Why Pledged Revenues Are Required to Be Paid to Revenue Bondholders in Chapter 9 Municipal Bankruptcy. And, Why the Assured Decision in Puerto Rico’s PROMESA Title III Proceeding Should Be Reconsidered or Reversed on Appeal

by James Spiotto

On January 30, 2018, the Court presiding over the Title III adjustment of debt proceeding for the Commonwealth of Puerto Rico and certain of its instrumentalities (including the Puerto Rico Highways and Transportation Authority (“PRHTA”)) entered a ruling on Assured Guaranty Corporation et al.’s (“Assured”) Complaint requesting protection, relief and payment of pledged revenues (special revenues) of a revenue bond financing of PRHTA.

Assured asserted the pledged revenues under PRHTA’s revenue bond financing were special revenues under Section 902 of Bankruptcy Code, the pledge continued post-petition under Section 928 of the Bankruptcy Code and payments of pledged revenues as collected net of necessary operating expenses (operation and maintenance costs) should be paid to the revenue bondholders under Section 922(d) and 928 of the Bankruptcy Code.  The Court focused on Section 305 of PROMESA (which is Section 904 of the Bankruptcy Code) and Section 922(d) of the Bankruptcy Code.  Section 902, 922(d) and 928 are all incorporated by reference into Title III of PROMESA in Section 301 of PROMESA.  The Court interpreted Section 305 of PROMESA as a limitation of the the court’s power by order, stay or decree to interfere with the municipality’s property interest, revenues and use and enjoyment of income-producing property of the municipal debtor without the debtor’s consent including as to pledged revenues to the revenue bondholders and even the reserve funds held by the bond trustee.  The Court then went on to interpret Section 922(d) of the Bankruptcy Code and its exemption to the automatic stay as if it “only permitted municipalities and others in possession of pledged special revenues to apply those revenues to the relevant debt without running afoul of the automatic stay.”  The Court interpreted Section 922(d) as not permitting the timely payment during the Chapter 9 case of the pledged special revenues to the revenue bondholders if the municipality chooses not to pay the bondholders.

The decision of the Court that pledged special revenues would not be paid during the Chapter 9 proceeding unless the municipality as debtor chooses to do so is contrary to the decisions or practices of the numerous Chapter 9 courts (including in Jefferson County, City of Stockton, Detroit, Sierra King Health Care District, San Jose School District and other Chapter 9 cases).  No Chapter 9 bankruptcy court has interpreted Section 922(d) to prohibit the payment of pledged special revenues as collected to revenue bondholders during a Chapter 9.  In the Jefferson County case, the timely payment of pledged revenues (special revenues) to the sewer bondholders was actively litigated and objected to by Jefferson County.  The Chapter 9 bankruptcy court in the Jefferson County case specifically ruled in a series of decisions that the net pledged revenues as defined in the revenue bond financing documents were to be timely paid to the bondholders as collected during the Chapter 9 case.

Further, Sections 902, 922(d), 928, among other sections of the Bankruptcy Code, were either inserted or amended in the 1988 Amendments to the Bankruptcy Code.  The purpose and intent of the 1988 Amendments, inter alia, as will be further detailed below, were to assure revenue bondholders that their benefit of the bargain would be unimpaired in Chapter 9 and the payment of pledged revenues of revenue bond financings (special revenues) to bondholders as required by state law would not be frustrated and the financial markets would not be needlessly disrupted by an automatic stay.

With due respect to the Court, these remarks herein are not intended to be critical of the Court’s decision in Assured.  It is acknowledged that the Court presiding over the Title III proceedings has a heavy burden given the severe financial distress of Puerto Rico, its instrumentalities and public corporation compounded by two horrific hurricanes that destroyed the island’s infrastructure and economic base.  Further, Chapter 9 and the principles of municipal law are not matters that most bankruptcy judges, bankruptcy attorneys or most judges or attorneys for that matter ever become involved with.  For that reason, most are not a familiar or well versed in the area of Chapter 9 and municipal law.

Further, as the loyal readers of MuniNetGuide.com are aware, given the unique financial distress and tragedy of Puerto Rico and the untold human suffering of its people, I believe Congress should and has the duty under the Constitution and the appropriate treatment of a territory in distress to provide a “Marshall Plan” for Puerto Rico to reinvest, rebuild and enhance its infrastructure and economic base for the health, safety and wealth of Puerto Rico and its people.  After such recovery, debt and other issues can be placed in proper perspective.

Some may say the Court’s decision is restricted to that case and only applicable to PROMESA.  However, the Court specifically attempted to interpret provisions of Chapter 9 and the 1988 Amendments that have vital importance to municipalities who desire to use revenue bond financing and the financial market.  Municipalities rely on the ability to have access to the financial markets and to borrow at as low a cost as possible because tax revenue collections are uneven and not regular and the cost of capital projects and infrastructure improvements are too large for the normal fiscal revenues available.  Since borrowings are paid by tax payer dollars, lower cost of borrowing is appreciated and valued by municipalities and tax payers.  The 1988 Amendments were a response to the need for clarity as to the treatment of revenue bonds so that access to the market at a low cost would be available.

The following will set forth the reasons, among others, that the Court decision should be reconsidered or reversed.

1) Municipalities are created by state law that authorizes and dictates what municipalities can do and the municipalities cannot act contrary.

It is well settled law that, unlike commercial corporations who control their own destiny and actions, municipalities derive their existence from the state and are restricted in what they can do by what state law authorizes or mandates.  Municipalities cannot act contrary to state law provisions that require, in the exercise of their governmental powers, municipalities to take certain action.  It was settled by the U.S. Supreme Court in the 1891 that a municipality has no authority or power except as provided for by state law.  Municipalities cannot act or consent to actions contrary to what is authorized and mandated by state law.

2) Revenue bond financing for municipalities is pursuant to state statutes that require the municipalities to pay the revenue bondholders the pledged revenues collected.

Revenue bond financing in the various states is generally authorized by state statutory provisions mandating that the municipality must timely pay pledged revenues as collected by the municipality to the revenue bondholders and cannot use such revenues for any other purpose.  Under the mandate of state law, the municipality does not have a choice other than to timely pay the pledged revenues to revenue bondholders.  This practice has been an honored tradition of municipal finance and the premise for the financial markets so that state and local governments have access and lower cost of borrowing given the reduced risk of noncompliance.

3) Chapter 9 does not impair or limit, and the Bankruptcy Court cannot stay or interfere with the power of the state to control by legislation the payment of pledged special revenues to revenue bondholders during the Chapter 9.

The first attempt by Congress to pass a municipal bankruptcy law in 1934 was declared unconstitutional by the U.S. Supreme Court in the Ashton case, Ashton v. Cameron County Water Improvement District (1937).  The second attempt at legislation in 1937 was successful and declared constitutional in the Bekins case, United States v. Bekins, 304 U.S. (1938) because language was added requiring in Chapter 9 respect for the sovereignty of the state as a co-sovereign with the federal government and no interference with the power of the state over municipalities and the state legislative mandate of municipalities exercise of government powers.  Sections 903 and 904 of the Bankruptcy Code (Sections 303 and 305 of Title III of PROMESA) incorporate the protection of state sovereignty to preserve the constitutionality of the Bankruptcy Code.

Under Section 903 of the Bankruptcy Code, Chapter 9 “does not limit or impair the power of the State to control by legislation or otherwise a municipality of or in such State in the exercise of the political or governmental powers of such municipality, including expenditures…”.  So, Chapter 9 cannot be interpreted as allowing the municipality to act contrary to State statutory mandates that such pledged special revenues are to be paid by the municipality or tax collector to the respective bondholders in a revenue bond financing.  Section 904 of the Bankruptcy Code provides that “unless the debtor [municipality] consents or the plan so provides the court may not, by any stay, order, or decree in the case or otherwise interfere with…property or revenues of the debtor…”.  So the Court cannot stay the timely payment of pledged revenues as collected by the municipality or tax collector to the bondholders as mandated by the State.  Further, the municipality cannot consent to the Court’s jurisdiction, stay or interference with the payment of the pledged special revenues contrary to the state mandate that in revenue bond financing the pledged revenues are to be timely paid to the revenue bondholders.  Sections 922(d) and 927 of the Bankruptcy Code and the legislative history of the 1988 Amendments all require the unimpaired and timely payments of the pledged revenues to the respective bondholders.

As the legislative history of the 1988 Amendments noted in the prior case of the San Jose School District in 1983, there was the timely payment of the revenue bondholders from the pledged revenues during the Chapter 9 without the benefit of Sections 902, 922(d), and 928 of the Bankruptcy Code due to the mandate of state law that the bondholders be paid by the pledged revenues as collected.  Clearly, Sections 903 and 904 gave support to that conclusion without the clarification and benefit of the 1988 Amendments.  So even before the 1988 Amendments, there was justification for the payment of revenue bondholders during the Chapter 9.  The 1988 Amendments were to make explicit what was already implicit.

The Senate Report to the 1988 Amendments stated: “The application of Section 552 in a Chapter 9 bankruptcy proceeding may also defy practical reality and state law mandates.  As in the case of the San Jose School District, In re San Jose Unified School District, No. 5-83-02387-A-9, (E.C.N.D. CaL. 1983), the continued payment of interest to bondholders not only helped ensure the debtor’s continued access to credit markets but also helps fulfill the requirement of state law that such collected funds be used to pay bondholders.  CaL. Educ. Code Ann. 15251.”  Id. At p. 6.

The San Jose case implicitly and the legislative history of the 1988 Amendments explicitly clarify that the correct interpretation of Section 904 (Section 305 of PROMESA) consistent with Section 903 of the Bankruptcy Code (Section 303 of PROMESA) and Section 922(d) and 928 of the Bankruptcy Code, is that, given the requirement of state laws, the pledged revenues are to be timely paid to revenue bondholders, the municipality has no other choice but to comply with the state laws and Chapter 9 cannot be in interpreted to prohibit such payments, and the Court cannot stay or otherwise interfere with such payments.  Chapter 9 courts have so ruled and should so rule.

4) Section 922(d) should only be read as lifting the stay for the timely payments of pledged special revenues to revenue bondholders as collected by the municipalities during the Chapter 9.

The court in the Assured ruling was concerned that the wording of Section 922(d) did not permit the enforcement of the payment of pledged special revenues to the revenue bondholders if the municipality chose not to pay during a Chapter 9.  The court held only the municipality and third parties holding pledged revenues could voluntarily choose to pay or not.  As noted above herein, under the legislative history of the 1988 Amendments and municipal law of the various states relating to revenue bond financing, there is no choice and municipalities are required to pay the pledged revenues to the revenue bondholders.  Further, as the San Jose School District case demonstrates and Section 904 provides, the municipality is not stayed in the use and employment of its revenues, and Section 903 prohibits any interpretation of Chapter 9 that would impair or limit the state legislative requirement that the municipality pay the collected pledged revenues to the revenue bondholders.  While the court in Assured interpreted Section 922(d) only to lift the stay for the debtor municipality, there would be no need for that since Section 904 of the Bankruptcy Code (Section 305 of PROMESA) clearly states there can be no stay or interference by the Court regarding a municipality’s use of its revenues and payments.  Since statutory interpretation does not support a reading of a statute that “would render the statutory words or phrases meaningless, redundant or superfluous”, the Assured opinions interpretation cannot be the full meaning of the words.  The court in Assured interprets the word “application” in Section 922(d) to be limited to the municipality, and does not include the mandated payment of pledged revenues to revenue bondholders.  The new Oxford American Dictionary has as the second definition of “application”, “the action of putting something into operation”.  There is similar language to that effect in Black’s Law Dictionary (Revised Fourth Edition) as to the “Application” related to payments.  Following the rule of the plain languages interpretation of words in statutes, Section 922(d) can and should be read as no stay of any action for the payment of pledged special revenues under Sections 362 or 922(a), consistent with the continuing lien on pledged revenues for the payment of indebtedness secured by special revenues.

That is what the San Jose School District did prior to the 1988 Amendments and what the Jefferson County bankruptcy court ruled after the 1988 Amendments.  Pursuant to Sections 903 and 904, given the mandate of state law for revenue bond financing, the municipality must pay pledged revenues to the revenue bondholders, and that is what the legislative history of the 1988 Amendments clearly supports.  This interpretation of Sections 922(d) and 928 of the Bankruptcy Code that pledged special revenues must be timely paid to revenue bondholders during a Chapter 9 case is strongly supported by the legislative history of the 1988 Amendments.

Specifically, the Senate Report for the 1988 Amendments states:

  • The application of certain commercial law concepts in Chapter 9 conflicts with the tradition of revenue bond financing and should be inapplicable.
    • “At that time, Chapter 9 generally was amended to apply commercial bankruptcy law concepts to municipal corporations.  However, due to the different nature of the evolution of municipal finance, some of the specific effects of the sweeping application of commercial law concepts to municipal corporations have raised serious concerns by municipalities.  Those efforts were not entirely successful because the resulting application of commercial law concepts to municipal corporations run afoul of the traditional structure of revenue bond finance.”  Senate Report at 3-4.
  • The 1988 Amendments were to protect revenue bond financing namely the benefit of the bargain: the unimpaired right in Chapter 9 for the payment of pledged revenues to revenue bondholders.
    • “The amendments protect the future effectiveness of revenue bond financing against the possibility of an adverse judicial determination in connection with municipal bankruptcy …”.
    • “Various questions have been raised that a pledge of municipal revenues and the lien created thereby will be terminated in a municipal bankruptcy due to the application of Section 552(a) to Chapter 9.  To eliminate the confusion and to confirm various state laws and constitutional provisions regarding the rights of bondholders to receive the revenues pledged to them in payment of debt obligations of a municipality, a new section is provided in the amendments to ensure that revenue bondholders receive the benefit of their bargain with the municipal issuer and that they will have unimpaired rights to the project revenues pledged to them.”  Id. at p. 12.
  • The automatic stay is inapplicable to the timely payment of principal and interest to revenue bondholders from pledged special revenues collected during a Chapter 9 case.
    • “Likewise, the automatic stay that becomes effective against creditors of a municipality is made inapplicable to the payment of principal and interest on municipal bonds paid from pledged revenues.  In this context, “pledged revenues” includes funds in the possession of the bond trustee as well as other pledged revenues.”  Id. at 13.
  • The 1988 Amendments and Sections 922(d) and 928 were intended to provide assurance of timely payment of pledged special revenues to revenue bondholders.
    • “Reasonable assurance of timely payment is essential to the orderly marketing of municipal bonds and notes and continued municipal financing …”
    • “Where a pledge of revenues survives under Section 927 [928], it would be needlessly disruptive to financial markets for the effectuation of the pledge to be frustrated by an automatic stay.  Further, the use of an automatic stay may be contrary to Section 904 and interfere with the government, affairs and the municipality’s use or enjoyment of income producing property.”  Id. at p. 21.

Given the above considerations, there should be no doubt as to purpose and intent of the 1988 Amendments to Chapter 9 that revenue bonds should be timely paid from the pledged special revenues collected by the municipality, as debtor, consistent with the requirements of state law authorizing the financing and the financial markets understanding that such payments will be made, as well as the inability under the Bankruptcy Code and state legislation governing revenue bond financing for the municipality to act differently or the court to stay or interfere with such mandated payment.  This discussion sets forth some of the reasons and justification of why pledged special revenues are to be paid to revenue bondholders during a Chapter 9.  This statement is not exhaustive of all of the reasons and support.  This overview of the reasoning for such a conclusion has additional support and justification for this result.  In difficult cases and extreme financial distress, this reasoning does not prevent revenue bondholders and the municipal debtor from reaching a voluntary agreement for a different result given the mutual understanding that, for the sake of the municipal enterprise and the continued and more favorable long-term flow of revenues from an ongoing operation, additional funds are necessary to be available to the municipality so that the future payments are more assured.  This can be done on a voluntary basis, with the consent of the revenue bondholders, but not on an involuntary basis.

Why is this Important?

The United States contains the most extensive and sophisticated public works system in the world, comprised of 4,092,730 miles of roadways, 607,708 bridges, 1,100 local bus systems, 19,453 airports (of which 5,155 are for public use), 25,320 miles of inland and intercoastal waterways, at least 87,000 dams, more than 2 million miles of pipe in water supply systems and over 15,000 wastewater treatment plants provided mostly by municipalities and political subdivisions of a state.[1]  The American Society of Civil Engineers (“ASCE”), in its 2013 Report, estimates the cost to maintain infrastructure at a passable level will be $3.6 trillion by 2020 or about 4 times the annual tax revenues for all state and local governments.  In 2009, ASCE’s number for the next 5 years was $2.2 trillion.  Inattention has caused the number to increase by $1.4 trillion in 5 years.  Any further deferral of needed infrastructure improvement could have devastating results.

Revenue bond financing is vital to state and local governments to provide the needed infrastructure improvement and capital expenditures for roads, schools, sewers, wastewater treatment, electric and water service and other municipal services and benefits.  Without the assurance to the financial markets of the ability of revenue bondholders to be timely paid including in Chapter 9, the access to this revenue bond financing necessary for needed improvements to governmental services and infrastructure could be drastically limited or the price of financing significantly raised higher than desired or practicable.  The vital need for financing for required infrastructure improvements cannot be disputed.  Puerto Rico may very well be in the future, as it was in the past, a grateful beneficiary of the intended reduced risk provided by the 1988 Amendments and the favorable treatment of revenue bond financing in the financial markets.

A cloud on revenue-based financing such as the drastic and unprecedented ruling in Assured that pledged special revenues will not be timely paid to revenue bondholders during a Chapter 9 contrary to the financial market experience in Chapter 9 cases so far and the 1988 Amendments to the Bankruptcy Code will cause heightened adverse perception of risk and increased costs.  Roughly the difference between an AAA rated bond and a risky bond is at least 200 basis points on principal amount per year as a 2% additional interest cost per year.  This would be a significant increased financial burden to our states and local governments that have more than enough competing demands for their limited tax revenues.  If an additional interest cost of 2% a year is required by the financial market for revenue bond financing due to the failure to provide appropriate assurances to the financial markets that pledged revenues would be timely paid to revenue bondholders in a Chapter 9 case, this would result in the additional present value cost to the municipality equal to about 25% of the original principal (based on a 20-year bond with bullet maturity at a 5% discount rate).  That additional cost could be better used for needed governmental services and improvements, paying public workers on underfunded pension or reducing the tax burden on taxpayers.  The reconsideration or reversal of the Assured opinion is vital to the preserving the beneficial financing needed and traditionally available to state and local governments.


[1]              Table 1-1:  System Mileage Within the United States (Statute miles), http://www.rita.dot.gov/bts/sites/rita.dot.gov.bts/files/publications/national_transportation_statistics/html/table_01.01.html (last visited Feb. 9, 2016); National Inventory of Dams, U.S. ARMY CORPS OF ENGINEERS, http://www.agc.army.mil/Portals/75/docs/pdf/NIDentire.pdf (last visited Feb. 10, 2016); 2006 Community Water System Survey Report, U.S. ENVIRONMENTAL PROTECTION AGENCY, http://nepis.epa.gov/Exe/ZyPDF.cgi?Dockey=P1009JJI.txt (last visited Feb. 9, 2016).