Bondholders have cut the line
Something doesn’t seem right in Central Falls, the Rhode Island city that declared municipal bankruptcy yesterday. Now that the state receiver has filed Chapter 9, all the town’s dirty laundry has been hung out in public, and, like any bankruptcy, it’s not pretty. Overspending and declining tax revenues doomed this poor town, along with liberal doses of alleged corruption.
Here is what doesn’t seem right in Central Falls. The city is dead broke and those they owe money to are lined up at City Hall to collect. But for some odd reason, the city’s bondholders have pushed ahead of all the others in line to claim full repayment of their debts; those later in line must settle for 50 cents on the dollar. Retired police officers and firemen will have their pensions cut by 50%.
It wasn’t Central Falls’s decision to give preferential treatment to bondholders. Last year legislators in the state capitol passed a law making the claims of bondholders superior to all other claims in bankruptcy. The Rhode Island General Assembly’s action flies in the the face of common bond market practice, which is that bondholders get in line with everyone else and a judge overseeing bankruptcy proceedings gives a fair resolution to all the creditors.
The law passed by the Rhode Island General Assembly upends the order of priority for payments in bankruptcy. Municipal bankruptcy is filed in federal court, and cities cast themselves at the mercy of the federal bankruptcy law. Because our federal constitution reserves all rights to the states that the federal government does not claim, it makes this area of the law a funny hash of competing jurisdictions. And it possibly encourages the Rhode Island legislators to try and change the rules.
The federal bankruptcy code does create some special protection for holders of “special revenue” bonds. The law firm Jones, Day characterizes the exemption:
Protection of Special Bond Revenues.
Chapter 9 of the Bankruptcy Code expressly provides protection to creditors holding liens on special project revenues of a municipal debtor. For example, municipalities often finance special projects, such as water and sewer plants, with bonds that are collateralized with the revenues and fees earned by such projects. Section 928 of the Bankruptcy Code states that the “special revenues” from these projects remain subject to the liens of the bondholders in the specific projects.
The bondholders of Central Falls hold “general obligation,” or GO, bonds. This type of bond has access to the revenues of the central taxing authority of the municipality. These are not “special revenue” bonds issued by a sewer or water entity that is legally separate from the municipal entity. So within Chapter 9 law, general obligation bondholders would not receive preferential treatment in bankruptcy proceedings.
Because a state is asserting privileges beyond current law, this issue could be litigated for a decade. It will probably go before the U.S. Supreme Court and provide lots of billings for the legal profession. But what about the moral issue of denying a retired policeman half of his annual $30,000 pension to pay a bond holder 100 cents on the dollar? Has our country enshrined creditors’ rights at so many levels above pension rights?
The Providence Journal has been doing an excellent job covering this story and made this video about the meeting between the state receiver and retired police officers and firemen. This is the human side of the story.
Central Falls, Vallejo and Jefferson County are local communities where fiscal issues spiraled out of control. For public entities in distress, we have a law, Chapter 9, to resolve their problems. The law was first enacted in 1934 during the Great Depression and has provided a template for fair treatment of all parties demanding payment. The Rhode Island General Assembly doesn’t need to mess with the coroner who is laying the deceased claims to rest. The legislature should instead devote its time to addressing solutions for Central Falls and other communities who are broken. This bold move to upset the order of things does not seem right or in the public interest.
Bond Buyer: Central Falls Aims to Protect GOs
Provindence Journal: State credit rating seen unaffected by filing
Financial Times: Rhode Island city files for bankruptcy
New York Times: Small City, Big Debt Problems