The COVID-19 pandemic is a triple threat to state and local solvency.
State and local governments must spend increasing amounts to save their citizens’ health and welfare through emergency treatment, testing, tracking, and unemployment insurance. The COVID-19 lock down cut retail sales, road tolls, and mass transit fares dramatically and immediately, putting budgets under immediate pressure. The Center on Budget Priorities estimated that state budget shortfalls will total $615 billion for the fiscal year ending (for most states) on June 30, 2020. Finally, a decrease in interest rates will increase pension plan liabilities (and annual funding requirements) for states with already challenged pension plans.
Thus, financial pressure on state and local governments is escalating at the same time the Bankruptcy Code is malfunctioning in Puerto Rico’s insolvency proceedings.
State and local governments with low credit ratings may obtain credit by pledging tax and other revenues, including what the Bankruptcy Code calls “special revenues”:
- receipts from systems providing transportation, utility, or other services;
- special excise taxes on particular activities or transactions;
- incremental tax receipts from an area benefiting from tax-increment financing;
- other revenues or receipts from particular functions; or
- taxes specifically levied to finance one or more projects or systems, excluding general property, income, or sales taxes used for general purposes.
Chapter 9 of the Bankruptcy Code contains protections for bonds secured by pledges of special revenues. Section 928(a) provides that special revenues received during and after a municipal bankruptcy remain subject to a prebankruptcy pledge, subject to the “necessary operating expenses” of “the project or system” under section 928(b). Section 922(d) provides that the automatic stay does not operate as a stay of “application” of pledged special revenues under section 927.
These sections had been widely understood to assure revenue bondholders that they would continue to be paid from pledged special revenues during a chapter 9 case except to the extent pledged revenues were required to fund “necessary operating expenses.” The U.S. Court of Appeals for the First Circuit destroyed that understanding in Assured Guaranty 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 may not interfere with any property or revenues of a municipal debtor. The First Circuit therefore held that the statute did not require the municipality to continue to pay pledged special revenues to bondholders; it only permitted the municipality to do so. The First Circuit reaffirmed that holding in a published decision denying en banc review over Judge Lynch’s dissent. 931 F.3d 111 (1st Cir. 2019).
Assured v. Carrion turned the statute from a straightforward assurance of during-the-case-payment into an incoherent, almost unenforceable mess.
As noted, a pre-petition pledge of special revenues continues to attach to post-petition revenues. However, the First Circuit holds that the bankruptcy court cannot enforce that pledge under section 904; thus, the debtor can just spend special revenues regardless of a bondholder pledge unless:
- the bankruptcy court lifts the automatic stay for lack of adequate protection under section 362(d)(1), as it must (931 F.3d at 918); and
- the bondholders get an injunction from a nonbankruptcy court to enforce their pledge.
However, then the bondholders’ pledge is subject to “necessary operating expenses” under section 928(b), 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 special revenues needed for operating expenses, that decision is good for that day only—operating expenses fluctuate. In the First Circuit, then, the bankruptcy court determining how to enforce a pledge of special revenues cannot enforce the pledge, and the court enforcing the pledge of special revenues cannot determine how to enforce the pledge.
None of this makes any sense.
Congress should amend chapter 9 to ensure that no future court adopts the misinterpretation of the First Circuit, and it should do so before that misinterpretation damages governments’ ability to issue revenue bonds at a time of financial crisis.
