In Rhode Island Bankruptcy, Bondholders Came First
Nearly two years ago, Central Falls, R.I., a tapped-out city of about 19,000 buried under $80 million in unfunded liabilities, filed for Chapter 9 bankruptcy.
Central Falls’ dire financial straits were hardly unique among U.S. cities struggling with the cross-currents of shrinking tax bases, the recent recession and the rising costs of employee pensions and health care benefits. What was unique was the approach Central Falls -- and the state of Rhode Island -- took toward righting the city’s fiscal ship.
The state’s strategy, which ensured that Central Falls’ general obligation bondholders were fully repaid on time, has garnered attention following Detroit’s historic bankruptcy filing last week.
“These are difficult, difficult policy decisions and anyone who thinks these are easy decisions hasn’t been involved in one of these situations.”
Rhode Island sought to protect Central Falls’ bondholders in order to maintain the municipal bond market’s confidence that the state’s cities and towns would continue to repay their bond debt obligations. The approach worked: Central Falls, a former mill town located a few miles north of Providence, emerged from bankruptcy in just over a year with its ability to borrow firmly intact.
In contrast, Detroit, prior to filing for bankruptcy, asked its general obligation bondholders to accept massive losses -- offering less than 20 cents on the dollar -- on their investments. The request was rejected and the city and its creditors seem headed for a long and messy court process.
A Statutory Lien on Property Taxes
In 2010, the Rhode Island state legislature, seeing the inevitability of a Central Falls bankruptcy, passed a law that put a statutory lien on the city’s property taxes, earmarking that revenue toward the city’s bondholders in the event of a Chapter 9 filing.
The law secured the city’s general obligation bonds “so that they would have priority in any bankruptcy,” a move which had the effect of giving “the bond market confidence that general obligation bonds purchased from Rhode Island municipalities are safe investments,” said Theodore Orson, who served as counsel to the receiver overseeing Central Falls’ bankruptcy.
General obligation bonds, generally used by municipalities to raise funds for various infrastructure projects (roads, schools and so forth) are ‘secured by the full faith and credit’ of the municipality. Essentially that means the municipality that issued the bond can always raise taxes to cover the debt if revenue runs short, ‘securing’ the bond for investors. Another type of bond, called secured bonds, are repaid by recurring income streams, such as a bridge toll.
Investors have long considered general obligation bonds as one of the safest kinds of investment because of municipalities’ ability to raise taxes to repay the debt. But the recent spate of municipal bankruptcies in Detroit, California and Rhode Island has called that belief into question.
“While general obligation bonds have always been thought of as the safest type of bonds for investors to purchase, in Chapter 9 bankruptcy it appears that they are no different than all other general unsecured claims,” said Orson. Consequently, if a bankrupt city’s vendors are required under a Chapter 9 filing to accept 30 cents on the dollar, holders of general obligation bonds may be required to take the same discount.
In Rhode Island, the statutory lien law changed the status of Central Falls’ general obligation bonds from unsecured to secured, ensuring that bondholders would be repaid in full.
Orson explained: “We did that because we were concerned that if the general obligation bonds in the Central Falls bankruptcy were treated like unsecured obligations and not paid in full then there may be ‘contagion effect,’ which means that the capital markets become unwilling to invest in other municipalities without charging high rates of interest. It worked in that the bond holders were paid in a timely fashion and under the bankruptcy plan approved by the judge they continued to be paid on time.”
James Spiotto, a Chicago-based bankruptcy attorney and an expert in Chapter 9 filings, said if municipal bond issuers, responding to a threat of non-payment, raise borrowing costs just 2% on a 30-year bond the borrower -- or municipality -- will pay 60% more of the principal amount in interest expense over the course of the loan.
“That 60% is money that isn’t going to infrastructure improvement or other necessary services, and it’s money that has to come from taxpayers,” said Spiotto, a partner at Chapman and Cutler LLP.
Proactive Approach
Rhode Island’s proactive approach for steering Central Falls through Chapter 9 has generally been praised by municipal bond analysts.
“It was probably one of the best orchestrated bankruptcies because as they saw it coming and that it would be necessary for Central Falls to file for bankruptcy, ahead of that actual filing, Rhode Island was managing the process with an eye toward mitigating any spillover to other bondholders in the state,” said Lisa Washburn, a managing director at Municipal Market Advisors, a Concord, Mass.-based research firm.
Detroit’s Chapter 9 filing is similar to Central Falls’ in that the Michigan city also faces substantial debts tied to general obligations bonds. The recent bankruptcy filings of two California cities, Stockton and San Bernadino, differ from Detroit and Central Falls because neither California city had general obligation debt outstanding at the time they filed for Chapter 9.
But in Detroit’s case, unlike in the Central Falls filing, there is no pre-determined plan for covering general obligation debts, which could mean protracted negotiations between the city and its bondholders and other creditors -- pensioners, unions and vendors -- as they all fight for what's left of the city's depleted revenues.
Detroit’s bankruptcy isn’t expected to lead to a contagion that impacts other Michigan municipalities -- or other big cash-strapped American cities, for that matter. Detroit’s situation is viewed as unique. Once the fourth largest city in the U.S., Detroit’s economy has been collapsing for decades as the U.S. auto industry has downsized in the region and moved elsewhere. Meanwhile, residents and small businesses have fled the city for the surrounding suburbs, draining Detroit of its once-sizable tax base.
“We view Detroit’s default and subsequent bankruptcy filing as idiosyncratic, and not as a symptom of a wider issue in the municipal market,” Jane Hudson Ridley, a credit analyst with Standard & Poor’s, said in a July 19 statement. “Although we have seen isolated pockets of distress across the country, we do not view bankruptcy filings or defaults as a trend.”
Credit Rating Upgraded Twice
Since Central Falls emerged from bankruptcy in September 2012 with a court-approved five-year recovery plan that provides for a balanced municipal budget the city has had its credit rating upgraded twice by Moody’s Investors Service.
But the fragile financial stability brought about by the Chapter 9 filing didn’t come without a steep price tag in human terms. The plan approved by the court slashed the city’s payroll by nearly one-third, and retired city employees saw their pensions cut by as much as 55%.
Orson, the attorney for the Central Falls receiver, recalled the dilemma facing Rhode Island in 2010: “We were very concerned about protecting our other municipalities and the taxpayers in those municipalities. It’s not to say that this was an easy decision. It was a very difficult decision to make but we believe we made the right decision from a statewide perspective."
Orson said other municipalities facing bankruptcy that may follow Central Falls’ lead in protecting bondholders should expect “pushback, and understandably so” from city employees and retirees who are forced to bear a bigger burden in the final settlement.
“These are difficult, difficult policy decisions and anyone who thinks these are easy decisions hasn’t been involved in one of these situations,” said Orson.