Despite predictions of increased municipal bond defaults, it is unlikely that filings under Chapter 9 of the United States Bankruptcy Code, which provides for the adjustment of a municipality's debts, will increase significantly.
However, the deterioration of the credit fundamentals of many state and local governments, coupled with the threat of a Chapter 9 filing and the difficulties facing the monoline bond insurance industry, have fundamentally changed the municipal bond market.
A municipal bankruptcy can be an expensive and time-consuming process. Importantly, a Chapter 9 filing may negatively affect a government's ability to access capital markets and attract new investors far into the future, particularly if existing bondholders are not paid in full under the municipality's restructuring plan.
Further, bankruptcy courts have limited powers in overseeing Chapter 9 cases and creditors cannot file competing plans or force a municipality to liquidate absent its consent.
Lacking such tools otherwise available in a Chapter 11 restructuring, combined with the often differing political interests in a Chapter 9 restructuring, can be significant impediments to an efficient Chapter 9 restructuring.
Although most municipalities may view both the political and the economic costs of a Chapter 9 filing as prohibitively expensive, issuers and investors should recognize that the municipal bond market has fundamentally changed.
Governmental entities rely heavily on municipal bonds to finance capital expenditures. Traditionally, general obligation bonds have been considered a more conservative investment than special revenue bonds.
Recently increased demand for special revenue bonds (which are secured by the income generated from the project that the bonds were used to finance) over general obligation bonds may be attributable to the favorable treatment of special revenue bonds in a Chapter 9 case.
Under the Bankruptcy Code, post-petition special revenues remain subject to a pre-petition lien resulting from a pre-petition security agreement. Moreover, notwithstanding the automatic stay provisions of Section 362 of the Bankruptcy Code, special revenue bond debt service continues to be paid during the pendency of the case.
As a result of this carve-out to the automatic stay, special revenue bondholders are assured of the benefit of their bargain in the form of a continuing revenue stream. Investors, however, should be aware that the Bankruptcy Code subordinates gross revenue pledges to the payment of necessary operating expenses, thereby effectively rendering them net revenue pledges.
Notwithstanding this effect, the protections accorded to a special revenue bondholder under Chapter 9 mitigate certain risks posed by a municipal bankruptcy filing.
Default rates on municipal bonds historically have been significantly lower than corporate bonds, but the past may not be a good bellwether for what the future holds given issuers' looming budget deficits and unsustainable cost structures.
Notably, monoline insurance companies have reduced their credit-enhancement products in connection with municipal bonds.
The decline in the availability of such products likely will have an effect on investors' willingness to invest, bond pricing, and the cost of capital for issuers.
As a threshold matter, investors will need to better assess the credit fundamentals of municipalities by treating them like businesses rather than relying on the full-faith-and-credit pledge of the government.
Underfunded pension and other post-employment benefit liabilities may be viewed as significant risk factors by investors, and in order to appropriately account for such risks, analysts will need to understand the basis of actuarial projections, their implications over time, and the timing of cash payments to fund shortfalls.
Investors will need to understand the issuer's underlying finance structure, sources and uses of cash, and the cost structure of an issuer's budget, as well as their own economic and legal rights as investors — in and out of court — in the event of a bond default.
Absent the ready availability of bond insurance, issuers will need to provide more disclosure, regular reporting, and increased due diligence to potential investors.
For issuers to be successful in maintaining access to the capital markets at an economically feasible issuance cost, they will need to be proactive in reaching out to the market through their relationships with underwriters and investment banks, providing greater and more regular access to financial information, managing budgets, maintaining operating reserves, responding to changing economic conditions, and actively managing debt capacity to protect their bond ratings.
While concerns about the efficacy, predictability and expense of a Chapter 9 case may dissuade municipalities from pursuing this option, the mere threat of a filing could be a powerful bargaining chip.
Therefore, municipal creditors should take note and keep informed of Chapter 9 developments in order to protect their rights and interests.
Simultaneously, they should work with issuers to ensure that they have the requisite information to maintain their public finance investments as a relatively safe and attractive venture.
Benjamin Gonzalez is a principal in the restructuring services group and Thomas Mulvihill is a managing director in the infrastructure advisory group at KPMG. Robin Spigel is special counsel and Shaunna Jones is an associate at Willkie Farr & Gallagher LLP.
