Having a statutory lien does not exempt municipal debt secured by the lien from the impact of the automatic stay under the Bankruptcy Code. This means that payments on that debt can in fact be interrupted when the municipality initiates a bankruptcy proceeding.
This point was acknowledged in a recent Bond Buyer op-ed ("Learning the Lessons of Chapter 9" by attorney Lawrence Larose).
Fitch has acknowledged that proposals to add a statutory lien can boost recoveries for the benefited debt and suggests a framework that intends to be supportive of bondholder claims. However, in many such proposals, the missing protection is the ability to avoid the automatic stay provisions of the Chapter 9 Bankruptcy Code.
The choice to pay or not pay debt secured by a statutory lien when bankruptcy commences is entirely in the control of the municipal debtor. In fact, the bankruptcy court is specifically limited in its power to order the municipality to use its revenues for one purpose or another.
As the bankruptcy of Central Falls, R.I., demonstrates, timely payment is certainly one possible outcome. But it is an outcome that remains the debtor's choice. It is not an outcome directed by anything in the bankruptcy code, nor one that can be controlled by the bondholders.
It is also within the power of the municipality to choose other options. Influenced by the more aggressive posture used in the Detroit bankruptcy, the debtor could delay payments, hope to gain leverage and seek to secure a haircut to recovery on a theory of "shared sacrifice". Yet another option available to the debtor is to use revenues that are subject to a stay, including those under a statutory lien, to secure post-petition financing (similar to so-called DIP financings) in the bankruptcy proceedings.
Mr. Larose appears to give too much weight to the application of adequate protection in the proceeding. He incorrectly concludes that Fitch's statutory lien analysis is "flawed" when we note that a statutory lien cannot on its own separate risk of nonpayment from the general obligation rating of a municipality. Adequate protection is intended to offer strong recovery prospects by preserving value. Adequate protection does not assure timely payments to debt holders. Mr. Larose acknowledges this fact when he writes "[b]ondholders should neither take too much, nor too little comfort in statutory liens. They do not guaranty timely or complete payment in bankruptcy."
How a municipality might choose among its options cannot be known until the bankruptcy proceedings commence. The debtor's power of choice is the risk to bondholders. Bondholders secured by a statutory lien may have to wait awhile to be paid, although their recovery prospects will be relatively better than those of the holders of general obligation debt.
Timeliness is the focus of Fitch's default risk ratings, not the potential for ultimate recovery after a period of disruption. A Fitch rating of a municipal debt instrument measures the likelihood of both full and timely payment of debt service without interruption. The best measure of the risk that a security's payment may be interrupted due to the automatic stay is the general obligation rating of a municipality.
Fitch is pleased that Chadbourne and Parke agrees with our legal analysis and conclusion that a statutory lien does not assure timely payment. We must disagree with their suggested approach to rating default risk on municipal debt.
