Municipal bond investors have long known that annual appropriation-type debt, such as certificates of participation, are inferior debt structures. Those investors who bought them had faith at the time in the issuer’s responsibility to stand behind the debt.

But recent traumas in Jefferson County, Ala., and Stockton, Calif., that involve non-general-obligation debt or other forms of “non-debt” debt, have investors concerned about the safety of their alternative securities in the shadow of a possible municipal bankruptcy. In the end, an individual issuer’s state laws on bankruptcy filing determine whether alternative debt securities are exempt from municipal bankruptcy, industry pros say.

Market participants are keenly aware of whether a general obligation bond has a specific tax-lien pledge, or whether it’s an obligation of the general fund, or a moral obligation, or a COP structure, said Duane McAllister, a portfolio manager of the BMO intermediate tax-free bond fund at BMO Asset Management.

“With all of those, you don’t just look at the credit today, you look at the legal structure of that,” he said. “Buyers are concerned about that, and less concerned if you’re talking about a triple-A issuer.”

There has been just under $95 billion in COP debt issued nationwide from 2002 through March 13, 2012, according to numbers from Thomson Reuters. But lately muni investors have noticed how issuers’ willingness to pay has come into question in an environment of constricting budgets, shrinking tax revenues and decreasing state support.

This has come to a head in Stockton, a city of 290,000 that had issued large numbers of revenue bonds tied to the general fund, some pension obligation, some COPs, and no general obligation debt.

Earlier this month, officials voted 6-1 to skip some debt service payments and began the process that leads to a bankruptcy filing.

The industry can recall past situations in California where a bankruptcy filing put moral obligors in difficult situations, such as in Orange County in 1994 and Vallejo in 2008.

“There’s an attempt to try and puncture the long-term, ironclad support on bonded debt, as debt clashes with maintaining core services of government,” said Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management. “And so the battle is just starting.”

So, how secure does BMO’s McAllister think many of these non-debt securities are? It really depends on the state, he said.

“You look at a Rhode Island; they’ve been really clear on their intent and their protection for bondholders,” McAllister said. “There are other states where you would be more concerned, and probably rightly so. Not all states are created equally when it comes to what a moral obligation pledge might mean.”

The case of Jefferson County also raised questions about the status of debt issued as warrants. Because the county issued warrants instead of bonds, bondholders objected to its bankruptcy filing on the grounds that the Alabama statute only authorizes municipalities with bond debt to file Chapter 9. And warrants, they argued, aren’t bonds under Alabama law.

The judge, though, looked closely at the evolution of the Alabama law and the authorizing statute before he determined that it was not a condition under state law for a municipality to file that had bond debt specifically. It only mattered that the municipality had indebtedness, said Vince Marriott, an attorney who specializes in Chapter 9 bankruptcy at the Philadelphia law firm Ballard Spahr. The warrants, he added, although they are not bonds, clearly represented indebtedness.

Close examination of state laws and statues related to the authorization of bankruptcy filings is important for COPs, as well, Marriott said. So long as a state has statutes that say that indebtedness is all that’s required for a Chapter 9 filing, COPs would then qualify.

“Whether or not a particular form of indebtedness is a prerequisite to authorization to file a Chapter 9 will be a function of how a particular state statute reads,” Marriott said. “If a state statute is not conditioned on having a particular type of indebtedness to authorize a filing under Chapter 9, then it won’t really matter what kind of indebtedness a municipality has, so long as it in fact has indebtedness, which presumably it does or it doesn’t need Chapter 9 to begin with.”

In a COP transaction, a municipal issuer gets possession or use of a facility that it needs through a lease, trust or some kind of vehicle. It agrees to pay rent or a service fee. The vehicle then sells participations to investors from the stream of revenue the facility generates.

For example, in a large city, a public authority would take title to land and issue bonds to pay for the construction of, say, a criminal justice center. The authority then would lease the building to the city, which in turn pays rent to use it. The authority would send those rent payments to the bond trustee to pay debt service.

COPs represent a means to finance improvements without it looking like the incurrence of debt beyond a year, Marriott said.

Because the rental stream of the facility in question is appropriated on an annual basis, there isn’t an obligation beyond each year’s appropriation cycle.

“And in the event that the rent is not appropriated, or if appropriated, then not paid,” Marriott said, “the remedy available to the certificate holders is to re-take possession of the facility, or whatever is being leased to the municipality.”

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