depend in part on municipality's willingness to pay."
With issuers in the driving seat on crafting a restructuring plan, Nuveen says it's difficult to predict outcomes for various creditor classes especially with so few filings actually being litigated. "Fundamental credit research of distressed municipalities must be done on a case-by-case basis when looking for value in this market," the authors wrote.
