Ciccarone: Borrowing Costs Could Rise if JeffCo Wins Appeal

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BRADENTON, Fla. - Uncertainty in the municipal market is rising as Jefferson County tries to overturn an interpretation of the municipal bankruptcy code that has so far protected those who invested in revenue bonds sold to finance essential infrastructure.

Alabama’s largest county is pursuing what is believed to be the first appeal ever of a federal judge’s decision upholding the long-held interpretation of bankruptcy code section 922(d) in which “pledged special revenues” are protected during a Chapter 9 bankruptcy.

That interpretation, which federal Judge Thomas Bennett agreed with in January, essentially protects pledged revenues securing the county’s sewer warrants and enables investors to be paid while the Chapter 9 case proceeds.

Jefferson County does not agree.

In a cross appeal on Oct. 9, the county said that investors who hold $3.2 billion of defaulted sewer system warrants should wait until the end of the bankruptcy case to get paid.

That scenario could leave fewer revenues available to pay warrant holders, a legal expert said.

“If the 11th Circuit Court of Appeals agrees with the county, and overturns the bankruptcy court’s ruling, that would be very significant,” said Karen Grande, a partner at Edwards Wildman Palmer LLP.

“Such a ruling would be totally at odds with how the public capital markets have understood Chapter 9 to protect special revenue bonds,” she said

If the county’s bankruptcy attorneys are right, the outcome could lead to higher borrowing costs for future issuers needing to pay for essential services such as water and sewer systems as well as other infrastructure typically financed with revenues bonds or warrants.

“Living up to the expectations associated with Chapter 9 protections for pledged special revenues is a critical foundation that has historically benefitted local governments who borrow in the marketplace for their revenue bonds,” said Richard A. Ciccarone, managing director and chief research officer for McDonnell Investment Management LLC.

“If a court would undo or weaken these protections, a reasonable reaction in the marketplace would be to require higher borrowing rates from governmental entities even on ‘essential-purpose’ revenue bonds,” he said

A decision in Jefferson County’s favor could also set a precedent for other financially struggling municipalities that seek Chapter 9 bankruptcy protection.

The stakes are high for the county, which filed the largest municipal bankruptcy last November with $4.2 billion of debt, most of which is in default and tied to the over-leveraged sewer system.

The stakes are also high for creditors in the case, and for the future of the municipal bond market where $2.4 trillion of revenue bonds are outstanding.

The county’s challenge, pending before the 11th Circuit Court of Appeals, concerns two significant issues: how revenue bonds or warrants are treated in bankruptcy, and the rights of bondholders to seek the appointment of a receiver when an issuer defaults on debt payments.

Jefferson County says Bennett was right when he tossed out the state court-appointed receiver in charge of the county’s sewer system, another first since it is believed to be the first time the issue of receivership has emerged in a municipal bankruptcy case.

Creditors disagree, and argue that the appointment is a traditional remedy that investors rely on.

However, the county argued in its appeal that Bennett was wrong when he favored bond investors holding sewer system warrants.

The Securities Industry and Financial Markets Association argued otherwise in a friend-of-the-court brief it has requested to file with the appellate court that was obtained by The Bond Buyer.

Preserving bondholders’ rights to pledged special revenues and bond payments, as well as the maintenance of receivership, is what Congress intended after a municipal bankruptcy filing, according to SIFMA’s brief.

The court has not decided if the brief will be accepted.

An interpretation of the bankruptcy code that cuts off a lien on revenues or impairs the effectiveness of a revenue pledge after the filing of a petition is “flatly inconsistent with Congress’s intent and would disrupt the revenue bond market in just the way the Congress sought to prevent,” SIFMA wrote.

“Congress acted to reassure the market that revenue bond investors’ security interests in pledged revenues would remain intact and that pledged revenues would continue to be applied to payment obligations during a municipal bankruptcy case, in accordance with the traditional structures of municipal revenue bond finance,” according to the brief prepared by SIFMA.

The argument before the appellate court boils down to an understanding, and a disagreement, of what Congress intended in amending the bankruptcy code in 1988.

Congress put the amendments in place to ultimately protect municipalities’ access to the revenue bond market at reasonable interest rates, SIFMA argues.

Jefferson County acknowledges that the bondholders have a lien on net revenues, according to Grande, who is not party to the case.

However, the county “asserts that the bondholders were entitled only to the cash the indenture trustee had on hand in the debt-service fund on the date that the bankruptcy was filed,” Grande said.

The county believes bondholders are not entitled to payments while the bankruptcy is pending, and that investors must wait till the end of the case to be paid, she said

With relatively few municipal bankruptcy cases — about 600 since 1930 — there is little precedent in Chapter 9, according to David A. Rosenzweig, a partner at Fulbright & Jaworski LLP, which represents a telecom provider to the county.

The appeal leaves open the possibility that Judge Bennett’s decision in Jefferson County’s case could be reversed, he said.

“I think there’s a lot of uncertainty” for the financial industry, Rosenzweig said. “The appeal just continues to cloud the [ultimate] decision.”

The appeal has potentially sweeping implications for revenue bondholders nationwide, said Matt Fabian, managing director at Municipal Market Advisors.

Jefferson County’s challenge created market anxiety until Bennett ultimately sided with the municipal bond industry, and now the angst continues until the appellate court rules.

“It’s still very much a concern for bondholders, but at least we now have one positive opinion in our favor,” Fabian said.

When asked if he investors are seeking more yield for revenue bonds in areas where issuers have defaulted or filed for bankruptcy, including Alabama, Fabian said: “I think investors generally would prefer to be lighter in Alabama paper right now, but again this is not the kind of market for choosy buyers,” referring to the lack of supply and yield.

As far as the appeal is concerned, Grande said that Jefferson County wants to hold on to sewer system revenues so that it can pay for operating expenses, maintenance and pay-as-you-go capital.

Bondholders would be paid later, Grande said after reviewing court papers.

“Even if the county applies revenues only to permitted costs, the county’s use of the money to pay current expenses rather than debt service puts the county in a better position at the expense of the bondholders,” she said.

“It is clear that the county is not planning to accumulate revenues for payment to the bondholders at the end of the bankruptcy.”

There is no time frame for the appeals court to rule. The parties have asked for oral argument, and the court has not yet responded.

If either side is unhappy with the appellate decision, the U.S. Supreme Court could be asked to review it.

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