NEW YORK (Reuters) - A new Rhode Island law that guarantees municipal bondholders will be paid back even if the cities and towns in which they invest go bankrupt could spur a nationwide trend -- if courts allow it to stand.
The law adopted last month gives municipal bondholders a lien on taxes and general revenues collected by the cities and towns whose bonds they buy.
This means the bondholders would be repaid before other creditors such as workers, suppliers and pension fund beneficiaries if the municipalities went bankrupt.
State officials hope the law boosts confidence among investors in a state whose communities face growing financial strain. Even larger cities such as Providence and Pawtucket face the potential for higher borrowing costs as their credit ratings, still investment-grade, face downward pressure.
The law was adopted three weeks before the small Rhode Island city of Central Falls, population 19,000, made headlines by filing a rare municipal bankruptcy, one year after having been put under state control.
"One of the big issues with a municipality filing bankruptcy is the effect on bonds, so if that's off the table, you can bet more states will think about passing these kinds of laws," said David Skeel, a bankruptcy and corporate law professor at the University of Pennsylvania Law School.
On August 1, Central Falls filed for protection from creditors under Chapter 9 of the federal bankruptcy code, which governs municipalities. It carried $21 million of debt, and was burdened by $80 million of unfunded pension and retiree liabilities, nearly five times its annual $17 million budget.
Central Falls' leaders will look to apply the new law as it tries to restructure the city's debt.
Legal experts said nothing in federal bankruptcy law appears to stop them from doing so. Indeed, similar legislation has been upheld in at least two Chapter 9 cases in California.
But the law is the first to apply retroactively to agreements with vendors owed money under pre-existing contracts with the city, said Karen Grande, Rhode Island's municipal finance counsel.
That retroactive component may be enough to sink the law, said Bill Brandt, chief executive of restructuring consulting firm Development Specialists Inc in Chicago.
"If I'm a vendor and I extended credit as a senior creditor, and now all of a sudden I find I'm subordinated, I'm not sure that's going to fly," said Brandt, who also chairs Illinois' Finance Authority. "The cardinal rule of markets is predictability."
Skeel said retroactively protecting bondholders at the expense of other creditors could violate the Contracts Clause of the U.S. Constitution. He said the matter could wind up being appealed, possibly to the U.S. Supreme Court.
"There are enormous uncertainties about the scope of the Contracts Clause, about the nature of state property rights and how far they extend," Skeel said.
But Grande said the law could be a "game changer" in municipal bankruptcies, saying it does not displace liens belonging to other creditors.
"With regard to anyone who's a secured creditor, they're still going to have their security, and with regard to unsecured creditors, they don't currently have any expectation of having a security interest to begin with," Grande said.
James Spiotto, a bankruptcy partner with Chapman and Cutler who has advised Congress on strengthening municipalities' right to use liens to ensure bondholder payback, believes the law would survive legal challenges -- for a different reason.
"This was passed before the Chapter 9 filing took place, so it's not really retroactive," he said. "States are co-sovereigns with the federal government, and they can make decisions about how to protect their own financial health."
Other states, however, are unlikely to follow Rhode Island's lead unless the law successfully ensures that the states' cities and towns maintain access to bond markets.
"The common belief is, once one city goes into Chapter 9, bondholders will look at nearby cities and towns as possibly being unstable as well," said Jonathan Henes, a bankruptcy partner with Kirkland & Ellis.
That fear was especially acute in Rhode Island, where unfunded pension liabilities continue to mount, Henes said.
More than 60 percent of the state's 36 pension funds are "at risk" due to low funded ratios and declining contributions, according to a February report by the state's Senate Fiscal Office.
"It was our hope, and in fact it was the reason we did all this," Grande said, "so that other municipalities and Rhode Island itself would not be adversely affected by one going bankrupt."
At least one credit rating agency, however, is taking a wait-and-see attitude toward the law.
"The fact is, we don't know how the judge will treat that law, and that will be a factor in our ongoing review," said Geordie Thompson, an analyst at Moody's.
Even if other states copy Rhode Island's law, it does not necessarily presage more cities and towns using bankruptcy as a possible means to solve debt problems.
"Chapter 9 is something we don't see a lot, and that speaks to how expensive it can be and how time-consuming," Thompson said. "You leave a lot of decisions to a federal judge that you'd normally make yourself. We think it will continue to be difficult, and continue to be a last resort."
Reporting by Nick Brown, editing by Dave Zimmerman