VI. THE ROLE OF PUBLIC-FINANCED DEBT
A. Treatment of Special Revenue Bonds versus General Obligation Bonds
General obligation bonds are debt obligations secured by the full faith and credit and taxing power of a governmental issuer. In most states, general obligation bonds represent a promise by the governmental unit to levy and assess taxes in order to pay debt service. Generally, this promise can be enforced by court order. Outside of the context of a Chapter 9 bankruptcy, general obligation bonds are considered the highest, most secure pledge of credit a municipal issuer can grant.
In contrast, special revenue bonds are limited obligations that provide for a security interest in a specified revenue stream, usually revenues of a project being financed by the bonds (i.e., a toll might create the revenue stream for the cost of a bridge). If the revenues are inadequate to pay the revenue bonds, the municipal issuer has no further obligation to pay the bonds. This is an application of the "special fund doctrine," which provides that if a particular fund is pledged as the source of payment for a debt without additional security, then payment of the debt is limited to monies in that fund. If the fund is depleted, the debtor has no additional obligation to pay.64
Outside of a Chapter 9 bankruptcy, revenue bonds are viewed by investors as a less secure investment than general obligation bonds. However, once a municipality has filed under Chapter 9, the relative priority positions of the obligations flip. Section 928 of the Bankruptcy Code provides that in the case of special revenue bonds, a security interest in special revenues remains valid and enforceable during the pendency of the Chapter 9 bankruptcy case.
Therefore, although outside of a Chapter 9 bankruptcy, general obligation bonds are considered the more secure investment; inside a Chapter 9 case, special revenue bonds have secured creditor status while general obligation bondholders are relegated to the status of general unsecured creditors. Special revenue bonds will continue to be paid, at least to the extent of available pledged revenues, while general obligation bondholders will share in what is left over (assuming anything is left over) with other unsecured creditors, which may include municipal employees under collective bargaining agreements and retirees.
B. Statutory Liens
In Chapter 9, a bankruptcy court generally must honor statutory liens created by state statute.65 The 2001 Amendments to the Uniform Commercial Code (the UCC) recognized statutory liens, and the UCC provides an exception to the requirement of filing UCC-1 Financing Statements in order to perfect such liens. In many states, it is quite common to find statutory liens for revenue bonds, but it is much less common to find statutory liens for municipal general obligation bonds.66
Probably the most far-reaching lien statute for general obligation bonds is found in the state of Rhode Island. The law was drafted in 2011 in advance of the city of Central Falls' Chapter 9 bankruptcy filing. Section 45-12-2 of the Rhode Island General Laws provides a first priority lien on a city's or town's taxes and general fund revenues to secure general obligation bonds. This lien has priority over all other obligations, including collective bargaining agreements and pension obligations.
C. Debate regarding Whether Impaired Treatment of General Obligation Bonds in Chapter 9 Will Lead to Contagion
The Rhode Island lien statute was enacted in order to preserve Central Falls' access to capital and also to prevent contagion that might otherwise prejudice the capital markets against other Rhode Island municipal issuers, precluding access to capital, or making credit more expensive to compensate for risk. The existence of a contagion effect within the entire municipal bond market, within states, or within neighboring communities is currently being debated.
In Rhode Island, there was anecdotal evidence that Central Falls' financial woes were having an adverse effect on some of Rhode Island's financially weaker municipalities. Likewise, when the city of Harrisburg, Pennsylvania, attempted to file for bankruptcy, there were concerns that municipalities surrounding Harrisburg would have difficulty with market access or be required to pay higher interest rates.67
With the announcement of the proposal of Detroit's state-appointed emergency manager to pay general obligation bondholders 10 cents on the dollar, commentators suggested that Detroit's actions could impair market access, or at least increase borrowing costs for the state of Michigan and its municipalities.68 The Pew Charitable Trust Report, The State Role in Local Government Financial Distress, issued in July of 2013, however, suggests that the risk of financial distress of one community adversely affecting its peers may be over-stated.69 It may be that the public capital markets have a short-term memory. Alternatively, the explanation may be that municipalities in larger states such as California and Michigan are less likely to be adversely affected by a community's bankruptcy than municipalities in smaller states such as Rhode Island and New Jersey. Similarly, neighboring communities in the same region of a state may be affected while those more distant will be unscathed.
D. Lessons...
