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Credit FAQ: Has S&P Global Ratings' View On Special Revenue Debt Changed Following The First Circuit Decision?


Credit FAQ: Has S&P Global Ratings' View On Special Revenue Debt Changed Following The First Circuit Decision?

Frequently Asked Questions

The U.S. Court of Appeals for the First Circuit decision affirming a lower court's decision that payment of Puerto Rico Highways and Transportation Authority's special revenue secured debt is voluntary, and not required, during bankruptcy, has generated significant market attention. While the decision is technically only binding precedent for cases arising in the First Circuit, its impact is broad. The decision differs from a long-held view of many in the municipal market that Chapter 9 of the federal bankruptcy code compels a debtor to pay bonds secured by special revenues while in bankruptcy. Here S&P Global Ratings addresses investors' most frequently asked questions on this topic.

What is the broader impact of the decision for credits across the municipal market?

It is important to highlight that the appellate court decision may not be the final or only decision on this topic. The decision could be appealed, or the same issue generate a different outcome in another circuit. The decision is technically only binding precedent for cases brought in the First Circuit, which includes Massachusetts, Rhode Island, New Hampshire, Maine, and Puerto Rico. Nevertheless, the decision offers influential guidance for the analysis of special revenue debt obligations across the municipal market given the infrequency of bankruptcy filings in this sector and thus the limited case law.

Does the decision differ from how S&P Global Ratings currently analyzes special revenue debt?

No. We see the decision as consistent with our view that the credit quality of special revenue debt--including priority lien debt, as we refer to it--is directly linked to the obligor's fundamental credit quality, whether in Puerto Rico or elsewhere in the U.S. In our view, the legal and judicial actions throughout the far-reaching Puerto Rico bankruptcy, as well as this decision, highlights the lack of predictability in distressed-credit situations.

While municipal bankruptcies and defaults remain rare, in S&P Global Ratings' view, when issuers fall under financial distress we expect that they may be motivated to explore all options to minimize the burden of their liabilities. This could include stopping or renegotiating the terms of their payment obligations, including special revenue secured debt. We already incorporate this concept into our analysis of priority lien obligations by linking these ratings to the fundamental credit quality of the related obligor. In this respect, given that the appellate court found that a municipal debtor can choose to pay or not pay special revenue debt while in bankruptcy, it does not alter our approach to analyzing priority lien debt or other revenue-backed debt issued in the municipal market.

Will there be changes to your methodologies based on the decision?

We have no plans to revise any criteria at this time based on the appellate decision. We believe our criteria updates over the last several years--which calibrated our analysis to focus on credit fundamentals as the driver of our ratings--already incorporate the exposure to the obligor that is highlighted by the decision. We've observed a shift in how some U.S. municipal issuers treat the pledges and promises on their general obligation (GO) and other revenue- or tax-backed bonds when they experience stress. A strategy of challenging these pledges and promises in the face of financial distress was apparent during high profile distress scenarios and bankruptcies, such as Detroit and Puerto Rico. In both of these instances legal provisions widely considered unalterable in the past were challenged and ultimately not honored in full and on time.

S&P Global Ratings' criteria updates over the last several years reflect our evolved view that legal structures and provisions to isolate revenues away from the obligor differentiate credit quality less than previously assumed. During distress, we believe the risk to full and timely payment of debt is heightened for municipal issuers because these legal protections come into direct competition with other priorities of a municipality, such as maintaining critical services, including public health and safety.

In our view, our criteria aligns with the decision because in analyzing special revenue debt we go beyond the legal structure and look at the broader credit characteristics of the entity making the pledge. For enterprise operations like a water or sewer system, this means looking at not only the system's operations, but also the credit quality of the municipality it serves.

Do legal protections matter?

Yes. We start from the premise that contracts are enforceable and legal provisions will be followed. We may also seek comfort from legal opinion on certain questions, including the expected treatment of debt in a bankruptcy scenario. When we find those opinions reasonable, our analysis incorporates them into our view of the linkage between an issuer and the related special revenue obligation. Legal protections, whether in bond documents or by operation of law, may strengthen a bondholder's recovery prospects, but from a ratings perspective may add only marginal credit strength, particularly because in times of distress an issuer may be motivated to challenge or renegotiate those legal protections, as we have seen in recent examples, such as Detroit and Puerto Rico. It is important to point out that our ratings reflect our opinion on the timely payment of principal and interest in full and do not factor in expected recovery if a default occurs.

We have observed that when an issuer's credit fundamentals deteriorate to the point where bondholders' main comfort is to rely on the legal provisions for payment, the situation isn't nearly as straightforward as it may have appeared when the bonds were issued. Like a spider web with the operating entity situated at the center, as pressure pulls on the center of the web, all associated credits and structures are likely to be stretched down to varying degrees, with the government trying to address all competing operating needs and payment obligations simultaneously. Legal protections and opinions alone cannot provide credit enhancement or a substitute for our assessment of credit fundamentals. In sum, legal opinions matter, but for the purposes of our credit rating analysis we don't rely on them to achieve separation of a revenue stream from the government pledging it.

Given the broad powers reserved for municipal debtors in Chapter 9 to raise taxes, and make expenditures as they see fit--as well as their ability to negotiate the terms and conditions of recovery with their creditors—we believe an evaluation of the credit fundamentals is an important component to an assessment of probability of payment, particularly when competing priorities are at play in bankruptcy.

How is the operating risk of the government pledging revenues to bonds incorporated into ratings?

In our view, the appellate court's decision has implications for two major types of revenue pledges: taxes levied by governments that are not property tax; and revenues generated from municipal-owned enterprise operations such as utilities.

To analyze special tax pledges (taxes other than property taxes such as sales, income, gas, and other excise taxes), we use our Priority Lien Methodology which was released in October 2018. Under this criteria, we consider bonds to have a "priority lien" when there is a specific statutory or contractual claim on pledged revenues, which generally include tax revenues limited by a fixed rate or amount; this methodology is applicable to non-property tax pledges. Our ratings on tax secured debt, including priority lien debt, incorporate our analysis of the underlying credit quality of the obligor and we link the rating on the tax revenue obligation to the general creditworthiness of the obligor. (For additional information regarding how we capture the operating risk of an obligor, please see "Issue Credit Ratings Linked To U.S. Public Finance Obligors’ Creditworthiness", Jan. 22, 2018.)

For revenue-backed transactions, such as government-owned utility systems, we also consider features of the general creditworthiness of the government as part of the rating process. This can include analysis of fiscal and governance issues, or an assessment of liquidity levels. In some criteria there are caps or overrides that apply to the final rating based on credit characteristics of the related government(s). However, regardless of the criteria used or enterprise revenue pledged, looking at the general credit quality of the government it services is an important part of how ratings are determined.

Is it possible for a government enterprise rating, such as a water, sewer or electric system, to be higher than that of the same government's GO rating?

Yes, while less common, this can occur. Given the diversity of our rated universe there is a nuanced analysis depending on the level of separation or linkage between the enterprise operation and the related government(s). A significant difference in service area can also make this kind of differentiation, such as water or sewer system that is owned by a municipality but provides service to a much broader geographic area.

This report does not constitute a rating action.

Primary Credit Analyst:Robin L Prunty, New York (1) 212-438-2081;
robin.prunty@spglobal.com
Secondary Contacts:Jane H Ridley, Centennial (1) 303-721-4487;
jane.ridley@spglobal.com
Geoffrey E Buswick, Boston (1) 617-530-8311;
geoffrey.buswick@spglobal.com
Theodore A Chapman, Dallas (1) 214-871-1401;
theodore.chapman@spglobal.com

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