Bondholders and financially stressed municipalities.

• Author: Gillette, Clayton P.

1. Competing Claims of Bondholders and Residents II. Assigning Entitlements to Superior Monitors A. Residents as Monitors B. Creditors as Substitute Monitors C. Surrogates for Bondholders Conclusion I. COMPETING CLAIMS OF BONDHOLDERS AND RESIDENTS

   In 1873, the city of Duluth issued bonds to improve its harbor and to create other municipal improvements. (1) The bonds were payable between twenty and thirty years from their date of issue and bore an interest rate of seven percent. (2) Shortly after their issuance, Duluth fell on difficult times. The company of the financier Jay Cooke failed, and with it Cooke's plans to transform Duluth into the eastern terminus and port facility for the Northern Pacific Railroad. (3) The population of the city decreased from 5,000 to 1,500 and those who remained were reluctant to dedicate the few tax dollars left to payment of debt service for bondholders. (4) The state legislature came to the residents' rescue. It carved from the boundaries of Duluth an area comprising "all the business part of the city and business houses, the harbor, railroad depots and tracks, nearly all the dwelling-houses, all the population except about [one hundred] inhabitants, and nineteen-twentieths of all the taxable property," and designated that area as the new village of Duluth. (5) The legislature also directed that service of process in any lawsuit against Duluth be made on the mayor, but then effectively terminated the incumbent mayor without making any provision for a replacement. (6) Finally, the legislature apportioned responsibility for the outstanding bonds between the city and the new village. (7)

   Bondholders objected, especially when the city failed to make payments on its outstanding obligations. (8) The bondholders thought they had found their own savior in the federal district court. (9) While that court agreed that the state legislature was free to rearrange municipal boundaries, it initially held that allowing rearrangements without providing for payment of creditors of the predecessor municipality "would be a mockery of justice" and overruled a demurrer interposed by the village with respect to overdue payments on city bonds. (10) After a full trial, however, the court concluded that the evidence revealed that the city, even as redrawn by the legislature, ultimately had "ample means ... to meet the plaintiff's demand," a result that the court speculated was "largely due ... to the successful operation" performed by the legislature. (11) As a result, there was no reason to interfere with the apportionment of city debt that the legislature had mandated. (12)

   The efforts of the Minnesota Legislature were not ignored by other states that similarly sought to assist distressed municipalities against the demands of bondholders. The Alabama Legislature restructured the city of Mobile into a new entity designated as the Port of Mobile in an effort to frustrate bondholders of the former by denying them access to taxes raised by the latter. (13) The Supreme Court invalidated that effort in an opinion that appeared to be based on the federal Constitution's Contracts Clause, (14) although that clause was not invoked by name. (15) The Court's intervention was also required to nullify Illinois legislation that withdrew from municipalities taxing power necessary to pay outstanding bonds (16) and to limit the ability of the legislature to divert from bondholders taxes collected by a municipality prior to legislative repeal of its charter. (17)

   These cases entail very different legal doctrines that, narrowly construed, address very different situations. Nevertheless, they, along with doctrines that I discuss below and that affect the validity of municipal obligations, share a common theme that warrants their collective consideration. They all illustrate a contest that threatens to become all too familiar as the current fiscal crisis continues to engulf municipal budgets: the effort to resolve competing claims by bondholders and residents to a limited municipal treasury. One might believe that the outcome of these contests had been resolved contractually when the debts that generate them were initially incurred. Implicit allocations of risk may arise from a variety of background legal rules that relate to municipal indebtedness. Issuers of general obligation bonds, those payable from municipal revenues generally, rather than from a specified source, pledge their "full faith and credit" to repayment, (18) and the content of that pledge may be thought to imply an obligation to pay bondholders prior to competing claimants. A preference for bondholder claims over those of residents may also be inferred from the provision of the Bankruptcy Code that permits distressed municipalities to exit bankruptcy only when a proposed plan serves the "best interests of creditors." (19) The content of that test is less definite in the municipal context than in the private sector, since the former does not entail an option of liquidation, (20) which could be used to determine whether a proposed plan makes creditors better off than an alternative resolution. As a result, bankruptcy courts must balance the propriety of imposing tax increases or service reductions on residents (21) against the propriety of compromising obligations to bondholders. The mandate of the "best interests of creditors" test arguably strikes that balance in favor of the latter.

   One could imagine that a consistent conception of the priorities between bondholders and residents would inform all of these doctrines. Although individual circumstances or the details of specific contractual arrangements might be cause for some deviation from the norm, a default rule favoring either creditors or residents would inform all parties involved in the extension of credit to a municipality of the risk allocation faced in the event that the debtor municipality incurs fiscal distress. That default rule, if based on some overall objective for the allocation of the risk of fiscal distress, could alleviate the vagaries inherent in the various legal principles that are invoked when municipalities seek relief from obligations that have become burdensome. The desirability of such a background default is apparent from the debates that characterize the Duluth litigation with which I began. One might believe that the strong version of the Contracts Clause jurisprudence that is frequently invoked when municipalities seek relief from contractual obligations reveals an unwavering policy of conferring on bondholders priority over residents. (22) But even in the nineteenth century, application of the various legal doctrines that affected the relative rights of bondholders and residents complicated any effort to discern a general priority principle. State courts, as well as legislatures, often exhibited little sympathy for bondholders when municipal projects went financially awry. State courts articulated a "public purpose" doctrine that placed restrictions on the use that localities could make of borrowed funds. Although the doctrine initially received a broad definition, so that assistance to privately held enterprises, such as railroads, could fall within its scope, (23) subsequent courts employed the doctrine to invalidate outstanding bonds as having been issued for projects outside governmental competence once it became clear that the costs of those projects would exceed any related increase in municipal revenues. The Iowa Supreme Court reversed (24) its earlier approval (25) of railroad aid bonds, after the demise of railroads whose commercial success was expected to render payment of the bonds painless. Other state courts similarly construed municipal authority narrowly in order to invalidate bonds issued for purposes that the courts had previously blessed. (26) In what is perhaps the best history of the railroad bond era, A. M. Hillhouse, somewhat derisively laid these reversals at the feet of an elected state judiciary whose terms in office depended on solicitude for an electorate unwilling or unable to satisfy obligations incurred in its name: "Decisions in favor of the bondholders by the state could not long stand in the face of hostile public opinion.... If the courts were not in agreement with public opinion, was this not plain evidence that they had been 'bought up' by the railroads? So reasoned the rural mind." (27) Ultimately, animosity towards bond issues spilled over from judicial willingness to invalidate outstanding indebtedness and into an unwillingness to permit municipalities to incur obligations in the first instance, even if nullification required some judicial creativity. The Wisconsin Supreme Court, for example, enjoined one issue of bonds that was to be used to aid a railroad on the grounds that residents had signed the authorizing petition on a Sunday. (28)

   Hillhouse and Charles Fairman have recounted the struggle between state and federal courts in which (in pre-Erie days) the latter intervened to prevent invalidation of bonds held by non-residents whose efforts at obtaining payment were disappointed by the homeward trend of the former. (29) Even the Supreme Court got into the act. While the Contracts Clause literally applies only to a state's ability to "pass any law" that impairs the obligation of contract, in Gelpcke v. Dubuque, the Supreme Court appeared to apply that same understanding to state judicial decisions that had the effect of invalidating bonds issued under a previous interpretation of state law. (30) Residents of Dubuque had voted to allow the city to subscribe to the bonds of two railroads. (31) Under state supreme court precedent in effect at the time of issuance, state law authorized such investments. (32) Subsequent to issuance of the city's bonds, the state supreme court overruled its prior decisions and held that municipal investments in railroad aid were constitutionally prohibited. (33) The Court determined that...