WASHINGTON -- Can bankruptcy make walking away from lease financings "socially acceptable" for municipal governments?
Bankruptcy experts and bond attorneys say that question may be answered in the bankruptcy case of California's Richmond United School District in coming months. At the least, they say, that case will heighten investor concerns about the weak structure and security of many lease securities.
While bond market participants generally have understood that lease obligations are less binding than bond obligations and can provide investors with limited recourse in cases of default, the California school district recently spelled out quite vividly what a bankruptcy can mean for investors.
The district notified the trustee of its outstanding $8.35 million of certificates of participation that it does not intend to make a scheduled $1.1 million lease payment on July 15 because it has run out of money. While that payment may be made from reserve funds, the source of future payments on the certificates, which mature in 1998, is "up in the air," according to participants in the bankruptcy proceeding.
Like many lease contracts, the Richmond lease is payable only from operating funds and is not backed by taxes or the district's or state's general obligation pledge or taxing powers. Thus, when the budget crunch came, other expenses took priority and the district opted out of its lease payment. The district's May 1988 offering statement had even warned that it "could choose to fund other services before making the lease payments."
Richmond's action stands in marked contrast to those of the state's San Jose school district, and even Bridgeport, Conn., when they filed for bankruptcy. Both pledged to continue making general obligation bond payments to preserve their access to the bond market, said James E. Spiotto of Chapman & Cutler, a leading municipal bankruptcy lawyer.
The fear of becoming a pariah in the market has also prevented the vast majority of municipalities from walking away from their lease obligations, even when they have the legal right to do so.
But attorneys says bankruptcy may provide some issuers with the "socially acceptable" excuse they need to get out of lease financings. One thing that was clear even before the Richmond case, Mr. Spiotto said, was that some municipalities view bankruptcy no longer as a "last resort" but as a way to restructure and lighten their debt load.
One of the most important questions that may be addressed in the Richmond case -- and one that Mr. Spiotto said has never yet been answered in a bankruptcy proceeding -- is whether the traditional leasing remedies of repossession and eviction from governmental property are available to creditors in a bankruptcy.
The Richmond certificates, issued largely to finance $6.7 million of operating expenses, provided as collateral an odd assortment of existing school property, including the district's administration building, central kitchen, and warehouses.
Under terms of the lease and certificates indenture, the trustee and investors can repossess and re-let the property when the district misses a payment and goes into default, but that remedy has been at least temporarily stayed by the bankruptcy filing.
Attorneys for the certificates' trustee, Security Pacific National Bank, have declined to say whether they will ask the bankruptcy court to lift the stay so they can attempt to possess the property or pursue other remedies. But the district's lawyers and other California attorneys are questioning whether the bankruptcy court or state courts would uphold such a motion.
Mr. Spiotto said federal bankruptcy law prohibits the bankruptcy courts from deciding matters involving a municipality's political powers or sovereign property, so it could not permit or enforce any foreclosure remedies.
Investors might get the bankruptcy court's permission to sue for possession in state courts, but he said he expects that "despite anybody's fondest desires, they won't be able to seize" the property. "A municipality is in essence a sovereign that has a lot of ways of frustrating investors," he said.
Victor Hsu, an attorney with O'Melveny & Myers, said the state courts could also give investors the cold shoulder. "If it violates California public policy, the court would have no problem in denying the right of eviction," he said. "One of the court's powers is to refuse to enforce remedies that interfere with public purposes."
The offering statement for the Richmond certificates had warned that recourse was limited. "Due to the governmental nature of the sites, it is not certain whether a court would permit the exercise of the remedies to re-let," it said. In any case, it added, the school property could only be used for governmental purposes and "may be of little value to others."
Just as the foreclosure rights of certificates holders may be frustrated in a bankruptcy proceeding, their rights in many California leases to sue for missed lease payments may be nullified by the courts, the attorneys said.
That remedy was automatically stayed by the Richmond bankruptcy filing, and may also be limited because of the sovereignty of the state and district. The Richmond offering statement had warned about "a limitation on enforcement of judgments against funds needed to serve the public welfare and interest."
The best hope for certificates holders -- and investors in any bankruptcy case -- is that the issuer will take on a "moral obligation" to pay the securities and retain its access to the credit markets, Mr. Spiotto said.