Municipal supply has been running very high. Why is this happening?
- A new court ruling arising from a bond default by PRHTA has important broad implications for municipal credit.
- The ruling concerns special revenue bonds issued by the PRHTA, which were secured by a lien in tolls, motor fuels taxes and other transportation related revenues.
- Many municipal market participants believe the court’s decision is in error.
- Most special revenue bonds remain highly rated.
Making Sense of the Puerto Rico Highways and Transportation Authority (PRHTA) Special Revenues Ruling
On January 30, the U.S. federal court overseeing Puerto Rico’s debt restructuring issued a ruling that may weaken the legal support for a subset of municipal securities known as “special revenue” bonds. In general, special revenue bonds are those backed by utility revenues, dedicated taxes or other dedicated payments and issued by a Chapter 9-eligible entity like a city, school district or special district government.1 Special revenue bonds often receive superior treatment to other bonds in Chapter 9 bankruptcy.
It is the first decision stemming from Puerto Rico’s insolvency that has meaningful implications for mainland credit quality.
The ruling surprised many market participants, and in our view it is the first decision stemming from Puerto Rico’s insolvency that has meaningful implications for mainland credit quality. While the near-term impact of the decision is likely to be modest, it could have long-term implications. Currently, few special revenue issuers exhibit credit stress, and the decision may be overturned on appeal. However, special revenue bonds may constitute up to 35 percent of the $3.8 trillion municipal bond market.2 If the ruling proves lasting, it could trigger ratings downgrades, alter municipal investment strategy at some firms and compel legislative fixes, among other actions.
In this piece, we summarize the recent court decision arising from a bond default by the Puerto Rico Highways and Transportation Authority (PRHTA). We believe it potentially poses long-term risks for special revenue investors.
The Court’s Decision
The ruling concerns special revenue bonds issued by the PRHTA, which were secured by a lien in tolls, motor fuels taxes and other transportation-related revenues. Puerto Rico enacted a restructuring plan that redirected these revenues away from bondholders and toward other Commonwealth priorities. Creditors, represented by bond insurers, alleged that the plan misappropriated funds owed to them.3
Provisions in the law that governs Puerto Rico’s insolvency suggested the insurers had a strong argument. The Puerto Rico Oversight, Management and Economic Stability Act or “PROMESA,” exempts special revenue bond payments from the automatic stay (which halts creditors’ debt collection efforts), and specifies that liens in special revenues remain in force after a bankruptcy filing.4 These provisions are identical to those in Chapter 9, and they have ensured timely payment on each special revenue bond in every municipal bankruptcy since 1988; that year, Congress added the special revenue language to the bankruptcy code.5
The court ruled that special revenue payments can be withheld from PRHTA bondholders.
Even so, the court ruled that special revenue payments can be withheld from PRHTA bondholders. The court acknowledged that liens in special revenues survive Chapter 9 bankruptcy filings, but it said that special revenues need not be turned over to bondholders while a case is pending. The court’s decision suggests that special revenue bondholders are entitled to the present value of their lien in special revenues, as opposed to the revenues’ timely flow. This would be more consistent with the treatment of secured creditors in a corporate bankruptcy.6
The ruling increases risks for municipal investors.7 If it is upheld, and bankrupt municipal issuers can withhold pledged special revenues from investors, then negotiating leverage for bondholders in Chapter 9 likely decreases. Notably, if special revenue investors are merely owed the present value of their claim, the risk of lower-than-expected recoveries should grow. Present value determinations would likely be based on projections of future pledged revenue and operating expenditures, and would require choosing a discount rate on which to value those flows. These estimates are often subject to uncertainty.8
Did the Court Err?
For several reasons, those familiar with municipal bankruptcy law believe the court’s decision is in error.
- First, the PRHTA decision runs counter to recent precedent in the bankruptcy case of Jefferson County, Alabama. There, the court concluded that in Chapter 9, “special revenues … continue to be paid uninterrupted to those to whom payment … is secured by a lien on special revenues.”9 The Jefferson County case is not binding as precedent on the PRHTA court, and the PRHTA court attempted to distinguish the issues involved in Jefferson County from the dispute before it. But it is hard to square the PRHTA court’s conclusion with that outlined in Jefferson County; the issue in both cases was whether pledged special revenues had to be turned over to bondholders.
- Second, the evidence strongly suggests that Congress amended the municipal bankruptcy code in 1988 to clarify that special revenues must be paid to bondholders during a municipal bankruptcy. The special revenue provisions were meant to “insure that revenue bondholders receive the benefit of their bargain with the municipal issuer, namely, they will have unimpaired rights to the project revenue pledged to them.”10 For bankruptcy purposes, “unimpaired” means a creditor’s claim is left entirely unaltered.11 A payment interruption like that in the PRHTA case should, therefore, be disallowed.
- Third, the PRHTA ruling poorly aligns with the overarching purpose of special revenue financing: to ensure that bonds secured by a dedicated revenue stream are not converted into general obligations (GOs) of an issuer, and vice versa. Special revenue bonds are non-recourse obligations. Special revenue bond issuers are responsible for handing over pledged revenues but nothing more, and bondholders are supposed to receive timely payments from pledged special revenues and only those revenues. This design is intended to insulate taxpayers from a special revenue default and to protect special revenue bondholders from an insolvent host government. States have functionally created special revenue bond protections by coupling municipal debt limit laws (which protect taxpayers and residents) with statutory liens and flow-of-funds rules (which protect bondholders). Chapter 9 honors these rules by protecting special revenue bondholders even where state law provisions are absent, and bondholders are protected solely by a contractual lien.12 As one court has put it:
“The 1988 Amendments were intended to preserve a dichotomy between general obligation and special revenue bonds for the collective benefit of bondholders (to secure the benefit of their bargain), municipalities (to maintain the effectiveness of the revenue bond financing vehicle) and taxpayers (to ensure that revenue obligations were not transformed into general obligations).”13
- Fourth, the PRTHA case likely misapplies a section of Chapter 9 that prohibits federal courts from interfering with a municipal issuer’s property. Section 904 of the bankruptcy code empowers a bankrupt issuer to use its property as it deems appropriate.14 The PRHTA court interpreted this provision as evidence that turnover of special revenues to bondholders is optional. However, that interpretation is probably overbroad. A better reading of section 904 is that it establishes a baseline rule, which is circumscribed by the special revenue provisions. As described above, the special revenue provisions are designed to conform bankruptcy laws to state statutes and industry norms that limit municipal power with respect to repaying non-recourse debt.15
Rationale for the Court’s Decision
Despite precedent and the legal history outlined above, the ruling is not entirely out of bounds. This is true for at least three reasons.
- First, the court’s plain-language reading of Chapter 9’s special revenue provisions has merit. As the judge noted throughout her opinion, nothing in Chapter 9 clearly requires special revenues to be paid during a bankruptcy case. Also, nothing in the bankruptcy code provides creditors with the right to enforce those claims. In addition, there is no language in Chapter 9 that prohibits the cram down of special revenue creditors. Absent a full appreciation of the legislative history behind the law, this silence can reasonably be read as evidence that Congress envisioned situations in which special revenue bondholders might not be paid in full or on time. Even before the PRHTA decision, some bankruptcy experts had noticed these deficiencies and recommended changes.16
- Second, Puerto Rico is a sympathetic borrower. In the Puerto Rico cases to date, the court has taken a conservative and narrow approach to its rulings. This is likely by design, to incent parties to negotiate settlements and to provide the Commonwealth with breathing room to propose workable fiscal solutions, both legally and politically. There is no municipal borrower remotely as insolvent as Puerto Rico, and post-Hurricane Maria, the situation has only worsened (Figure 1). In this sense, even if the PRHTA ruling lacks legal accuracy, it may not be unjust.
- Third, Puerto Rico is a legal oddity: It is not quite a state, not a sovereign country, unusually large and significant as federal territory, and nor is it a municipality. Yet Congress saw fit to impose on it provisions of the municipal bankruptcy code through PROMESA. This may have been shortsighted. Recall that bankruptcy laws are supposed to honor creditors’ rights under state law, as much as possible. To the extent that Puerto Rico is best understood as a state, PROMESA fails to do this. A sovereign state facing an imminent fiscal emergency has the authority to redirect pledged special revenues to its general fund if it is necessary to protect the public health, safety and welfare.17 Viewed this way, the notion that Puerto Rico must hand over pledged PRHTA revenue to bondholders feels misplaced. The PRHTA court has not made this argument, but this kind of thinking may have colored the judge’s approach.
The PRHTA decision injects a bit more uncertainty into a broad portion of the municipal market. We estimate that special revenue bonds constitute between 20 and 35 percent of total municipal bonds outstanding. The high end of the range includes bonds issued in states that presently do not authorize Chapter 9 filings, as well as some larger issuers that may not qualify as a “municipality,” which is a prerequisite for Chapter 9 (Figure 2).
Fortunately, in the near term, only a small portion of special revenue bonds are likely to be affected. Most special revenue bonds remain highly rated, and very few will ever have a strategic need to disrupt pledges of special revenue for any reason. Near-term risks are probably concentrated among a small subset of special revenue bonds that are unrated, low-investment grade or non-investment grade.
Near-term risks are probably concentrated among a small subset of special revenue bonds that are unrated, low-investment grade or non-investment grade.
Still, if upheld on appeal, the ruling would leave a taint that could:
- Lead to ratings downgrades. To date, neither Moody’s Investors Service nor S&P Global Ratings has articulated a view on the PRHTA case. However, rival rating agencies Fitch Ratings and Kroll Bond Rating Agency have cautioned that they may take downward rating actions on some credits if the decision is upheld.18 Ratings might drift lower for A-rated or BBB-rated special revenue issuers. Weak stand-alone issuers or higher-rated issuers attached to a weak central government are probably most at risk.
- Alter investment strategy at some firms. Since Detroit’s impairment of its unlimited tax GO bonds, some market participants have reallocated their portfolios toward revenue bond financings and away from local GOs, which are now widely perceived as “unsecured” regardless of their security features. Some investors might rethink that strategy if special revenue protections are also proved to be exposed to political risk.
- Compel revenue bond issuers to better disclose legal risks. Bond-offering disclosures for special revenue bonds would likely need improvements if the PRHTA case withstands scrutiny. Many official statements for special revenue bonds suggest that the lien in special revenues will survive bankruptcy filings and that payments will remain uninterrupted.
- Increase the cost of capital for vital infrastructure needs. In the current market environment with low credit spreads, investors are paid little to take additional credit risk. However, these conditions can change, and investors in non-recourse obligations will likely charge more to invest in such obligations if it becomes clear that pledged funds can be redirected to other purposes.
What’s Next for the PRHTA?
Absent a settlement, the appeals court is likely to decide the PRHTA case in late 2018 or early 2019. The best outcome for municipal investors would be a reversal. Overturning the decision would provide additional precedent (over and above the Jefferson County case) for the proposition that special revenue bonds must be paid during a bankruptcy.
However, if the appeals court affirms the PRHTA decision, lawmakers at both the state and federal level might act. Notably, several states have passed new protections for municipal bondholders in recent years. States have proactively sought to maintain access to capital in the wake of municipal distress in California, New Jersey and Rhode Island, among other states (see The Changing Status of Statutory Liens). This behavior suggests that states would take steps to protect special revenue bonds even if the PRHTA ruling is upheld. States could pass statutory lien or trust legislation, or create special purpose entities for collection and payment purposes.
Congress might also act. The special revenue provisions were written in 1988 to protect issuers’ access to non-recourse financing nationwide. Notwithstanding today’s Congressional gridlock, if a federal court upends the ability of states and local governments to access non-recourse financing, Congress seems likely to eventually revise the bankruptcy code.
Breckinridge will continue to monitor developments in the PRHTA case and in Puerto Rico more broadly. Current market conditions warrant limited concern. But if upheld, the ruling’s impact could weaken fundamentals for the special revenue sector. The case has potentially broad long-term implications for mainland credit quality and market intermediation.
 11 USC 902(2).
 Breckinridge estimate based on an analysis of Bloomberg data in March 2018.
 The bond insurers guaranteed the debt service on the PRHTA bonds and are paying bondholders timely principal and interest payments. Puerto Rico began defaulting on the PRHTA bonds in July 2016. When the insurers make debt service in this way, they become subrogated to the rights of the bondholders. That is, they gain the same rights that the original bondholders would have had in the absence of insurance.
 11 USC 922(d) and 928(a) outline special revenue lien protections. This treatment is superior to that of other secured obligations. Usually, the automatic stay operates to halt claims for payment during a bankruptcy, and liens fall away when an issuer files. 11 USC 362(a)(4) and 11 USC 552(a).
 Fitch Ratings, “What Investors Want to Know: The Impact of the Puerto Rico Ruling on Special Revenue Debt,” February 14, 2018.
 Either via the adequate protection rules or at the confirmation stage. See: 11 USC 361 and 1129(b).
 While not binding on mainland bankruptcy courts, the decision is likely to be cited by attorneys in future municipal insolvencies as legal confirmation that special revenue obligations need not always be timely paid.
 In re Mirant Corp., 334 B.R. 800 (Bankr. N.D. Tex. 2005). See discussion of valuation methodologies.
 In re Jefferson County, Ala., 465 B.R. 243 (2012), at 287.
In re Jefferson County, Ala., 465 B.R. 243 (2012), at 284. Italics added by Breckinridge for emphasis.
 In re PPI Enters, 324 F. 3d 197 (3rd. Cir. 2003), at 202.
 The Senate Report from the 1988 Amendments notes that the “simple answer to the Section 522 problem is that Section 904 and the tenth amendment should prohibit the interpretation that pledges of revenue granted pursuant to state statutory or constitutional provisions to bondholders can be terminated by the filing of a chapter 9 case. Likewise, under the contract clause of the constitution (article 1, section 10), a municipality cannot claim that a contractual pledge of revenue can be terminated by the filing of a chapter 9 proceeding.” See: “Municipal Debtors: “Cram Down of Special Revenue Debt,” David Lemke, Blake D. Roth, and Courtney M. Rogers, Waller Lansden Dortch & Davis, LLP.
 In re Heffernan Memorial Hosp. Dis., 202 B. R. 147 (1996).
 11 USC 904 says “notwithstanding any power of the court, unless the debtor consents or the plan so provides, the court may not ... interfere with … any of the property or revenues of the debtor… ”.
 This latter reading gives effect to the special revenue provisions as a matter of statutory construction. If the court’s view is correct, it is unclear why the special revenue language is needed at all, as an issuer can always choose whether to pay an obligation under section 904. Note that in the bankruptcies of Vallejo, Stockton and San Bernardino (all in California), the cities paid pensioners in full, in part because section 904 permitted it. This was the case even though other unsecured obligations received far lower recoveries.
 David Dubrow, Chapter 9 Revisited: Preparing for the Next Downturn, Pratt’s Journal of Bankruptcy Law (April/May 2016). Also, note that Fitch Ratings and other market participants never completely bought into the idea that section 11 USC 922(d) mandates turnover of special revenue funds. These observers and investors merely believed that Chapter 9 provides bondholders with enforcement rights if pledged revenue was withheld. Under this construction, special revenues are always very likely to be paid because there is no incentive to withhold them. “What Investors Want to Know: The Impact of the Puerto Rico Ruling on Special Revenue Debt,” Fitch Ratings, February 14, 2018.
 U.S. Trust v. NJ, 431 US 1 (1977).
 “Has Special Revenue Bond Protection Been Turned on its Head,” Kroll Bond Rating Agency, February 12, 2018 and “What Investors Want to Know: The Impact of the Puerto Rico Ruling on Special Revenue Debt,” Fitch Ratings, February 14, 2018.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.