Municipal Bankruptcy Remains "Last Resort" Despite Troubled Economy
Jun 8, 2010 | Cities, Towns & Villages, Municipal Bankruptcy and Default, Municipal Bond Market News/Research, Municipal Finance - General, Municipal Finance - Public Pension Funds
Vallejo, California made headlines in 2008 when it filed for Chapter 9 municipal bankruptcy protection. Since then, the economic downturn has exerted increased pressure on state and local government coffers, causing many to struggle with how to cover their debts, including repayment to bondholders.
However, as James Spiotto, a partner with the Chicago law firm of Chapman and Cutler LLP, who specializes in special litigation, bankruptcies and workouts, explains in the following interview, municipalities turn to Chapter 9 bankruptcy protection only when all other alternatives have been exhausted and insolvency appears otherwise incurable.
MuniNet: Most people think of debt – particularly government debt – as negative. However, you've said that debt isn't always bad. Can you explain?
Spiotto: Economic growth depends upon efficient operation of government facilities, much of which is financed by municipal debt. In the past, increased issuance of state and local debt has often helped stimulate state and local economies. This issuance of debt has augmented governmental financing and infrastructure improvements that create jobs for the unemployed, business opportunities for local businesses, demand for goods, and increased GDP growth and employment, which lead to increased tax revenues.
However, to ensure that capital markets are receptive to municipal government financing, financing must be structured to recognize and respond to economic cycles. And while debt itself is not inherently bad, it certainly has the potential to become problematic when the governmental body encounters difficulty in repaying their creditors.
MuniNet: Why would a municipality have cause to file for Chapter 9 bankruptcy protection?
Spiotto: Chapter 9 was originally developed to end litigation during the Depression against municipalities for not paying their debts, to give them a breathing period, to come up with a plan of debt adjustment and a fresh start. Generally, what municipalities believe they can get out of a Chapter 9 is a resolution of the problems they have with their current debtholders and a fresh start for the future.
MuniNet: A fresh start sounds appealing – especially in today's economic climate. So why don't we see more Chapter 9 filings?
Spiotto: Municipalities must prove insolvency in order to file for Chapter 9 protection, showing a complete inability to pay debt as it matures. Traditional U.S. state and local government bonds enjoy a proud history of a low number of defaults and, when they rarely occur, higher recoveries compared to corporate debt, both investment grade and speculative. The default rate for municipal securities dramatically lags the default rate for corporate counterparts. According to Moody's, between 1970 and 2007, there were 54 rated municipal bond defaults -compared to 1,707 rated corporate defaults.
MuniNet: Can all types of governmental bodies file for Chapter 9 protection?
Spiotto: No. A state is a sovereign and, as a sovereign, is not authorized to file a Chapter 9 as a municipality. A municipality, being a subdivision or agency of the state, therefore, can file if specifically authorized by its State.
For purposes of eligibility, a municipality can be a city, town, village, county or special district, including school district, public healthcare agency, fire protection district and utility. But not all municipalities are authorized to file for Chapter 9 protection. Sixteen states specifically authorize municipal bankruptcy; 7 states conditionally authorize municipal bankruptcies; 2 generally prohibit filing, 3 have very limited authoriziation of special entities to file, and the remaining 22 states are either unclear or do not have specific authorization.
MuniNet: Looking back over the past two years, what implications did the Vallejo bankruptcy filing have on municipal bankruptcy in general?
Spiotto: The Vallejo filing may have brought the problem of unfunded pension obligations and labor costs into clearer focus. Prior to the Vallejo case, for example, many people may not have recognized that labor contracts could be rejected in bankruptcy proceedings.
One thing the Vallejo filing did not do was inspire other municipalities to hop on the bandwagon. In fact, there were only ten Chapter 9 filings in 2009, and only two through May of 2010. Most of these were special districts, three of which were Nebraska utilities. Only one filing was for a special district in California, and the others have been somewhat dispersed around the country.
MuniNet: When we think of "credit problems of the past," Bridgeport, Philadelphia, and Orange County are well-known case studies. In your opinion, which credits from this decade will leave a similarly dubious legacy?
Spiotto: I think that Vallejo will leave its mark on municipal finance history books, along with the Sierra Kings Healthcare District, which will likely be noted for its treatment during the Chapter 9 proceeding of timely scheduled payment to G.O. bondholders based on a statutory unlimited ad valorem tax pledge dedicated to such payments.
We've seen some unusual stories coming from smaller municipalities as well, including Moffett, Oklahoma, which became cash-strapped when speed traps (which had accounted for over 80 percent of the town's operating budget) were eradicated.
MuniNet: While we know you don't have a crystal ball, do you see more on the horizon for later this year, or perhaps 2011?
Spiotto: The answer will depend largely on how prolonged the current economic downturn will turn out to be. Employment recovery is vital in that it provides a source of income for citizens, who can translate personal income into revenue for the municipality via sales, real estate, and income tax. Until we see real improvement in employment figures, more municipalities could be at risk.
At the same time, I don't foresee municipalities rushing to file for Chapter 9 bankruptcy protection. Because of the stigma associated with bankruptcy protection, and the ensuing difficulty in selling bonds, the strained relationship with other creditors, and the cost of bankruptcy proceedings, filing for Chapter 9 protection is really a last-resort solution that most municipalities would consider only if there were no other possible alternatives.
James Spiotto is a partner with the Chicago-based law firm of Chapman and Cutler LLP which specializes in the law of finance: banking, corporate finance, securities and public finance.
Mr. Spiotto is head of the firm's Special Litigation, Bankruptcy and Workout Group. He has represented banks, insurance companies, institutional investors, funds, indenture trustees and bondholders in litigation or workouts for more than 400 troubled debt financings in over 35 states and 10 foreign countries.
He has lectured before various academic institutions, professional associations, authorities and governmental bodies regarding unfunded pension liabilities and OPEB, municipal defaults, bankruptcy, and disclosure issues. He testified before the United States Senate and House Judiciary Committees in conjunction with the amendments to the Bankruptcy Code including those involving Municipal Bankruptcy.
He has written numerous books and articles on municipal defaults and bankruptcy, and he is a co-author of the volume The Law of State and Local Government Debt Financing (Thompson West) and author of the book, Defaulted Securities: The Prudent Indenture Trustee's Guide published by the American Bankers Association.
Recently, he authored chapters on municipal defaults and bankruptcy in The Handbook of Municipal Bonds (Frank J. Fabozzi Series (Sylvan Feldstein and Frank Fabozzi, editors, published in 2008 by John Wiley & Sons, Inc.). He is past president of the Society of Municipal Analysts. Mr. Spiotto has been awarded the National Federation of Municipal Analysts' Municipal Industry Contribution Award. In addition, the National Association of Bond Lawyers has presented him with the Carlson Prize for the best Scholarly Article for his presentation on Municipal Defaults and Bankruptcy to the United States House of Representatives Subcommittee Hearing on the Orange County Crisis.