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Treatment of Bondholders and Other Lenders

Under Chapter 9 Bankruptcy, different types of bonds receive different treatment.

General obligation bonds are treated as unsecured or general debts in the chapter 9 case. The municipality does not have to pay either principal or interest on account of such bonds during the case. The obligations created by general obligation bonds are subject to negotiation and possible restructuring under the plan of adjustment.

On the other hand, Chapter 9 of the Bankruptcy Code expressly provides protection to creditors holding liens on special project revenues of a municipal debtor. For example, municipalities often finance special projects, such as water and sewer plants, with bonds that are collateralized with the revenues and fees earned by such projects. Holders of special revenue bonds can receive payment on such bonds during the chapter 9 case if special revenues are available. Special revenues must be used to fund the necessary operating expenses of the special project and may not be diverted to support the general obligations of the municipality. The application of pledged special revenues to indebtedness secured by such revenues is not stayed as long as the pledge is consistent with the regulations.   This ensures that a lien of special revenues is subordinate to the operating expenses of the project or system from which the revenues are derived.

Generally, bondholders need not  worry about the threat of preference liability with respect to any prepetition payments on account of bonds or notes, whether special revenue or general obligations.  Municipality can continue paying bondholders without violating the automatic stay. Any transfer of the municipal debtor’s property to a note holder or bondholder on account of a note or bond cannot be avoided as an unauthorized payment to a creditor made while the debtor was insolvent.

Inside Treatment of Bondholders and Other Lenders