* Calpers protecting top spot in bankruptcy workouts
* Rare municipal bankruptcies hold landmines for creditors
* Chapter 9 usually last resort for ailing governments
By Michael Connor and Tim Reid
MIAMI/LOS ANGELES, Nov 30 (Reuters) – America’s rarely used
municipal bankruptcy law is presenting unexpected risks for
investors in the $3.7 trillion U.S. tax-free bond market.
The largest U.S. pension fund, the California Pension
Retirement System (Calpers), this week sued a small,
cash-strapped California city in a bid to halt its bankruptcy,
creating fresh uncertainties for municipal bond buyers.
At stake is much more than the few million dollars that San
Bernardino, a city of 210,000 people just east of Los Angeles,
owes in arrears for pensions – a token amount in comparison with
the $241 billion managed by Calpers.
But the courtroom face-off in California may help establish
who feels the most pain in municipal bankruptcies under Chapter
9, a section of federal bankruptcy law that poses multiplying
risks to bondholders and other creditors of ailing local
governments.
Similarly, bankruptcy experts and bond investors are closely
watching t he judge handling the year-old $4.23 billion Chapter 9
case filed by Alabama’s Jefferson County that may affect risk
assessments and interest rates for tax-free revenue bonds.
Both cases could set important legal precedents that would
weaken or change safeguards for bond investors and potentially
raise borrowing costs for cities and other issuers of tax-free
revenue bonds used to finance water works and other
infrastructure.
“It is a huge concern,” said David Manges, municipals
trading manager at BNY Mellon Capital Markets in Pittsburgh.
“Chapter 9 bankruptcies are so rare that there are few
precedents for dealing with muni bonds. Every example is
creating new tax law ad hoc.”
ALABAMA CASE MAY STING REVENUE BONDS
Lawyers in the Alabama case have clashed over how much of
sewer-system revenues should go to owners of some $3 billion of
county sewer-system bonds. The dispute challenges decades-old
assumptions that revenue bonds go untouched in Chapter 9 cases.
“Jefferson County has really opened a Pandora’s Box,” said
Richard Larkin, senior vice president at investment firm H.J
Sims.
Desperate for revenue to pay for basic government services,
Jefferson County officials have aggressively claimed
sewer-system fees and are forcing a rethink among investors
about the safety and relative risk of revenue bonds backed by
dedicated cash flows, such as tolls or water bills.
“A lot of people buy revenue bonds because they think they
are safer than general obligation bonds,” Larkin said. “They
believe their payments would continue during any bankruptcy.”
Calpers worries that San Bernardino, in halting bi-weekly
payments of $1.6 million to the city’s pension accounts until
the 2014 fiscal year, is threatening its customary first-in-line
status as a creditor in workouts by distressed governments.
Calpers’ legal move may mean that bondholders and other
creditors of San Bernardino could see their rights to payments
hurt if Calpers wins its argument.
Historically, bondholders have fared better in Chapter 9
proceedings than those in corporate bankruptcies, though only a
few large local governments with outstanding bonds have gone
through Chapter 9 in recent years.
Twenty two states either do not authorize or have bans on
municipal bankruptcy. Most Chapter 9 cases have involved
entities such as special tax districts supporting arenas, ports
or water utilities.
However, Chapter 9 was used in the two largest U.S.
municipal bankruptcies to date: those of Jefferson County in
Alabama and Orange County, in California.
No U.S. municipality in the past 30 years has used
bankruptcy to pay anything less than the full principal due to
bondholders, though some interest payments have been lost.
Only the Californian city of Vallejo, which emerged from
bankruptcy in 2011, forced bondholders to take a haircut when
its finances were restructured. Interest payments to a single
major creditor, U.S. Bank, a unit of USBancorp, were
reduced, though principal payments were met.
In Orange County, which declared bankruptcy in 1994,
bondholders continued to be paid in full, although for some it
took longer to get full interest and principal payments.
CHAPTER 9, AN UNUSUAL MIX OF FEDERAL, STATE LAWS
In practice a tangle of federal and state laws, Chapter 9
differs greatly from the Chapter 11 laws for corporate
bankruptcies, under which companies reorganize their finances
under court supervision. Chapter 9 offers troubled local
governments the chance of a stronger bargaining position with
creditors and labor unions, as well as continued control over
their services.
“It has been the last resort,” said James Spiotto, a
prominent Chapter 9 specialist and a partner at Chapman & Cutler
in Chicago. “Other methods have been viewed by policymakers as
more acceptable, and the use of Chapter 9 by cities and towns
has been small.” For a FACTBOX please see:
Unlike failed department stores or people overwhelmed by
hospital bills, Chapter 9 cases leave managers of busted water
systems and counties with more autonomy than a corporate boss
would have under Chapter 11.
U.S. bankruptcy judges can order companies to liquidate
assets or force a debtor to sell a home but have no power to
tell a city to shop downtown parkland to property developers or
hike trash-hauling fees as ways to satisfy debts.
“It’s not like a retail enterprise,” said bankruptcy lawyer
George South of DLA Piper in New York. “Cities can’t shut down.
They provide vital services.”
Chapter 9 cases, which have included three Californian
cities that declared bankruptcy since June, also sting citizens
by cutting services, put at risk government workers’ jobs and
retirement benefits and can deter business investment.
Alternatives to Chapter 9 have been financial control boards
in New York, financial managers in Indiana, intergovernmental
cooperation in Pennsylvania and receivers in Rhode Island.
“The goal of the municipalities is to be able to deliver
essential services and right-size their governments,” Spiotto
said. “There’s a lot of creativity out there beyond Chapter 9.”
(Reporting By Michael Connor in Miami and Tim Reid in Los
Angeles, Editing by Tiziana Barghini and Dan Grebler)
