PHOENIX — California Gov. Jerry Brown has signed a new law securing revenues for general obligation bonds issued by local governments — a move designed to protect bondholders in a bankruptcy proceeding. But rating agencies have mixed feelings about whether it will be of much benefit to holders of local GOs in the nation's most populous state.
The law, known as SB 222, is designed to preserve bondholder rights to the tax revenues used to back bonds, which are received by a municipality after it enters bankruptcy proceedings. The bankruptcy code defines statutory liens like those mandated under SB 222 as created by force of law, as opposed to typical consensual liens that are created by an agreement. "Secured" creditors of a bankrupt municipality are supposed to be first in line to recover their money, but California law was previously silent on whether local GOs were "secured" for that purpose. The new law removes that ambiguity.
"Many have argued that the taxes levied to pay California GO bonds are 'special revenues' under the bankruptcy code, but this analysis has never been certain," said Orrick, Herrington & Sutcliffe attorney John Palmer, who drafted SB 222. "This is the first time we have been able to say that GO bondholders are secured creditors in a municipal bankruptcy. Being a secured creditor in bankruptcy dramatically decreases the risk of nonpayment. This newfound certainty should permit investors and rating agencies to focus more narrowly on the tax-base as the credit for California GO bonds, and less heavily on issuers' general funds."
State Sen. Mary Block, D-San Diego, introduced the bill earlier this year. It passed through both the Assembly and the Senate with strong support last month. The new law, which becomes effective on Jan. 1, is very similar to legislation enacted in Rhode Island in 2011 after Central Falls filed for Chapter 9 protection. California has been home to some high-profile bankruptcy proceedings, including the cities of Stockton, which emerged from Chapter 9 earlier this year, and San Bernardino, which has not yet completed the process.
Moody's Investors Service was upbeat about the implications for holders of bonds sold by California issuers.
"Generally speaking, the security for California local government GO bonds is a dedicated, unlimited, voter-approved property tax levy, the proceeds of which cannot be used for any purpose other than the bonds authorized by voters," Moody's analysts wrote. "The California Constitution makes the debt service levy separate from the property tax levied for operating purposes. State statute is nonetheless silent on whether GO investors would be secured in the event of a local government's bankruptcy filing, and case law on this matter is also very limited. The new law is positive for GO investors because it clearly establishes their secured status."
Although Moody's views the bill as a credit positive, the agency said it would not likely have a "material effect" on the ratings of California local GOs.
Fitch Ratings analysts had a conservative take on the law.
"Revenues supported by a statutory lien are not free from the automatic stay of a municipality's general revenues once bankruptcy proceedings begin," Fitch said. "Rather, the statutory lien prevents the municipality in a bankruptcy from generally diverting the revenues subject to the statutory lien. The statutory lien does not prevent use of the revenues in the bankruptcy process as long as adequate protection for recovery is offered to bondholders benefiting from the statutory lien. These protections will not guarantee full or timely repayment, only potentially higher recovery."
Palmer said that agencies no longer having to look as closely at general funds due to the assurance of a statutory lien on revenues could be a big positive for issuers paying too much because of general fund weaknesses.
"This would potentially save taxpayers billions of dollars over the time," he said.
