It has been just over a month since Detroit’s emergency financial manager Kevyn Orr announced to our market that Detroit would treat its GO bondholders as “unsecured” creditors and pay them only pennies on the dollar.
It is past time for the bond market to forcefully react. We might start by rejecting Mr. Orr’s attempt to group Detroit’s GO debt into either a “secured” or “unsecured” category. The security for a traditional GO bond is altogether something other than “secured” or “unsecured,” and the market needs to educate the courts and policymakers about its unique, albeit hard-to-pinpoint, place in the municipal capital structure.
The precise security for a GO bond differs by state. Some states require issuers to back their GO bonds with statutory liens or structure their GOs in ways that should insulate them from impairment in Chapter 9 (this may even include Detroit). Other GO debt is backed, by a “limited” amount of taxes, explicitly or implicitly.
But the traditional GO bond is backed merely by a municipality’s pledge of its “faith and credit” and “taxing power.” The pledge is understood to mean that a municipality will make its utmost good faith effort to draw on its resources, including its authority to tax, to repay bondholders. Because a municipality’s resources are often extensive, including the ability to tax, borrow, cut spending, sell assets, regionalize services, etc., common practice and market expectation is that a struggling local government must do everything in its power to avoid defaulting on a full faith and credit GO bond.
Nonetheless, a full faith and credit GO is not “secured” in the traditional sense. Full faith and credit GOs are not backed by any lien, property, collateral, or claim against a specified source of revenue.
Full faith and credit GOs are also not properly characterized as “unsecured.” A GO consists of a pledge of faith and credit. That pledge has been given to creditors, and just as with a bond backed by a dedicated tax or revenue stream, a default should be permitted only when the pledge has been fulfilled but fallen short. That is, a municipality, having given its best effort to repay and having tapped out its taxing ability and access to other funds, should be able to default on a GO.
But that is the only situation in which a GO should go un-honored.
GO bonds default very infrequently. Consequently, the courts have considered their security on few occasions. It is likely for this reason that the “secured”/”unsecured” framework continues to be used by market participants and lawyers. More accurate terminology is needed. The “true” meaning of a full faith and credit pledge encapsulates something other than these terms.
The most oft-cited modern case concerning the meaning of a “full faith and credit” GO pledge (the 1976 Flushing Bank case) essentially concluded that a GO security is valuable precisely during times of financial distress (e.g., recessions) and should be honored to the fullest extent possible, even during financial emergencies that threaten the public health and safety. This seems about right, and it suggests that a GO has a form of priority during a financial calamity. However, the extent of that priority remains unclear.
Better terminology is urgently required because the federal bankruptcy code is vague regarding GO security. Bankruptcy law appears to insulate only a subset of GO bonds from impairment. These include GOs secured by statutory liens, special revenue liens, or bond structures that limit the debtor’s control over the pledged tax revenue. Many bond lawyers worry that full faith and credit GO bonds will not be protected in the same way.
The 1997 National Bankruptcy Review Commission recognized the disparate treatment of “secured” and “unsecured” GO bonds and recommended correcting Chapter 9 to prioritize all GO bonds. No change was made. The intent, however, was to conform GO priority in federal bankruptcy court to that under state law. This kind of conformity is a fundamental principle of the bankruptcy code.
Detroit’s proposal to write-down its full faith and credit GOs in the 90% range is a bridge-too-far. Maybe Detroit has given its best effort and can only afford 10 cents on the dollar. But probably not. Show us some asset sales. Prove to the market that the tax base is exhausted, and explain why Detroit’s GOs were honored in each of the past several years but are now, suddenly, almost completely unpayable. That is the City’s burden and threshold to which a bankruptcy court should hold it.
Detroit should be a wake-up call for our market. For the sake of Detroit, other Michigan GO issuers, and the GO market generally, a clearer, accurate, and more rigorous understanding of “full, faith, and credit” is needed.