ATMs: Increasing financial flexibility of public companies
The current economic environment creates significant vulnerability for many public companies.
On July 13, 2015, California enacted Senate Bill 222 (“SB 222”), which clarifies that all general obligation bonds (“GO Bonds”) issued by most California municipalities and instrumentalities are secured by a “statutory lien” on future tax revenues (typically ad valorem property tax revenues). This change (or clarification) should reduce the risk to California GO Bonds in municipal bankruptcies, and therefore enhance the market status of GO Bonds of distressed municipalities. While it remains to be seen whether the affected GO Bonds are now completely insulated from impairment in bankruptcy, the new law is without question an important positive development for the municipal bond market.
Investors historically viewed GO Bonds as among the safest securities that municipalities could issue (with the exception of obligations secured by pledged special revenues). Backed by a pledge of the issuing municipality’s full faith and credit—and often by an additional pledge of dedicated tax levies and a covenant to increase those levies as necessary to ensure full payment—GO Bonds were viewed by many as virtually sacrosanct. However, recent Chapter 9 bankruptcy cases, and in particular the recent case of Detroit, Michigan, revealed that certain GO Bonds are vulnerable in bankruptcy.
Municipal bankruptcy law generally divides debts into only a handful of categories. First, “unsecured debt” refers to obligations that are not supported by a lien on assets (or to obligations that exceed the value of any supporting lien). Creditors holding general unsecured debt often receive among the lowest recoveries in bankruptcy.
Second, “secured debt” refers to obligations that are secured by a lien. Creditors holding secured debt are generally entitled to receive at least the value of their collateral. However, bankruptcy “cuts off” consensual liens on the date the case is filed—they do not attach to revenues received by the debtor postpetition. Statutory liens are not cut off and continue to attach to postpetition revenues. This difference is critical in municipal bankruptcies because applicable state law often forbids municipalities from pledging their physical assets. Municipalities therefore often pledge specified future revenues, such as property tax proceeds or state aid. If that pledge is in the form of a statutory lien, it continues to apply postpetition, leaving bondholders relatively protected. If the pledge is consensual, i.e. created by contract rather than statute, it is “cut off,” leaving bondholders secured only by pledged funds already on hand when the case is commenced. Statutory lien-based claims are thus superior to unsecured claims and claims secured by a consensual lien.
Finally, special revenue-financed projects are intended to be wholly separate from a municipality’s general finances. Consequently, bonds secured by a lien on pledged special revenues (e.g., “water bonds” secured by a lien on the revenues taken in by a municipality’s water department) are intended to remain unaffected by a Chapter 9 case of an affiliated municipality, and are also unaffected by the general rule that liens do not attach to revenues received postpetition. Debt secured by a lien on pledged special revenues has never been impaired in a municipal bankruptcy case without creditor consent.
Prior to its bankruptcy, Detroit issued a variety of GO Bonds, which fell into three distinct categories. First, the “Secured GOs,” were so-called “double-barreled” bonds, meaning that they were backed both by the full faith and credit of Detroit, as well as by a statutory lien on certain state aid funds that were regularly distributed to Detroit. Second, the unlimited tax general obligation bonds (“UTGOs”) were supported by the full faith, credit, and taxing power of Detroit and had the benefit of a pledge of a specific voter-approved “millage”—incremental property taxes without limitation as to rate or amount assessed solely for payment of the UTGO debt and required by Michigan law to be kept separate from Detroit’s general fund. Third, the limited tax general obligation bonds (“LTGOs”) were supported by Detroit’s full faith and credit, as well as a general pledge of ad valorem property taxes (but without separation of the pledged funds or a covenant to increase taxes as necessary to pay the bonds).
When Detroit entered bankruptcy, there was little doubt that the Secured GOs would “ride through” the bankruptcy case undisturbed (or, at the very least, be paid 100 cents on the dollar). Whatever the status of the “full faith and credit” pledge supporting the Secured GOs, the separate pledge of state aid revenues constituted a statutory lien that was fully enforceable postpetition. In contrast, Detroit argued that its LTGO and even UTGO bonds were mere unsecured obligations, despite their supporting tax pledges, claiming that those pledges did not amount to liens and were, in any event, not statutory liens that could be enforced postpetition. UTGO and LTGO bondholders of course took the opposing view, arguing, among other things, that the pledges constituted enforceable statutory liens that rendered the UTGO and LTGO bonds secured obligations. Nevertheless, Detroit indicated that it would seek to substantially impair UTGO and LTGO bondholders as part of any plan of adjustment (and indeed sought to do so in the various iterations of the plan that it filed).
Unsurprisingly, Detroit’s position and actions resulted in a great deal of litigation between Detroit and UTGO and LTGO bondholders. Ultimately, that litigation settled, with UTGO bondholders receiving approximately 74 cents on the dollar (much more than general unsecured creditors received) as well as a “most favored nations” clause. LTGO bondholders received substantially less, although still significantly more than general unsecured creditors.
Although the Detroit UTGO and LTGO settlements were broadly positive results for bondholders in the context of a contentious, political, and highly publicized Chapter 9 bankruptcy case, they nevertheless sent ripples through the municipal bond community. Suddenly, many bondholders who previously believed themselves to be fully secured had reason to doubt that their security would be enforced in bankruptcy. Moreover, they realized that, if the issuing municipality became distressed, they would at the very least likely be forced to litigate—with no assurance of victory—whether they possessed an enforceable lien on or claim against postpetition revenues.
The effect of the Detroit settlements were felt particularly strongly in California, which has an enormous number of distressed municipalities and which has been a hotbed of Chapter 9 bankruptcies over the last several years. To address the problem, California enacted SB 222, which is intended to eliminate any doubt that California municipal GO Bonds are protected by a statutory lien that can be enforced postpetition. The key text of the bill reads as follows:
General obligation bonds issued and sold by or on behalf of a local agency shall be secured by a statutory lien on all revenues received pursuant to the levy and collection of the tax. The lien shall automatically arise without the need for any action or authorization by the local agency or its governing body. The lien shall be valid and binding from the time the bonds are executed and delivered. The revenues received pursuant to the levy and collection of the tax shall be immediately subject to the lien, and the lien shall immediately attach to the revenues and be effective, binding, and enforceable against the local agency, its successors, transferees, and creditors, and all others asserting rights therein, irrespective of whether those parties have notice of the lien and without the need for any physical delivery, recordation, filing, or further act.
After the bill takes effect on January 1, 2016, there will be no room to seriously dispute the statutorily secured status of new GO Bonds issued by California municipalities. This development should preempt litigation of the sort that surrounded the Detroit UTGO and LTGO bonds.
This is not to suggest that the new law will be a panacea for California municipalities. First, the SB 222 is ambiguous as to whether it protects already existing California GO bonds, which leaves room for litigation on that front. Second, the underlying municipal financial distress will remain. Third, the rating agencies are (perhaps mistakenly) unlikely to take into account the existence of the statutory lien when providing ratings for California municipal GO Bonds.
Nor will the existence of a statutory lien necessarily shield GO Bonds from the effects of bankruptcy. As an initial matter, the automatic stay applies to revenues subject to a statutory lien to the same extent as other pledged assets. However, bondholders must be provided with “adequate protection” before revenues subject to their statutory lien can be diverted. Providing adequate protection with respect to a municipal revenue stream may prove impossible, meaning that a municipality with statutory lien debt could be left to choose between diverting but not spending the revenues or paying bondholders as scheduled. Thus, some municipal debtors (such as Detroit) choose to pay statutory lien debts during bankruptcy even though that outcome is not dictated by the Bankruptcy Code. Just as important, Debtors may argue that, as with normal secured debts, GO Bonds can be crammed down with extended maturities and/or reduced interest rates. Nevertheless, SB 222 does bring clarity to one critical aspect of the market, which is already helping to restore investor confidence in California municipal GO Bonds and noticeably tightening interest rate spreads. In this respect, California is on the right track and other states should take heed and follow California’s lead.
Lawrence Larose is a partner in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group. Eric Daucher is an associate in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group.
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