AuthorGulati, Mitu

Introduction 658 I. The Challenge of Determining Bankruptcy Eligibility 665 II. Data and Findings 672 A. Access to Bankruptcy 674 B. Payment Terms 677 C. Non-Payment Terms 678 D. Governing Law 680 III. Interview Findings 681 A. Other Things Matter More 682 B. Access to Chapter 9 is a Moving Target 683 C. It's Complicated 684 D. Defaults are Rare 686 E. Only Hedge Funds Care 687 IV. Implications, Open Questions, and Next Steps 688 A. Implications 688 B. Extensions 692 Conclusion 693 INTRODUCTION

A central puzzle in the economics of sovereign debt is why investors lend to governments. (1) Governments, after all, cannot be compelled by state force if they refuse to pay their debts. Assuming that there will be circumstances when politicians would rather not pay creditors--such as when voters are unwilling to pay the high taxes needed to repay --it becomes a problem that there is no way to force the government to pay.

One answer to the puzzle is that governments seeking to borrow do find ways to credibly commit to investors that they will not, or at least are less likely to, expropriate from creditors. (2) Over the years, researchers have identified a variety of commitment devices ranging from constitutional promises to independent central banks. (3) The focus of this Article is on one of these commitment devices: the (self-) denial of access to a bankruptcy-type mechanism, (4) which we examine in the context of U.S. sub-sovereign (municipal) debt.

The theory of why access to bankruptcy might matter to investors has to do with incentives. If bankruptcy allows debtors to easily escape their contractual obligations, then access to bankruptcy might cause debtors to irresponsibly overborrow in the first place. Aware of this dynamic, lenders either demand a higher interest rate at the outset or simply refuse to lend. For the government, therefore, tying its hands ex ante by promising not to use the bankruptcy process might be a rational strategy to reduce the cost of borrowing. (5)

The foregoing is especially likely to be the case if, ex post, investors are not able to tell whether a government is genuinely in crisis (in which case creditors might rationally want to give relief) or is opportunistically asking for a debt reduction. Knowing that the costs of government default tend to be high for everyone involved, investors, in the ex post scenario, are going to feel pressure to agree to a renegotiation of the debts so as to avoid the default. To prevent this problem, investors might want to put rules in place to ensure that governments do not too readily seek restructurings. (6) If renegotiation is costly and painful, the theory goes, governments will work hard to avoid ever having to ask for it. (7)

In the literature on sovereign finance, this moral hazard story is often used as an argument for why the process by which governments are able to ask for a restructuring should be made onerous. (8) This can be achieved in two ways. First, government entities can deny themselves the right to utilize a statutory bankruptcy process by refusing to set it up in the first place. Second, the contractual conditions under which a debtor can ask for a renegotiation of its obligations can be made difficult to satisfy. To the extent creditors believe that the foregoing incentives work, governments will get cheaper financing. (9)

But is this frequently told moral hazard story in fact an important determinant of government behavior? Politicians may not actually respond to the hypothesized incentives created by the lack of bankruptcy access. (10) In the real world, some argue, governments default "too little, too late" rather than "too often and too early." (11)

The question that motivates our project is: How much do investors care about how easy it will be for the government entity to do a debt restructuring? This Article seeks to answer that question by looking at the voluntary disclosures that issuers in the municipal debt market make to investors.

The perspective we take, of looking at voluntary disclosures regarding access to bankruptcy or its contractual equivalent, is different from that of prior researchers. The bulk of the previous research looks at the ex ante cost of capital for entities with and without access to statutory bankruptcy or its contractual equivalents. (12) In the municipal debt context, this research examines the cost of borrowing for different states relative to the presence of core features, such as whether the state has passed a statute authorizing its local municipalities to file for bankruptcy, whether the state imposes conditions on those filings, or whether the state has refused to authorize such filings. (13) On its face, this fairly straightforward categorization is tailor-made for an empirical analysis of the cost of capital as a function of what type of bankruptcy access a state allows a municipal issuer of debt. Empirical tests appear to mostly find that bankruptcy availability is disfavored by creditors and therefore issuers pay higher interest rates in those jurisdictions that allow it. (14) For our part, we instead look at the disclosures made in the bond offering documents regarding access to bankruptcy. If the fact of access to bankruptcy is a crucial determinant of the interest rate that investors will charge government issuers, then investors will want to know the degree of access the entity in question has at the outset of the transaction. Our premise is the following: If the matter is of importance to lenders, those issuers who benefit from releasing that information should, in theory, voluntarily and prominently provide that information in the offering documents for their securities. Other issuers, for whom the information looks bad, should try to explain it away so that investors do not unduly discount their bonds.

Before proceeding, some background on this Article's particular intervention is needed. As noted, municipal borrowers in the United States operate under state-imposed regulatory schemes that determine whether, and under what conditions, they may access federal bankruptcy. (15) These same borrowers also enter into contracts with their lenders that specify the processes by which a renegotiation of their obligations might occur outside of bankruptcy. Put differently, a municipal entity that does not have access to federal bankruptcy can nevertheless enter into a contractual agreement with its creditors regarding how a possible distress situation in the future will be worked out (i.e., bankruptcy by contract) (16). Figuring out how easy or difficult it will be for a particular municipal issuer to access either the statutory bankruptcy scheme or use a contractual mechanism to engineer a workout, therefore, requires some legal analysis. That analysis can be done by examining the relevant state statutes, reading the contract terms of the bond issuances, and then determining how they are likely to be interpreted in light of relevant prior case law.

The foregoing is not rocket science. Although the answers are frequently not going to be clear to a lay observer, a specialist municipal finance lawyer should be able to determine the answers with a few hours of time and effort. If, therefore, one is an investor considering whether to buy the bonds of a particular municipal issuer and the ability of that institution to access statutory or contract bankruptcy is a key factor, one should expect meaningful disclosure as to what those chances are. If investors care about something and are willing to pay for it, the theory goes, bond issuers will provide it and pass those costs on to the investors.

To see what kinds of disclosures about the availability of bankruptcy access were provided to investors, our team hand coded nearly six hundred randomly chosen municipal bonds from a major bond database. For each bond offering, we examined what the disclosures were for statutory and contractual access of the issuer to a restructuring process, and specifically access to federal bankruptcy filing under Chapter 9 of the U.S. Bankruptcy Code. (17) Our plan was to then use what we expected to be nuanced answers regarding access to bankruptcy--in either the statutory or contract form--to do our own empirical analysis of the effect of access to bankruptcy on the cost of capital.

What we found was that the vast majority of issuers provided little meaningful information on the issuer's ability to access either statutory bankruptcy or use an alternative contractual workout. (18) Instead, on the statutory bankruptcy front, the majority of offering documents, regardless of credit ratings, provided only vague boilerplate statements about how the issuer might or might not be able to access federal bankruptcy. (19) Vague boilerplate language was provided even when the issuing municipality operated under a state law that was relatively clear about the availability or unavailability of bankruptcy--indeed, even in states that explicitly prohibit municipal access to bankruptcy. (20) As for the legal opinions usually appended to the offering documents--the place where bond counsel might tackle especially complex and uncertain matters (21)--not one of the documents contained any indication that special attention had been paid to the question of bankruptcy access or restructuring.

The absence of these disclosures raises a puzzle. Our findings could indicate that investors in this market do not care enough about bankruptcy access to demand disclosure, or do not think it is important --despite empirical findings indicating that bankruptcy access affects the price of debt. Or it could be that investors have access to the information from publicly available sources or that they are hiring their own lawyers or analysts to assess bankruptcy risk. It could also be the case that the relevant information is already incorporated into the price of the debt through some efficient market process.

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