The Myth and Reality of Statutory Liens and Special Revenues Treatment in Chapter 9

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1 The Myth and Reality of Statutory Liens and Special Revenues Treatment in Chapter 9 James E. Spiotto, Chapman Strategic Advisors LLC presented as part of A Focus on Evolving Issues in Municipal Credit October 7, by James E. Spiotto. All rights reserved. The views expressed herein are those of the author and not necessarily those of other panelists, their firms or the conference sponsors. This presentation discusses the current state of the government debt restructurings including a detailed analysis on these issues and bondholder rights and remedies. For further reading: a book entitled MUNICIPALITIES IN DISTRESS? published by Chapman and Cutler LLP which is a 50-State Survey of State Laws Dealing with Financial Emergencies of Local Governments, Rights and Remedies Provided by States to Investors in Financially Distressed Local Government Debt, and State Authorization of Municipalities to File Chapter 9 Bankruptcy, which is available from Chapman and Cutler LLP or on Amazon.com, PRIMER ON MUNICIPAL DEBT ADJUSTMENT, published by Chapman and Cutler LLP, which is available from Chapman and Cutler LLP, The Role of the State in Supervising and Assisting Municipalities, Especially in Times of Financial Distress, by James E. Spiotto in the MUNICIPAL FINANCE JOURNAL, Winter/Spring 2013, Lessons Learned from Detroit s Bankruptcy MUNINET GUIDE (November 10, 2014) and the article How Municipalities in Financial Distress Should Deal with Unfunded Pension Obligations and Appropriate Funding of Essential Services, 50 WILLAMETTE LAW REVIEW 515 (2014), Reducing Risk to Payment of State and Local Government Debt Obligations, Statutory Liens from Rhode Island to California SB 222 MUNINET GUIDE (July 28, 2015)

2 Table of Contents I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 4 A. Default rate for state and local government debt has been relatively low especially when compared to corporate debt default 4 B. Historically the use of bankruptcy by a municipality has been rate and a last resort 9 C. Since the Depression of the 1930 s, states and local governments have diversified the source of tax revenues 10 D. Changes in the source of state and local governments revenues ( ) 11 E. The rise of statutory liens and special revenues 13 F. Summary of Chapter 9 priorities 19 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 22 A. Myth: In Chapter 9, bankruptcy courts and municipalities do not need to comply with state law mandated liens, priorities and dedication of revenues 22 B. Myth: The Bankruptcy Code and legislative history of the Bankruptcy Code does not address how statutory liens and special revenues should be treated in Chapter 9 so it is an open question 26 1

3 Table of Contents C. Myth: There is no case law to support the position that payment of revenues subject to statutory lien and special revenues must be paid timely and not impaired 33 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation 41 A. Access and the cost of borrowing is a reflection of the perceived risk of the government credit 41 B. The recent use of statutory lien legislation to gain market access in financially distressed times and to lower the cost of borrowing for the benefit of all 44 C. Reducing the risk with statutory liens and special revenues can benefit all in lower costs of borrowing 47 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism A. Past mechanisms appear to be inefficient in reaching a quick, effective resolution 48 B. There is a growing awareness of the need for a new mechanism for sovereign debt problems 54 C. The new mechanism must address the needs of the government and the concerns of the creditors and lenders 56 2

4 Table of Contents D. Government Oversight, Recovery and Debt Adjustment Commission 59 E. Now is the time to enact GORDAC before the next waive of government debt crisis 69 V. Checklist of Disclosures to Maximize Market Acceptance in Evaluating Repayment of Bond Debt 70 A. Authorized to file Chapter 9? 70 B. What is source of payment? 70 C. Is there a lack of diversification of tax sources and limits on taxes that could realistically be triggered? 71 D. Are there required priorities, set asides or appropriations to support payment? 71 E. Are there effective remedies available if there is a default? 72 F. Is effective state oversight and assistance available to prevent defaults or aid a financially troubled municipality? 72 Appendix A Appendix B 3

5 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues A. Default rate for state and local government debt has been relatively low especially when compared to corporate debt default: 1. Historically, while political risk of non-payment was a possibility, it was a rare occurrence, if not in reality a non-existent concern, with a few exceptions (i.e. 8 States and one Territory repudiated their debt between 1841 to 1843 with 7 of the 9 resuming payment by 1849, repudiation of Civil War related debt by 8 states in the late 1860 s, railroad bond and real estate defaults of the 1870s to 1890s and Washington Public Power Supply System, 1983). There are current situations that may test the long-term viability of the historical premise. Namely, it is hoped that Detroit, Stockton, San Bernardino and Jefferson County will be viewed in hindsight as rare aberrations rather than indicative of a growing trend. 4

6 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 2. Historically, there is a low default rate for bonds issued by municipalities and states: The late Dr. John Petersen of George Mason University noted in his paper on Municipal Defaults: Eighty Years Made a Big Difference (2011) that, between 1970 s-2000 s, the municipal default for municipalities averaged per decade.10% to.24% (adjusted for WPPSS and Jefferson County, Alabama) not including the fact that over 80% of the defaults were in conduit financing and not essential public financings. This is a far cry from the corporate bond default rate on average for investment grade and noninvestment grade of about 10%. (Petersen, 2013) States have not defaulted on general obligations bonds since the late 1880 s, with the exception of Arkansas debt in 1933, which was thereafter refinanced. 5

7 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues Recorded Defaults, by Type of Local Government Unit and Geographical Region a The number of local government units has changed rapidly. For example, in 1932 there were 127,108 school districts, 8,580 other districts, and 175,369 state and local government units. b The percent of annual default in total defaults by type divided by number of governments divided by 130 (years). Sources: Default information in The Daily Bond Buyer, The Commercial and Financial Chronicle and The Investment Bankers Associations Bulletin: default lists from Federal Deposit Insurance Corporation, Life Insurance Commission, and U.S. Courts; and Albert M. Hillhouse, Defaulted Municipal Bonds (Chicago: Municipal Financial Officers Association, 1935). Number of local government units from: U.S. Department of Commerce, Bureau of Census, Census of Governments, 1967, Vol. 1 Governmental Organization (Gov t Printing Office, 1969) and ACIR Report Bankruptcy, Defaults and Other Local Government Financial Emergencies U.S. Government

8 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues Recently monetary defaults on state and local government public debt ranged from 108 issuers for $1.95 billion in default in 2012 to 68 issuers for $8.57 billion in default in 2013 to 58 issuers for $9.02 billion in default in (Municipal Market Advisors) While there was a decline in the number of issuers in default by almost 50%, there was, however, a rise in dollar value of defaults in 2013 and This was due to Detroit s filing for bankruptcy and defaulting and a large energy company bankruptcy. For example, $5.4 billion of the $9.02 billion in default in 2014 were the Detroit water and sewer bonds that ultimately were unimpaired in the plan of debt adjustment. In addition, TXU, a subsidiary of Energy Future Holdings Company, declared bankruptcy in April 2014, which filing caused the default on $1.16 billion of Industrial Development Bonds. 7

9 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues Historically, based on default rate, there is little support for the willingness to pay to be deemed a real problem since there is an absence of political risk. Essential service debt financing has historically enjoyed a significantly lower default rate than healthcare, housing and conduit state and local governmental financing. Unfunded pension obligations and deferred infrastructure cost are a more recent phenomenon Prior to 1960s, most pension obligations were treated as gratuities and a significant number of big ticket infrastructure costs are only now starting to age such as the interstate highway system, electric grid, waste water treatment facilities, etc. We are closer to a tipping point and departure from the historical assurances than we have ever been. The difference may be whether there will be adherence to the Washington-Hamilton principle of honoring the payment of public debts and reinvesting in state and local government going forward. 8

10 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues B. Historically the use of bankruptcy by a municipality has been rare and a last resort: 1. Since 1937, the advent of Chapter 9, there have only been 664 Chapter 9 filings. Virtually all of those municipalities that filed Chapter 9 were small or not major issuers of Bond Debt except for Bridgeport, CT in 1991, Orange County in 1994, Vallejo, CA in 2008, Jefferson County, AL in 2011, Stockton and San Bernardino, CA in 2012 and Detroit in Both Harrisburg, PA and Boise County, ID. were dismissed as was Bridgeport in Of the 295 Chapter 9 filings since 1980 and of the 320 filings since 1954, 175 (190 since 1954) have been municipal utilities and special districts and only 54 (64 since 1954) have been cities, counties, towns and villages. The remaining 52 have been hospitals or healthcare, 8 transportation and 6 school or educational facilities. Less than 70% of the Chapter 9 filings resulted in a confirmed plan of debt adjustment. (See Appendix A for more details.) 9

11 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues C. Since the Depression of the 1930 s, States and Local Governments have diversified the source of tax revenues to reduce reliance on property taxes and to spread the burdens and reduce the risk of concentration. 10

12 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues D. Changes in the source of state and local governments revenues ( ). General State and Local Governments Revenues : Totals and Percentage Distribution Amount of Gen. Rev. (billions of dollars) Percent Distribution Property Tax Sales Tax Income Tax Other Tax Misc. Rev Federal Aid TOTAL Source: Bureau of the Census John Petersen Municipal Defaults Eighty Years Makes a Big Difference 5/21/11 p. 9 George Mason University 11

13 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 1. Property, income and sales taxes made up over 70% of state and local governments revenues in but only 50% of state and local governments revenues by More diverse and varied tax base in 2008 with more federal assistance. 2. Property taxes which made up over 60% of the revenues of state and local governments between was only 16.7% of revenue by 2008 with increases in sale, income, other miscellaneous, and federal aid making up the difference. 12

14 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues E. The rise of statutory liens and special revenues. 1. The increasing benefits of statutory liens and revenue bond financing have evolved from the recognized need to identify and dedicate sources of payment given the experience of default in the 1800 s and the 1930 s and the advent of Chapter 9 in There was a growing recognition in the municipal market to identify the credible source of payment and what was available in revenues for payment and what was not. 2. Statutory Liens. Some states provide by statute that the state or local government, upon issuing debt pursuant to a specific state statute, automatically grants a lien (dedicated revenues or proceeds only to be used to pay the debt prior to any other use) on specified property, proceeds or tax revenue for the payment of the debt so incurred. 13

15 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 3. Basic Provisions for a Statutory Lien. Generally, the statute from which the statutory lien arises provides: The force and effect of the statute creates the interest in the dedicated revenues or proceeds to pay the debt without need of further action by the issuing governmental entity. May also provide for the priority of payment, a first lien or provision that the dedicated pledged revenues can only be used to pay the debt or in the order specified in the statute or authorizing documents. May also provide an intercept or segregation of the revenues or require a governmental entity or officer to collect and pay over to a special account or to the bond trustee. 14

16 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 4. Treatment in Chapter 9 of Statutory Liens. This statutory lien is intended to remain unaltered in a Chapter 9 proceeding, and there is a continuing right to be timely paid after the filing of a Chapter 9. This was recognized in the Orange County Chapter 9 in 1994 (delay in payment due to appeal and reversal of Bankruptcy Court as to effect of a statutory lien) and Sierra Kings Health Care District Chapter 9 in 2009 (relating to General Obligation Bonds). (There are a number of states with statutory lien provisions. See e.g., Rhode Island, California, Colorado, Idaho and New Jersey (Municipal Qualified Bond Act). There is statutory lien legislation pending in Michigan (HB 4495), Nebraska (LB 67) and Illinois. See the 50 State Survey in the forthcoming new edition of Municipalities in Distress? ). See Appendix B. 15

17 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 5. Special Revenue. What is Special Revenue. Every state provides for some form of special revenue bonds and, in certain cases, the special revenue pledge can be granted for general obligation debt. A special revenue pledge is one that promises to pay the debt from a pledge or dedication of revenues from a specific source or governmental enterprise, special excise taxes, incremental tax receipts for tax incremental financing, revenues derived from a particular governmental function, taxes levied to finance a project or system (except for general sales, property and income taxes levied for general purposes). 16

18 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues How are Special Revenues to be Treated in Chapter 9? A special revenue pledge is to be unaltered by a chapter 9 Municipal Bankruptcy and the timely payment of the pledged revenues by the municipality is required by the Bankruptcy Code. Special revenues were intended by the 1988 Amendments to the Bankruptcy Code to be unimpaired in Chapter 9 and the debt holders to receive the benefit of the bargain. This was respected in Sierra Kings Health Care District Chapter 9 (Eastern District of California), the Jefferson County Chapter 9 (Northern District of Alabama) Stockton Chapter 9 and Detroit Chapter 9 (for those who continued to hold Water and Sewer Revenue Bonds, the case reaffirmed the unaltered status and timely payment of special revenue pledges in a Chapter 9 proceeding). 17

19 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 6. What is the Purpose for Using Statutory Liens or Special Revenues Financings. These types of financings are intended to create predictable priorities in Chapter 9 so municipal bond market participants can be protected by a predictable result as to payment outside of Chapter 9 by enforcing payment by writ of mandamus or other remedies and the fact that a governmental officer must comply with the mandate of state law or suffer the penalties. In Chapter 9, there is intended to be established priority and assurance of payment so that governmental bodies suffering from temporary illiquidity would have access to the municipal bond market with a dedicated source of payment that would survive Chapter 9. (See legislative history of 1988 Amendment to the Bankruptcy Code regarding solving the dilemma of the City of Cleveland in 1978.) 18

20 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues F. Summary of Chapter 9 Priorities: TYPE OF CLAIM 1. Obligations secured by a statutory lien to the extent of the Pledged Revenue collected. ab 2. Obligations secured by Special Revenues (subject to necessary operating expenses of such project or system) to the extent of the Pledged Revenue collected. ab These obligations are often non-recourse and, in the event of default, the bondholders have no claim against non-pledged assets. (Reaffirmed in Jefferson County Court Ruling and the ultimate treatment of Water and Sewer Revenue Bonds in Detroit.) EXPLANATION Debt (Bonds, Warranties, Notes, Trans, Rans) issued pursuant to statute that itself imposes a pledge. (There should not be any delay in payments due to automatic stay since the Bankruptcy Court and municipality have no authority to do otherwise due to the mandate of state law to only use or expend revenues or proceeds for the designated purpose under 903 of the Federal Bankruptcy Code and the municipality cannot act or consent differently since it is unable to do so under state law that controls under 904 of the Federal Bankruptcy Code.) Special Revenue Bonds secured by any of the following: (A) 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; (B) special excise taxes imposed on particular activities or transactions; (C) incremental tax receipts from the benefited area in the case of tax-increment financing; (D) other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or (E) taxes specially 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. c There should be no delay in payment since automatic stay is lifted under Section 922(d). If the state statute also creates a statutory lien or mandate that the pledged tax revenues can only be used for payment of the debt obligations and for no other purposes before payment in full of the obligation then no reduction for necessary operating expenses 903 and 928 of the Federal Bankruptcy Code. a Chapter 9 incorporates 506(c) of the Bankruptcy Code which imposes a surcharge for preserving or disposing of collateral. Since the municipality cannot mortgage city hall or the police headquarters, municipal securities tend to be secured by a pledge of a revenue stream. Hence, it is seldom a surcharge will be imposed. But see numbers 3 and 4. b Chapter 9 incorporates 364(d) of the Bankruptcy Code, which permits a debtor to obtain post-petition credit secured by a senior or equal lien on property of the estate that is subject to a lien if the prior lien holder is adequately protected. However, if state law mandates the use of the pledge revenues solely or first to pay the statutory lien or special revenue debt that mandate of state law cannot be violated and no priming lien or other use of revenues can be authorized. c A pledge of revenues that is not a Statutory Lien or Special Revenue Pledge may be attached as not being a valid continuing Post-Petition Lien under 552 of the Bankruptcy Code. 19

21 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues TYPE OF CLAIM 3. Secured Lien based on Bond Resolution or contractual provisions that does not meet test of Statutory Lien or Special Revenues to the extent perfected prepetition, subject to the value of prepetition property or proceeds thereof. c EXPLANATION Under language of Sections 552 and 928, liens on such collateral would not continue postpetition. After giving value to the prepetition lien on property or proceeds, there is an unsecured claim to the extent there is recourse to the municipality or Debtor. You may expect the creditor to argue that pursuant to Section 904, the Court cannot interfere with the property or revenues of the Debtor, and that includes the grant of security to such secured creditor. 4. Obligations secured by a municipal facility lease financing. Under Section 929 of the Bankruptcy Code, even if the transaction is styled as a municipal lease, a financing lease will be treated as longterm debt and secured to the extent of the value of the facility. 5. Administrative Expenses (which would include expenses incurred in connection with the Chapter 9 case itself). d Chapter 9 incorporates Section 507(a)(2) which, by its terms, provides a priority for administrative expenses allowed under Section 503(b). These would include the expenses of a committee or indenture trustee making a substantial contribution in a Chapter 9 case. Pursuant to Section 943, all amounts must be disclosed and be reasonable for a Plan of Adjustment to be confirmed. d These expenses strictly relate to the costs of the bankruptcy. Because the bankruptcy court cannot interfere with the government and affairs of the municipality, general operating expenses of the municipality after filing of the Chapter 9 are not within the control of the court (unless the municipality consents and is not otherwise prohibited under state law from interfering with the payment, are not discharged and will remain liabilities of the municipality after the confirmation of a plan or dismissal of the case. 20

22 I. The History of Payment of State and Local Government Debt in the United States and the Importance of Statutory Liens and Special Revenues 6. Unsecured Debt includes: TYPE OF CLAIM EXPLANATION A. Senior Unsecured Claims with benefit of subordination paid to the extent of available funds (without any obligation to raise taxes) which include any of B, C, D, or E below. B. General Obligation Bonds. Secured by the full faith and credit of the issuing municipality. Postpetition, a court may treat general obligation bonds without a statutory lien or Special Revenues pledge as unsecured debt and order a restructuring of the bonds. Payment on the bonds during the bankruptcy proceeding likely will cease. e C. Trade. Vendors, suppliers, contracting parties for goods or services. Payment will likely cease for prepetition goods or services. f D. Obligations for Accrued but Unpaid Prepetition Wages and Pensions and other Employee Benefits. These do not enjoy any priority, unlike in a Chapter 11. g E. Unsecured portion of secured indebtedness. F. Subordinated Unsecured Claims. Any debt subordinated by statue or by contract to other debt would be appropriately subordinated and paid only to the extent senior claims are paid in full. Senior debt would receive pro rata distribution (taking unsecured claim and subordinated claim in aggregate) attributable to subordinated debt until paid. e However, if state law mandates specific appropriation, set aside or priority of payment of revenue collected the failure to honor state law may be an obstacle to confirming a plan of debt adjustment since the plan, court and municipality cannot going forward. See 903 of Federal Bankruptcy Code. f Section 503(b)(9) provides for a priority claim to be paid on confirmation of a plan for the value of goods provided prepetition within 20 days of the petition date. g Chapter 9 does not incorporate 1113 of the Bankruptcy Code, which imposes special provisions for the rejection of collative bargaining agreements (making the standard less restrictive, i.e., impairs ability to rehabilitate ) or 507(a)(4) and (5), which give a priority (before payment of unsecured claims) to wages, salaries, commissions, vacation, severance, sick leave or contribution to pension plans of currently $12,475 per employee. 21

23 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues A. Myth: In Chapter 9, bankruptcy courts and municipalities do not need to comply with state law mandated liens, priorities and dedication of revenues. Reality: The Bankruptcy Court cannot limit or impair the power of the state to control by legislation or otherwise a municipality s exercise of governmental powers including expenditure or state law dedicated revenues to be used solely for payment of debt obligations. Any Plan of Debt Adjustment must comply with state law as to the action necessary to carry out the Plan so future payment of dedicated revenues must be provided for. See Sections 902 and 943(b)(4) of the Bankruptcy Code and Ashton v. Cameron County Water Imp. Dist. No. 1, 298, U.S. 513 (1936), United States v. Bekins, 304 U.S. 27 (1938). 22

24 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 1. The municipality in Chapter 9 cannot act contrary to mandates of state law: Timely mandated payment without delay: Some may argue that, under Section 904 of the Bankruptcy Code, the municipality in Chapter 9 may consent to the court enforcing the automatic stay, preventing or delaying the payment of revenues subject to a statutory lien. (The automatic stay is not applicable to special revenues under 922(d) of the Bankruptcy Code). However, if the municipality is not authorized or able under state law to take such action then it is prohibited from so consenting or acting. The failure of a municipality to follow a state law mandate that revenues are to be used solely to pay the statutory lien debt could be fatal to the court s ability to approve any Plan of Debt Adjustment for the municipality and may mandate dismissal of the case. See Ashton supra at 49 ( a condition of confirmation of a plan it must appear that the petitioner is authorized by [state] law to take all action necessary to be taken to carry out the plan and if the judge is not satisfied on that point as well as others mentioned, he must enter an order dismissing the proceeding ). Further, Section 903 of the Bankruptcy Code prohibits the court from limiting or impairing the state s control over state law mandated payments. 23

25 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues No other use of revenues subject to statutory lien or special revenues are permitted:! No Diversion for DIP Financing of Special Revenues. Some may argue that revenues subject to special revenues can be subject to a senior lien for needed DIP (Debtor-in-Possession) financing during the Chapter 9 at the request of the municipality and revenues can be diverted to other uses subject to providing adequate protection under Section 364(d) of the Bankruptcy Code. To do so would be contrary to Sections 922(d) and 928 of the Bankruptcy Code and the legislative history of the 1988 Amendments thereto.! No Delay in Payment of Special Revenues. Special revenue treatment under Sections 902, 922(d) and 928 of the Bankruptcy Code and the legislation history of the 1988 Amendment that the revenues pledged to pay the special revenues debt cannot be impaired in any way and must be as collected applied as set forth in the relevant documents governing the financings. Finally, the amendment insures that revenue bondholders receive the benefit of the bargain with the municipal issuer, namely they have the unimpaired right to the project revenue pledged to them. Senate Report at

26 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues! No Delay or Diversion for DIP Financing of Revenues Subject to a Statutory Lien. Statutory lien created by state law cannot be subject to a priming lien or use in DIP lending under 384(d) unless the trustee and bondholders consent. There can be no diversion or other use since the municipality is not permitted or able under state law to act contrary to and without the municipality s consent (which cannot be given under state law), and the Bankruptcy Court has no jurisdiction over revenues or governmental power under Section 904 of the Bankruptcy Code. Further, as Section 903 of the Bankruptcy Code provides, the Bankruptcy Court cannot impair or limit the state mandate under state law that revenues subject to a statutory lien cannot be delayed or diverted and must be timely paid as collected to the statutory lien debt as required by state. 25

27 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues B. Myth: The Bankruptcy Code and legislative history of the Bankruptcy Code does not address how statutory liens and special revenues should be treated in Chapter 9 so it is an open question. Reality: From the U.S. Supreme Court rulings on Chapter 9 as constitutional and in specific provisions of the Bankruptcy Code and its legislative history, it is clear statutory liens and special revenues are to be unimpaired in Chapter 9 and the Bankruptcy Court and municipality cannot and should not act contrary to the mandated timely payment. 26

28 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 1. The U.S. Supreme Court rulings in Ashton and Bekins require the municipality and the court to comply with state law as to mandated payment of revenues. In Bekins, the court recognized the Bankruptcy Court cannot interfere with the fiscal or governmental affairs of the municipality and the mandate of state law as to how revenues are to be used. This is based on the Tenth Amendment and the Co-sovereignty of the state with the Federal Government. In Ashton, the court declared the first attempt at Chapter 9 unconstitutional for interference with the sovereign power of the state. In the ruling declaring Chapter 9 unconstitutional, the court recognized the required protection of dedicated revenue and the limitation on the Bankruptcy Court that protects revenues subject to a statutory lien or special revenues. 27

29 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 2. Specific provisions of the Bankruptcy Code require revenues subject to a statutory lien or special revenues to be paid as collected. As noted above, Sections 903, 904, 922(d) and 928 of the Bankruptcy Code can all be read to mandate timely payment of revenue as collected and pledged to the debt holders that are subject to a statutory lien and special revenues. The purpose of Sections 903 and 904 can only be interpreted as requiring timely payment of such revenues as noted above. Under Sections 922(d) and 928(a), special revenues as collected are to be paid (applied) as set forth in the relevant documents (the bond indenture or bond resolution should be clear it is the Security Agreement providing for the payment of pledged revenues). 28

30 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 3. The legislative history of the 1988 Amendments supports the timely and unimpaired payments of revenue subject to statutory lien and special revenues. The Senate Report on the 1988 Amendments specifically noted that the Amendments to Chapter 9 of the Bankruptcy Code providing for special revenues were consistent with the requirement that mandated payment of the pledged revenues created by a statutory lien or state law mandated payment even in Chapter 9 must be timely paid and not impaired as was done in the San Jose School District case (discussed in following slides). 29

31 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues The Senate Report for the 1988 Amendments Provides: The application of Section 552 in a Chapter 9 bankruptcy proceeding may also defy practical reality and state law mandates. As in the case of the San Jose School District, In re San Jose Unified School District, No A-9, (B.C.N.D. Cal. 1983), the continued payment of interest to bondholders not only helped ensure the debtor s continued access to credit markets but also helps fulfill the requirement of state law that such collected funds be used to pay bondholders. Cal. Educ. Code Ann Accordingly, as a practical matter, even though Section 552 of the Bankruptcy Code provides that the pledge is terminated, given the mandate of the law and the practical reality of municipal finance, a municipality might well attempt to ignore that provision and continue to pay the bondholders as originally promised. Municipalities, prior to and after the enactment of the Bankruptcy Code, have so acted, such as the San Jose School District. 30

32 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues In the municipal context, therefore, the simple answer to the Section 552 problem is that Section 904 and the tenth amendment should prohibit the interpretation that pledges of revenues granted pursuant to state statutory or constitutional provision to bondholders can be terminated by the filing of a chapter 9 case. Likewise, under the contract clause of the Constitution (article I, section 10), a municipality cannot claim that a contractual pledge of revenue can be terminated by the filing of a chapter 9 proceeding. S. Rep. No at 6 (1988). Accordingly, the statutory lien pledge of ad valorem tax revenues for the timely payment of the Unlimited Tax General Obligations ( ULTGOs ) debt service was not interfered with in the San Jose School District case and is not to be interfered with under Chapter 9 as the legislative history for special revenue treatment so provides. 31

33 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues This legislative history noted the recognized principles that are embodied in Sections 903 and 904 of the Bankruptcy Code and the Tenth Amendment as recognized in the Supreme Court of the Ashton and Bekins: that the statutory lien cannot be terminated nor the mandated payment impaired so that revenue subject to the statutory lien or special revenues must be paid timely as intended to the debt holders. 32

34 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues C. Myth: There is no case law to support the position that payment of revenues subject to statutory lien and special revenues must be paid timely and not impaired. Reality: The only case law that exists support the timely payment as collected of revenues subject to statutory lien and special revenues to their respective debt holders. 33

35 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 1. San Jose School District. In 1983, the San Jose School District lost a labor arbitration and claimed to be unable to make the payments required thereunder. On July 1, 1983, San Jose School District filed for protection under Chapter 9. The scheduled debt service was due payment on its ULTGOs as of July 1, 1983 and that payment was timely paid and continued to be paid through the Chapter 9. Under California law, the County Treasurer was to levy a tax sufficient to pay debt service and the County Treasurer was to collect the specified levy of tax and pay it into a special account or directly to the bond trustee for payment on the ULTGOs. California law specifically mandates that such pledged revenues could only be used to pay debt service on the ULTGOs and no other purpose. Accordingly, the County Treasurer was required by state law to levy, collect and pay for the benefit of the ULTGOs and could not take any different action. The School District had no right to the separately levied tax revenues that could not be paid to or used by the School District under state law. (Cal. Ed. Code ). 34

36 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 2. Sierra King Health Care District. In the Fall of 2009, Sierra King Health Care District in California filed for Chapter 9 protection. The District had just issued ULTGO bonds pursuant to Cal. Health & Safety Code in August of The good faith issuance by the District was called into question given the timing of the Chapter 9 filing. Various securities law claims were considered. California law required after the two-third approval of the electorate that the debt service for payment of the ULTGOs be levied by the County as collected be paid to a special account or directly to the Bond Trustee (which was the practice) and the levied and collected revenues could only be used to pay the ULTGOs and no other purpose and any surplus was to be paid back to the taxpayers. Given the threat of securities fraud litigation, there was a settlement of those claims and a reaffirmation and ruling by the court that the revenues so levied and collected to pay the ULTGOs were subject to a statutory lien and were special revenues not to be impaired during the Chapter 9 or in the Plan and were to be timely paid. 35

37 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 3. Heffernan Memorial Hospital District (202 B.R. 147 (Bank. S.D. Cal. 1996)). It has long been recognized in California and other jurisdictions that special tax or a portion of a general tax specifically levied to pay for a municipal financing and not for general purposes should be treated as special revenues and timely paid as collected to the debt holders. 36

38 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 4. No Adverse Rulings in Jefferson County, Vallejo, Stockton and Detroit. (a) Jefferson County: Jefferson County recognized special revenue treatment for sewer debt and payment consistent with the terms of the documents. While the case authorized payment of special revenues to pay debtor counsel fees in part it was purportedly due to the language of the indenture being interpreted to allow such payment and ultimately settled. The ultimate plan treatment was a compromise or settlement. Accordingly, Jefferson County case does not stand for any impairment or delay in payment as collected other than as purportedly authorized by the documents or voluntarily agreed to. (b) Vallejo and Stockton: In Vallejo and Stockton bankruptcies, there was recognition of the mandated payment and the timely payment of special revenue bond issues (even though there was a dispute over lease financing relating to extent of the collateral and payments with one major holder). 37

39 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues (c) Detroit Water and Sewer Bonds: In Detroit the special revenues of the water and sewer bonds were timely paid and if the holder did not accept Detroit s tender offer in the plan, the remaining holders were unimpaired (except for those who voluntarily settled and took the tender offer). (d) Detroit s ULTGOs: There was no adverse ruling in the Detroit case as to statutory liens and special revenues. There was a voluntary settlement approved by the court that as agreed provided less payments than state law would have required. The ULTGOs in Detroit were impaired and claimed by Detroit not to be subject to a statutory lien or special revenue treatment. Since this class claim was settled with the insurers receiving 74 cents on the dollar and the bondholders being paid 100 cents on the dollar by the insurers, there was only a voluntary impairment and no court ordered impairment. 38

40 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues Detroit s unlimited tax general obligation ( UTGO ) bonds had voter approval of additional tax revenue dedicated to payment of these bonds which raises some fundamental government finance issues as noted above as to Sections 903 and 904 of the Bankruptcy Code. What does it mean to have a tax revenue pledge approved by the voters and dedicated to pay the general obligation bonds? What does Article IX Section 25 of the Michigan Constitution mean that The repayment of voter approved bonded indebtedness is guaranteed? What consequences are there to the Municipal Bond Market if UTGO Bonds are ultimately treated as unsecured debt. Can the plan of debt adjustment be confirmed if it is not in compliance with state law and if the claimant does not consent to a settlement that provides for an impairment. Presently there is pending in the Michigan Senate legislation reconfirming a statutory lien on ULTGOs in Michigan. This legislation has already passed the Michigan House (H.B. 4495). 39

41 II. Dispelling the Myths and Misconceptions of Statutory Liens and Special Revenues 5. Federal Courts Have Ruled that the Bankruptcy Court Cannot Confirm a Plan that Violated the Mandates and Priorities of State Law. In the case of In the matter of Sanitary and Imp. Dist. No. 7, 98 B.R. 970 (B.C.D. Neb. 1989) the court recognized where a plan proposes action not authorized by state law or without satisfying state law requirements, the plan cannot be confirmed. The issue was whether the state law priority of payment of bonds over warrants required the plan to provide for full payment of bonds as required by state law in order to be confirmed. While these were unsecured claims (not covered by a statutory lien or special revenues) which can be modified in a Chapter 9, the court noted mandated priorities under state law as well as state law provision for payment post confirmation should be honored in order for the court to confirm the plan. See also Colorado Springs Creek General Imp. Dist. 177 B.R. 684 (B.C.D. Colo. 1995). 40

42 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation A. Access to the Market at a Low Cost of Borrowing is Desired by All Government Borrowers. 1. Access and the Cost of Borrowing is a Reflection of the Perceived Risk of the Government Credit (a) Fiscal Distress for Government Begets Higher Cost of Borrowing and Even Loss of Access to the Market On March 2, 2012, Greece had a ten year bond annual yield of 37.1% and in July, 2015, after the third attempted bailout and austerity package being implemented, Greece annual yield is still over 10.5% with a 52 week range of 5.5% and 19.5%. Greece has defaulted on its sovereign debt since 1826 at least five times prior to its recent financial crisis (1826, 1843, 1860, 1894 and 1932). Brazil, a large developing economy which defaulted or restructured its sovereign debt eleven times since 1826, the last time 1990, had an average ten year bond annual yield between 2006 and 2015 of approximately 12.3% with all time high of 17.91% in October,

43 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation Puerto Rico, given its recent financial distress experience, had yields on its ten year G.O. bonds exceeding 10% in February, At the same time, other sovereigns experienced usually low bond annual yields of 2.27% for U.S.A., 1.52% for Canada,.74% for Germany and 1.03% France. A review of selected sovereigns that have defaulted since 1998 demonstrates default does result in a time out or lack of access to the international bond market. 42

44 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation 2. In Detroit the Emergency Manager s Unjustified Attack on ULTGOs Raised the Perception of Risk and Increased Annual Interest Rates! The filing of the Detroit Chapter 9 proceedings and the Emergency Manager s unwarranted attack on ULTGOs caused other municipalities in Michigan, like school districts, to experience approximately 100 basis points increase in the annual interest rate, the cost of borrowing, on ULTGOs due to the Detroit contagion.! In California, the Detroit fall out cost school districts a basis point increase, which was historically unjustified given the Chapter 9 experience of San Jose School District and Sierra King Health Care District cases.! California response through the efforts of CDIAC was to attempt to clarify the intended low risk of California ULTGO by passing SB 222 to reconfirm that California state law provides a statutory lien intended to be unimpaired and paid in a Chapter 9. 43

45 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation B. The Recent Use of Statutory Lien Legislation to Gain Market Access in Financially Distressed Times and to Lower the Cost of Borrowing for the Benefit of All 1. Rhode Island. In 2011, in response to the threat of bankruptcy of Central Falls and economic distress in other local governments, the legislature and Governor of Rhode Island passed legislation that provided outstanding notes and bonds of cities and towns shall be paid and shall have a first lien on all ad valorem taxes and general fund revenues by the power and force of a state statutory provision (RI Gen ). The expressed intention of this law was to assure market access at a lower borrowing cost especially in times of financial distress. 44

46 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation 2. California. As noted above, in response to the Detroit contagion due to the unjustified attack on ULTGOs in its Chapter 9 case, California, through the efforts of CDIAC and California legislature proposed and had passed SB 222 which expressly provides and reconfirms a statutory lien on voter approved unlimited ad valorem tax specifically levied, collected and dedicated to pay those ULTGOs and under California law cannot be used for any other purpose by the local governments (See e.g. California Ed. Code and California Gov. Code 53515). 3. Michigan. As was noted in the exiting financing for Detroit after confirmation of its Plan of Debt Adjustment, it was necessary in order to domesticate the financing to be acceptable to the public market that the Michigan legislature had to pass legislation providing that financing had a statutory lien on pledged revenues. At the end of 2014 and in 2015, the Michigan legislature has considered legislation reconfirming a statutory lien for ULTGOs in Michigan. The Michigan House has passed HB 4495 and it is now pending before the Michigan Senate. 45

47 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation 4. Other States. In Nebraska, there is pending legislation granting statutory lien status to the bonds and notes issued by local government (NE LB 67). As part of the proposed legislation regarding authorizing Chapter 9 for certain local government in Illinois, there is a proposed statutory lien for all bonds and notes with pledged revenues as the source of payment as a first lien (unless otherwise specified) automatically attaching and perfecting and being senior to any other claims. (See Illinois Governor Rauner s Pension Proposal). See e.g. also statutes in California (Section of CA Education Code and Section CA Gov. Code), Rhode Island (R.I. Gen. Laws Chapter 45-12), Colorado (Colorado Revised Statute ), Idaho (Id. Code Title 57, Chapter 2, Section 234). Compare: e.g. Louisiana (LA Rev. Stat. 39:14301), Oregon (OR Rev. Stat. 287A.310), Texas (TX Govt. Code Title 9, Subtitle A, Sec and ) and Utah (UT Code ). 46

48 III. Why States and Municipalities Desire the Benefits of Statutory Liens and Special Revenue Designation C. Reducing Risk with Statutory Liens and Special Revenues Can Benefit All In Lower Costs of Borrowing. 1. The Basis Point Spread Between Strong and Weak Credits. Traditionally the spread in the municipal market between strong credits (top investment grade) and significantly weak credit (lower non-investment grade) was basis points. 2. Being Classified as a Weaker Credit Increases the Cost of the Borrowing By 25% or More of the Face Amount of Debt and Should be Avoided if Possible. To a state or local government, a 200 point per year or 2 percent more interest cost a year on a 20 year bond with a bullet maturity would be 40% more of the principal amount paid as interest over 20 years. Put another way, on a billion dollar debt issue with a twenty year maturity and a bullet payment of principal at maturity, a 2% additional interest cost per annum would be a present value at a 5% discount of about $250 million or 25% of the face amount. That is $250 million not available to state or local government to pay needed infrastructure improvements, public services, worker salaries, retiree benefits or tax relief to its citizens. 47

49 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism A. Past Mechanisms Appear to be Inefficient in Reaching a Quick, Effective Resolution 1. Diversity of the Type of Debtholders? (a) Sovereign Defaults. In past centuries, the sovereign s external debt creditors were generally a known group of governments or led by known commercial banks so either the London Club for commercial banks or the Paris club was conducive to an effective consensual restructuring. New and diverse and unknown participants bring a new challenge to quick resolution. 48

50 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (b) State and Local Governments. States cannot file Chapter 9 and must address financial distress by increasing taxes, reducing expenditures (services), slow or significant delays in paying creditors until the financial distress is adjusted. No state has defaulted on G.O. bonds since Arkansas in the 1930 s. As noted above and in Appendix A, Chapter 9 filings have been rare and until recently limited, for the most part, to small utilities, special tax districts and other local governments (cities, towns, villages, hospitals, etc). The debt holders of state and local debt especially publicly traded bonds have changed over the last 50 years. Banks, institutional holders (traditional bond funds and insurance companies) and retail (mom and pop) holders have especially in time of distress morphed into more high yield funds and hedge funds who are more focused on short term yields and less tolerant of prolonged workouts. The new entrants are more likely and sooner to resort to litigation and assertion of remedies. The new entrants have neither the long term market relations or desire to slavishly go along with past resolution mechanisms. 49

51 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 2. The Rise of Litigious Debt Holders Using Foreign Courts have Created New Problems: (a) Sovereign Debt. The Peru Debt Litigation in the 1990s and Argentina s litigation of the 2000 s have proven that foreign courts and attempts to attack the foreign debtor government s assets in other jurisdictions could be a real obstacle to past resolution mechanisms. Recently, the court in the Argentina litigation held Argentina s Central Bank s assets are not available for creditor attachment consistent with similar rulings by the courts of other countries all to foster consensual as contrasted to litigious resolution of sovereign debt. (b) State and Local Debt. There has been a rise of more extreme litigation in connection with local government defaults in the U.S.A. An example is the litigation between bond insurers, warrant holders and trustee in Jefferson County that was ultimately settled in the Chapter 9 Plan of Adjustment and the banks and bond insurers and emergency manager as to ULTGOs, SWAPs and water and sewer bonds in Detroit s Chapter 9. The eligibility issue and lease treatment in the Stockton Chapter 9 and the Puerto Rico litigation with bond funds and hedge funds over the Puerto Rico Debt Enforcement and Recovery Act are other examples 50

52 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 3. The Increase in the Number and Extent of Hold Outs Who Do Not Care What Others Think: In sovereign defaults, when the London Club or Paris Club was used, the lender participants knew in the next restructuring they would be facing the same institution and being a hold out had adverse consequences, and some large institutions had developed long memories. In Chapter 9 and local government defaults situations in the U.S.A., there had been the tradition that since the municipal market participants and the ongoing lenders to local governments were quite defined, prolonged distress hurt everyone and pressure was felt to go along to get along with a refinancing or restructuring the terms of which were not the absolutely desired result. The new entrants whose role in future financing is not assured feel less pressure to conform and more freedom to take a hold out path. The increase in the types of lenders and their ability through mutual or hedge fund vehicles to bring billions of dollars to the table resulted in the expansion of the small group of friendly lenders to the unknown lenders with significant capital and staying power as noted with the unsuccessful use of CAC in the Greece restructuring (only 17 of 30 financings reached agreement of a super majority approving the bail out terms) and the dynamic of Detroit, Jefferson County, Stockton, San Bernardino and Vallejo Chapter 9 cases and the Puerto Rico Debt Restructurings like PREPA, etc. 51

53 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 4. The Increase of Legacy Costs of Government and Crowding Out of Funding for Essential Services and Infrastructure Mandate a More Complex Restructuring of Past Financial Mistakes: The civil and public pensions that lack funds dedicated to pay with increasing costs of benefits have strained the past restructuring methods of reaching an agreement. The age and delay in infrastructure improvements and increased costs of public workers and essential government services reduce dollars available for the restructuring. 5. Increased Tension Between Repayment of Debt of Governments and the Government s Right to Reserve Funds for the Public and Social Good: Recent efforts in Belgium and English law to establish dedicated reserve funds to be used for pensions, governmental services or infrastructure that could not be attached by creditors have eraised new concerns and a new battle ground. The litigation in the U.S.A. over pension reform due to unaffordable and unsustainable underfunded public pensions that crowd out funding for governmental services and needed infrastructure improvements have not been resolved in a satisfactory manner. These struggles are tied to the notion of sovereign immunity and the provision of essential governmental services are not commercial activities that should be involved in sharing the pain in a financial debt restructuring. Since a government cannot be sold, liquidated or capitalized, there are practical limits to the extent a restructuring can infringe on social and political issues. 52

54 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 6. Investment in the Government to Stimulate Economic Development May Be the Best Assurance to Creditors They Will Be Paid: Generally sovereigns, states and local governments have fallen into financial distress due to years, if not decades, of neglecting to provide services at level that attracts new businesses and business development and failure to make infrastructure improvement desired by citizens and businesses. The best recovery plan for a financially struggling sovereign is to reinvest in essential services and needed infrastructure to stimulate the economy, encourage business expansion and creation of new good jobs all of which create new additional tax revenues to pay restructured creditors. Economic studies have shown $1 spent on necessary infrastructure improvement yields over $3.20 economic stimulus over 20 years, most of which is front end loaded. Job multiplies mean for one good job creates its stimulus for 2 to 3 or more jobs due to direct, indirect and induced effects of economic activity. Starving the government s economic development can directly adversely affect the ability of restructured creditors to be paid. 53

55 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism B. There is a Growing Awareness of the Need for a New Mechanism for Sovereign Debt Problems 1. The Problem of Past Practices. In sovereign defaults, the London Club and Paris Club have been less used and efficient with the significant growth of the non-traditional non-bank and non-government participants who will not necessarily play by the old rules. This has been evident in recent debt restructurings of Peru, Argentina, Russia and, most recently, the Greece debt crisis. Likewise, less than effective pension reform and financial distress of state and local governments have created dynamic uncertainty for bondholders, workers, taxpayers and the local government with less ability to proceed with the traditional refinancing and more likely partisan battles over who will be paid and when. While the process of Chapter 9 provides debt adjustment, it does not necessarily assure the development of a recovery plan that is sustainable and affordable that provides funding for necessary services and needed infrastructure. 54

56 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 2. No Quick Fixes. In international sovereign debt restructurings the use of contractual or statutory resolution mechanisms for ad hoc or non-traditional banks or government lenders have not been as effective as thought. The use of CAC, exit consents, exchange offers and forbearance, standstill agreements have been less effective recently due to the less collegial nature of lenders. See e.g. Argentina, Peru and Greece. For local governments, the lack of structured support, interim financing and expertise in developing effective recovery plans acceptable to all has made Chapter 9 and municipal default time consuming, expensive and less than desired. 3. Need for Predictability of Results. The predictability of results has fallen to the questions of uncertainty of method to be used, the willingness and ability of the government and lenders to reach and honor the agreement, the unpredictable nature of non-traditional lenders and the questionable availability of interim or future financing and liquidity. 55

57 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism C. The New Mechanism Must Address the Needs of the Government and the Concerns of the Creditors and Lenders 1. The Government Concerns: The government believes its debt restructuring is more complicated than a corporate restructuring or bankruptcy. The governments recognize there is a difference between mere survival and a real economic recovery. A government in financial distress cannot be liquidated or sold. The government requires the continued ability to provide essential services and necessary infrastructure to its citizens, provide economic structures for jobs and commercial activity, provide for national and public safety, education, health and welfare. Receiverships and overbearing oversight is not socially or politically popular especially in a democracy. (See the extensive local objections to the Emergency Manager in the Detroit bankruptcy). 56

58 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 2. Lender Concerns: The lenders do not want to fund wasteful governments or unjustifiable life styles or explain to their citizens or stockholders why losses have been incurred without reasonable justification. Lenders want to be assured of a predictable, just and fair system that addresses all issues so there is no continuing systemic problem, no use of a band-aids as opposed to a permanent fix. 3. Common Concerns of Sovereign and Leaders/Creditors: (a) A need for a formal method of announcing and beginning the process. (b) The ability to coordinate the creditors and avoid the holdouts or free rides problem. (c) A means of building consensus and knowing there will be support or at least a definite resolution if some parties cannot agree. 57

59 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (d) An automatic stay of litigation for any court in any country. (e) A full transparent means of classifying and providing a treatment of all claims that will be disclosed to all creditors with full disclosure of ability to pay and justification for treatment. (f) Recognition of unimpaired status of fully secured creditors (like statutory liens and special revenues in Chapter 9) along with provision for priority funding of necessary services and infrastructure. (g) Interim and continuing financing to assure liquidity of the sovereign to preserve the ongoing ability to pay. (h) The ability of the government to cram down or reduce debt to what is sustainable and affordable without impairing the economic growth and future of the government. (i) Assuring the lenders agreed upon restructuring is also feasible and capable of stimulating and to the extent possible growing the economy since that is really the essence of best interest of creditors, government and taxpayers. 58

60 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism D. Government Oversight, Recovery and Debt Adjustment Commission ( GORDAC ) 1. Creation. There should be established by treaty or agreement of affected creditors and lenders for sovereigns and by U.S. Congressional legislation for territories of the United States (under Article IV, Section 3 of the U.S. Constitution) and by federal or state legislation for local governments in the U.S.A., to the extent possible, a three phase process under an independent, separate and newly established GORDAC. 2. Phases of GORDAC Process. Phase One: Initiation and investigation and determination of sustainable and affordable governmental services, needed infrastructure and debt ( Sustainability Determination ). 59

61 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism Phase Two: Development of recovery plans for the government consistent with the Sustainability Determination that sets forth the recovery plan demonstrating the governmental services to be funded and stimulus for economic development to encourage increase in business activity, creation of jobs, and increase in GDP and tax revenue so that assurances can be given to creditors as to the recovery and increasing revenues for payment of the debt owed to the lenders. Phase Three: Presentation of recovery plan after creditors opportunity to comment, negotiate and raise objection to recovery plan proposals. If through GORDAC oversight and mediation the desired agreement on a recovery plan cannot be reached by the government and the creditors, then the less preferred quasi judicial determination and hearing stage would proceed similar to Chapter 9. Creditor voting by affected class and the approval of the recovery plan by the commission with any modifications or changes the commission believes necessary to be consistent with the Sustainability Determination. The goal of the recovery plan and this process is a permanent resolution of the systemic financial issues of the government in order to avoid systemic problems of the past and to provide a fresh start. 60

62 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 3. Commission: The GORDAC Commission shall consist of at least three commissioners panel and a professional staff with experience in finance, government, accounting and governmental and financial restructuring sufficient to fulfill its mission. The Commission shall initially have an oversight and technical assistance function which, if not successful, would progress into a quasi judicial and final resolver of open issues. The Commission shall be funded by fees from the participating governments who are subject to the treaty and by fees imposed upon the distressed government (state and local governments) who use GORDAC. It shall be completely independent of governments or lenders. 4. The Process: (a) Initiation. Petition by participating government or designated percentage of debt outstanding that demonstrates government has defaulted on a designated percentage of debt or cannot pay its debts as they will mature and will default within a year. Commission can request a response from the government if initiated by designated percentage of creditors. Within a short period of time, the Commission will decide if government financial distress exists for the GORDAC to take jurisdiction. If the Commission takes jurisdiction, then it will immediately issue an order to: 61

63 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism 1. Stay all litigation involving the government or actions to obtain a preference by one creditor over others. 2. Schedule discussions, discovery, negotiations or mediation as the Commission deems necessary to first determine what debt and governmental services are sustainable and affordable. The Sustainability Determination to be made first and then the recovery plan debt adjustment determination. 3. The timing for determination of sustainability and government filing of recovery plan and comments from creditors on the recovery plan. 4. Dates for hearing on sustainability and, if necessary, the process of voting on the proposed recovery plan and dates for hearing on objections to recovery plan. 5. Dates when the Commission will make its determination of sustainability and ruling on recovery plan with any Commission imposed modifications to the recovery plan. 62

64 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (b) Commission Management of the Process: The Commission is to manage the collection of information necessary to the determination of sustainability of a recovery plan and supervise and facilitate negotiation, mediation and resolution of issues and development of a recovery plan. The process will start more like a financial oversight authority assisting and facilitating negotiations and resolutions of issues in a recovery plan. If agreement is not reached, the oversight turns to judicial determination of issues binding on all parties with the power of the Commission to enforce its decisions on all parties in all courts of all jurisdictions. The Commission consisting of at least three Commissioners would be designated as:. 1. The Chair who would preside over hearing and be the ultimate determination of designated matters and the recovery plan; 2. The Commissioner for Mediation who would be in charge of supervising and establishing the procedures and rules for mediation and appoint special master or the Associate Judge to preside over mediation and settlements to be recommended to the Chief Judge; and 3. The Commissioner for Sustainability Determination who would be in charge of the sustainability determination process and the work of the professional staff of GORDAC as well as disclosure of all necessary discovery and collection of information from the government and creditors necessary for the sustainability determination and the recovery plan. GORDAC is a blend of the benefits of a Financial Oversight Authority (such as Act 47 in Pa., Financial Control Board in N.Y. and Emergency Manager in MI) and Chapter 9 with expanded powers and no appeal. This strong medicine if agreement is not reached is intended to encourage early agreement to avoid a harsher judicial result. 63

65 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (c) The Commission Shall Have the Power to: (a) Subpoena or request information required to fulfill its mission from the sovereign or creditors. (b) Engage any professionals necessary to fulfill its mission. (c) Mediate and determine, if necessary, issues related to budget and appropriation, appropriate levels of governmental services, costs, taxes, pension funding and benefits to ensure sustainability during the process and ability of the sovereign to pay its adjusted debts and provide essential services to its citizens. (d) Encourage and approve settlements between the government and creditor groups or individual creditors. (e) Recommend or approve government interim financing and continued financing with, if necessary, super priority protection to ensure liquidity and funding during the process at the lowest borrowing cost possible. If necessary negotiate and obtain necessary funding. 64

66 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (f) Recommend cuts in governmental spending and tax increases as necessary for continued operation of the government. (g) Recommend mediation by government and any creditor or creditor group and require attendance and participation of affected creditors. (h) Require update on mediation discussion with creditors and the sovereign, progress reports and status of recovery plan and resolution with creditors. (i) Recommend the approval or disapproval of contracts, expenditures, loan creation or elimination of certain positions or operations. (j) Recommend staffing levels in relation to determination of sustainability and adjustment to staffing, hiring and compensation. 65

67 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (k) Recommend or require sale or other transfer of any asset, right or claim of the sovereign including privatization and lease. (l) Take any other action necessary for the fulfillment of its mission. (d) GORDAC to Encourage Sovereign to Resolve Matters Before Having to Issue a Ruling Binding on all Parties The government and creditors are encouraged to use the process to quickly and effectively resolve their issues, develop a sustainable and affordable recovery plan that stimulates growth and development of business, provides for essential governmental services and the best return to creditors consistent with the Sustainability Determination. Only if the government fails to act in good faith or fails to reach agreement on a recovery plan shall the Commission rule and be the final word binding on all without the right to appeal. 66

68 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (e) Recovery Plan The Recovery Plan shall provide for: (1) Consistent with the Sustainability Determination the continued operation of government. (2) Payment of the adjusted debt. (3) Any necessary modification, rejection, termination, renegotiation or replacement of contracts including social programs and public workers pensions paid for by the government. (4) Justification of the reduction in services or adjustment of debt, the reinvestment in the government and projected increases in GDP, employment and tax revenues, if any. (5) Any other matters that the Commission or the circumstances may require to allow the government to alleviate the financial emergency and accept the Recovery Plan. 67

69 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism (f) Final Approval and Continuing Oversight The Commission may require as part of its approval continuity, oversight of operation, budgeting, tax collection or any other matters as a condition for approval of the recovery plan. This oversight may be by a board or overseer selected by the Commission or by periodic reports to the Commission. (g) Sovereign Immunity for GORDAC GORDAC and its judges, employees, agents and professionals shall all have global sovereign immunity from any claim or damage suffered. 68

70 IV. The Need for a Workable Sovereign Debt Restructuring Mechanism E. Now is the Time to Enact GORDAC Before the Next Waive of Government Debt Crisis 1. As noted above, sovereign, state and local government debt crises follow economic downturns, war, political unrest and unforeseen events. Now is the time before the next wave hits. 2. On the sovereign level, the London Club, Paris Club, SDRM, use of CAC, exit consents, exchange offers, have merit but have not been as effective as desired. On the state, territory and local government level Chapter 9 is either not available or has been marked with experiences of stigma, high costs, significant delay and less than hoped for results. With changing times and recently experienced problems, GORDAC appears to provide the promise of the best, most effective and efficient means of resolving government debt crisis in the best interest of all constituents. 69

71 V. Checklist of Disclosures to Maximize Market Acceptance in Evaluating Repayment of Bond Debt A. Authorized to file Chapter 9? Can the issuer file for Chapter 9, if not, then right to enforce obligation in state court by mandamus and other remedies without a required restructuring? B. What is source of payment? Is the general obligation debt a naked full faith and credit promise or does it have a pledge of special revenues or statutory lien pledging and dedicating a specific and adequate tax revenue source for payment. (Alexander Hamilton in the 1790s said the secret of making public credit immortal is that whenever public debt is increased, it ought to be accompanied by a sufficient tax increase dedicated to its payment. (Syrett, The Papers of Alexander Hamilton, Vol. 6, p. 106 and Vol. 18, p. 103)) 70

72 V. Checklist of Disclosures to Maximize Market Acceptance in Evaluating Repayment of Bond Debt C. Is there a lack of diversification of tax sources and limits on taxes that could realistically be triggered? Are sources of tax revenues too limited or are there tax limits and debt limits close to being triggered that may prevent the raising of taxes to pay the obligation? D. Are there required priorities, set asides or appropriations to support payment? Do state constitutions or statutes provide for a priority of payment for general obligation debt or mandatory set aside of revenues or appropriations for payment of the debt? (Can plan of debt adjustment be confirmed if it is not in compliance with state law by not permitting mandatory priority of payment, set asides or appropriations? Could be a real obstacle to confirming a plan). 71

73 V. Checklist of Disclosures to Maximize Market Acceptance in Evaluating Repayment of Bond Debt E. Are there effective remedies available if there is a default? Do the state statutes and case law provide effective remedies (mandamus, intercept, constitutional or statutorily, required set asides, priority of payment, or appropriation) and does state court effectively enforce them? F. Is effective state oversight and assistance available to prevent defaults or aid a financially troubled municipality? Does the state provide by statute or practice the ability to monitor and oversee a financially challenged municipality, provide financial guidance and support to bridge the economic downturn and avoid litigation meltdown and Chapter 9. 72

74 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 The largest cities, towns, villages and counties to have filed Chapter 9 bankruptcy in the last 60 years (including Detroit): Approximate Population Approximate Debt in Millions Orange County (filed 1994) 3,000,000 $1,974 Vallejo, California (filed 2008) 115,942 $175 (2008) Jefferson County (filed 2011) 658,931 (2011) Stockton, California (filed 2012) 291,707 (2010) San Bernardino (filed 2012) 213,012 (2011) Detroit, Michigan (filed 2013) 701,475 (2012) $4,200 $1,032 (2011) $492.3 (2011) $18,500 (2013) 73

75 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 FREQUENCY OF MUNICIPAL BANKRUPTCIES (as of 08/20/2015) * Since passage of the Bankruptcy Code * Series1 74

76 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and FREQUENCY OF MUNICIPAL BANKRUPTCIES BY DECADE (as of 08/20/2015) s 1950s 1960s 1970s 1980s 1990s 2000s Series

77 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and CHAPTER 9 FILINGS BY STATE (as of 08/20/2015) AL AK AR AZ CA CO CT FL GA ID IL IN KY LA MI MS MO MT NC NE NH NJ NM NY OK PA RI SC TN TX UT VA WA WV 76

78 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and CHAPTER 9 FILINGS BY YEAR (as of 08/20/2015)

79 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and CHAPTER 9 FILINGS BY TYPE (as of 08/20/2015) Municipal Utilities and Special Districts City, Village or County Hospital, Health Care Transportation School, Education 78

80 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 MUNICIPAL BANKRUPTCY RECOVERY * Total Filings: 362 Aggregate Admitted Debts: $217,230,541 Average Debt Per Filing: $600,084 Average Percentage Recovery: 64.7% Admitted Losses: $76,615,745 Amount Paid or to be Paid as Extended: $140,614,796 * See Table 5-1, City Financial Emergencies: The Intergovernmental Dimension, Advisory Commission on Intergovernmental Relations, July

81 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 MUNICIPAL BANKRUPTCY RECOVERY * Aggregate Losses: $3,457,621 Total Filings: Aggregate Admitted Debts Average Debt Per Filing: Average Percentage Recovery: 18 $13,227,624 $734, % Aggregate Amounts Paid or Paid as Extended: $9,770,003 * See Table 5-1, City Financial Emergencies: The Intergovernmental Dimension, Advisory Commission on Intergovernmental Relations, July

82 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 DISPOSITION OF CASES Cases Confirmed Cases Dismissed Cases Pending or Disposition Unknown Cases Confirmed Cases Dismissed Cases Pending 1954-August 20, August 20, Cases Filed 172 Cases Filed 55.9% Resulted in Plan Confirma6on 65.7% Resulted in Plan Confirma6on 81

83 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 Eligibility to file controlled by the state:! In order to file a Chapter 9, the municipality must be specifically authorized under state law and must negotiate in good faith with its creditors. This requirement does not require the municipality to perform an impossible task. If the position of a creditor group has so crystallized as to make it in impossible to negotiate in good faith, the good faith requirement will be deemed to have been met. (Jefferson County, Stockton and Detroit). Harrisburg, PA and Boise County, ID were both dismissed as not being authorized to file Chapter 9 (not authorized by the state and not insolvent, respectively). Since 1954, at least 103 Chapter 9 cases out of 320 or 32% of all Chapter 9 cases have been dismissed without a plan of debt adjustment being confirmed. 82

84 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and 2015 Limited eligibility to file for municipal bankruptcy Chapter 9: The municipality must be specifically authorized by state law:! Less than half of all states specifically authorize their municipalities under state law to be a debtor in Chapter 9. Twelve states have statutory provisions in which the state specifically authorizes filing (AL, AZ, AR, ID, MN, MO, MT, NE, OK, SC, TX, WA without any conditions), another twelve states authorize a filing conditioned on a further act of the state, an elected official or state entity or neutral evaluator (CA, CT, FL, KY, LA, MI, NJ, NC, NY, OH, PA, RI). Three states (CO, OR and IL) grant limited authorization, two states prohibit filing (GA) but one of them (IA) has an exception to the prohibition. The remaining 21 are either unclear or do not have specific authorization so they cannot file for Chapter 9.! Those municipalities that are in states that have a condition to filing Chapter 9, namely a second look by an elected official or state agency, are approximately 5 times less likely to file than those that are in states that unconditionally allow their municipalities to file. 83

85 Appendix A - The History of Payment of State and Local Government Debt in the United States and Summary of Significant Chapter 9 Events during 2011, 2012, 2013, 2014 and

86 Appendix B Municipalities in Distress? Chapman and Cutler LLP has published in 2012 a book entitled Municipalities in Distress?, which is an analysis of state laws dealing with financial emergencies of local governments (50-State Survey of State Law providing (1) oversight, supervision or assistance to financially distressed municipalities, (2) rights and remedies provided by states to investors in financially distressed local government debt and (3) state authorization of municipalities to file Chapter 9 bankruptcy). Municipalities In Distress? is being updated for lessons learned from recent cases, court decisions recently rendered and recent changes in statutes and constitutional provisions. A revised 2015 edition is due out later this year and preliminary results may be briefly summarized by the following chart: 85

87 Appendix B Municipalities in Distress? 86

88 Appendix B Municipalities in Distress? 87