Twelve states, including California, impose no restrictions on municipalities’ ability to file for Chapter 9 bankruptcy. On the other extreme, there are three states that do not allow local Chapter 9 filings and more than 20 that are silent on the matter, which is generally considered a prohibition.

As California Assembly Bill 155 — drafted by state Sen. Tony Mendoza with support from labor unions — has moved through the legislative process, changes have made it less onerous for local governments that have opposed the bill in significant numbers.

Recently, AB 155 was amended to allow municipalities, under specific conditions, to file even when the California Debt and Investment Advisory Commission, the reviewing body, refuses their request.

The May 2008 Chapter 9 filing by the city of Vallejo is viewed as a threat to union contracts and unions favor AB 155. Local governments oppose it because they do not wish to give up their autonomy.

Is it in bondholders’ interest to support or oppose this kind of legislation? Should bondholders favor the bonds of governments located in states that limit Chapter 9 filings versus those of states that do not? Does Chapter 9 filing flexibility hurt bondholders more than receivership or other “solutions” like receiving state oversight?

Let’s take a look at the basic characteristics of Chapter 9.

Chapter 9 is not a fast process like the June 2009 General Motors Chapter 11 bankruptcy. Vallejo has been in Chapter 9 for more than two years. Orange County, Calif., was in Chapter 9 for almost two years.

The diverse constituencies of any municipal entity make a “wrapped and packed” bankruptcy similar to GM’s unlikely. Bankruptcy is a time drain and distraction for management, vendors, unions, employees, and bondholders.

The outcome of a Chapter 9 is less certain than for a distressed credit that does not file because once the unit goes into bankruptcy court, the state exits the process and events are driven by the court. Once a Chapter 9 filing has started, it cannot be well-controlled by any constituency.

Chapter 9 is not cheap. Everybody in a bankruptcy proceeding needs a barrel- full of attorneys. Unfortunately, there are not that many attorneys with substantive Chapter 9 experience. As the Orange County bankruptcy showed, lack of public finance experience is not a barrier for attorneys wanting to represent issuers and creditors.

There is a learning curve involved, though, that someone has to pay for. Other than motivating an eventual outcome, Chapter 9 is not very efficient.

Filing for Chapter 9 is likely to be considered worse than being fiscally challenged in the eyes of businesses that are considering relocation to the affected community.

The ability of a community to offer incentives and provide infrastructure support for the company’s new facility will be questioned in either case, but more so in the case where the community is actually in bankruptcy.

Chapter 9 will not enhance the image of the community. The bankrupt entity is forever referred to as “______, which filed for bankruptcy in ...” just as Orange County is now.

For Orange County, the automatic stay provided by a bankruptcy filing was critical. The stay allowed the county to stop the run on their investment pool and then negotiate with all of the governments that had invested in the pool. Assets were sold off in an orderly fashion. This feature of bankruptcy has meaningful application to governments, just as in the private sector, although perhaps to a lesser degree.

Bondholders don’t want their credits to become distressed or to file for Chapter 9. But should they prefer to invest in local credits where the state allows complete freedom to file, or to invest where partial or complete prohibitions against filing exist?

Pennsylvania and Michigan are examples in the middle of the continuum where local units must file with a state authority before filing for Chapter 9. In Pennsylvania, most distressed municipalities are placed under Act 47 as an alternative to Chapter 9.

The act provides for state help in budgeting, managing debts, and forming plans to return to solvency. While Act 47 has prevented bankruptcy filings, the main criticism has been that once a municipality enters, they never get out.

In Michigan, municipalities in fiscal distress are placed under a receiver with strong powers who can renegotiate union contracts, outsource services and reduce payrolls. While this program was effective in resolving financial problems in the city of Ecorse, who knows if future receivers can routinely motivate positive outcomes.

The data on bankruptcy filings offers limited clues as to the advisability of Chapter 9 from the investors’ point of view. States that have no restrictions — California and 11 others — do have more Chapter 9 bankruptcies per unit of government than those that restrict Chapter 9, but almost all of the data represented are debt issues that were sold as nonrated at the time of sale.

In other words, for nonrated — mostly real estate development — debt that is below investment grade when issued, there appears to be an association between the lack of state involvement and the number of bankruptcies per unit of government. It is important to note that there is insufficient data to suggest that this preliminary finding would stand up for issues priced as investment-grade securities.

The credit turbulence unleashed by the Great Recession will eventually provide the data to answer the question of where an investor may want to position their investments along the Chapter 9 continuum. Central Falls, Rhode Island, which was placed into receivership last week because the state does not allow Chapter 9 filings, is a litmus test.

Chapter 9 is seldom used. Unfortunately, the lack of usage represents a problem. The case law regarding bankruptcies for general investment-grade municipalities is thin and leaves plenty of room for new precedents. These could change the direction of Chapter 9 and generate very uncertain outcomes.

A recent article, “Two Recent Rulings Address Eligibility for Chapter 9 Bankruptcy Protection,” by Winston & Strawn LLP that appeared in Lexology, provides an example.

Rulings rendered by Judge Bruce Markell in the Las Vegas Monorail case currently in Chapter 11, clarified narrow distinctions between entities and their ability to file under Chapter 9 as a municipality.

Meanwhile, Judge Martin Glenn, overseeing the filing of the New York City Off-Track Betting Corp., made a related ruling and found it eligible for Chapter 9 since its status as a “municipality” was the result of a legal executive order by the governor of the state. These rulings will provide precedents for future cases.

It is hard to say now whether AB 155 is good, bad or indifferent for bondholders of local California credits. In today’s environment of credit challenges, however, investors should add to standard credit analysis a more detailed review of the constitutional and statutory underpinnings of state and local credits.

This ought to include not only laws that govern each state’s management of the credit problems of their local units and how the issue of Chapter 9 is handled, but also laws regarding budgeting and those that establish the protections afforded public sector pensioners.

Investors should revisit their assumptions about how they would fare with a Chapter 9 filing with the understanding that there is no clear answer at present. The past presumption of full recovery, however, may come under fire now that we are entering a period of greater fiscal limits.

 

Chris Mier is a managing director in the analytical services division of Loop Capital Markets LCC, which has no position on this legislation. The firm has client relationships with the state of California, local governmental units, and other entities with a stake in the legislation. This piece is offered a framework for discussion only.