There’s an old joke that no one wants to see how the sausage is made – which is one of the reasons why what’s happening these days in the world of municipal bankruptcies is so painful for the parties involved.
Unlike corporate bankruptcies, there’s so little precedent for cities filing for bankruptcy protection that case law is being written with each major decision. The big difference is, of course, that cities cannot liquidate like a business can. But beyond that divide there are more nuanced scenarios where that distinguishing characteristic is playing out.
In Chapter 11, for example, judges can use their vast authority to move a case along – in Chapter 9, they have few overarching powers. Creditors in Chapter 11 are well versed in their options but the options in municipal bankruptcy are limited and still being tested.
In other words, it’s still a crapshoot.
“An effective Chapter 11 is an elaborate negotiation where the parties know the rules of the game,” said Federal Judge Christopher Klein, who is presiding over Stockton, Calif.’s bankruptcy case. “If you look at Chapter 9 where the judge has far less authority, what that really means is the negotiation model there is on steroids except nobody really quite knows the boundaries.”
Klein’s comments came during a teleconference hosted Tuesday by the American Bankruptcy Institute in which lawyers and municipal finance experts weighed in on what lies ahead for distressed municipalities.
Patrick Darby a partner at Bradley Arant Boult Cummings LLP in Birmingham, added that lenders are at least more comfortable with corporate bankruptcies because they know what to expect. And there is a higher chance of getting paid back in Chapter 11 because the process allows for the selling off of assets. Creditors in Chapter 11 can also submit reorganization plans for the debtor whereas in municipal cases, only the city has that authority.
“Commercial lenders have become very sophisticated about [recouping losses in] bankruptcy,” he said. “I think the next steps will be to see if these [bond investors] become more like commercial lenders and use bankruptcy to adjust debts in a reasonable and equitable fashion.”
Meanwhile, in both Chapter 11 and Chapter 9 bankruptcies the plan of reorganization “must be in the best interest of the creditors, meaning they get at least as much in chapter 11 as they would if the debtor entity liquidates,” added Juliet Moringiello, a professor at Widener University School of Law in Harrisburg, Penn. But just how that intent is carried out in Chapter 9 when there is no possibility of liquidation is fuzzy.
“So the question is, what exactly does that mean?” she said.
Natalie Cohen, managing director for Wells Fargo Securities, said investors are watching cases closely to get even small clues about what’s in their future if they are dragged into a municipal bankruptcy. For example, a ruling in Jefferson County, Ala., helped draw the line between secured and unsecured creditors in the world of Chapter 9. Last July, a judge limited Jefferson’s use of revenues generated by its sewer system by ruling that Jefferson could not use that money for bankruptcy-related expenses.
The ruling meant that general obligation bonds, generally considered the gold standard of muni debt because they are backed by the government, fall into the unsecured debt category in bankruptcy. Meanwhile, special revenue bonds, which are repaid with the proceeds from the projects they finance, are treated as secured debt because the funds are protected.
“The marketplace is watching very carefully to see if there’s any droplet on … these points,” Cohen said.