By now, many investors are aware that Detroit has filed for bankruptcy – making it the largest U.S. city ever to do so. As a review of the bankruptcy process, here are some excerpts from a piece we distributed to financial advisors in August 2008.
How do municipal bondholders fare when a municipality files for bankruptcy? The answer begins with an understanding of how a municipal bankruptcy filing works. Regardless of a municipality’s solvency, special revenue bonds typically remain secured during a bankruptcy proceeding, and debt service payments should continue uninterrupted. General obligation bonds, however, may be restructured or re-negotiated.
Municipal bankruptcy proceedings are filed in Bankruptcy Court, the federal court charged with administering bankruptcy laws. The Municipal Bankruptcy Act of 1937 (the “Act”) is the federal framework within which municipal debts are resolved. Interestingly, fewer than 200 municipal bankruptcy petitions have ever been filed since these laws were enacted.
Chapter 9 of the Act lets municipalities reorganize their debts and protects them from creditors. Debt reorganization is often done by extending debt maturities, reducing principal or interest amounts, or refinancing. Chapter 9 is the only chapter in the Act that has no provisions for liquidating municipal assets and distributing the proceeds to creditors. Such provisions would most likely be deemed unconstitutional.
At the Outset, a Voluntary Filing: A Chapter 9 proceeding begins with a voluntary filing of a petition to the Court. To be eligible for relief, the filer must prove that it is a municipality, that is, a political subdivision, a public agency or an instrumentality of a State. Additionally, the filer must prove that it is authorized to be a debtor, that it is insolvent, that it seeks to create a debt-adjustment plan, and that it has negotiated-successfully or unsuccessfully—a debt—adjustment plan with its creditors. A list of creditors must also be filed either with the original petition or at a later time. The need to prove insolvency at the outset often discourages municipal leaders from pursuing bankruptcy protection. Many worry that being declared insolvent could impair the municipality’s long-term ability to access capital markets and find buyers for its bonds.
Upon filing of the petition, an automatic stay of all collection proceedings against the municipality is granted. Further, enforcement actions against officers and inhabitants of the debtor municipality are prohibited. During this period, however, the municipality may continue to pay debts secured by pledged revenues. However, a municipality is not required to pay principal or interest on general obligation bonds during a Chapter 9 bankruptcy proceeding.
After the petition is filed, the case is assigned to a judge, a “notice of commencement” is published and objections are heard. The case will proceed unless the original petition fails to withstand objections. The Bankruptcy Court generally limits its activities to reviewing a municipality’s bankruptcy petition, confirming its debt adjustment plan and helping ensure the plan works as smoothly as possible. If a municipality consents, the Court may also exercise jurisdiction in other areas.
Next, a Plan for Debt Adjustment: Before any obligations can be discharged under Chapter 9, a plan for debt adjustment must be confirmed by the Bankruptcy Court. The Court is bound by specific confirmation standards, among them determining that the plan is in the best interest of creditors. This standard has been interpreted to mean that creditors should benefit more from the adoption of the plan than they would from other available alternatives.
In most cases, the only real alternative would be for creditors to compete with each other to maximize their recovery. As a result, the “best interest of creditors” test is generally met when the municipality’s plan requires it to apply a reasonable effort to repaying its creditors. If the municipal debtor cannot confirm a plan or if the Court refuses to confirm the plan, the Court’s only option is to dismiss the case, leaving creditors to seek their own recourse. This outcome, by the way, is feasible even if the Court agrees that the municipality is insolvent and even if continuing the proceeding would benefit creditors.
Case studies: When the City of Vallejo, California, filed for Chapter 9 bankruptcy protection in May 2008, its declaration of insolvency triggered a raft of questions and memories (some fuzzier than others) about municipal bankruptcy proceedings. Was Vallejo similar to Orange County, California, or Bridgeport, Connecticut, two municipalities that filed bankruptcy in the 1990s? And, just how did those situations turn out, anyway?
When Vallejo filed for bankruptcy protection on May 23, 2008, its two largest unsecured debts were obligations to retired public employees ($136 million for health care benefits and $84 million for pensions, according to the filing). The City also listed four municipal debts, totaling $80.1 million, among its top 10 unsecured creditors. For Vallejo, bankruptcy has proven an obstacle to subsequent borrowing.
Before Vallejo in 2008, Bridgeport, Connecticut, was the only large city to file a Chapter 9 bankruptcy petition. (Most bankruptcy filings involve municipal instrumentalities, like waste removal or public utility districts, rather than cities or counties.) Bridgeport’s 1991 Chapter 9 filing failed because the city could not prove that it was insolvent.
Orange County, California, commenced the largest municipal bankruptcy proceeding in history with its filing on December 6, 1994. Earlier, county officials acknowledged facing $1.5 billion in losses related to high-risk investments. In April 1995, the county’s treasurer pleaded guilty on six felony charges and was eventually sentenced to a short jail term, fined $100,000 and ordered to complete 1,000 hours of community service.
Orange County emerged from its bankruptcy proceeding in June 1995. Significantly, Orange County municipal bondholders were repaid in full, including principal, interest and penalty interest. Orange County was thus able to raise an additional $800 million in the capital markets—through the sale of newly issued municipal bonds.
A financially distressed municipality’s alternative to bankruptcy is to restructure its debt under applicable state law—a process that could require voter approval and be very difficult to execute. The option of filing a Chapter 9 bankruptcy petition, despite its hurdles and limited relief, could easily be considered the lesser evil for municipalities under extreme financial duress. While seeking bankruptcy protection, however, it remains in the best interest of any municipality to maintain good relations with capital markets. Orange County regained its footing in the credit markets when it made its municipal bondholders whole.
Financial institutions often remind their clients that “past performance is no guarantee of future results.” While some bondholders have escaped harm during municipal bankruptcies, we believe that the “past performance” warning applies. No matter what the future brings, our commitment to in-house credit analysis and to securing attractive levels of tax-free yield for our investors remains rock solid.