Bankruptcies are not all one flavor
Municipal bankruptcy under Chapter 9 is not like a corporate Chapter 11 or Chapter 7, and municipal bondholders should be aware that their rights in the reorganization roadmap are quite different. In a chapter 11 corporate reorganization, the creditors of the corporation have control rights, and other strengths in a bankruptcy, such that they can take possession of the collateral through the court process to satisfy their debts. Alternatively, if corporate creditors chose to force a liquidation through Chapter 7 they can use this to sell off property and assets to help pay their claims. Municipal bondholders do not have these rights, which are in fact strengths in the reorganization process.
In the case of Chapter 9, Municipal Bankruptcy, the function of the court is generally limited to approving the municipal debtor’s petition and determine whether the municipal entity is eligible for Chapter 9. The court then confirms the debt adjustment plan and ensures the plan’s implementation. Muni bondholders cannot liquidate a city. Public interests are counterbalanced against creditor’s demands. Municipal debts are typically reorganized by extending the maturity period, reducing the amount of interest and/or principal owed or obtaining new loans to refinance the bankrupt bonds often at a discount to creditors.
Municipal Bankruptcy is becoming a more common tool
Municipal bankruptcy under chapter 9 was first enacted in 1934 during the Great Depression, and was later revised in 1937. Unlike corporate bankruptcies which are an everyday occurrence, municipal bankruptcies remain rare, with less than 500 having been filed over the last 80 years. Today, the credit markets are seeing more economic distress for towns, cities, counties, taxing districts, sewer and utility authorities and school districts and these municipal entities are more willing to use the courts to adjust debt.
Detroit’s $18 billion dollar bankruptcy was particularly brutal to bondholders with recoveries ranging from 74 cents on the dollar for unlimited GO bondholders and 34 cents on the dollar for limited GO bondholders. Jefferson County Alabama Sewer Authority clocked in with $4 billion in 2011, only to outdo the notable Orange County, California’s $2 billion dollar clean up in 1994. Stockton and San Bernardino, California also adjusted their large debts recently. And today Puerto Rico’s $73 billion dollar reorganization is far and away the largest that the municipal bond market has ever seen.
Regaining access to capital markets for future capital needs has become less of a carrot to avoid Chapter 9
This is where it starts to get scarier for municipal creditors, because the argument seemed to be that if you, the municipal entity, files for a plan of adjustment and cannot reach a consensual agreement with bondholders then you will be locked out of the bond market for years to come. What the Detroit Chapter 9 case shows is that the city considered this inability to access the market for years to come and factored it into their plan of adjustment. The city provisioned their capital needs for 10 years following their plan’s confirmation, putting aside enough funds to virtually eliminate the need to enter the public finance markets to raise debt for an entire decade. Thus, the monies set aside to ensure this plan only made the write downs deeper for Detroit’s municipal creditors. How this concept of self-funded capital plays out in the context of Puerto Rico’s dive into protection under PROMESA will be quite interesting since PROMESA requires that Puerto Rico have access to sufficient capital as part of its reorganization which may not bode well for its municipal bondholder creditors.