The Bottom Line:

On July 14, 2011, Governor Lincoln Chafee signed a new law securing all general obligation bonds and notes issued by every city, town and district in Rhode Island – including bonds and notes already outstanding, thus advancing municipal bondholders ahead of all other creditors, including in particular pensions.  (2011 – S 0614, amending Sections 45-12-1 and 45-12-22.4 of the Rhode Island General Laws Chapter 45-12, “Indebtedness of Towns and Cities.”).  

The Rhode Island statute and the expected challenge in Central Falls’ chapter 9 case have national significance.  The nationwide unfunded pension liabilities of state and local governments have been estimated at over $3 trillion.  In the winter of 2011, Republican politicians such as Newt Gingrich, Jeb Bush and Texas Senator John Cornyn floated the idea of a federal statute that would allow states to file for bankruptcy for the purpose of rejecting labor and pension agreements.  The idea of a federal statute died quickly, but the Rhode Island statute represents another front in the political conflict between retirees and state and local governments.  The Rhode Island battle lines were themselves interesting – the statute was proposed by Senator Daniel DaPonte, a Democrat, at the request of Governor Chafee, an independent, and opposed by the Rhode Island League of Cities and Towns, which advocates on behalf of the state’s 39 municipalities. 

If the statute is upheld, other states may follow suit.  The chapter 9 bankruptcy of Central Falls, Rhode Island, which prompted the statute, will likely see constitutional and bankruptcy challenges to the statute.  This blog post predicts and analyzes those challenges.

What Happened:

The statute pledges all ad valorem taxes and general revenues of every municipality to secure its bonds and notes.  It also requires each municipality to appropriate funds for the timely payment of bonds and notes and further provides that any sum not appropriated shall be automatically added to the municipality’s annual tax levy and then applied to payment of bonds or notes. 

Finally, the statute provides that any municipal officer who intentionally violates the statute will be personally liable to the municipality for any amounts not used to pay bonds or notes.  It is not clear why the officer’s liability runs to the municipality (which presumably wants him or her not to pay the bonds) as opposed to the bondholders.

The statute aimed to increase the creditworthiness of municipal bonds and decrease the relative rights of retired workers.  It specifically prohibits any municipality from selling a long-term bond to fund pension obligations or other post-employment benefits without prior approval by the state auditor general and director of the state department of revenue. 

Central Falls filed for chapter 9 on August 1, 2011, about two weeks after the statute was passed.  Central Falls owes approximately $21 million in bonds.  As a result of the new statute, these bonds are now secured and rank ahead of more than $80 million in unsecured pension and health insurance liabilities.  Central Falls has already moved to reject its pension and retiree medical benefit plans; its public employee unions and pensioners are expected to challenge the validity of the statute.

Potential Challenges:

The statute does in fact present several issues under the U.S. Constitution, the Rhode Island Constitution and the Bankruptcy Code.

David Skeel, a University of Pennsylvania law professor, has said that the Rhode Island statute violates the U.S. Constitution because its retroactive preference of bonds impairs other unsecured creditors’ contracts.  However, Congress and the states routinely pass laws that secure or prefer one group of existing unsecured creditors over another – mechanics’ liens, sub-contractors’ liens, or indeed new priorities under the Bankruptcy Code.  No court has yet found the U.S. Constitution to provide unsecured creditors with a “negative pledge.”  Even if unsecured creditors could show that the statute impaired their rights, the statute could still survive challenge if it is reasonable and necessary to an important public purpose. 

Rhode Island’s Constitution has its own “no impairment of contract” clause, but it has been interpreted in the same way as the U.S. Constitution.1  Of greater interest is the state constitution’s exhortation that the “burdens of the state ought to be fairly distributed among its citizens.”2  Pensioners could argue that a statute retroactively securing outstanding bonds, to their prejudice, violates this exhortation.  In addition, the state constitution provides municipalities with “home rule” powers while also reserving to the General Assembly control over municipalities’ taxes and property.  The statute does not specifically authorize delegation of such control to members of the executive branch.  However, the Supreme Court of Rhode Island rejected similar arguments against the Central Falls’ receiver prior to bankruptcy.3  

Finally, the statute could be challenged under Section 545(1)(D) of the Bankruptcy Code which states:

“The trustee may avoid the fixing of a statutory lien on property of the debtor to the extent that such lien (1) first becomes effective against the debtor . . . (D) when the debtor becomes insolvent . . .” 

The legislative history of Section 545, and cases interpreting the statute, have read it to prohibit “springing liens” – that is liens that come into existence when the debtor becomes insolvent.  A statutory lien does not violate Section 545 merely because the debtor was bankrupt when the statute was enacted.  Courts look to the statutory language to determine if the lien is contingent upon the debtor’s insolvency.

However, “[s]tatutory liens that are disguised state-created priorities upset the priority scheme of the federal bankruptcy law and will fall within the group that is subject to avoidance.”4  It can be argued that the Rhode Island statute is fundamentally a “disguised state-created priority” designed to upset the federal bankruptcy priority scheme with respect to the existing bonds of Central Falls in particular and other Rhode Island municipalities generally. Chapter 9 is not a bad forum, and the First Circuit (which governs Rhode Island) is not a bad venue for this argument.

Pensioners may also try to challenge the statutory lien as a fraudulent transfer, although our recent experience suggests that such a fraudulent transfer challenge faces substantial obstacles.

Conclusion:

As indicated above, the Rhode Island Statute and the case of Central Falls pose many difficult questions. A detailed explanation of each is beyond the scope of this blog. Please contact the author of this post to discuss any of these points in further detail.