Illinois Gov. Bruce Rauner wants Chapter 9 bankruptcies permitted in Illinois; municipal market experts say it is unclear what such a filing would mean for bondholders of the troubled Chicago Public Schools.

CHICAGO – The impact a Chapter 9 bankruptcy would have on Chicago Public Schools and its investors is cloudy, market participants say.

If Illinois Gov. Bruce Rauner gets his way and the state enacts a statute to permit Chapter 9 filings, the ability of the district to force a haircut on holders of much of its $6 billion of debt is uncertain.

The district in its most recent bond sale declared that one of its pledged repayment streams under the state’s alternate revenue bond structure would meet the bankruptcy code’s designation of “special revenues” that are largely shielded in Chapter 9.

Analysts, lawyers, and investors disagree over the strength of the structure and whether it would hold up in bankruptcy court given the limited litigated precedent, but agree it would be a contested issue with no guaranteed outcome.

The definition of “special revenues” appears clear, says James Spiotto, of Chapman Strategic Advisors LLC, but the interpretation and application of some provisions in bankruptcy is not.

“I think eventually there won’t be any doubt” on what qualifies as special revenues, but in the meantime “it will be argued because that’s what people do in bankruptcy,” said Spiotto, who spoke generally about Chapter 9 and declined to comment specifically on how he thinks CPS’ debt might fare.

The district is struggling to remain afloat with little cash in the bank, nearly $10 billion in unfunded pension obligations, a looming $1 billion deficit, and a rising annual teacher pension payment that is close to $700 million.

The special revenue issue took center stage on the eve of CPS’ last deal Feb. 3, a $725 million pricing that required 8.5% tax-exempt yield to draw buyers.

After a flurry of meetings with investors, CPS’ finance team acquiesced to their pressure and added to its bond disclosure the language from a special opinion that provides the legal reasoning behind CPS’ position that the bonds’ structure provides a security which preserves the statutory lien on pledged revenues and offers relief from the automatic stay provisions of the bankruptcy code.

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 pledge allowed by Illinois' Local Government Debt Reform Act.

The pledged tax revenues are levied as part of the bond resolution but are abated by the district because it uses pledged 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 tax levy for debt service, which has never been triggered, is not subject to the property tax caps that non-home-rule units like CPS fall under for operating purposes.

Most of the board's $6 billion in debt uses the 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 and personal property replacement tax revenues have been pledged on earlier deals.

The structure allows non-home rule governments like CPS to get around voter approval requirements. The backdoor referendum model requires a public vote only if sufficient signatures are raised after CPS publishes its intent to issue the bonds.

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

Some market participants have also questioned the worth of the statutory lien on state aid because its value assumes the state’s continued payment of aid.

The board acknowledges there is no binding legal precedent for its position and doesn’t guarantee the debt would avoid a cramdown where the pledged tax revenue could be stayed and terms adjusted in a plan of adjustment deemed "fair and equitable" by the court.

The Rating Debate
The question over how such status influences ratings was highlighted in a recent Fitch Ratings’ report that delved into California school districts’ strong general obligation security features, which have driven higher ratings for some deals there. Fitch compared them to what it considers the weaker CPS structure.

While the special revenue designation from revenues that come from the operation of a utility or transportation system are more clear cut, questions arise on tax-supported school GOs that can qualify under the category of revenues raised from a particular function of the debtor.

CPS did not provide Fitch with its special opinion – which sources said was authored by Katten Muchin Rosenman LLP -- but Kroll Bond Rating Agency did receive it and gave the recent issue a one notch boost over the BBB-minus rating it assigned to other CPS bonds.

The other three rating agencies peg Chicago school debt as junk, citing its severely distressed overall credit profile.

Kroll, after also consulting with its own external counsel, believed the structure likely means bondholders would be treated as secured creditors 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.

Fitch believes California offers more statutory and constitutional clarity on collection of taxes that back school GO bonds and the use of their proceeds. California also offers a framework for a bankruptcy filing.

Those features are either absent or less clear-cut in CPS’ framework.

The Chicago deal comingled uses including a debt restructuring and repayment of swap termination payments. No procedures are in place to govern a Chapter 9 filing, which is currently not possible under Illinois law, and CPS is exempt from some state oversight rules.

The school board is authorized to direct the county to deposit pledged property taxes with the trustee but that direction can be revoked, which Fitch worries “lends a level of control to the board that could leave it in possession of pledged tax revenues in a bankruptcy proceeding.”

Even with a legal opinion in hand, the district would not have met Fitch’s threshold to warrant a higher rating.

“There were enough other concerns besides that lack of a legal opinion,” Fitch analyst Arlene Bohner said.

Fitch said the punishing 7% coupons, yielding 7.75% on the deal’s 10-year and 8.50% on the 28-year maturity, also suggest that the market has concerns over the validity of the special revenue claim and make a challenge more likely.

The Threat
Rauner included in his “turnaround agenda” the creation of a Chapter 9 statute to give local governments a bargaining chip in union negotiations and suggested CPS was a candidate.

Earlier this year, he endorsed state legislation backed by fellow Republicans that would subject the district to state statutes allowing for oversight and pave the way for bankruptcy.

The threat, dismissed as dead on arrival by the Democrats who control the General Assembly, still scared off enough investors ahead of the district’s $875 million sale, forcing it to postpone the deal a week and scale it back to $725 million.

If CPS is correct about the way its bonds would be treated in a bankruptcy, such a Chapter 9 outcome would leave pensions and contracts to take the hit.

Rauner critics say curbing union powers is the governor’s goal.

Public pension benefits enjoy strong protections under the state constitution – a status that was reinforced by the Illinois Supreme Court’s ruling last week that benefit cuts in Chicago’s 2014 pension reforms violate state law giving contractual status to membership in governmental pension funds.

Any effort to authorize a CPS Chapter 9 could face a challenge with opponents arguing that such a filing would be unconstitutional based on the pension protections, one lawyer said.

Just having the bankruptcy option on the table “really compels negotiation and compromise,” said state Rep. Ron Sandack, R-Downers Grove, who introduced a Chapter 9 bill. He added there’s still the potential for sufficient value in savings from contract and pension modifications to stabilize a struggling government’s finances even if bondholder haircuts are not in the equation.

Sandack’s bill would require a third party independent evaluation and attaches statutory lien status on pledged revenues on future issuance.

Precedent
Municipal bankruptcies often end in settlements, precluding an actual precedent-setting finding in court.

Holders of Detroit’s more than $5 billion of water and sewer utility debt that market participants believed clearly met the special revenue designation were still dragged into the city’s Chapter 9 filing.

The city sought to impair call protections or lower existing coupons. The city ended up purchasing about $1.3 billion at various price levels through a tender and remaining bondholders were not impaired.

“Special revenue investors have been better protected during a bankruptcy, as payments are likely to continue,” Moody’s Investors Service said in a February report that analyzed credit risk and recoveries of recent municipal bankruptcies. “Except for Jefferson County, all recent Chapter 9 cases where investors had debt secured by a water and sewer revenue pledge did not experience a default.”

“The Detroit, Stockton and Vallejo cases demonstrate that retirees have done better in Chapter 9 cases than investors in general government debt,” Moody’s said.

In Detroit, pensioners were hit with a single-digit cut in their benefits and their annual cost-of-living adjustments were suspended, but unlimited tax GO holders suffered a 26% loss and limited tax GO holders took a 66% haircut. If CPS bonds were protected, and that’s a big if, “bankruptcy could still be an option if they thought that considerable savings by restructuring compensation,” said Richard Ciccarone, president of Merritt Research Services LLC.

"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," one buyside source said at the time of the pricing.

“It’s a difficult question” because the state does not currently permit a Chapter 9 filing, said Adam Buchanan, senior vice president in sales and trading at Ziegler. “I think clarity on the issues is what the market always wants and we are seeing a lot of opinions but no clear path….it all depends on your own view.”

History
Only four school districts have filed for Chapter 9 in the last six decades because most states hold oversight powers that can help stave off bankruptcy, Spiotto said.

“Two of the four never got to a plan of adjustment. They realized once they got in there was a better way,” he said.

California’s San Jose Unified School District filed in 1983, saying it couldn’t afford to scheduled salary increases. The parties reached an agreement on a new wage plan and the Chapter 9 was dismissed.

Another California school system, the Richmond Unified School District in California, now known as West Contra Costa Unified District, filed in 1991 due to fiscal and operational woes. Parents sued the state which loaned the district $29 million, ending the bankruptcy.

Copper River School District in Alaska filed in 1986 to reject its teachers’ contract and the Chilhowee-R-IV in Missouri adjusted its debts in 1993.

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