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Chapter 9 in Rhode Island Sparks Questions

As soon as Central Falls, R.I., filed for Chapter 9 bankruptcy protection, questions emerged.

Foremost among them: How will the U.S. Bankruptcy Court system deal with a new Rhode Island law that appears to strengthen bondholder security by establishing a priority for general obligation bond and note payments over other creditors?

“It is unclear how the federal court will treat the tenets of this new law in a bankruptcy proceeding,” Moody’s Investors Service said Tuesday.

Moody’s, one day after Central Falls filed for bankruptcy in the U.S. Bankruptcy Court for the District of Rhode Island in Providence, placed Central Falls’ Caa1 GO rating on review for possible downgrade, affecting $20.8 million of outstanding debt.

Central Falls, with a population of 18,683 and a size of just one square mile, has an unfunded pension liability of $80 million.

“I’m not sure how that will stand up in court,” Brian ­Fraser, a partner with law firm Richards Kibbe & Orbe LLP, said of a law, which Rhode Island passed this year, guaranteeing that lenders get first rights to property taxes and general revenue, should a government entity file bankruptcy.

Cities and towns must pledge their ad valorem property tax and general fund revenues to payment on all GO bonds and notes.

“The state has created this law after the bonds have been issued. I’m not even sure if that’s been tested. In bankruptcy, a court must decide whether the creditor classes are being treated fairly,” Fraser said.

Central Falls filed after state-appointed receiver and former state Supreme Court Chief Justice Robert Flanders could not get unions and retirees to agree to reductions in benefits of up to 50%, even after saying they could risk losing everything in bankruptcy court.

Flanders has asked the bankruptcy court to negate collective bargaining agreements with police and fire unions that expire June 30, 2012.

The move came four days after a federal judge confirmed Vallejo, Calif.’s bankruptcy exit plan, in which it reworked union contracts.

“The precedent from the Vallejo case puts Central Falls in pretty good ground in dealing with unions. I think Flanders has the upper hand,” Fraser said.

Moody’s said in a statement Tuesday that its rating action “reflects the uncertainty of the timing and outcome of bankruptcy proceedings,” and that the length and complexity of the bankruptcy proceedings could further affect its rating, Moody’s in June dropped the city’s rating one notch.

Flanders, speaking at a press conference in Central Falls on Monday, envisioned an exit within six months.

“I see Central Falls as a one-off,” Fraser added. “I don’t see the needle leaning too far one way or another.”

Central Falls is Rhode Island’s first community to file for bankruptcy. “It is unfortunate that the hard-working people of Central Falls, already hit hard by the recession, must now pay for years of poor management and patronage,” said Councilman James Diossa.

Judge Frank Bailey has scheduled a status conference for 11 a.m. Wednesday in Providence.

Chief Judge Sandra Lynch of the U.S. Court of Appeals for the First Circuit, assigned Bailey, from the Boston bankruptcy court, to hear the case. Bailey, 56, a former commercial litigator with Sherin and Lodgen LLP in Boston, has served on the bankruptcy bench for three years.

Last month Bailey signed off on a Chapter 11 exit plan by Molecular Insight Pharmaceuticals Inc. that would slash about $160 million in debt from its balance sheet.

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