CHICAGO - As Detroit has shown, the Chapter 9 world and the municipal bond finance world often just don't speak the same language, according to Nixon Peabody LLP attorneys.
"Bankruptcy lawyers and the bankruptcy code think in different terms than municipal bondholders," attorney Robert Christmas said Wednesday during a webinar hosted by the firm titled "Recent Developments in Municipal Finance: 'General obligation' Bonds, Chapter 9 Cases (Detroit/Stockton) and Beyond."
What's considered a secured obligation is a key disconnect, the attorneys said.
"For the two different perspectives of the bankruptcy world and the municipal finance world, this is a collision," said Christmas.
The collision has been most evident in Detroit, which last year filed for the largest Chapter 9 case to date.
The city had, until recently, treated its general obligation bondholders as unsecured, saying the debt, lacking a statutory lien, was as unsecured as retiree health care and other traditionally unsecured obligations.
The move startled the muni world, which considers GOs, backed by a full faith and credit pledge as well as other protections, as among the safest investments.
But for bankruptcy attorneys, secured debts are only those in which state law recognizes that the creditor has an interest in the debtor's property, Christmas said.
"If it's just a naked full faith and credit pledge, that's generally understood to be a promise," Christmas said.
"In bankruptcy, promises get broken. And that's where the bankruptcy law faces in the municipal debt world results in a collision of cultures."
The question of treatment of GOs in a Chapter 9 is complicated by the lack of case law and precedent, though some is starting to be set in cases like Stockton, Calif., the attorneys said.
It's unlikely that any precedents will come out of Detroit, which has reached settlements with both its ULTGO and LTGO holders.
Even if the Motor City had opted to treat its GOs as secured, it may not have been possible to keep paying them as the city sank under massive fiscal pressure, attorney Mark Berman said.
"The usual solution, and the one on which the full faith and credit pledge relies upon, is that the municipality will raise taxes to accommodate its bond obligations," Berman said. "But that simply doesn't work in Detroit and may not work in other locations," suffering from falling population and revenue, he said. "So the traditional solution is just not available to them."
In light of the uncertainties surrounding GOs in bankruptcy, investors should look for a specific statutory lien in a bond, Berman said. And issuers should improve their disclosure to include a discussion of how the bonds might be treated in a Chapter 9 and if the issuer is allowed to file for bankruptcy.
"In addition to the full faith and credit pledge, I want to see language that says there's the granting of a lien on a specific asset or a stream of revenue," Berman said. "That would make a big difference."
Public finance advocates should also consider lobbying state legislatures to change laws to heighten bondholder protections, he said.
Another new lesson is the value of bond insurance, added Berman. "Despite some problems bond insurers have had over the years, they stepped up big time in Detroit and they're stepping up in other cases," he said. "It really matters whether or not you have insurance."
