A wave of municipal bankruptcies in California and the two largest-ever Chapter 9 bankruptcy cases in Jefferson County, Alabama and Detroit, Michigan, have forced participants in the municipal finance market to reexamine some basic assumptions. In particular, the sanctity of municipal "general obligation" bonds, which are traditionally viewed as the gold standard of municipal obligations, is being reconsidered.
As recent cases have demonstrated, a municipality's general obligation pledge of its full faith and credit (and often taxing power), without more, may not be immune from challenge in bankruptcy, and municipal debtors have argued that their general obligation bonds should not even be treated as secured claims or otherwise granted priority of payment. To reduce bankruptcy risk, some states have recently enacted legislation granting "statutory lien" protection to certain municipal bonds. These statutes aim to ensure that bankruptcy courts treat bonds as secured claims. Yet risks remain, and are being compounded by misinformation regarding bankruptcy law's treatment of statutory liens. This article aims to reduce the confusion by clarifying statutory lienholders' rights.
Why Statutory Liens?
In bankruptcy, creditor claims are either unsecured or secured.A third category of municipal debt, known as special revenue debt, is beyond the scope of this article.) Unsecured claims are those that are unsupported by a lien or exceed the collateral's value. Unsecured claims often receive among the lowest recoveries. Secured claims are those that are supported by a lien. Creditors holding secured claims are generally entitled to receive at least the value of their collateral.
Yet not all secured claims are created equal. Bankruptcy "cuts off" consensual liens on the date the case is filed—they do not attach to revenues received by the debtor postpetition. Statutory liens are not cut off and continue to attach to postpetition revenues. This difference is critical in municipal bankruptcies because applicable law often forbids municipalities from pledging their physical assets. Municipalities therefore often pledge specified future revenues, such as property tax proceeds or state aid. If that pledge is in the form of a statutory lien, it continues to apply postpetition, leaving bondholders relatively protected. If the pledge is consensual, i.e. created by contract rather than statute, it is "cut off," leaving bondholders secured only by pledged funds already on hand when the case is commenced. Statutory lien-based claims are thus superior to unsecured claims and claims secured by a consensual lien.
California: Statutory Liens for GO Bonds
In response to recent Chapter 9 cases, on July 13, 2015, California enacted Senate Bill 222, which declares that all general obligation bonds issued by California municipalities are protected by a statutory lien on future ad valorem property tax revenues. Once SB 222 takes effect on January 1, 2016, new GO Bonds issued by California municipalities indisputably will be secured by a statutory lien, which should preempt the sort of litigation that clouded the status of many of Detroit's GO Bonds. Unfortunately, SB 222 is ambiguous as to whether it affects preexisting GO Bonds. If it is a mere "clarification" to current law then preexisting GO Bonds should receive its benefits. If SB 222 is a new protection, preexisting GO Bonds may be treated as unsecured. Expect litigation on that point if SB 222 is not clarified.
New Jersey: Statutory Liens for Bonds Secured by Certain Funds from the State
On Aug. 10, 2015, New Jersey quietly enacted its own statutory lien bill. Rather than targeting GO Bonds, the New Jersey law grants statutory liens to certain municipal bonds that were already "secured" by a pledge of State aid revenues appropriated for local municipalities. As with California's SB 222, the statutory lien automatically arises and is perfected without further action. Moreover, in an improvement over SB 222, New Jersey's law "appl[ies] to all qualified bonds whether issued prior to or following enactment of that act." That unambiguous retroactivity clause should prevent disputes over whether preexisting bonds are secured.
Market Confusion
Unfortunately, the treatment of statutory lien obligations in bankruptcy is often misunderstood or misreported. For example, in an August 6, 2015 report, Moody's declared that statutory lien "debt service could not be stayed" by bankruptcy. As a result, Moody's suggested that bankruptcy would not shield a municipality facing statutory lien obligations. In adopting SB 222, California went even further, declaring that "GO bonds backed by statutory liens are secured claims meaning they cannot be altered."
Both claims are incorrect. Statutory lien obligations are like any other secured debt except that the lien continues to attach to postpetition revenues. As Fitch noted in a special report dated July 16, 2015, "[r]evenues supported by a statutory lien are not free from the automatic stay of a municipality's general revenues once bankruptcy proceedings begin." Although some municipal debtors choose to pay statutory lien debts during bankruptcy, that outcome is not dictated by the Bankruptcy Code. Nor does secured status guaranty non-impairment—only that bondholders will receive at least the (often disputed) value of their collateral or the indubitable equivalent of their claims.
Fitch's statutory lien analysis is also flawed, including its conclusion that a "statutory lien does not reduce default risk relative to unsecured general obligation debt." As Fitch concedes, bondholders must be provided with "adequate protection" before revenues subject to their statutory lien are diverted. Providing adequate protection with respect to a municipal revenue stream may prove impossible, meaning that a municipality with statutory lien debt could be left to choose between diverting but not spending the revenues or paying bondholders as scheduled. Thus, statutory lien debt is often paid when other debts default.
Takeaway: A Strong Protection, But Not Infallible
Bondholders should neither take too much, nor too little comfort in statutory liens. They do not guaranty timely or complete payment in bankruptcy. They do, however, enhance the likelihood of timely payment in full. While a statutory lien is not a perfect protection, it is vastly better to have one than to not. States enacting statutory lien legislation should therefore be applauded for clarifying bondholders' rights and limiting municipal bankruptcy uncertainty, but should go further still. California should amend SB 222 to clarify that it protects preexisting GO bonds. New Jersey should expand the protections of its well-crafted statutory lien legislation to other types of bonds, including GO bonds. Other states should follow their lead.
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Lawrence Larose is a partner in Chadbourne & Parke's Bankruptcy and Financial Restructuring practice in the firm's New York office. He leads the firm's municipal restructuring practice and represents major creditors in virtually every major municipal restructuring in recent memory, both in and out of court. Eric Daucher is an associate in the practice, and focuses on representations in complex-cross border insolvency matters, municipal restructurings, and various bankruptcy litigation matters and related appeals. The views expressed in this article are the authors' own, and do not represent the views of Chadbourne & Park or its clients.
