As investors familiarize themselves with their respective issuer’s credit profile, they are essentially looking to ensure that the debtor is financially strong enough to pay back its obligations in a timely manner. Now, what happens when a municipality is unable to meet its financial obligations? The simple answer is the reorganization of municipalities, which includes cities, towns, counties, taxing districts, municipals utilities and school districts, under Chapter 9 of the Bankruptcy Codes.

Although Chapter 9 cases are rare and the restructuring laws can be very different for every state, recent local government’s bankruptcies like Detroit, Michigan (2013); Jefferson County, Alabama (2011); Stockton, California (2012); and San Bernardino, California (2012), were few of the major examples in recent times that served as a rude awakening for many municipal debt investors who originally thought that municipal debt was the safest investment option out there and showed full faith in the taxing power of each local government.

In this article, we will take a closer look at the purpose of municipal bankruptcy, the eligibility requirements for municipalities, plan of adjustment and, finally, how it impacts the bondholders.

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When a local government is struggling with its crippling debts and unable to meet its financial obligations, it can seek protection under Chapter 9 bankruptcy from its creditors while developing a comprehensive plan to put forward for adjusting its debts. This plan mainly includes a way to reorganize the municipality’s debts and potentially extend the maturities to lower its debt service payments and/or possibly refinance its debt obligations to lessen the financial burden.

At an individual level, this may sound similar to a mortgage loan refinancing or loan modification that will prolong the term of the loans, which, in turn, decreases the monthly payments. However, unlike bankruptcy laws reserved for individuals, there is no provision under Chapter 9 bankruptcy code that warrants the liquidation of assets of the municipality and distribution of the proceeds to investors or creditors.

Under the Chapter 9 bankruptcy protection, the municipality files for a petition, drafts a plan of debt adjustments and follows this plan. All these stages are approved by the bankruptcy court and require monitoring to ensure proper adherence to the plan of adjustment. Again, these stipulations and laws can be very different for every state.

Want to learn more about what happens to municipal bonds when municipalities go bankrupt? Click here.

The Chapter 9 rules extend protection to municipalities that are also defined as a political subdivision or public agency that’s part of a state government. According to the U.S. courts, the bankruptcy code Chapter 9 assigns four eligibility requirements for municipality bankruptcy protections:

• The municipality must be specifically authorized to be a debtor by state law or by a governmental officer or organization empowered by state law to authorize the municipality to be a debtor;

• The municipality must be insolvent, as defined under the Bankruptcy Code. Under the Code, a municipality is insolvent if it is either (i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute or (ii) unable to pay its debts as they come due. These two standards are typically referred to as tests of insolvency;

• The municipality must desire to effect a plan to adjust its debts; and

• The municipality must also:
  • obtain the agreement of creditors holding at least a majority in amount of the claims of each class that the debtor intends to impair under a plan in a case under chapter 9;
  • negotiate in good faith with creditors and fail to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that the debtor intends to impair under a plan;
  • be unable to negotiate with creditors because such negotiation is impracticable; or
  • reasonably believe that a creditor may attempt to obtain a preference.

When filing for the protections under Chapter 9, the municipality is obligated to craft a plan to reorganize its debts and present this plan to the bankruptcy court for its approval before it can be enacted and followed by the municipality. The court reviews and confirms a plan if the pertinent conditions, set forward under the Chapter 9 code, are met, such as:

• All amounts to be paid by the debtor related to the plan have been fully disclosed and are reasonable;

• The debtor is not prohibited by law from taking any action necessary to carry out the plan;
  except to the extent that the holder of a particular claim has agreed to a different treatment of such claim, the plan provides that on the effective date of the plan, each holder of a claim of a kind specified in section 507(a)(1) will receive, on account of such claim, cash equal to the allowed amount of such claim;

• Any regulatory or electoral approval necessary under applicable nonbankruptcy law in order to carry out any provision of the plan has been obtained, or such provision is expressly conditioned on such approval; and

• The plan is in the best interest of creditors and is feasible.

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The treatment of municipal debt obligations is different based on their types and the revenue structures; for example, the municipalities are generally not required to make payments on their general obligation debt during the case. This entails both principal and/or interest payments. All debt obligations secured under general obligation debt are subject to negotiations and possible restructuring under the code. However, any special revenue-backed debt will be serviced during the bankruptcy based on the pledged revenue sources.

This difference in treatment of GO debt and special revenue-backed debt has taken center stage in the financial restructuring of Puerto Rican debt, where there has been an emergence of disputes between GO and revenue-backed debt. The general obligation bondholders and their legal representatives have brought forward lawsuits claiming that their debt obligations must be met by the island’s government before special revenue debt obligations, secured by the island’s sales tax revenues, are paid, irrespective of any revenue pledges, liens or secured debt.

Don’t forget to click here to know more about Puerto Rico municipal debt.

The entire process of Chapter 9 bankruptcy can take years before a plan of adjustment is approved, enacted and followed by the municipalities. The municipal debt investors must carefully analyze the structure of their holdings and understand how this structure will be treated in the event of municipal insolvency.

The recent bankruptcies of well-known American municipalities should admonish investors who may think that municipal debt is immune to financial downturns.

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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.