By James E. Spiotto
Fiscal distress of or perception of risk of nonpayment by government begets higher cost of borrowing and even loss of access to the market
The perception of fiscal distress leads to higher interest rates (cost of borrowing) in the global markets:
- On March 2, 2012, Greece had a ten year bond annual yield of 37.1% and in July, 2015, after the third attempted bailout and austerity package being implemented, Greece’s annual yield is still over 10.5% with a 52 week range of 5.5% and 19.5%.
- Since 1826, Greece has defaulted on its sovereign debt since 1826 at least five times prior to its recent financial crisis (1826, 1843, 1860, 1894 and 1932).
- Brazil, a large developing economy which defaulted or restructured its sovereign debt eleven times since 1826, the last time in 1990, had an average ten year bond annual yield between 2006 and 2015 of approximately 12.3% with all time high of 17.91% in October, 2008.
- Puerto Rico, given its recent financial distress experience, had yields on its ten year G.O. bonds exceeding 10% in February, 2014.
- At the same time, other sovereigns experienced unusually low bond annual yields of 2.27% for U.S.A., 1.52% for Canada and 1.03% France.
- A review of the adverse effect of state and local governments trying to balance the budget by defaulting or devaluing the currency has been met with harsh consequences, and the inability to pay due to financial distress, which is understood by the market, raises borrowing costs and could even deny market access.
The 200-300 basis point spread between strong and weak credits. Traditionally, the spread in the municipal market between strong credits (top investment grade) and significantly weak credits (lower non-investment grade) was 200-300 basis points. (See e.g., approximate 200 basis point trading spread between Detroit sewer and water with and without Chapter 9 threat and Chicago sale tax securitization approximate 275 basis point lower than similar Chicago maturities.)
Being classified as a weaker credit increases the cost of the borrowing by 25% or more of the face amount of debt and should be avoided if possible. To a state or local government, a 200 point per year or 2 percent more interest cost a year on a 20 year bond with a bullet maturity would be 40% more of the principal amount paid as interest over 20 years. Put another way, on a billion dollar debt issue with a twenty year maturity and a bullet payment of principal at maturity, a 2% additional interest cost per annum would be a present value at a 5% discount of about $250 million or 25% of the face amount. That is $250 million not available to state or local government to pay needed infrastructure improvements, public services, worker salaries, retiree benefits or tax relief to its citizens.
This perception of risk can stress taxes and leverage issues:
- The perception of risk can cause the inefficient use of the revenues to unnecessarily pay large interest cost equal to 60% or 90% of the original principal amount.
- This increased cost of borrowing can exacerbate already existing leverage problems.
- The solution is to use market-accepted assured payment structures that reduce risk of nonpayment and lower cost of borrowing such as statutory liens, special revenues, securitization of tax receivables, irrevocable statutory or constitutional mandates, set asides and priority of payments.
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:
(2) “special revenues” means—
(A) 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;
(B) special excise taxes imposed on particular activities or transactions;
(C) incremental tax receipts from the benefited area in the case of tax-increment financing;
(D) other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or
(E) 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).
- Case 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 recently released Second 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.
The cloud raised by the recent Puerto Rico decision:
On January 30, 2018, the Federal District Court hearing the Puerto Rico Debt Adjustment proceeding under PROMESA entered a ruling that startled the municipal market by pronouncing that, unless the municipality voluntarily decided to make the timely payment of special revenues pledged to the bondholders, the payment was stayed during the bankruptcy proceeding.
This decision of the court in the Puerto Rico PROMESA case 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 the pendency of a Chapter 9.
The Puerto Rico court ruling was such a shock some contended it should only apply to PROMESA and U.S. territories and not to municipalities of states. But the Federal District Court did not appear to limit its ruling or interpretation of sections of Chapter 9 of the Federal Bankruptcy Code to just PROMESA ,and its analysis of the language specifically discussed sections of Chapter 9 that had applicability to PROMESA.
There appears to be no quick fix to the conflicting positions of all Chapter 9 courts supporting the timely payment of pledged special revenues to bondholders in a Chapter 9, and the PROMESA court ruling that special revenues will be paid to bondholders on a timely basis during a Chapter 9 only if the municipality so chooses.
Could the municipal markets understanding of special revenues and the prior Chapter 9 court rulings on special revenues and the 1988 Amendments including Section 922(d) be so wrong? The answer is NO! The Puerto Rico court decision is on appeal to the U.S. Court of Appeals for the First Circuit. Since all prior Chapter 9 court rulings were contrary to the Puerto Rico decision and the 1988 Legislative History clearly supports the reversal of the Puerto Rico decision, the result of the appeal should be a reversal.