The Chicago school district added a legal argument to its sales pitch for $875 million of bonds.

CHICAGO – The Chicago school district, bringing $875 million to market Wednesday after a week's delay, is amplifying its support for the idea that the bonds' pledged tax revenue stream could survive a Chapter 9 bankruptcy.

The cash-strapped, junk-rated school district's position may sway some investors, but several market participants said they are skeptical.

The Chicago Board of Education outlines its position in a supplement to the deal's offering statement published late Tuesday. The revised language under the document's "bankruptcy" heading appears aimed at calming investor jitters over Gov. Bruce Rauner's backing of GOP sponsored legislation to put Chicago Public Schools under state oversight and on a possible path toward bankruptcy, market participants said.

CPS also provided an update on the oversight efforts in the supplement, as well as its announcement of spending cuts amid a setback in efforts to reach a new teachers contract.

Layered over the full faith and credit pledge of the board is a double-barreled security with an ad valorem tax and state aid pledged under an alternate revenue structure -- allowed by Illinois' Local Government Debt Reform Act – that provides a statutory lien. CPS in its investor presentation promoted the structure as one that is triple-barreled when counting all three pledges.

The pledged tax revenues are levied as part of the bond resolution but are abated by the district because it uses state aid to cover debt service. Abatement comes only after CPS makes its annual February deposit into the debt service account to cover June and December payments with state aid or some other revenue if necessary.

"The district has never had to extend ad valorem property taxes for collection to provide sufficient revenues for payment of any of its alternate revenue bonds," the board reports in its offering statement. The tax is not subject to the property tax caps that non-home-rule units like CPS fall under.

Some believe the board should do that, but such a move is politically unpalatable. Municipal Market Analytics said this week "a tax hike now would greatly bolster investor confidence in the credit. MMA expects that such a development is unlikely, however, implying a worsening time for CPS bond performance in the next two weeks."

Most of the board's $6 billion in debt uses the alternate revenue structure with about $4.7 billion repaid with pledged state aid. The district receives $909 million of state aid and $600 million of block grants annually. Tax-increment financing, intergovernmental agreement revenue, and personal property replacement tax revenues have also been used.

The board acknowledges that if Illinois were to enact a bankruptcy statute and it found itself in Chapter 9 the bonds' pledged revenues could be stayed and terms adjusted in a plan of adjustment if the judge deems them "fair and equitable" as permitted under the code.

The newly inserted language goes on to say that the board believes that the pledged taxes constitute 'special revenues' as defined in the U.S. Bankruptcy code and would be subject to a lien and "could not lawfully be used by the board other than in compliance with the series indentures" and would not be subject to a stay.

No opinion is offered as to how pledged state aid would be treated in bankruptcy. Those funds are comingled with other revenues and so may not meet bankruptcy code's definition of special revenues.

The board acknowledges there is no binding legal precedent for its position.

The district has been hawking its position on the structure's sturdiness through a special legal opinion at investor meetings, according to several buyside representatives. Kroll Bond Rating Agency rated the pending sale BBB, a notch higher than its rating on CPS' existing debt, based on the special opinion and an analysis from the firm's own external counsel.

The other rating agencies place CPS well into speculative-grade territory.

"Buyers have the leverage here and if they want to market the deal as bankruptcy protected they need to memorialize that in the bond documents," said one buyside source.

Some buyers could be swayed by the opinion's significance because it is now part of CPS' official investor disclosure, but others said in a post-Detroit Chapter 9 environment they are skeptical as the status of pledged revenues under the alternative revenue structure because it has not faced a Chapter 9 test here.

“They did a good job of laying out the statutory lien and special revenue implications,” said Richard Ciccarone, president of Merritt Research Services. “The disclosure appears to conform with best practice.  The big question is whether buyers will gain greater confidence in knowing that the dedicated tax will be sufficient to keep their debt service flowing on time in the event of a bankruptcy if the state changes the law” and allows for Chapter 9.

"Even if deemed special revenues, I'm not putting shareholder money on the line with the hope that an activist federal bankruptcy judge makes Chicago Board of Education implement a never before levied property tax," said another buyside source. Special revenue status also does little to avoid a cramdown should a judge deem the impairment "fair & equitable," the source added.

Democratic leaders who control the General Assembly have called the GOP's legislative moves toward oversight and bankruptcy dead on arrival but the threat rattled investors and without sufficient orders CPS pushed the pricing off to this week. Rauner on Tuesday reiterated his support for a takeover.

Kroll gave the bonds a higher rating due to the opinion from the board's special counsel that the alternate revenue bond structure provides a statutory lien of pledged revenues. Kroll, after also consulting with its own external counsel, believes the structure likely means bondholders would be "treated as secured creditors in a bankruptcy proceeding of the board, independently of whether there is a special revenues lien on pledged taxes.

"In addition, the automatic stay arising upon the filing of the bankruptcy petition does not stay the application of those special revenues to payment of the bonds secured by those special revenues," so "regularly scheduled payments of principal and interest to bondholders likely would continue," Kroll wrote.

KBRA also cited an Illinois appellate court that upheld the alternate revenue structure and tax pledge in a 2002 case involving a hospital that had closed.

The other three rating agencies assign single-B level ratings, citing its severely distressed overall credit profile.

The supplement also updates cuts announced earlier in the day by CPS Chief Executive Officer Forrest Claypool after the Chicago Teachers Union rejected the board's four-year contract offer and discloses the potential for a strike.

Claypool announced $100 million in spending cuts and said the district will end its coverage of 7% of the teachers' 9% pension contribution for annual savings of $170 million. The two measures combined with previously announced administrative cuts of $45 million will generate $172 million of savings in the current fiscal year and $315 million in fiscal 2017. The district is short $480 million in the current budget year and faces a $1 billion deficit in fiscal 2017 which begins July 1.

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