The 1st Circuit U.S. appeals court sent shudders through the municipal market in March, when it ruled that Puerto Rico highway bonds' revenue pledge can be set aside in a bankruptcy-like proceeding.
That any payment should be considered voluntary contravenes the development of thinking on municipal bankruptcy that has been expanding since the 1970s. The legal argument made against the treatment of revenue bonds just does not make sense in the market-based world that relies on revenue pledges.
The battle of Winterfell might appear to be a small skirmish when compared with what may unfold in the revenue bond arena.
The Dean of Municipal Bankruptcy, James Spiotto, has weighed in on these matters in a Municipal Finance Journal article, "The History and Justification for Timely Payment of Statutory Liens and Pledged Special Revenue Bond Financing in a Chapter 9 Municipal Debt Adjustment Proceeding: Is a Model State Law Necessary or Required?"
Besides taking the award for the longest title I have ever read for a 50-page paper, there is a cornucopia of knowledge and wisdom in it.
This report is a must read for any serious student of municipals and of municipal bankruptcy. I lived through many of the cases that Spiotto discusses in support of his thesis. One conclusion is that nothing is certain in a default and/or bankruptcy scenario. However, when it comes to the payment of revenue bonds in a distressed or bankrupt scenario, this matter was supposed to be clarified some time ago.
The bankruptcy code amendments that were passed in 1988 were crafted with several key points in mind. Not long before the adoption that Detroit’s general obligation bonds were non-investment grade and the water and sewer revenue bonds were in the A category, the concern in the market was that if the GOs were to founder,would it be possible to divert the revenue streams on the revenue bonds to pay the GO bondholders. It had become generally accepted wisdom that after the 1988 Amendments, the revenues pledged to said revenue bonds would continue to flow unimpeded to the revenue bondholders.
That is until now.
In scholarly style, Spiotto explains the current scenario in a succinct conclusion: “The Court of Appeals’ interpretation of this language as not requiring ongoing payments during a Chapter 9 case appears to be based upon the use of corporate bankruptcy law to interpret municipal issues, not municipal law principles. The purpose of the 1988 Amendments was to avoid this result.”
He goes on to argue that special revenues should not be subject to the automatic stay.
All of this reasoning has been arrived at after the arduous road of bankruptcies over the last half century. So as not to lean on the 1988 Amendments too much, Spiotto takes us back to what the Founders intended in the Constitution.
You see it comes down to sovereign powers and state sovereignty.
States retain powers over their own affairs, and localities are subject to state law. If under state law it is deemed that payments must be made, the federal government may not interfere. The one reservation that I have is that a clever legal mind, constitutional or otherwise, may find a way to challenge this premise.
Credit practitioners need to appreciate and understand the intent of the law. Many other premises and evaluations are layered on top of this fundamental principle. If I have a revenue bond and I have a first lien on the revenue stream supporting that bond, I need to comprehend and rely on the fact that the flow and the payment should not be interrupted as long as there are revenues to be had. Otherwise, how could bond ratings be assigned to revenue bonds with any high degree of reliance?
Many in the marketplace share the conviction that the First Circuit court ruling needs to be reconsidered and overturned. There is also a hope that the Supreme Court may decide to review the case. The latter is not a foregone conclusion and the earliest time frame for such a review would be near the end of the year.
As another practical approach, Spiotto argues that the states should adopt a Model Statute that should clear up any ambiguity about the payment of revenue bonds with independent revenue streams in a bankruptcy scenario. He includes sample language in the article in draft form that would serve this purpose. One would expect that if a state were to take such a step, said state would adapt the Model Statute to conform with state law in that jurisdiction.
The topic of the payment of Special Revenue bonds has become important enough to be a feature at our Bond Buyer conferences. There is great consternation in the land about this ruling whether it is good law or not. I believe the general market has not overreacted because the Puerto Rico case is still not viewed as core event to the mainstream municipal market.
However, Spiotto and I share the view that the recent rulings could metastasize into the general market if left unaddressed. In that scenario, extra reassurances, legal and otherwise, would be necessary in the daily functioning of the municipal market. In the last year, just less than two thirds of the bonds that came to market were revenue bonds. The ruling is no small matter.
Spiotto is right to raise our awareness and cause alarm in the municipal market, and I am grateful that he is sharing his beliefs. I am not alone.
