State law issues are central to the overall legal analysis necessary in a Bond transaction. These matters are reviewed in-depth by Bond Counsel as part of its responsibilities and provide the foundation for the Bond Counsel Opinion at the close of a Bond transaction.
Bond Counsel Opinion
What’s in it? Who’s involved? And how’s it produced.
Disclosure of State Law Matters
When determining what state law matters are required to be disclosed in the Offering Document, it is necessary to keep in mind the federal securities law disclosure standard set forth in Rule 10b-5. A fact is “material” if there is a substantial likelihood that a reasonable investor would consider it important when making an investment decision. Many states have similar securities disclosure standards.
Security and Source of Payment
- General Obligation Bonds: There are three main categories of information that investors may consider material when analyzing a Security Pledge on a General Obligation Bond:
- Procedural Components of the Pledge: What procedural steps must an Issuer take to generate sufficient revenue in the event of a shortfall? Common steps include budgetary approval, voter approval, legislative approval or notice to state regulators. It is also important to consider whether such steps are discretionary or conditional and if any of them require action by another governmental entity. Finally, if compliance with these procedural requirements takes time, consider whether the revenue will be collected in time to pay the Debt Service on the Bonds.
- Substantive Components of the Pledge and General Economic Conditions of the Issuer: Is the full faith and credit pledge, in substance, a Pledge of the general fund or a stream of restricted/unrestricted funds? General funds are often comprised of multiple sources of revenue that can include income taxes, property taxes, utility taxes/revenues, sales taxes, hotel (lodging) taxes, business taxes and/or real estate excise taxes. It must be determined which of those revenues would be available to pay the Debt Service on the Bonds. In addition, information about the unemployment rates, average incomes for residents and other general economic information about the Issuer needs to be included and verified with a third-party source, if possible.
- Other Limitations on the Pledge: Are there other limitations on the ability to raise/collect taxes? Common limitations include statutory and constitutional limitations; uniformity requirements; the methodology used to calculate the assessed value of property; and miscellaneous state statutes that limit collection.
- Pledge of and Security Interest in Revenue/Property: Bondholders may or may not have a Security Interest in particular revenues or assets of the Issuer and/or the Borrower.
- What Type of Bond is It: The threshold inquiry is whether the Bond is a General Obligation Bond (subject to Debt Limit and lacking a Security Interest in particular revenues) or a Revenue Bond (not subject to a Debt Limit due to a perfected Security Interest and an inability of investors to require a levy of Ad Valorem Property Taxes). The authority to grant a Security Interest in real or personal property as collateral for an obligation is determined by state law.
- What is the Nature of the Pledge and General Financial Information about the Borrower, if applicable: It is important to disclose the relevant state-specific considerations, such as the nature of the pledge, whether it is unsecured or secured, the limitations on the source of revenue, the lien position (senior, parity, junior, etc.), the limitations on foreclosing/liquidating the assets securing the Debt Service on the Bonds and financial and other material demographic information about the Borrower, if applicable.
Events of Default and Remedies
Remedies available to bondholders in the Event of a Default are not uniform and depend on many factors, including the type of breach (payment default vs. technical default); the availability of remedies under constitutional, statutory and contractual provisions; and the type of remedy being sought. State law, judicial actions and local rules may provide for, or limit remedies available to, bondholders upon Default. The Events of Default, potential remedies and any limitations on remedies should be disclosed to bondholders. Common limitations on bondholder remedies include the following:
- Seizure of Public Property: It is extremely rare to be able to seize and sell the property of a public entity.
- Acceleration: Most Governmental Bonds cannot be accelerated because the underlying taxes, rates and charges cannot be accelerated. This means that, if there is a Default, bondholders are typically unable to declare all outstanding Principal immediately payable and due. As such, bondholders must bring a separate enforcement/mandamus action for each failed payment.
- Writ of Mandamus: The principal remedy available to bondholders of Governmental Bonds is to seek a Writ of Mandamus to compel performance of non-discretionary or ministerial duties (e.g., impose or collect taxes or rates and charges). State and/or local law will dictate the procedural steps necessary to compel performance. Some of those steps may be discretionary, conditional or out of the Issuer’s control (e.g., steps that must be taken by entities other than the Issuer).
- Other Rights and Remedies:
- Receivers: Some states allow, pursuant to a judicial or legislative appointment, the appointment of a receiver to undertake budgetary or other Issuer functions. The powers vary widely by state. For instance, the receiver’s powers might be so broad as to supplant the powers, functions and responsibilities of some or all elected officials of the Issuer. Or, the receiver may have a more limited role providing oversight (e.g., budgetary approval) of Issuer actions. Note, however, that the powers of a receiver are likely very limited in a Chapter 9 bankruptcy context.
- Attachment: While attachment and execution are not generally permitted against a governmental entity, exceptions may be applicable in some jurisdictions.
- Other Considerations: State law often contains detailed statutory notice, timing and other requirements that must be fulfilled to exercise tax liens and other remedies. Other material factors include the value of the property subject to the lien, competing rights to the proceeds of any sale and any limitations on a bondholder’s right to seek a deficiency judgment against the property owners.
Chapter 9 Bankruptcy
- Filing Considerations: Municipal bankruptcy is different from Default and is quite rare. Many states limit (or prohibit) Chapter 9 bankruptcy filings and municipalities cannot be forced into involuntary bankruptcy. Express authorization is often required. Even when they are authorized, there are often extensive procedural requirements to obtain bankruptcy protection.
- The Automatic Stay: Many states/localities have automatic stay provisions that force a municipality to stop paying Debt Service on its obligations once the bankruptcy petition is filed.
- Special Revenue Pledge: Bankruptcy proceedings treat General Obligation Bonds and Revenue Bonds very differently. Additionally, any “special revenues” (as defined in Section 902(2) of the Bankruptcy Code) acquired by a municipality after the commencement of the Chapter 9 case remain subject to any lien resulting from any security agreement entered into by the municipality before the commencement of the case.
State Tax Exemption
Federally Tax-Exempt Bonds may also be exempt from state income taxation. Whether a Bond is exempt from state income tax is typically addressed in the Bond Counsel Opinion and must be disclosed because it is material to investors. Check local laws as well to see if Interest is exempt from local income taxes.
Refunding/Defeasance of Bonds
Rights of Redemption and any state/local law limitations on those rights should be disclosed to investors. State law may also limit eligible investments for an Escrow Fund. Some states do not allow for legal Defeasance of municipal obligations. It is important to disclose that a bondholder no longer has an interest in the original Security pledged for the repayment of the Bonds following a legal Defeasance. Similarly, the Issuer should tell potential investors that in the event of a legal Defeasance, many of the promises and covenants in the Bond documents are released and the Security Pledge for the repayment of the Bonds becomes the investments deposited in Escrow Fund.
Post-Issuance State Law Considerations
The engagement of Bond Counsel generally ends with the delivery of the Bond Counsel Opinion at the issuance of the Bonds. However, it is very important for the Issuer/Borrower to be aware of, and to stay in compliance with, ongoing, post-issuance tax and disclosure obligations. These include various federal law requirements and state filing/record retention requirements. Finally, a change in use may implicate federal income tax law and state laws. Bond Counsel should inquire about, and consider encouraging, the adoption of post-issuance compliance procedures by the Issuer/Borrower.
Start with the Bond Basics
Term of the Week
In a private placement, the agreement between the issuer and a lender (e.g., a bank) pertaining to the loan of the bond proceeds to the issuer. In conduit financings, the agreement between the borrower and the issuer pertaining to the loan of the bond proceeds to the borrower.