Attorney David Dubrow is challenging some widely held assumptions about municipal bankruptcy.
Over the last four years there has been an “embryonic trend” of municipal bankruptcies, in the words of Arent Fox partner Dubrow. These include Vallejo, Calif., Central Falls, R.I., Harrisburg, Pa., and Jefferson County, Ala.
He noted that in recent weeks “we have witnessed an unprecedented series of events.” He pointed to Stockton, Calif.’s default on general fund debt, along with Harrisburg’s and Jefferson County’s defaults on their general obligation debt.
The recent bond defaults and Chapter 9 municipal bankruptcy filings “have begun to call into question seven fundamental assumptions in the marketplace,” Dubrow told the Municipal Analysts Group of New York last week.
The first assumption is that a Chapter 9 filing is never in the interests of bondholders.
Dubrow said the Central Falls bankruptcy was an example of a filing that benefited bondholders. In the bankruptcy the investors have first lien on revenue. If the approved plan is carried out, the city’s finances will be stabilized while the bondholders will get all their money. So the bankruptcy was in the interest of investors.
In the Great Depression, bondholders brought mandamus actions to force cities in default to increase taxes and fulfill bond pledges.
However, many judges did not approve the tax hikes. After that experience Chapter 9 municipal bankruptcy was introduced with the support of bondholders.
A second false assumption is that a Chapter 9 bankruptcy is costly and takes years, Dubrow said.
The assumption was true with Vallejo, where there was $12 million in costs over three years. However, the bankruptcy also provided the city with $60 million in short-term savings.
Central Falls learned from Vallejo, according to Dubrow. After filing for bankruptcy, the Central Falls government immediately annulled the existing collective bargaining agreements. Within months it had settlements with its retirees and all unions except the one for teachers.
A third assumption is that all general obligations of a municipality are the same. Dubrow said this too is false. A GO secured by a statutory lien, as found in Rhode Island, is best for bondholders. Next is a pledge of full faith and credit. Third is an obligation of a general fund.
The worst is found with Jefferson County, where there are county warrants with a pledge of full faith and credit but the county has no power to raise taxes — only the state does.
The fourth assumption is that special revenue bonds cannot be harmed in a Chapter 9 case. This is being tested in Jefferson County, Dubrow said.
After Jefferson County defaulted on its sewer warrants, a form of special revenue bonds, bondholders went to state court and had a receiver appointed. Dubrow said the receiver did a good job and was looking after the interests of bondholders.
Jefferson County declared bankruptcy in November 2011. In January a judge declared the county in control of the sewer system, though with his oversight. The county has not been as good as the receiver at attending to bondholders’ interests, Dubrow said.
The judge is allowing the county to cover necessary operating expenses prior to paying debt service. The bondholders are disputing what qualifies as operating expenses.
There is a risk of a cram-down for investors, when the value of the property backing the debt is less than the debt owed. A secured creditor can be forced to accept a deal if another impaired class votes for it and if the creditor gets what is said to be equivalent to what they own as collateral.
For example, if a sewer system is worth $20 million and the bonds were worth $30 million, the bondholders would get $20 million.
The fifth assumption Dubrow mentioned is that a municipality emerging from Chapter 9 would not have access to capital markets. This is not always the case, Dubrow noted. For example, after its bankruptcy in 1994 and 1995, Orange County, Calif., got access to borrowing with state help. Hedge funds and other investors with a taste for risk may be willing to lend to municipalities emerging from bankruptcy.
Assumption number six is that in recovering municipal bond money after a bankruptcy, states are basically the same. Dubrow said Rhode Island is an example of the best situation for bondholders. Alabama is turning out to be among the worst because the state government has been unwilling to allow a tax increase to help Jefferson County.
California’s mediation process is fairly weak, he said. Pennsylvania can assign a receiver. While Harrisburg’s bankruptcy petition has been thrown out of court, the state has allowed its capital city to default on a GO bond, which should make bond investors wary about the state.
A seventh assumption is that a Chapter 9 filing allows a municipality to restructure all of its pension obligations. That is true for local pensions and other post-retirement benefits, Dubrow said. However, it is not true for pension obligations under a state plan.
Dubrow went on to talk about the use of Chapter 9 in the next few years.
Many cities are using the threat of Chapter 9 to obtain concessions, he said. He gave the examples of Rhode Island and California.
States are likely to pass new laws restricting the use of Chapter 9 and strengthening the ability of state government to intervene in situations of severe fiscal distress. Rhode Island, Michigan and Pennsylvania have all recently done this, Dubrow said.
Over the next few years, extreme fiscal distress is likely to result in additional city government bankruptcies, he said.
These will likely be in Rhode Island, California, Pennsylvania and the Midwest. A large wave is unlikely, Dubrow said. However, the combination of filings would be historically unprecedented.