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Public Finance Matters

Updates on recent public finance and municipal bond developments

SEC Proposes Expansive New Continuing Disclosure Requirements Regarding Private Debt and Other Financial Obligations

Posted in Disclosure

By CHARLES E. CAREY

On March 15, 2017, the Securities and Exchange Commission (“Commission” or “SEC”) published in the Federal Register for comment proposed amendments to Rule 15c2-12 (the “Rule”) under the Securities Exchange Act of 1934 (“Exchange Act”) that would amend the list of event notices required under the Rule in a manner that, if such amendments are finalized in their proposed form, would likely require issuers of, or “obligated persons” on, publicly offered municipal bonds to provide detailed ongoing disclosure of any new debt, derivatives and other “financial obligations.”

The Rule requires that a broker, dealer, or municipal securities dealer (collectively, “dealers”) acting as an underwriter in a primary offering of municipal securities reasonably determine that an issuer or an obligated person has undertaken, in a written agreement or contract for the benefit of holders of the municipal securities, to provide to the Municipal Securities Rulemaking Board (“MSRB”) through the MSRB’s Electronic Municipal Market Access (“EMMA”) system, prompt notice of specified events. The proposed amendments would amend the list of such event notices to include;

  • (i) incurrence of a financial obligation of the obligated person, if material, or agreement [by the obligated person] to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation of the obligated person, any of which affect security holders, if material; and
  • (ii) default, event of acceleration, termination event, modification of terms, or other similar events under the terms of a financial obligation of the obligated person, any of which reflect financial difficulties.

The proposed amendment provides a broad definition of “financial obligation” which includes: a (i) debt obligation, (ii) lease, (iii) guarantee, (iv) derivative instrument, or (v) monetary obligation resulting from a judicial, administrative, or arbitration proceeding. The “financial obligation” definition excludes traditional municipal bonds which are already covered by the Rule.

In the release accompanying the proposed amendments, the SEC noted that if new financial obligations or new material covenants, events of default or remedies impacted an issuer’s or obligated person’s liquidity and creditworthiness, the credit quality of the issuer’s or obligated person’s outstanding debt could be adversely affected which could impact an investor’s investment decision or other market participant’s credit analysis. Such changes to credit quality could also affect the price of the issuer’s or obligated person’s existing bonds.  Items the SEC referenced as potentially material include debt service coverage ratios, rate covenants, additional bond tests, contingent liabilities, events of default, remedies and priority payment provisions (including structural priority such as balloon payments, for example).

The Commission’s accompanying release stated that the event notice of incurrence of a material financial obligation generally should include a description of the material terms of the financial obligation. According to the release, examples of such material terms include the date of incurrence, principal amount, maturity and amortization, and interest rate, if fixed, or method of computation, if variable (and any default rates); the release states that disclosure of other terms may be appropriate as well, depending on the circumstances.

Unless the proposed amendments are pared back following the comment period, they are likely to result in the required disclosure by issuers or obligated persons of municipal bonds subject to the Rule of virtually all new loan agreements with banks or other private lenders, privately placed municipal bond indentures or loan agreements, swap agreements, real estate leases, and material judgments or arbitration rulings, as issuers and obligated persons are unlikely to shoulder the administrative burden and legal risk associated with determinations of which obligations, and which terms of such obligations, are “material” and which are, and will remain in hindsight, clearly immaterial.  Similarly, for expense and risk reasons, it is more likely that full legal documents will be disclosed versus substantially redacted or summarized versions.

The proposed amendments do not appear to require disclosure of the termination or satisfaction of financial obligations previously disclosed on EMMA as material events; accordingly they may result in the accumulation over time on EMMA of a variety of lengthy loan agreements, indentures, swap agreements and the like with no clear way for bondholders or brokers accessing EMMA to determine whether the relevant obligations and the related agreements continue in effect. Such overdisclosure may limit the pool of investors with respect to the obligations of the issuer or obligated person, in that brokers responsible under MSRB Rule G-47 for conveying to customers all material information about the security accessible on EMMA may opt not to do so for securities with EMMA postings that include unwieldy amounts of raw legal documents.

Issuers and obligated persons may also deem the requirement to publicly disclose otherwise private transactions adverse to their business interests. Currently, for example, an issuer or obligated person may negotiate different covenants and different covenant levels with different private lenders, without each lender necessarily having access to the covenants of the other lenders.  If the amendments require the issuer or obligated person to disclose on EMMA the coverage, days cash on hand, interest rates and other material terms of its private loan arrangements, the result over time may be for each new lender to require, in effect, most favored nation status with covenants and other terms at least as tough as the toughest terms previously agreed to by the applicable issuer or obligated group.  Reasonable minds may disagree on whether that should “come with the territory” when an issuer chooses to access the public municipal market, but to date such public disclosure of the details of private transactions has not been required.

The second new event notice, for the occurrence of a default, event of acceleration, termination event, modification of terms, or other similar events under the terms of a financial obligation of the issuer or obligated person, presents a different judgment call for issuers and obligated persons, as such disclosure is only required if the event “reflects financial difficulties.” Some of the examples cited in the release for subsequent events include monetary or covenant defaults that might result in acceleration of the debt, swap events, such as rating downgrades, which might require the posting of collateral or the payment of a termination payment and changes to the contract rights of the counterparties to financial obligations. Again, it is unlikely that entities subject to such requirements would expend much legal capital on parsing through whether a swap termination event, or even an amendment of loan documents, “reflects financial difficulties”, and the tendency is likely to be towards overdisclosure.

There are additional ambiguities in the proposed amendments. According to the accompanying release, the amendments will only be applicable to continuing disclosure agreements executed after the amendments are finalized, but it is unclear, for example, whether an issuer or obligated person that executes a continuing disclosure agreement governed by the amended Rule will be required to disclose all previously incurred material “financial obligations”, or whether only “financial obligations” incurred following the execution of such an agreement will be subject to such disclosure.  The accompanying release does indicate that the required notice of default, event of acceleration, termination event, modification of terms, or other similar events under the terms of a financial obligation which reflect financial difficulties would apply with respect to financial obligations previously incurred.

Unlike many of the existing events for which event notices are currently required under the Rule, which occur rarely, incurrence of financial obligations occurs regularly for many issuers and obligated persons. Accordingly, these amendments arguably would constitute the broadest expansion to date of the Rule’s continuing disclosure requirements. They are sure to generate many comments from affected parties before they are finalized.

Tax Guidance to Slow Under Trump. Even More Emphasis on Letter Rulings in Bond Transactions?

Posted in Tax/arbitrage

By MAXWELL D. SOLET and CHRISTIE MARTIN

As the Trump administration attempts to substantially reduce the amount of federal regulations, both the Deputy Tax Legislative Counsel of the Treasury Department and an Associate Chief Counsel at the Internal Revenue Service indicated this week that we are likely to see a virtual halt to formal tax law “guidance” for the foreseeable future.  Such guidance includes regulations, revenue rulings, and revenue procedures, the principal means by which Treasury and IRS provide interpretations of tax statutes.  However, both officials stated that the IRS will continue to provide taxpayer-specific private letter rulings (PLRs).  In addition to more PLRs being requested to resolve ambiguities in connection with particular transactions, the freezing of the formal guidance process could result in PLRs being given more weight than ever in the analysis of other transactions.  Not only will bond attorneys have more incentive to read and rely upon the only available tea leaves as to the IRS’s position, but IRS attorneys may write more substantive letter rulings with the expectation that they will guide practice beyond the particular transactions being ruled upon.  While officially non-precedential, PLRs have long been of particular importance in the tax-exempt bond practice, where formal guidance is slow and case law is almost nonexistent. 

 

IRS Clarifies New Management Contract Safe Harbors

Posted in Tax/arbitrage

By MAXWELL D. SOLET and CHRISTIE MARTIN

In August, 2016, the IRS issued Revenue Procedure 2016-44, the first comprehensive revision of its management contract safe harbors since Revenue Procedure 97-13.  Rev. Proc. 2016-44 (see our description here) built upon and amplified principles laid out in private letter rulings issued over many years and in Notice 2014-67.  Now, less than six months later, the IRS has published Revenue Procedure 2017-13, which clarifies and supersedes Rev. Proc. 2016-44 but does not materially change the safe harbors described therein.  The clarifications are in response to questions received with respect to certain types of compensation protected under earlier safe harbors, incentive compensation, timing of payments, treatment of land when determining useful life, and approval of rates.

 

 

Treasury/IRS Provide Early Holiday Present: Final “Issue Price” Regulations Released

Posted in Tax/arbitrage

By CHRISTIE MARTIN and MAXWELL D. SOLET

After two sets of proposed regulations, Treasury and IRS have now released final regulations on the definition of “issue price” for purposes of arbitrage investment restrictions that apply to tax-advantaged bonds (the “Final Regulations”) and it appears that the third time’s the charm. Practitioners are particularly praising the addition of a special rule for determining issue price for competitive sales and clarification on determining issue price for private placements.  The Final Regulations were published in the Federal Register on December 9, 2016 and can be found here.

Several years ago, tax regulators became concerned that the longstanding practice of allowing an issue price to be calculated based on reasonable expectations could lead to abuse in that “reasonably expected” issue prices for bonds sometimes differed from the prices at which bonds were actually being sold to retail investors. A determination by the IRS that the “issue price” has been erroneously calculated can have ramifications for the calculation of arbitrage yield that could ultimately cause loss of tax-advantaged status.  A clear and predictable definition of issue price is therefore essential for the tax-advantaged bond community.

After the first set of proposed regulations, published in the Federal Register on September 16, 2013, caused an uproar in the bond counsel community as being largely unworkable, they were withdrawn and re-proposed on June 24, 2015 (the “2015 Proposed Regulations”). The 2015 Proposed Regulations were subject to a comment period followed by a public hearing.  These Final Regulations build on the 2015 Proposed Regulations with certain changes in response to the public comments.

The Final Regulations look to actual facts as the general rule for determining issue price. Generally, the issue price of bonds is the first price at which a substantial amount (at least 10%) of the bonds is sold to the public.  For bonds issued in a private placement to a single buyer, the Final Regulations clarify that the issue price of the bonds is the price paid by that buyer.

In recognition of the need in the tax-advantaged bond community for certainty as of the sale date (particularly in the case of advance refundings), the Final Regulations offer a special rule in the event a substantial amount of bonds has not been sold to the public as of the sale date. The special rule allows reliance on the initial offering price to the public if certain conditions are satisfied including evidence that the bonds were actually offered at the initial offering price and the written agreement of each underwriter that it will not offer or sell the bonds to any person at a price higher than the initial offering price during the period starting on the sale date and ending on the earlier of (i) the close of the 5th business day after the sale date, or (ii) the date on which the underwriters have sold at least 10% of the bonds to the public at a price that is no higher than the initial offering price.

Procedures for satisfying the conditions for use of this special rule will have to be developed but it is reasonable to expect that changes will need to be made to bond purchase agreements and underwriter selling agreements to comply with these requirements.

The special rule for competitive sales provides that in a competitive sale meeting certain requirements, an issuer may treat the reasonably expected initial offering price to the public as of the sale date as the issue price if the winning bidder certifies that its winning bid was based on this reasonably expected initial offering price as of the sale date. This special issue price rule for competitive sales has been repeatedly requested by practitioners and is a welcome improvement over the prior proposed regulations which treated both negotiated sales and competitive sales in the same manner.

The Final Regulations will be effective for obligations that are sold on or after June 7, 2017 and there is no option to rely upon the Final Regulations with respect to obligations that are sold prior to that date. This delayed effective date should allow bond counsel and underwriters time to develop effective and hopefully uniform procedures and documentation to implement the new regulations.

Federal Appellate Court Rules That Post-Acceleration Payment in Bankruptcy Constitutes Optional Redemption

Posted in Bankruptcy

By LEN WEISER-VARON

The linked Mintz Levin client advisory discusses a recent Third Circuit Court of Appeals ruling that held a “make-whole” optional redemption premium to be due upon a refinancing of corporate debt following its automatic acceleration upon bankruptcy. As noted in the linked advisory, the Second Circuit Court of Appeals also is considering this issue; whether it will come to the same conclusion remains to be seen. One way or another, these decisions will have spillover effect on judicial interpretation of optional redemption provisions in municipal bond transactions, and shine a spotlight upon the discrepancies between optional redemption provisions and other early payment provisions in most municipal bond indentures.

The Third Circuit case involved a debtor, Energy Future Holdings, that filed for bankruptcy for the explicit purpose of refinancing the debt at favorable interest rates while avoiding the hefty make-whole premiums payable upon an optional redemption of the refinanced notes. The bankruptcy court and the federal district court found nothing in the applicable corporate indenture requiring payment of a make-whole following an acceleration.  The Third Circuit reversed, interpreting the applicable corporate indenture’s “optional redemption” provisions to be applicable to the bankruptcy-triggered acceleration followed by repayment of the accelerated debt via a refinancing.

The Third Circuit’s ruling that the repayment following acceleration was an “optional redemption” may have been driven by the factual context of what could be characterized as an “optional bankruptcy” filed solely or primarily to jettison the make-whole payments and lock in lower rate replacement financing. The indenture’s acceleration provision was, as is usual, a remedial provision entirely separate from the indenture’s optional redemption provisions, and, as is typical but not universal, did not specify a premium to be due upon payment of the accelerated debt. Although once the accelerated payment was due there was nothing “optional” about paying it, the appellate panel opined that the payment on the applicable date was “optional” because the issuer chose to file for bankruptcy and chose not to deaccelerate the debt after the bankruptcy triggered the automatic acceleration.  The fact that the bondholders objected to repayment without a make-whole premium also seems to have factored into the court’s determination that the payment by the issuer was “optional.”

The federal appellate court also concluded that under New York law a “redemption” may occur at or before maturity of bonds, and that therefore a “redemption” is not synonymous with a prepayment.  (Indeed, the court suggested that if the make-whole premium had been labeled a “prepayment” premium rather than an “optional redemption” premium, it may have held the make-whole inapplicable, a curious distinction that leads back to the question of under what circumstances payment of an amount that has become due can be deemed optional.) The court disregarded indenture provisions that were technically inconsistent with its determination that the payment was an “optional redemption”, such as the optional redemption requirement of prior notice from the issuer to the bondholders. According to the court: “[The issuer] offers no reason why it could not have complied with [the redemption] notice procedures. In any event, it cannot use its own failure to notify to absolve its duty to pay the make-whole.”

By interpreting the indenture’s optional redemption provisions as applicable to the payment of the accelerated debt, the Third Circuit panel mooted and declined to address the noteholders’ alternate argument that the bankruptcy court should have granted relief from the bankruptcy stay to permit the bondholders to deaccelerate the accelerated debt. Whether that would have provided a more straightforward means of getting to the same result is debatable, as debt generally is deemed accelerated upon a bankruptcy whether or not it is contractually accelerated by the terms of the indenture.

The optional redemption provisions that are typical in municipal bond indentures refute the equivalence found by the Third Circuit between an optional redemption and a payment after acceleration. In contrast to the permissibility in corporate transactions of optional redemption at any time at a make-whole premium, the norm in municipal bond transactions is a lockout period (often 10 years) during which optional redemption is impermissible, followed by a declining fixed optional redemption premium. The fact that municipal indentures permit acceleration whenever there is an event of default, including upon bankruptcy, while imposing a lockout period for optional redemption, suggests that in the municipal bond context there may be less receptiveness by courts to the notion of deemed equivalence between an optional redemption and a payment following acceleration. Accordingly, a court may be less likely to deem an optional redemption premium applicable to a post-acceleration payment on a municipal bond absent express language requiring a premium in a post-acceleration context.

Whether corporate or municipal bonds are at issue, the best way to ensure the intended result is to draft clearly and specifically.  Municipal bond indentures often permit or require bonds to be paid ahead of schedule not only upon acceleration but upon a so-called extraordinary redemption.  These provisions, which typically permit payment ahead of schedule at par, are infrequently deployed relative to optional redemption provisions. Use of bankruptcy as a means of avoiding a prepayment premium is less likely in the municipal context, where the prepayment premium is typically 3% or less versus the often substantially larger make-whole premium, but “default refundings” of municipal bonds have been attempted to circumvent the optional redemption lockout period. There is no difference in the economic impact to a bondholder of early payment, no matter the degree of optionality or lack of optionality from the issuer’s perspective, and whether an early payment premium is expressly provided by the indenture in cases other than “optional redemption” is primarily a risk allocation question.

Drafting acceleration provisions and/or extraordinary redemption provisions in a manner that applies an equivalent premium to the optional redemption premium upon their exercise during the post-lockout period, and a make-whole or other premium during the optional redemption lockout period, provides better protection against any perceived risk of abuse of those provisions than reliance on the courts to figure out what the parties intended and/or is equitable in borderline scenarios.

IRS Relaxes Restrictions on Management Contracts for Bond-Financed Facilities

Posted in Tax/arbitrage

By CHRISTIE  L. MARTIN and MAXWELL D. SOLET

The IRS on August 22, 2016 released long-anticipated Revenue Procedure 2016-44 (Rev. Proc. 2016-44), which substantially increases flexibility in, and provides a less formulaic approach to, the ability of a tax-exempt bond issuer or 501(c)(3) conduit borrower to contract with private parties without jeopardizing the tax-exemption of bonds that financed the facilities at which the applicable services are provided. Under the revised guidance, the term of the contract can be up to 30 years, but not in excess of 80% of the weighted average reasonably expected economic life of the managed property, and there are no restrictions on the percentage of compensation that can be variable, so long as none of the compensation constitutes a share of net profits.

The Internal Revenue Code restricts private use of facilities financed by certain categories of tax-exempt bonds, including governmental bonds and bonds issued for the benefit of hospitals, colleges and other organizations that are tax exempt under Section 501(c)(3) of the Internal Revenue Code. A manager of a facility is generally treated as a user of the facility. Rev. Proc. 2016-44 addresses so-called “management contracts” which are defined as “management, service, or incentive payment contracts between qualified users and service providers under which the service provider provides services for a managed property” and provides a revised management contract safe harbor under which a private management contract does not result in impermissible private business use of projects financed with tax-exempt bonds. This revised safe harbor generally permits almost any type of fixed or variable rate compensation for services rendered under a contract provided that the compensation is reasonable for services rendered during the term of the contract. It removes the previous requirements for prescribed percentages of fixed compensation for contracts with different terms. The revised safe harbors add certain new principles-based constraints (governmental control, governmental risk of loss, and no inconsistent tax positions by private service providers). As with the previous safe harbors, there is a prohibition against sharing of net profits.

The new safe harbor components are as follows:

  • Compensation for services rendered during the term of the contract must be reasonable.
  • The contract must not provide the service provider with any share of the net profits from operation of the managed facility. The guidance states that compensation to the service provider will not be treated as providing a share of net profits if no “element” of the compensation takes into account or is contingent upon, either the managed property’s net profits or both the managed property’s revenues and expenses for any fiscal period. For this purpose, “elements” of the compensation include eligibility for, the amount of, and the timing of the payment of the compensation. Incentive compensation will not be treated as providing a share of net profits if the eligibility for the incentive compensation is determined by standards that measure quality of services, performance or productivity.
  • The service provider must not bear the burden of any share of net losses from operation of the managed property.
  • The term of the contract cannot be greater than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property.
  • The bond issuer or conduit borrower (each a “qualified user”) must exercise a significant degree of control over the use of the managed property. The guidance states that this control requirement is met if the contract requires the qualified user to approve the annual budget of the managed property, capital expenditures with respect to the managed property, each disposition of property that is part of the managed property, rates charged for the use of the managed property, and the general nature and type of use of the managed property (for example, the type of services).
  • The qualified user must bear the risk of loss upon damage or destruction of the managed property.
  • The service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property (e.g. agree not to take depreciation or amortization, tax credit or deduction for rent).
  • There can be no circumstances that would substantially limit the qualified user’s ability to exercise its rights under the contract based on all of the facts and circumstances. A safe harbor is provided for governance overlap between the contracting parties, under which governance overlap is permitted if (i) no more than 20 percent of the voting power of the governing body of the qualified user is vested in the directors, officers, shareholders, partners, members, and employees of the service provider or a related party thereof, (ii) the governing body of the qualified user does not include the chief executive officer of the service provider or the chairperson (or equivalent executive) of the service provider’s governing body, and (iii) the chief executive officer of the service provider is not the chief executive officer of the qualified user or any of the qualified user’s related parties.

The overall impact of Rev. Proc. 2016-44 would seem to be an increase in the ability of bond issuers and tax-exempt users of bond-financed facilities to use for-profit contractors at bond-financed facilities. However, practitioners have already noted that the increased flexibility comes with less certainty and more facts and circumstances analysis with respect to many aspects of the safe harbor. One area in which flexibility may be diminished is in the conditions under which payments may be subordinated or deferred, as the guidance indicates that timing of payment may not be conditioned on tests involving both the managed property’s revenues and expenses for any fiscal period.

The revised safe harbors are effective for any management contract that is entered into on or after August 22, 2016, and an issuer may apply these safe harbors to any management contract that was entered into before August 22, 2016. In addition, an issuer may apply the safe harbors in Rev. Proc. 97-13, as modified by Rev. Proc. 2001-39 and amplified by Notice 2014-67, to a management contract that is entered into before February 18, 2017 and that is not materially modified or extended on or after February 18, 2017 (other than pursuant to a renewal option as defined in Treasury Regulations §1.141-1(b)).

Three Strikes and Recovery Act is Out

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

Today’s U.S. Supreme Court decision in Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust puts an end to one of Puerto Rico’s multi-pronged efforts to deleverage itself.  Given the comprehensiveness of the First Circuit’s intermediate appellate opinion upholding the district court’s invalidation of Puerto Rico’s Recovery Act, it was surprising that the highest court took the case, a decision apparently prompted by Justice Sotomayor’s interest in obtaining a reversal.  Comments of some other Justices at oral arguments raised the possibility of Sotomayor attracting a majority for the proposition that the preemption provisions of Section 903 of the U.S. Bankruptcy Code were inapplicable to Puerto Rico, but in the end only Justice Ginsburg joined what turned out to be Sotomayor’s dissenting opinion in a 5-2 ruling upholding the relegation of the Recovery Act to the dustbins of history.

As  we have written previously, the Recovery Act was damaged goods from the beginning: even if the fairly clear preemption argument had not prevailed, the Contracts Clause constraints on non-federal bankruptcy legislation would have severely constrained, if not eliminated, the effective use of  the Recovery Act to break bond contracts. In any event, the Recovery Act, and the Supreme Court’s decision, were  a couple weeks away from being moot, as it appears evident that Congress will pass PROMESA, the federal oversight and debt restructuring legislation that has always constituted the logical legal mechanism for those favoring a less chaotic denouement to Puerto Rico’s debt woes.

You Can Lead a Horse to Water, But You Can’t Call it an Airplane: Supreme Court Oral Arguments Suggest Puerto Rico’s Recovery Act May Recover

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

  • Due to Justice Scalia’s death and Justice Alito’s recusal, only 7 Justices heard the case and only 4 votes are needed for a majority.  Almost all of the questioning at oral argument came from Justices Sotomayor, Kagan and Breyer, plus a couple noteworthy questions from Justice Ginsburg.  With the standard disclaimer that questions at oral argument are not necessarily predictive of a Justice’s votes, it seems clear from the questioning that Justice Sotomayor will vote to reinstate the Recovery Act and is the most passionate of the Justices about the issue, and, even if the relatively silent Chief Justice Roberts and the silent Justice Kennedy and Justice Thomas vote to affirm,  the questions and musings of Justices Kagan, Breyer and Ginsburg suggest that Justice Sotomayor could sway them to her position and thereby obtain the 4 votes necessary for reversal of the First Circuit’s holding and reinstatement of the legislation.
  • All that can be said about the actual statutory language that the Supreme Court will interpret is that the drafting does not represent Congress’s finest work.  (Justice Breyer provided the only moment of merriment on the Scalia-less panel when, after a suggestion that the opaque statutory language requires a contextual reading, he responded, “That may be, but I can’t say that an ‘airplane’ means a horse.”) There is no relevant legislative history, so it is not clear that Congress, when it amended the Bankruptcy Code to exclude Puerto Rico’s (and the District of Columbia’s) government instrumentalities from Chapter 9 eligibility, thought about the question of how that would or should impact Puerto Rico’s and D.C.’s right to enact their own insolvency statutes.  So while nominally a statutory interpretation case, this is, on a technical level, almost purely a “what makes the most sense” case.
  • The First Circuit was persuaded that it would make no sense for Congress to act affirmatively to withhold from Puerto Rico the right to authorize its insolvent instrumentalities to file for bankruptcy under Chapter 9, while intending that Puerto Rico have the right to authorize such filings under some insolvency statute of its own creation.  That seems almost unassailably correct; basic common sense suggests that whatever distrust of Puerto Rico must have motivated Congress to close the door to Puerto Rico’s ability to authorize its instrumentalities to file under Chapter 9 cannot be reconciled with Congressional intent that Puerto Rico be allowed to authorize such filings under its own version of an insolvency statute that might be identical to, or differ in unpredictable ways from, Chapter 9.
  • However, Puerto Rico seems to have gotten some traction before the Supreme Court with the proposition (which the First Circuit correctly rejected) that Congress cannot have intended to leave Puerto Rico’s instrumentalities in a “no man’s land” where they had no access to Chapter 9 and no access to an alternative insolvency regime. The short answer is that there is a high likelihood that Congress, if it had an intent on the matter when it eliminated Puerto Rico instrumentalities from Chapter 9 eligibility, precisely intended that Puerto Rico instrumentalities would not have access to an insolvency process unless and until Congress specifically authorized the applicable process (as it is currently being pressed to do by Puerto Rico and the U.S. Treasury.)  Such federal control would be and is consistent with Puerto Rico’s status as a U.S. territory, however it is labeled in the Bankruptcy Code.
  • Justice Sotomayor also raised the issue of whether the principles of federalism and state sovereignty that make the federal Chapter 9 available only to instrumentalities of states that have elected into the Chapter 9 regime would be violated if Chapter 9 were the only insolvency regime available to a state, i.e. whether interpreting Section 903 of the Bankruptcy Code as applicable to states that have not exercised such option (as well as to Puerto Rico and D.C., which have no such option to exercise) would be unduly coercive and raise Tenth Amendment issues.  The First Circuit left that question unaddressed on the grounds that Puerto Rico is not protected by the Tenth Amendment.  But as Section 903 applies to any “State”, if the Supreme Court interprets it, and its restriction on a “State’s” ability to enact insolvency legislation for its instrumentalities, as applying to Puerto Rico, it also will be interpreting it as applying to the 50 states, including those that have not opted to authorize their instrumentalities to use Chapter 9.  Whether or not any of the other Justices would view such an interpretation as presenting a substantial Tenth Amendment concern cannot be discerned from the oral argument, but the Court often interprets ambiguous statutes in a manner that avoids a potential constitutional concern, and Sotomayor’s apparent invocation of that principle may be targeted at her fellow Justices as a counterweight to the proposition that Congress, in eliminating Chapter 9 access for Puerto Rico’s instrumentalities,  must have intended to preclude any access to bankruptcy by such  instrumentalities absent direct authorization by Congress.  In divining what Congress intended by Section 903, Sotomayor appears to be suggesting, the Supreme Court cannot focus myopically on what Congress would have intended for Puerto Rico.
  •  As we have previously discussed, even if the Court revives the Recovery Act, the Recovery Act is, from Puerto Rico’s perspective, a problematic, and possibly ineffective, insolvency process.  A principal purpose of bankruptcy is to adjust, restructure and impair contracts.  The federal government is not subject to the constitutional restriction on impairment of contracts, and therefore the federally-enacted Chapter 9 process can impair debts and contracts.  Puerto Rico, and therefore its Recovery Act, have been held to be subject to the constitutional restriction on impairment of contracts.  A couple of the Justices noted this constraint, both in questioning what benefit Puerto Rico would derive from a reinstatement of the statute and as a potential protection that Congress might have taken into account if it did not intend to preclude non-federal insolvency law.  If the Recovery Act is reinstated and used by Puerto Rico, one can expect years of litigation on the question of whether any debt adjustment (or other contract adjustment) effected thereunder does or doesn’t meet the high bar of public necessity and unavailability of reasonable alternatives required for such adjustment not to constitute an unconstitutional “impairment.”
  • Puerto Rico’s persistence in seeking reinstatement of the Recovery Act reflects a calculus that an insolvency process that produces a legally questionable and potentially unenforceable result is better than no process, and provides creditors more incentive for consensual resolutions than no process.  Chapter 9 eligibility for Puerto Rico’s instrumentalities, and, if Congress were to grant it, “super Chapter 9“ eligibility for Puerto Rico itself,  would clearly, in Puerto Rico’s view, constitute a far more advantageous and conclusive process.  However, there is some risk to Puerto Rico that if the Supreme Court reinstates the Recovery Act before Congress acts on federal legislation to address Puerto Rico’s financial woes, the revival of the Recovery Act would undercut any Chapter 9 momentum, leaving Puerto Rico with its legally wobbly Recovery Act.  But Puerto Rico appears willing to gamble that the Supreme Court will issue its decision after Congress has done whatever it will do, and, in any event, to believe that a constitutionally vulnerable local bankruptcy statute in the hand is worth a constitutionally bulletproof federal bankruptcy statute in the bush.

 

Statutory Liens vs. Consensual Liens: Why it Matters and When it may Not

Posted in Bankruptcy

While secured creditors are entitled to special rights in bankruptcy, those rights may differ depending on whether creditors have a statutory or consensual lien on their collateral. This is primarily because section 552(a) of the Bankruptcy Code provides, in part, that “property acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement . . . .” In other words, consistent with the concept that a debtor receive a ‘fresh start’ following a bankruptcy discharge, section 552(a)* strips certain secured creditors of liens in the post-petition property received by a debtor. However, section 552(a) does not apply if a creditor is secured by a statutory lien; a statutory lien ‘flops over’ the petition date and attaches to post-petition receipts of a debtor.

In general, the Code contemplates three types of liens: (1) consensual liens (i.e. a lien created by a security agreement), (2) judicial liens and (3) statutory liens. The primary distinction is that consensual liens are created by a security agreement between a debtor and a creditor, while judicial and statutory liens are created by operation of law and/or an order of a judge and do not require a debtor’s agreement. As the name suggests, a statutory lien arises automatically by statute.

Most statutory liens are obvious; you ‘know ‘em when you see them’. Perhaps that is why caselaw on the subject is so limited. The most substantial analysis of the issue appears in two decisions from the Orange County, California chapter 9 bankruptcy case where noteholders sought continued post-petition payment of pledged taxes and other revenues of the debtor. The Bankruptcy Court concluded that the noteholders held a consensual lien which was cut-off by the bankruptcy filing. The District Court disagreed, finding that the noteholders were secured by a statutory lien. Despite the reversal, we think the Bankruptcy Court got it right.

The Bankruptcy Court enumerated the key characteristics of a statutory lien: “the lien is automatic, and there is no need for any consent by the borrower or designation of revenues.” For example, a statutory lien is created if a statute provides that debt issued pursuant to that statute shall be secured by a lien on property specified by that statute. The lien is automatic, there is no need for any consent of the borrower. If instead a statute provides that a borrower may borrow money and may pledge property to secure such borrowing, any lien granted by the borrower pursuant to the statute would be consensual.

One area where the consensual/statutory lien distinction may not be as significant is in a chapter 9 bankruptcy case when a creditor has a lien on ‘special revenues’ (as defined in section 902(2) of the Code). This is because, pursuant to section 928, a creditor’s consensual lien on special revenues ‘flops over’ the petition date and attaches to post-petition receipts—much like a statutory lien does in all instances. However, it may still be preferable to have a statutory lien on special revenues because, in addition to the ‘flop-over’ effect, section 928 also subordinates a creditor’s lien to “necessary operating expenses” of the project or system. Since by its terms it appears that only consensual liens are addressed in section 928 (referencing “any lien resulting from any security agreement. . .”), section 928(b)’s subordination mechanism may not affect statutory liens on special revenues.

* All section references are to the Bankruptcy Code.

Draft Treasury Legislation Would Give Puerto Rico Access to “Super Chapter 9” and Chapter 9 Bankruptcy

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

 

A draft of the U.S. Treasury’s proposed debt restructuring legislation began circulating earlier today.  The draft legislation would give Puerto Rico, as well as other U.S. territories, and their municipalities access to U.S. bankruptcy court under a new chapter of the U.S. Bankruptcy Code (so-called “Super Chapter 9”) as well as making Puerto Rico’s instrumentalities (but not Puerto Rico itself) potentially eligible to file for bankruptcy under existing Chapter 9. The prospects for bipartisan cooperation on some form of such legislation appear somewhat more promising than those for the confirmation of a new Supreme Court justice, but whether this trial balloon will fly remains uncertain.

Some initial observations:

  • The legislation would provide access to bankruptcy to Puerto Rico and other U.S. territories (Guam, American Samoa, Northern Mariana Islands and U.S. Virgin Islands) and their municipalities.
  • The availability of bankruptcy to a territory and/or any “municipality” (i.e. political subdivision, public agency, instrumentality or public corporation of a territory) would be conditioned on the establishment of a Fiscal Reform Assistance Council (Council) at the request of the applicable territory’s Governor.  The Council would consist of 5 members appointed by the President of the United States and would have to approve any such bankruptcy filing.  The Council would have a variety of oversight powers including budget and debt issuance approval powers.
  • The legislation preserves the concept of “special revenue” bonds that benefit from more protective provisions under Chapter 9, such as the continued application of a lien on special revenues to such revenues arising after the filing of the bankruptcy petition, and the inapplicability of the bankruptcy stay to the application of special revenues to payment of debt service on special revenue bonds.  However, the definition of “special revenues” is narrower under the draft legislation than it is under Chapter 9.  As under Chapter 9, “special revenues” include “receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems.”  However, for Puerto Rico and other territories, the draft legislation would not include as “special revenues” “special excise taxes imposed on particular activities or transactions,”  “incremental tax receipts from the benefited area in the case of tax-increment financing,” “other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions” or “taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax-increment financing) levied to finance the general purposes of the debtor.”  Accordingly, debtors that under the legislation could file under either Chapter 9 or this new chapter would have an incentive to file under this new chapter if their revenues would constitute “special revenues” under Chapter 9 but not under the new chapter.
  • The legislation creates a one-year stay (from the date of establishment of a Council) on (i) the commencement or continuation of any action or proceeding that seeks to enforce a claim against the territory and (ii) the enforcement of a lien on “or arising out of” taxes or assessments owed the territory.  Note that the stay becomes effective without regard to whether a bankruptcy petition is filed.
  • A territory may be a debtor upon the establishment of a Council and approval of the filing by the Council.  A municipality of a territory must, in addition, be specifically authorized by territory law to be a debtor.
  • In contrast to Chapter 9, a debtor need not be insolvent in order to be eligible to file for bankruptcy under the proposed new chapter.
  • A territory and its municipalities may file bankruptcy petitions and plans of adjustment jointly.
  • If the debtor is a territory, the presiding judge in the bankruptcy is appointed by the Chief Justice of the U.S. Supreme Court.  If the debtor is a municipality filing separately from a territory, the presiding judge is appointed by the chief judge of the applicable federal circuit court of appeals (the 1st Circuit, in the case of Puerto Rico).
  • Among the various conditions for confirmation of a plan, noteworthy conditions include that “the plan does not unduly impair the claims of any class of pensioners.”  The draft legislation does not define what is meant by “unduly.”
  • The legislation provides a limited degree of protection for Puerto Rico’s general obligation bonds, including as a plan approval condition that “if feasible, the plan does not unduly impair” the claims of holders of the territory’s general obligation bonds that are “identified in applicable nonbankruptcy law as having a first claim on available territory resources.”   Notably, this protection is provided “if feasible” whereas there is no feasibility requirement on the protection of pensioner claims.  Again, the protection of general obligation bonds, “if feasible” is against being “unduly” impaired, without clarity as to what constitutes undue impairment.  Oddly, the implication is that general obligation bonds can be “unduly impaired” if it is not feasible to “duly” impair them.
  • The draft legislation makes many but not all of the general provisions of the Bankruptcy Code, many but not all of the provisions of Chapter 9, and some of the provisions of Chapter 11, particularly those relating to plan confirmation,  applicable to a bankruptcy involving a territory or a territorial municipality.