[By Bhaskar Vishwajeet]
The author is a student of Jindal Global Law School.
Introduction
Municipal bonds have gathered steam in India. As of when this piece was written, the country has 29 active municipal bonds on the NSE’s IBMX index for municipal bonds. Municipal debt instruments are a great alternative to raising capital for public infrastructure/service works. That said, assuming that the debt obligation is watertight may not be prudent because the issuer is a sovereign. There may be issues with revenue generation and projects being delayed. However, a far more significant threat is the municipal corporation’s bankruptcy.
This article aims to contextualize municipal bonds within India’s bankruptcy regime and assess whether these debt instruments and investors are secured through regulation in case of possible bankruptcy. We shall also refer to the United States to see how the sovereign’s promise of “faith and credit” to back the bond’s health is not always guaranteed.
What are Municipal Bonds?
Municipal bonds are government debt instruments financing public projects and utilities. They attract investors by allowing them to lend money to local government institutions in return for regular interest payments and the return of their principal when the bond matures. The potential tax benefits, such as income tax exemptions on interest income, make municipal bonds appealing, especially to investors in higher tax brackets.
Municipal bonds are of two types: General Obligation (GO) bonds, supporting general development works through revenue from property tax and revenue cess, and Revenue Bonds, funding specific projects like schools and water filtration plants through project-generated revenue. Backed by the respective government’s reliability in repaying debts, municipal bonds receive ‘investment-grade’ ratings from agencies, exemplified by AA+ ratings for New Delhi Municipal Council and Navi Mumbai bonds.
Municipal Bond Health
Municipal Bonds are generally considered safer than other investments in the market for two primary reasons. First, municipal corporations are state instrumentalities. A sovereign pledge supports the bond’s health, and there is a sense of assurance that the state will make good on the interest income and any default whatsoever.
Second, to reinforce investor confidence in the value and health of the bonds, regulators require municipal issuers to meet certain eligibility requirements. The SEBI (Issue and Listing of Municipal Debt Securities) Regulations 2015 stipulates eligibility requirements in regulation 4 and requires the issuing local government authority or ULB to, inter alia, not have a history of defaulting on debt repayments in the past 365 days of the issuance of a municipal bond and to have at least an investment grade credit rating (BBB- or above) by a SEBI-registered credit rating agency.
The Detroit Case Study and Chapter 9 Protections
Despite their perceived safety, municipal bonds face financial distress, as evidenced by the City of Detroit’s bankruptcy in 2013. Detroit’s case illustrates how legislative protections, such as Chapter 9 of the U.S. Bankruptcy Code (Adjustment of Debts of Municipalities), facilitated a resolution.
Detroit had issued various bonds before its bankruptcy, including GO bonds backed by taxing power and Revenue bonds secured by specific project revenues. Financial problems, stemming from issues like population decline and rising pension costs, led to a severe budget deficit, prompting the city to file for Chapter 9 bankruptcy protection in July 2013. Chapter 9 allows municipalities to restructure debts without asset liquidation, enabling negotiations with creditors under court supervision. This ensures a fair repayment plan while maintaining essential services. Detroit emerged from bankruptcy in 2014 after a federal judge approved a financial restructuring plan.
Does India’s Bankruptcy Regime Protect Municipal Issues?
India’s Insolvency and Bankruptcy Code (IBC) lacks provisions akin to Chapter 9 in the U.S., raising concerns about the protection of municipal bondholders during bankruptcy. Even SEBI offers no guidance on municipal bankruptcies or defaults. Regulators seem to have complete faith in the sovereign pledge of these municipalities and the principle of not interfering with the state’s powers. This logic is akin to the history behind Chapter 9 in the United States, wherein the original municipal bankruptcy legislation from 1934 was held unconstitutional for violating the sovereignty of states. The United States Congress later revised the Act in 1937, which was constitutionally affirmed in United States v. Bekins, and subsequently retained as Chapter 9 through the 1978 Bankruptcy Reform Act.
Chapter 9 is unique because it is tailored for municipal bankruptcies. It includes an automatic stay on any associated claims or litigation against the debtor. The provisions include restrictions on the court’s interference with the municipal debtor’s powers, such as not interfering with the municipality’s borrowing powers and converting the proceeding into a liquidation proceeding. These restrictions are necessary to preserve the constitutional status of Chapter 9 (as the borrower is a sovereign). As a corollary, the municipal debtor must propose a plan to adjust its debt since creditors cannot file plans under Chapter 9. The entire process provides space to negotiate and restructure a debt repayment plan for municipal debt. Indian law does not guarantee such a position.
The problem worsens with the incompatibility of general bankruptcy laws as List I (Central) subjects with List II municipalities. As local governments, municipalities are state subjects in Entry 5 of List II. Multiple states have statutory municipal corporation acts (“Acts”), enabling municipal corporations to raise money by issuing debentures or other instruments (see Section 114A of the Uttar Pradesh Municipalities Act 1916). Almost every Act stipulates the security interests that may be created in a bondholder’s name. These range from municipal taxes, borrowed funds from public financial institutions and even, rarely, immovable property vested in the Corporation. Most municipal corporations/councils must maintain a municipal/sinking fund to ensure an adequate corpus to return the borrowings on debentures/loans. However, many Acts are unclear on whether the sinking fund can be used for other forms of issues, i.e., if the municipality chooses to issue, say – non-debt securities.
There is some guidance concerning the order of payments. Section 151 of the erstwhile Municipal Corporation Act 2000 (Jammu and Kashmir) stated that interest income and loan repayments will be paramount. However, this instance is too remote for broad application. In isolation, these provisions are not of any consequence, and it cannot be said whether they will be resorted to in the event of a municipal bankruptcy.
Second, municipal bonds are classified as secured debt in India. For instance, the Lucknow Municipal Corporation Bond is offered as a secured claim against collateral/assets. However, the Acts do not prescribe how claims will be weighed or in what order. As reiterated recently in PVVNL v Raman Ispat, secured creditors are fifth in the order of claims per the waterfall mechanism under Section 53 IBC. But that order of priority applies to general bankruptcies under the IBC. What, then, about municipal bankruptcies? If municipal bonds are secured claims, can Section 53 principles also be applied to municipal creditors? GO bonds offered by Detroit were considered the most senior debt in the order of claims by creditors. However, during bankruptcy proceedings, Detroit’s emergency manager concluded that the bonds were unsecured claims in bankruptcy, rejecting the claim on ad valorem taxes. This created a problem for bondholders, as they claimed the collateral behind the promise of a secured claim was a lien on Detroit’s ad valorem taxation. Detroit had to reconcile this conflict by restructuring the debt to provide bondholders with a lien on taxes from the city’s casinos. Such puzzles are probably why Chapter 9 is rarely triggered in the United States. Nevertheless, the mechanism is the only viable channel to resolve municipal bankruptcies in the US.
The Detroit restructuring seems to harken to the Acts wherein corporations create a security interest for bondholders at the time of issue. However, neither the Acts nor the IBC mentions the process of negotiating and possibly restructuring any municipal debt. This must trouble bondholders, as a municipal bankruptcy may have to deal with conflicting interpretations or inadequate laws on municipal corporations and general bankruptcies.
Lastly, in addition to the sinking funds, some municipal corporations also provide specific escrow accounts to service their debt. The Pune Municipal Corporation, for instance, has a ‘no-lien escrow account’ for debenture payments. This demonstrates that structurally speaking, municipal bond arrangements do not intend to provide bondholders with a lien on municipal property at the outset. Thus, lien-related concerns may also arise as creditors would be concerned about recouping their investments in bankruptcy.
Conclusion
Lawmakers must confront the possibility that municipal bonds may constitute a greater chunk of household/retail individual investors’ portfolios. As cities grow and envelop surrounding satellite towns, municipal corporations will have a more significant role in regulation and governance. Executive institutions like the SEBI must start simulating the impact on retail investors if municipal bonds go on to default. This is important as the ticket size of entry into the municipal bond market is relatively low at an average minimum investment of ₹10,000. On the other hand, a municipal bankruptcy framework must confront the anxiety of involving the courts in directing municipalities in so far as their accounts and funds are concerned, for that would be a principled distinction with Chapter 9 in the United States.