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Municipal Bankruptcy

The revised federal Bankruptcy Code, which took effect on October 1, 1979, appears to have been drafted without recognition of certain fundamental differences between corporate and municipal finance. If enforced literally, upon commencement of a municipal bankruptcy case, the Code would invalidate prior liens on revenue streams dedicated to the repayment of municipal obligations. This is because the Bankruptcy code does not recognize a present security interest in future revenues except as "proceeds" from the sale of property in which a security has been granted.

Purchasers of corporate securities are protected from having their lien invalidated by bankruptcy proceedings because bondholders have recourse to fixed assets that can be used to repay the debt. Municipal obligations, however, are debentures that are generally not secured by an interest in specific property. Rather, municipal bonds are often secured by pledges of future general tax or specific project revenues or betterment assessments. Under the present Bankruptcy Code, it appears that liens on any of these revenue sources dedicated to the payment of debt service on municipal obligations could be invalidated once a municipality entered bankruptcy, regardless of the validity of the lien under state law.

The failure of the revised Bankruptcy Code to account for the difference between private and public financing means that contracts with bondholders may be invalidated by fiscally stressed jurisdictions. For example, a bankruptcy court judge, faced with an insolvent municipality, may legally divert revenues from a wastewater treatment facility dedicated to the payment off debt service to other municipal uses, such as the payment of salaries.

The Government Finance Officers Association (GFOA) supports efforts to clarify the Bankruptcy Code so as to maintain the effectiveness, in accordance with state law, of liens granted on revenues and other monies to secure indebtedness and of limitations on the use of monies derived from one purpose, source or activity for another.

Adopted: April 17, 1984