‘There is no lien, there is no property interest, these creditors are like all others’

February 20, 2014

A showdown between bond insurers and city attorneys in Detroit’s bankruptcy highlights the level of protection that secured bondholders have in Chapter 9 bankruptcy. Detroit attorneys argued that federal bankruptcy law trumps Michigan state law and that “secured” bonds could be impaired. From Chad Livengood of the Detroit News:

[Bond insurers] Ambac Assurance Corp., Assured Guaranty Municipal Corp. and National Public Finance Guarantee Corp. want [federal bankruptcy judge Stephen] Rhodes to order the city to segregate special property taxes Detroit voters approved for economic development, cultural and recreation projects and public safety facilities and resume paying bondholders the full amount owed.

‘These monies were raised solely for repaying the bonds and no other purpose,’ Guy Neal, attorney for National Public Finance Guarantee, said in court Wednesday.

But city attorney Bruce Bennett argued the federal bankruptcy code allows Detroit to sidestep state laws requiring the city to pay bondholders with designated funds while the city reorganizes its finances in Chapter 9.

The argument about the supremacy of federal bankruptcy law over state law comes forward again. More from Detroit News:

Bennett said the bondholders and their insurers have no more right to be paid for their debts than pensioners and other unsecured creditors.

‘There is no lien, there is no property interest, these creditors are like all others,’ Bennett told U.S. Bankruptcy Judge Steven Rhodes.

Bennett argued that state laws about general obligation bonds being backed by unlimited taxes only provide ‘secured feelings to creditors that are concerned about things that could change inside a municipality.’

Detroit’s legal team has argued that general obligation bondholders owed $369 million do not have a legal lien against specific tax revenues like other bondholders who get repaid through state aid distributions to the city or water and sewer bondholders, whose investment is secured by revenue from ratepayers.

Public Sector Inc organized a debate about the status of general obligation bonds in bankruptcy. Here is the argument of Kevin Kordana a Professor of Law at the University of Virginia:

General obligation bonds are, for the purposes of municipal bankruptcy, unsecured.

Their ‘full faith and credit’ pledge is, as a matter of contract law–and to the (rather considerable) extent that bankruptcy law reflects the ‘creditors’ bargain,’ therefore bankruptcy law as well–merely equivalent to an ‘and I really mean it’ pledge, lacking the discrete and tangible connection to a particular property interest necessary to constitute a secured claim in bankruptcy.

More from law professor Kordana:

The [general obligation] pledge is made against the backdrop of, and therefore subject to, federal bankruptcy law. As a policy matter, this outcome is desirable, as it allows some risk to be shifted to investors, who are better risk-bearers than municipal residents.  As a Depression-era federal court declared, the ‘purpose’ of municipal bankruptcy is to ‘permit the scaling down of municipal securities, on the theory that half a loaf is better than no bread.’ (Getz v. Edinburgh Consolidated Independent School District, 101 F.2d 734, 736 (5th Cir. 1939)).

The amount of risk borne by general obligation bondholders is constrained by municipal bankruptcy law’s requirement that a reorganization plan be in ‘good faith’ and in the ‘best interests of creditors.’ These requirements, overseen by a bankruptcy judge, provide protection to general obligation debt-holders.

The basic issue is whether legal covenants made in a general obligation bond contract can be adjusted in bankruptcy.

Comments made by Judge Rhodes suggest that bond insurer attorneys were unable to successfully argue that “secured” bonds have special protection when a municipality works to reduce its liabilities under the bankruptcy code.


Judge Rhodes encouraged bond insurer attorneys and Detroit attorneys to negotiate a settlement about the treatment of secured bonds, otherwise he would make a clear ruling:


Stay tuned.


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SCOTUS will find that federal bankruptcy law trumps the GO pledge. GO = unsecured.

Posted by nixonfan | Report as abusive

Here is the audio file for the hearing this post refers to:

http://www.mieb.uscourts.gov/sites/defau lt/files/detroit/docket2699.pdf

Posted by Cate_Long | Report as abusive

Do listen to the audio… it really gives a flavor of how ardently Judge Rhodes is pushing this case.

Posted by Cate_Long | Report as abusive

It’s humorous watching Wall Street try to come up with a “senior” Puerto Rican bond. First of all, the island has mortgaged everything but its sand. Second, when the legislature passes the debt restructuring law, it will make no fine distinctions between classes of bondholders. Everyone will get the same perpetual zero coupon bond.

Posted by nixonfan | Report as abusive