What You Need To Know In Doing Business With And Holding Municipal Bonds With States, Counties, Cities And Other Municipalities

Given the tremendously uncertain financial issues created by the impact of the coronavirus pandemic, it now appears that issues may arise with respect to the financial condition of states, counties, cities and other municipal entities where revenue sources may be curtailed at the same time expenses are increasing. Any businesses or individuals doing business with such a municipal entity or investing by the holding or purchasing of municipal bonds need to be aware of the risks associated with what may ensue if the municipal entities are unable to pay their debts.

Chapter 9 of the Bankruptcy Code deals with municipal entity bankruptcies and is the only remedy available to any municipal entity seeking debt relief. Municipal entities include counties, cities, towns, villages, water districts, hospital districts and other entities that are deemed to be appropriately supported by municipal revenues. Until the publicity surrounding Detroit's use of Chapter 9, the law's provisions were generally unknown to the business and investment community.

It was recently reported in the media that there may be some political pressure brought by the U.S. Senate to force states into utilizing the bankruptcy process in order to deal with revenue shortfalls and increasing expenses. The easy answer to this is that it cannot occur because states are not permitted to utilize the provisions of Chapter 9 of the Bankruptcy Code.  In other words, none of the 50 states can seek bankruptcy relief absent some action by Congress in amending the Bankruptcy Code. 

In essence, Chapter 9 is very much like a Chapter 11 reorganization for a business in that the municipal entity may seek to reject leases and other agreements known as executory contracts (an executory contract is an agreement where there is performance still to be completed by all parties to the agreement similar to license agreements, franchises, employment agreements, etc.), and the municipal entities may also seek to adjust secured and unsecured debt obligations. Unlike Chapter 11, municipalities can also seek to modify or adjust pension, benefits and retirement obligations.

It should be remembered that in any bankruptcy proceeding, including those for municipal entities filed under Chapter 9, the Bankruptcy Code's automatic stay is in effect which enjoins any person or entity from taking any action in order to collect any debt or take possession of any property of the municipal entity debtor. Violation of the automatic stay can subject the offending creditor to sanctions including contempt. 

Similar to Chapter 11 business reorganizations, a municipal entity utilizing Chapter 9's relief may modify or adjust any unsecured debt obligation that was in existence at the time of the commencement of the case. This is not limited just to trade debt. Municipal bonds that are not specifically designated as revenue bonds are nothing more than unsecured obligations of the municipal entity, and, as such, may be substantially modified or even eliminated as part of the municipal entity's Chapter 9 reorganization plan. Additionally, general obligation municipal bonds may not receive interest payment during the course of the Chapter 9 proceeding.

Municipal bonds that are tied to specific revenue such as toll facility bonds, certain water district bonds, etc., are treated separately from general obligation bonds. Although much more complicated, in essence, the municipal entity must continue to utilize the designated revenue to satisfy the bond obligations, but if the revenue is insufficient to satisfy the bond obligations, the insufficient or unsecured portion may be modified or adjusted as part of the Chapter 9 reorganization plan.  This issue is very significant for those individuals and entities that invest in municipal bonds, as there is an unsubstantiated belief that since they are general obligation bonds, they always must be paid in full including principal and interest.

Also in a Chapter 9 municipality proceeding, avoidance actions may be pursued in order to recover or "claw back" payments to vendors and others made within 90 days prior to the filing of the Chapter 9 proceeding, and any transfers deemed to be fraudulent transfers. This, then, puts at risk those businesses that regularly provide goods and services to the municipal entity where the finances are in the state of deterioration. In such a situation, it is critically important that the vendors seek competent bankruptcy legal counsel while continuing to do business with the municipal entity in order to protect to the extent possible ongoing transactions with the municipal entity.  This should not be interpreted to scare away businesses from providing goods or services to municipal entities experiencing financial difficulty, but only to create an awareness of the need for heightened business and legal scrutiny.

For those businesses and individuals who do business with municipal entities that may experience significant financial problems, it is very important that they take a proactive approach in order to become fully aware of rights, remedies and potential problems should the municipal entity be required to seek Chapter 9 relief.

Tripp Scott's bankruptcy and creditors' rights practice group has substantial experience in representing vendors, lessors, counter-parties to agreements and bondholders who are affected by a Chapter 9 bankruptcy proceeding. Because of the unusual nature of these proceedings, experienced counsel is important in order to provide advice as to available rights and remedies.