Municipal Revenue Bonds Under Attack In Federal Court

Includes: MUB, MUNI
by: Carl Dincesen

Jefferson County, Alabama’s widely reported filing for bankruptcy protection is the largest ever filed by a U.S. municipality.

This action, threatened for almost two years, became reality when a refinancing deal at about 66% on the dollar collapsed. The system can generate only about half of the amount necessary to pay debt service. The filing also includes about $1 billion in County general obligations, a near record.

By way of background, the majority of bondholders were also underwriters of the bonds. They have been fined hundreds of millions of dollars for violations of law in connection with the financing. Former County officials accepted bribes and kickbacks and were sentenced to jail.

Municipal bond investors should keep a close eye on the Federal District Court handling the case. What’s at stake is whether revenue bond default is handled by federal bankruptcy courts. State courts have exclusively administered those settlements since the Nation’s founding.

To date no federal court of any kind has ruled over the settlement of debt secured by a lien on state or local government revenue specifically pledged in repayment of publically sold bonds.

Revenue bond defaults are much more frequent than are general obligation bond defaults which themselves usually not settled through municipal bankruptcy.

By accepting the case, the Federal Court would greatly expand the scope of bankruptcy protection to include enterprise debt of municipalities. For the first time including municipal revenue bonds issued to build essential service infrastructure without the use of tax dollars. I would have to assume that a default on bonds secured by an exclusive lien on a dedicated tax would also be protected.

Local governments in the U.S. are generally prohibited from pledging public property to secure repayments of debt. Instead, they grant a security interest, a lien on operating revenue to borrow money that is repaid by means other than general taxation.

When a municipal utility, airport or toll road defaults, the parties eventually agree to terms based on the bond documents, state law, and most heavily the economic reality of the situation. Both parties want a settlement. Somehow, Jefferson County has apparently fooled a Federal Judge into letting secured revenue bond debt into its warmer, more comfortable waters. Of course, a price will be paid if this stays the case.

From the investor’s point of view, this looks like a new wildcard that would needlessly add risk where there was none, however little solace that may be for the owners of heavily over capitalized revenue bonds. For issuers it would increase borrowing costs because secured creditors will want more for taking the added risk.

The County has no legal or moral obligation to pay a dime of sewer revenue bond debt service, so on what basis is it seeking to have that, along with its own debt, settled in federal rather than state court?

Let’s not forget, the citizens of the County elected the current and former County Commissioners. They cannot be completely absolved but that might now prove to be the case.

A week ago, Tuesday Federal Judge Dickerson who is handling the case said in so many words that he would not ever sever the receiver appointed by the state at the behest of the trustee for bondholders. He has also apparently decided to turn down the trustee’s request to sever his courts’ jurisdiction over settlement of the revenue bonds.

This is a disturbing development for public finance. It could seriously dilute the strength of local government and their bonds over time. The Court’s final decisions are expected December 15.

For more background on subject bonds please see my previous article here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.