Governments Rethink Their 'Moral Obligation' to Municipal Bondholders
In the post-recession era, some struggling governments are choosing not to pay bondholders -- and judges are allowing their refusal.
When a government defaults on debt, it’s usually because it can’t afford the payment -- not because it doesn’t want to make the payment.
But that’s changing.
In Missouri, a judge ruled last week that Platte County, home to the Kansas City area, was completely within its rights when it opted six months ago to not pay a $765,000 bond payment due for a long-struggling shopping development. In his decision, Circuit Court Judge James Van Amburg noted there was “no promise or requirement” for the county to pay the debt on the Zona Rosa retail center, even if the county auditor’s proposed budget included a line item for the payment (which was the case last year).
The ruling validates a trend in the post-recession era -- at least in Missouri -- of municipal governments placing their obligations to taxpayers ahead of what they may owe to bondholders.
The 'Moral Obligation' to Pay
In Platte County’s case, the Zona Rosa bonds were issued by the county’s Industrial Development Authority to finance parking garages in the shopping center. The bonds were supposed to be paid back with revenue from a 1 percent sales tax on Zona Rosa businesses, but sales have fallen short.
Although Platte was not legally obligated to cover any payments in the case of a shortfall, investors and credit agencies have typically considered governments in those situations to be “morally obligated” to do so. That's because a default by a related government entity -- in this case, the Industrial Development Authority -- would still be a mark against the credit worthiness of the main government -- the county.
But Platte County refused to pay anyway.
“The county’s budget is tight, so they’ve decided it's worth [fighting] this,” says Court Street Group municipal analyst Joseph Krist. “Like many other things, a ‘moral obligation’ to pay is -- for better or worse -- not what it once was.”
That’s becoming true for other types of bond debt, too.
Earlier this year, an appeals court in New York ruled that Puerto Rico was not required while in bankruptcy to continue paying bonds that are paid back through a special dedicated revenue. (Think: water or sewer bonds paid back from consumers’ bill payments.) The ruling undermined the market’s view that special-revenue bonds were safe harbors in a municipal bankruptcy.
Even when courts allow governments significant leeway -- such as the ability to cut retiree pensions in municipal bankruptcy -- governments have tended to make bondholders give up more.
Detroit’s bankruptcy in 2013 shook the municipal world when it pushed through a restructuring plan that placed general obligation (GO) bondholders behind the city's pensioners when it came to who would recover the most of what they were owed. GO debt is supposed to be backed by the full faith and taxing power of the government selling them. Before Detroit, they had been considered unbreakable.
To some extent, these deeds don’t go unpunished.
Even before it let the Zona Rosa bonds go into default, Moody’s Investors Service downgraded Platte County to junk status. In reaction to the Puerto Rico ruling, Moody’s and Fitch Ratings have placed dozens of other governments with related special revenue bonds under review for a downgrade.
Still, Todd Graves, an attorney for Platte County, said the ruling in Missouri helped stop a “bondholder bailout” by the taxpayers.
“This is a great day for taxpayers -- and a firm rebuke to financiers attempting to abuse the public treasury,” he said.
UMB Bank, the trustee for the bonds, told the Kansas City Business Journal that it will "continue to work with counsel to explore options and keep working in the best interest of bondholders.”
Perhaps more than ever, municipal bond investors need to be careful about what they’re buying, says Krist, the municipal analyst.
“The onus,” he says, “is on the investor to understand the legalities.”
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