Pub. 4 2014 Issue 4

24 www.azbankers.org Municipal Bankruptcy … What Every Lender Should Know COUNSELOR’S CORNER I NTRODUCTION Banks generally view lending to mu- nicipalities as a low risk proposition. Lending to municipal entities is benefi- cial to banks for the opportunity that often exists to cross sell other services of the bank, including deposit account services, cash management, and wealth management services. Recent public bankruptcies such as the City of Detroit redefine the relative strength of a general obligation pledge of security and make repayment less certain than it once was. C OMMON TYPES OF CREDIT SECURITY FOR MUNICIPAL LENDING BY BANKING ORGANIZATIONS Banks make various types of loans di- rectly to municipalities. These loans are repaid through property taxes, general cash flow or through specific revenue streams, such as water and sewer fees. REVENUE BONDS Revenue bonds often finance revenue producing projects such as utility proj- ects and are payable solely from cash flows generated from the project. If cash flows are insufficient to meet the debt service requirements, the financial insti- tution might be forced to restructure the transaction or seek to obtain financial support from the municipality. Munici- palities typically do not guarantee this type of debt but often offer financial support to ensure that services continue to be provided to their citizens. Under a Chapter 9 bankruptcy filing, holders of revenue backed bonds gener- ally are considered secured creditors because the bankruptcy laws provide that bonds secured by "special reve- nues" are not impacted by the automatic stay. GENERAL OBLIGATION BONDS Several types of bonds are often referred to as "general obligation" bonds. How- ever, not all general obligation bonds are created equal. Lenders who have experienced a municipal bankruptcy can attest to this fact. The highest form of a general obligation bond involves the levy of a property tax dedicated to the payment of the bonds and is levied in an amount and at a rate sufficient to pay debt service on the bonds without By TIMOTHY A. STRATTON and E RIC MCGLOTHLIN , Gust Rosenfeld P.L.C. limit as to rate or amount. Some bonds are payable simply from the general fund of the municipal issuer and any lawfully available funds. This second type of borrowing is generally believed to be less secure than a property tax backed bond because no new specific source of pay- ment is pledged. Under a Chapter 9 bankruptcy filing, there is some uncertainty about how a general obligation bondholder will be treated. The Detroit bankruptcy resulted in general obligation bondhold- ers being treated as unsecured creditors under the theory that the bonds were not secured by specific revenues in the absence of any statutory lien to protect the funds used to pay the bondhold- ers. Some states, such as Rhode Island, specifically create a statutory lien on any property taxes pledged for the payment of general obligation bonds. Other states, such as Arizona, do not. It can be argued that a property tax backed bond is backed by "special revenues" and because those tax dollars can only be used for the repayment of the bonds. In contrast, non-property tax-backed bonds are subject to the counter argu- ment that there is no specific revenue source pledged for their repayment and therefore they constitute unsecured debt of the municipality. Property tax-backed general obligation bonds are therefore thought of as more secure. ANNUALLY APPROPRIATED FINANCINGS The least secure form of municipal financing, from a lender's point of view, is the annually appropriated or "walk- away" financing. This is generally done to avoid any requirement to obtain voter approval. This can be useful to the municipal borrower, but banks should proceed with caution. Under various provisions of state law, borrowers may have the ability to enter into certain loans or leases which provide pay- ments must be annually appropriated by the governing body. However, state budget law may limit a bank's ability to recover in the event of a shortfall or non-appropriation. Lenders should take a close look at the financials of such