Fiscal Distress Myths and Realities Part VI: Types of Public Debt Honored in Full in Chapter 9

Part VI of James Spiotto’s Series on Fiscal Distress Myths & Realities:

Public Debt That Has A Pledge of Special Revenues or Statutory Liens is to be Unimpaired in Chapter 9 Bankruptcy and is to Have the Benefit of the Bargain Honored in Full

Myth: All Municipal Bank Debt is Adjusted and Adversely Affected in Chapter 9 Municipal Bankruptcy

Reality: The Pledge of Payment on Statutory Liens and Special Revenue Bonds is Intended to be Unimpaired and Not Adversely Affected in a Chapter 9 Municipal Bankruptcy

What is a Statutory Lien or a Special Revenue Pledge:

Basic Provisions for a Statutory Lien. Generally, the statute from which the statutory lien arises:

Contains language such that the force and effect of the statute creates the interest in the dedicated revenues or proceeds to pay the debt without need of further action by the issuing governmental entity.
May also provide for the priority of payment, a first lien or provision that the dedicated pledged revenues can only be used to pay the debt or in the order specified in the statute or authorizing documents.
May also provide an intercept or segregation of the revenues or require a governmental entity or officer to collect and pay over to a special account or to the bond trustee.
Additionally, some states provide by statute that the state or local government, upon issuing debt pursuant to a specific state statute, automatically grants a lien (dedicated revenues or proceeds only to be used to pay the debt prior to any other use) on specified property, proceeds or tax revenue for the payment of the debt so incurred.
The granting by a local government pursuant to a local ordinance, without more, is unlikely to give rise to a statutory lien.

Defining Special Revenues: Section 902(2) of the Bankruptcy Code defines Special Revenues as:

“Special Revenues” means—

Receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems;
Special excise taxes imposed on particular activities or transactions;
Incremental tax receipts from the benefited area in the case of tax-increment financing;
Other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or
Taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax-increment financing) levied to finance the general purposes of the debtor.

What are the Benefits of Statutory Liens and Special Revenues?

Create Predictable Priorities in Chapter 9. These types of financings are intended to create predictable priorities in Chapter 9 so municipal bond market participants can be protected by a predictable result.

Outside Chapter 9 Payment is Enforceable. Outside of a Chapter 9 proceeding, participants would be protected through enforcing payment by writ of mandamus or other remedies and the fact that a governmental officer must comply with the mandate of state law or suffer the penalties.

Assured Payment is the Intended Result. In Chapter 9, there is intended to be established priority and assurance of payment so that governmental bodies suffering from temporary illiquidity would have access to the municipal bond market with a dedicated source of payment that would survive Chapter 9. (See legislative history of 1988 Amendments to the Bankruptcy Code regarding solving the dilemma of the City of Cleveland in 1978.)

How are Special Revenues to be Treated in Chapter 9?

Timely Payment as the Pledge of Special Revenue Provides. A special revenue pledge is to be unaltered in a Chapter 9 proceeding, and the timely payment of the pledged revenues by the municipality is required by the Bankruptcy Code.

Obligation and Payment to be Unimpaired. Special revenues were intended by the 1988 Amendments to the Bankruptcy Code to be unimpaired in Chapter 9 and the debt holders to receive the benefit of the bargain.

Case Law Supports the Unimpaired Status. This unimpairment was respected in the Chapter 9 proceedings of the Sierra Kings Health Care District Chapter 9 (Eastern District of California), Jefferson County, Alabama (Northern District of Alabama) Stockton, California, and Detroit, Michigan (for those who continued to hold Water and Sewer Revenue Bonds, the case reaffirmed the unaltered status and timely payment of special revenue pledges in a Chapter 9 proceeding).

How are Statutory Liens Treated in Chapter 9?

Statutory Lien is to be Unaltered and Timely Paid. A statutory lien should remain unaltered in a Chapter 9 proceeding, and there is a continuing right to be timely paid after the filing of a Chapter 9.

Chapter 9 Cases Recognize the Unaltered Treatment. Such unimpairment was recognized in the Chapter 9 proceedings of Orange County, California in 1994 (delay in payment due to appeal and reversal of Bankruptcy Court as to effect of a statutory lien) and the Sierra Kings Health Care District Chapter 9 in 2009 (relating to General Obligation Bonds).

Analysis of Statutory Liens by State. A number of states have statutes containing statutory lien provisions. See e.g., Rhode Island, California, Colorado, Idaho, Louisiana and New Jersey (Municipal Qualified Bond Act). Statutory lien legislation is pending in Michigan (HB 4495), Nebraska (LB 67) and Illinois. See Appendix which is taken from the 50 State Survey in the forthcoming new edition of “Municipalities in Distress?” for breakdown of statutory lien categories for further analysis).

Legislative History of the 1988 Amendments to Chapter 9 Support the Unaltered Status of Statutory Liens and Special Revenues

The Senate Report for the 1988 Amendments notes:

“In the municipal context, therefore, the simple answer to the Section 552 problem [lien or pledged termination on filing] is that Section 904 [limitation on jurisdiction and power of court] and the tenth amendment should prohibit the interpretation that pledges of revenues granted pursuant to state statutory or constitutional provisions to bondholders can be terminated by the filing of a chapter 9 case. Likewise, under the Contract Clause of the Constitution (article I, section 10), a municipality cannot claim that a contractual pledge of revenue can be terminated by the filing of a chapter 9 proceeding.” S. Rep. No. 100-506 at 6 (1988).
The Senate Report accompanying the special revenue provisions provides: “Finally, the amendment insures that revenue bondholders receive the benefit of the bargain with the municipal issuer, namely they have the unimpaired right to the project revenue pledged to them.” Senate Report 100-506 at 12.

The San Jose School District Case. Accordingly, the statutory lien pledge of ad valorem tax revenues for the timely payment of the Unlimited Tax General Obligations (“ULTGOs”) debt service was not interfered with in the San Jose School District case and is not to be interfered with under Chapter 9 as the legislative history for special revenue treatment so provides.

Past Supreme Court Rulings and Provisions of Chapter 9 Support This. This legislative history noted the principles that are embodied in Sections 903 and 904 of the Bankruptcy Code and the Tenth Amendment as recognized in the Supreme Court of the Ashton and Bekins:

That the statutory lien cannot be terminated nor the mandated payment impaired so that revenue subject to the statutory lien or special revenues must be paid timely as intended to the debt holders.

Earlier articles in this series:

Fiscal Distress Myths and Realities Part I: Default Rate

Fiscal Distress Myths and Realities Part II: Use of Chapter 9

Fiscal Distress Myths and Realities Part III: Consequences of Default

Fiscal Distress Myths and Realities Part IV: Can a Municipality File Chapter 9?

Fiscal Distress Myths and Realities Part V: Factors that Help Prevent Municipal Default

Look out for more parts of James Spiotto’s Fiscal Distress Myths & Realities coming soon.