Municipal Debtors: 'Cram Down' Of Special Revenue Debt

Municipal financing differs in a number of significant ways from traditional commercial financing. Therefore, while chapter 9 of title 11 of the United States Code (the "Bankruptcy Code") incorporates many provisions applicable in cases under chapter 11 of the Bankruptcy Code, including section 1129(b), a/k/a the "cram down" section, it also contains its own provisions with respect to the confirmation of a plan of adjustment - i.e., sections 943 and 944 of the Bankruptcy Code. See 11 U.S.C. § 901(a) (incorporating sections of the Bankruptcy Code). When considering the differences between cram down scenarios in cases under chapter 11 of the Bankruptcy Code and cases under chapter 9 of the Bankruptcy Code, one must consider the prevalence of special revenue financing by municipal debtors and the protections that are built into chapter 9 of the Bankruptcy Code.


  1. Special Revenue Financing

    Our system of federalism grants state governments the independence and the freedom (with the consent of their citizens) to authorize local governmental bodies to finance various governmental functions and necessary improvements through the issuance of municipal bonds. Municipalities issue their own debt obligations either based on their full faith and credit (general obligation bonds) or based upon the revenues to be collected by the municipality from the financed improvement (revenue bonds). Local government borrowing differs in a fundamental way from either individual or corporate borrowing. The municipal borrower is an entity having special characteristics that differ from those of private actors. See Joel A. Mintz et al., Fundamentals of Municipal Finance 45 (2010). The local government exists solely to provide governmental services; it does not exist for profit-making purposes. Id. Due to the public benefit of financed projects, like water and sewer systems, municipalities are limited in the actions they can take with these assets, including certain restrictions on the right to mortgage or transfer the property, or to allow foreclosure or possession of the property by a secured creditor in the event of default.1 Further, limitations exist due to the state's interest in protecting the credit of the state and insuring that municipalities do not harm the state's credit by undertaking obligations which cannot be repaid.

    As municipalities have grown, so has their need for financing. Protecting the integrity of municipal financing is essential to the continued confidence of the municipal bond markets. Thus, municipalities have traditionally made every effort to honor their public debt obligations.

    i. Protections for Special Revenue Creditors

    Unlike general obligation bonds, which are backed by the full faith and credit of the issuer and, therefore, rely on the assessment and collection of taxes for repayment, revenue bonds do not increase the tax burden of the citizens. They are non-recourse obligations repaid solely from the revenues (and other specified pledged funds) generated by the project that is being financed, such as a sewer or water system, toll road, toll bridge, tunnel, or the like. Consequently, in many jurisdictions, revenue bonds may be issued without voter approval or other procedures often required for the issuance of general obligation bonds. See Fundamentals of Municipal Finance, at 3-4.

    To entice the public to purchase revenue bonds in particular, states have enacted statutory provisions designed to promote this type of financing. Since repayment of the revenue bonds are limited to the stream of income from the financed public projects, states authorize the issuing municipality to irrevocably pledge (or set aside) the revenue stream (or net revenue stream) for the benefit of the revenue bondholders. Typically, the pledge includes the creation of a first lien on the revenue stream. Some states even provide that the pledged revenue streams are held in trust for the benefit of the special revenue creditors. For example, Alabama recognizes that pledged revenues "shall constitute a trust fund or funds which shall be impressed with a lien in favor of holders of the warrants to the payment of which such pledged funds are pledged" and that the pledged revenues are "irrevocably pledged for the payment of the principal and interest on such warrants as provided in Section 11-28-3." Ala. Code §§ 11-28-2, 11-28-3.

    Other protections that are authorized by state law and that are often contained in revenue bond documents are covenants in which the issuer pledges: (a) to issue all bonds necessary to finance the project; (b) to complete project construction expeditiously; (c) to maintain specified amounts of reserve funds; (d) to fix, establish, and collect appropriate fees, rates, tolls, or user charges; and (e) to restrict the investment of bond proceeds. Fundamentals of Municipal Finance, at 3-4. In addition, where revenue bonds are issued to finance a series of projects undertaken by the same issuer, the municipality that issued them will usually pledge not to issue any additional bonds that are secured by the same revenue stream, unless current revenues are sufficient to cover a specified percentage of both current and future debt service on both outstanding bonds and the new bonds. Id. Once entered into, the revenue bond covenants may not be modified or abandoned by the municipality. Id.2

    Since bondholders are unable to take ownership of certain public assets, municipalities will often transfer certain control rights to bondholders to provide the holders with a meaningful remedy in the event of nonpayment. One such remedy is the right to the appointment of a receiver to oversee the particular project in question, and, if appropriate, raise rates sufficient to pay the special revenue debt issued to finance the project.

    The states and their municipalities have designed these financing structures to guaranty that the revenue stream relied upon by special revenue bondholders will be protected and not impaired. These statutory provisions protect not only bondholders but also protect the overall credit of the state and all of its municipalities. See Fundamentals of Municipal Finance, at 4. As will be discussed in more detail below, given the prevalence of this type of financing, and with it being particular to municipal debtors, Congress, in amending chapter 9 of the Bankruptcy Code in 1988, intended to protect and preserve the bargain made between the municipal debtors, as issuers, and the holders of special revenue debt.

  2. Chapter 9 And A Brief History Of Municipal Bankruptcy Legislation3

    Chapter 9 of the Bankruptcy Code is the sole chapter under which a municipality may seek bankruptcy relief. Chapter 9 has evolved since it was first enacted in 1934. Prior to 1988, chapter 9 lumped all of a municipality's debt into one pot and did not distinguish between general obligation bonds and special revenue bonds. In 1988, Congress approved a series of amendments (the "1988 Amendments") aimed at distinguishing between the two types of bonds. The intent of Congress in enacting the 1988 Amendments was to ensure that state laws protecting special revenue financing were honored in a chapter 9 proceeding and the rights of special revenue creditors would receive additional protections not granted prior to the 1988 Amendments. See S. Rep. No. 100-506, at 13 (1988) (the "Senate Report"). Specifically, the 1988 Amendments sought to ensure that special revenue bondholders would have unimpaired rights to the project revenues pledged to them.

    The ultimate intent of Congress in enacting the 1988 Amendments was to provide assurances to the capital markets that special revenues essential to municipal financing remain unimpaired in the event of a Chapter 9 filing. The Senate Report for the 1988 Amendments noted that "[r]easonable assurance of timely payment is essential to the orderly marketing of municipal bonds and notes and continued municipal financing." Id. at 21. The Senate Report further noted that:

    To eliminate the confusion and to confirm various state laws and constitutional provisions regarding the rights of bondholders to receive the revenues pledged to them in payment of debt obligations of a municipality, a new section is provided in the amendment to ensure that revenue bondholders receive the benefit of their bargain with the municipal issuer and that they will have unimpaired rights to the project revenues pledged to them. . . .

    Id. at 12 (emphasis added). For example, prior to the 1988 Amendments, special revenue bondholders were at risk that section 552(a) of the Bankruptcy Code would strip them of their liens on post-petition revenues. The Senate Report addressed that issue:


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