The Painful Truth: Some Municipal Bondholders Will Take A Hit

The Painful Truth is that as debt increases, so do the risks it will be politically, economically and financially worthwhile for borrowers to walk away from paying back their loans to bondholders. To see a real time list of the largest defaulted municipal bonds.

Municipal bankruptcy is very different than the two most common forms of bankruptcy protection under the Bankruptcy Code – Chapter 7 liquidations and Chapter 11 reorganizations. Like individuals and companies, municipalities can also file for bankruptcy protection under Chapter 9 of the Bankruptcy Code. California has had several municipal bankruptcy filings in 2012 including the cities of Stockton, San Bernadino and other. These are some of the largest cities to file for municipal bankruptcy protection following major municipal bankruptcy filings in Jackson County, Alabama and Harrisburg, Pennsylvania. While municipal bankruptcies remain few, but their numbers are increasing as municipal revenues decline and obligations such as pensions increase. Not only do municipal bankruptcies give us a window into the state of the public sector, but they may impact municipal bondholders even investors of General Obligation bonds.

Chapter 9 of the Bankruptcy Code changes this equation. Chapter 9 is the chapter of the Bankruptcy Code allowing for municipalities to file for bankruptcy protection and restructure their obligations in a manner similar to Chapter 11 bankruptcy for private entities. Like the other chapters of the Bankruptcy Code, Chapter 9 allows a municipality to gain “breathing room” from its creditors, including GO bond holders. Meanwhile, the municipality may reorganize its debts by reducing principal, extending maturity dates, or refinancing the debt. As in Chapter 11, the municipality submits a plan of reorganization to the courts for approval that can significantly alter its contractual obligations to various creditors as allowed under the Bankruptcy Code.

And this rule applies to General Obligation (GO) bondholders as well. Bankruptcy case law makes it clear: GO bonds need not be paid in full for a bankruptcy court to approve a municipal restructuring plan under Chapter 9. See, e.g., In re Sanitary & Improvement Dist. #7, 98 B.R. 970 (Bankr. D. Neb. 1989). In the District 7 case, the Bankruptcy Court approved a municipal reorganization plan that impaired the rights of GO bondholders. Even though the municipality could have, in theory, raised taxes to cover their bond debt obligations, the Bankruptcy Court refused to force them to do so. The Bankruptcy Court explained that “[i]f a municipality were required to pay prepetition bondholders the full amount of their claim with interest . . . and the [debtor] had no ability to impair the bondholder claims over objection, the whole purpose of Chapter 9 would be of little value.” Id. at 974. Other courts have followed similar lines of logic. See, e.g., In re City of Columbus Falls, Montana, Special Improvement District No. 25, 26, 28, 143 B.R. 750 (D. Mont. 1992) (allowing Chapter 9 debtor to impair GO bondholders so long as other requirements of Chapter 9 were met); see also In re City of Camp Wood, Texas, Case No. 05-54480 (Bankr. W. D. Tex. June 13, 2007) (allowing a municipality to write-down the principal amount and interest rate of municipal GO bonds and amortize payments over a longer period).
What this means for GO bondholders is that their investments are still generally safe, but once a municipality files for Chapter 9 bankruptcy, they are in the same boat as any general unsecured creditor. While Chapter 9 bankruptcies are relatively rare, they do happen. For example, Jefferson County, Alabama filed for Chapter 9 protection after accumulating over $3 billion in debt from a court-mandated upgrade to its sewer system. The sewer system upgrade was conducted in a blatantly illegal manner, and the former Mayor of Birmingham, Alabama and the President of the County Commission are both serving prison terms for bribery. Twelve others were convicted of bribery and conspiracy, and over twenty others are serving jail time on related counts. Despite the governor of Alabama attempting to work with the County to forestall bankruptcy, Jefferson County was forced to file for Chapter 9 protection.
Only 5% of Jefferson County’s municipal bonds were GO bonds, but those bondholders may be forced to take a haircut. When municipal bond markets were flush, it was easier for municipalities to hide fiscal problems. With the recession, that has changed. Now, municipalities are finding that their fiscal problems are straining budgets as tax revenue plummets. Municipalities in states from New York to California are also feeling the cash crunch, especially since state government coffers are insufficient to give municipalities a backstop.

Chapter 9 of the Bankruptcy Code may be a relatively little-known section of bankruptcy law, but some municipal bondholders are learning the hard way that it can have a major effect on their investments.