COVID-19, Authorities Bankruptcies and Malfunctions Chapter 9
The COVID-19 pandemic poses a triple threat to state and local solvency.
State and local governments must spend increasing amounts of money to save the health and well-being of their citizens through emergency treatment, testing, follow-up and unemployment insurance. The COVID-19 lockdown drastically and instantly reduced retail sales, road tolls, and local transit tariffs, putting immediate pressure on budgets. The Center on Budget Priorities estimated that national budget deficits for the fiscal year ending June 30, 2020 (for most states) will total $ 615 billion. Finally, lowering interest rates will increase pension liabilities (and annual funding needs) for states with pension plans that are already challenged.
Financial pressures on state and local governments mounts as the bankruptcy code no longer works in the Puerto Rico bankruptcy process.
State and local governments with low credit ratings can obtain credit by mortgaging taxes and other revenue, including what the bankruptcy code calls “extra revenue”:
- Revenue from systems that provide transportation, utilities, or other services;
- special excise taxes on certain activities or transactions;
- additional tax revenue from an area benefiting from additional tax funding;
- other income or income from certain functions; or
- Taxes raised specifically to fund one or more projects or systems, excluding general property, income, or sales taxes, which are used for general purposes.
Chapter 9 of the Insolvency Act contains protective measures for bonds that are secured by pledging special receipts. Section 928 (a) provides that special income generated during and after a municipal bankruptcy remains subject to a pre-insolvency obligation, subject to the “required operating costs” of the “project or system” set out in Section 928 (b). Section 922 (d) provides that auto-residence does not serve as an “application” of the special income pledged under Section 927.
These sections had been widely understood to reassure bondholders that, in a Chapter 9 case, they would continue to be paid out of special income pledged, unless pledged income was required to fund “necessary operating expenses”. The U.S. First Circuit Court of Appeals destroyed that understanding in the Assured Guarantee Corp. v Carrion, 919 F.3d 121 (1st Cir. 2019), a case under the Puerto Rico Oversight Management and Security Act of 2016 (PROMESA).
PROMESA Section 305 (a virtual copy of Bankruptcy Code Section 904) provides that the court must not disrupt any property or income of any municipal debtor. The First Circuit therefore ruled that the law did not require the community to continue to pay promised extra income to bondholders. it only allowed the church to do so. The First Circle reiterated that in a published decision it refused to review the rejection of Judge Lynch’s dissent. 931 F.3d 111 (1st Cir. 2019).
Assured v. Carrion turned the law from a simple pledge of payment on the case to an incoherent, almost unenforceable mess.
As already mentioned, a commitment of special revenue before the petition is still associated with revenue after the petition. However, the First Circuit believes that the bankruptcy court cannot enforce that promise under Section 904. Thus, regardless of whether the bondholders are pledged, the debtor can only spend special income, unless:
- the bankruptcy court cancels the automatic residence due to insufficient protection according to § 362 (d) (1), as it has to be (931 F.3d at 918); and
- The bondholders receive an injunction from a bankruptcy court to enforce their pledge.
However, the Noteholders’ pledge is then subject to Section 928 (b) “necessary operating expenses” which must be determined by the bankruptcy court, not the court enforcing the pledge.
Even if the bankruptcy court’s decision on adequate protection determines the amount of extra revenue required for operating costs, that decision only applies to that day – operating costs fluctuate. In the first cycle, the bankruptcy court, which determines how a pledging of special receipts should be enforced, cannot enforce the pledge, and the court which enforces the pledging of special revenues cannot determine how the pledging is to be enforced.
None of this makes sense.
Congress should amend Chapter 9 to ensure that no future court will accept the First Circuit misinterpretation, and it should do so before that misinterpretation affects governments’ ability to issue tax bonds in times of financial crisis.