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Considerations in Middle Market Tax-Free Bond Restructurings

Mar 3, 2017

Recently co-authored article in the Journal of Corporate Renewal (JCR), the official publication of the Turnaround Management Association (TMA).

Most people think of municipal bonds as debt issued by state and local governments and their agencies and authorities. In fact, federal tax laws treat a wide array of entities and projects as eligible for “municipal financing.”

Most U.S. cities and states have created “municipal authorities” as the technical issuer of special-purpose tax-exempt bonds that “loan” the proceeds to eligible entities and projects. The legal structures used vary from situation to situation and from state to state, but they generally take the form of loans, leases, or lease-leasebacks. In certain situations, rather than an authority, a municipality creates a taxing district that issues bonds for certain land/infrastructure development projects that are then repaid by a special tax on residents of the district.

Due to the unique nature of municipal bonds, restructuring them in the event the issuer defaults posts a host of considerations that differ from other forms of debt. This article explores those considerations and differences.

The term “nonprofit” is a tax designation, not necessarily an indication of a charitable mission. Over the years, special-purpose bonds have been used to finance major projects for nonprofit entities, particularly those involved with healthcare, such as hospitals, nursing homes, and continuing care retirement communities. Other users of special-purpose bonds include colleges/universities, low-income housing, home developers, certain types of small manufacturing operations, certain types of hotel/convention centers, airports, solid waste disposal facilities, sewer systems, cultural institutions, etc. Depending on the transaction and purpose, the bonds are structured and issued either as general obligation or revenue bonds, or revenue bonds with additional collateral.

General obligation bonds are issued directly by state and local governments and are backed by the full faith and credit of the issuer, generally because they can raise taxes and otherwise pay the debt from other general governmental revenue. Revenue bonds are paid from a dedicated source, such as tolls, stadium receipts, special taxes, etc. To take advantage of revenue bonds, the entity or project generally must pledge its business revenue toward repayment of the bonds. Examples include hospital financings, where the hospital pledges its operating revenues as collateral for the bonds. Revenue bonds of all types are typically limited in collateral; i.e., only the revenue pledged can be looked to for bond repayment. To get a bond issue financed, entities issuing revenue bonds often must add collateral to the transaction, such as mortgages on buildings and security interests in equipment, receivables, and other assets.

Indenture Trustee

In the 19th century, bond investors had to deal directly with the issuer if payment problems occurred. If a bond defaulted, for example, each bondholder had to sue the issuer individually. Imagine how costly and difficult that was. In 1939, as part of the post-crash depression legislation, Congress enacted the Trust Indenture Act of 1939 (TIA). The law required all publicly issued bonds to be registered with the federal Securities and Exchange Commission and to have an indenture trustee to represent bondholders and deal directly with the issuer.

Although municipal bonds are technically exempt from registration and other requirements of TIA, the municipal bond industry has adopted the practice of having an indenture trustee as the bondholders’ representative. Typically, indenture trustees today are corporate trust departments of banks or trust companies. The largest national corporate indenture trustees are Wells Fargo Bank, US Bank, BNY Mellon, and UMB Bank. There are many others.

The indenture trustee acts in a fiduciary capacity and monitors the issuer as provided in the trust indenture for the bonds. The indenture trustee collects the debt service payments and pays the bondholders on the required payment dates. The indenture trustee holds whatever collateral is given by the issuer to support the debt and receives and distributes any financial reports from the issuer. The indenture trustee monitors compliance with any financial and operating covenants in the transaction documents and if there is a default notifies the bondholders and asserts remedies for the default as provided in the documents and generally under the law.


For many years, underwriters generally sold bonds to individuals. Where these types of offerings still exist, they are referred to as “retail” distributions. In the last 30 years, the increased dominance of mutual funds (and more recently exchange-traded funds (ETFs)) that invest in a broad array of municipal debt has relegated retail deals to a distinct minority. Today, retail deals are not generally favored and usually represent smaller transactions, which, on the whole, are fairly risky. Funds today purchase the vast majority of municipal debt sold in the marketplace. Fund families typically have many different funds to choose from for investors: insured portfolios, individual state portfolios (since the interest on the bonds may also be exempt under that state’s income tax laws), high yield portfolios, and industry-specific portfolios.

Where institutions own a majority of the bonds, the trust indenture typically gives them (or any majority holders) the right to control the remedies available to the indenture trustee upon a bond default. This is generally what is prevalent today. Either one fund investor or a few from different fund families, alone or together, own more than a majority of the bonds and can control the dealings with the issuer. In certain cases, they can also remove and replace the indenture trustee. Many funds have become very active in asserting rights and controlling the process after a default. This includes selecting outside professionals for the indenture trustee, negotiating with the issuer (or project debtor), and determining whether it is appropriate to restructure the debt or even liquidate/sell the project.

Where a few bondholders get together and, as a majority, undertake direct contact with the issuer (or project debtor), the information they gather is usually considered “material nonpublic information” (MNPI). Under federal and state securities laws, trading on MNPI is generally considered an insider trading violation, which can incur severe penalties. Thus, the bondholders forming the majority may have to agree to restrict trading in the bonds upon receiving information not available to the general public.

Sometimes they negotiate with the issuer, project debtor, or the indenture trustee to release this information to the public so that the information is no longer restricted. However, it is usually difficult to do this while restructuring negotiations are going on. It is important for bondholders to understand that the negotiations themselves can be considered MNPI and that designating outside professionals as gatekeepers may not be sufficient protection. In general, municipal bond information is publically disseminated through the Electronic Municipal Market Access (EMMA) system, the official information repository for municipal bonds.

Taxable bonds frequently have hundreds of investors. The fact that most tax-free special-purpose bond issuances are held by a limited number of institutions makes it far easier for an entity in default to engage in solution-oriented negotiations with the indenture trustee and bondholders. As nonprofits aren’t seeking equity value optionality in negotiations (boards are generally most interested in preserving the mission), there is a greater opportunity to build trust and transparency between the defaulting entity and the bondholder constituency (however, management expectations may have to be tempered).

Bond Insurers

From the 1970s until the 2008 market crash, a significant portion of the governmental bonds and certain revenue bonds were insured by municipal bond insurance companies. The three that dominated the field for many years were MBIA, FGIC, and AMBAC. As of 2005, close to 60 percent of new issuances were insured. However, most of the traditional bond insurers did not fare well through the 2008 market crash, and the industry today is a shell of its former self. Post-2008, bond insurance of new issuances dropped below 5 percent and has slowly rebounded to approximately 10 percent of issuances as of 2015.

A new host of bond insurers have cropped up, but the number of transactions that are insured is still far below previous levels. Insured transactions typically would receive AAA ratings by the rating agencies, even if the underlying issuers were not AAA-worthy, since the rating essentially applied to the bond insurer’s ability to repay the debt, not the actual issuer’s. The advantage of the higher rating was typically to lower the coupon rate of interest on the bonds since they were less risky. The issuer would weigh the present value of the interest rate savings over the life of the bonds against the insurer’s premium (paid as a lump sum at closing) to determine whether the bond insurance was worth buying.

A bond insurer generally had all rights that the bondholders would otherwise have had against the issuer, the theory being that the bond insurer was taking the ultimate risk of nonpayment of the bonds. Therefore, a bond insurer is really the “bondholder” for all intents and purposes. Indeed, in many pre-2008 insured transactions, bondholders seldom performed individual due diligence, rather leaving it to the bond insurer to negotiate the transaction and issue the bond insurance policy. Thus, it is common in post-default situations for the bond insurer to become the control party under the indenture.

Bond Restructurings

Bonds can go into default because of covenant violations (i.e., the project debtor did not meet various financial tests) or because of a payment default. Covenant violations tend to presage payment defaults and are usually taken seriously. Payment defaults are obviously treated seriously.

Upon the occurrence of a default, the indenture trustee usually notifies the bondholders and meets with the issuer to determine why the default occurred. Some defaults are temporary, due to conditions that are atypical of the project and have the capacity for quick reversal. In these situations, the indenture trustee (with the approval of the majority bondholders, if any) simply takes a wait-and-see approach. If slightly more serious or if there is a payment default and future payment defaults are expected, a number of approaches might be taken.

Assuming that the project (or business) is still generally viable (a liquidation/sale is not contemplated), a forbearance may be negotiated. In a forbearance, the indenture trustee (with the approval of the majority bondholders, if any) enters into a written agreement not to exercise remedies for a period of time in exchange for promises from the project debtor to do things it is otherwise not required to do under the documents. Forbearances seldom do more than temporarily suspend financial covenants and may involve reduced (but not forgiven) interest payments. The advantages of a forbearance are cost savings, since the expenses of a full-blown bankruptcy are averted, and the indenture trustee usually gets concessions that will assist in resolving continuing defaults later if the situation persists.

In many cases, the parties simply can’t reach agreement on terms of a forbearance. The project debtor simply does not want to operate long-term with the debt structure in place. It is seeking reduced principal, as well as interest, on the debt. At that point, full-scale prebankruptcy restructuring negotiations begin, either resulting in a nonjudicial workout or ending up in U.S. Bankruptcy Court.

The difficulty with workouts is that a group of bondholders that do not own 100 percent of the bonds cannot, without the consent of all bondholders, permanently change the principal amount or coupon amount of interest on the bonds, or the maturity and payback schedule for that matter. Under the trust indenture, a majority but less than 100 percent of the bondholders may only have the ability to change collateral or financial covenants. Bankruptcy is the only process that can force all of the bondholders to accept real changes in the terms or amount of the bonds. In bankruptcy, all bondholders can be bound to standard plan acceptance rules (two-thirds in amount of the outstanding bonds and one-half of the number of bondholders).

Thus, some type of prebankruptcy negotiations must occur. Remember, the issuer, assuming it is not a state or local government, always has the right to file for reorganization under Chapter 11. There is nothing the creditors can do to stop it if the entity is otherwise eligible for bankruptcy protection.

The best and least costly approach, depending upon the complexity of the situation, is to negotiate a prepackaged bankruptcy plan, in which all terms for the “restructured bonds” would be stated in advance of the bankruptcy. This typically works when a majority of bondholders who hold at least two-thirds in amount of the bonds outstanding agree to support the terms.

A “plan support agreement” is usually drafted in which, in exchange for the majority bondholders agreeing to vote for the reorganization plan, the project debtor agrees to conduct the bankruptcy within certain time frames and other provisions that have been agreed upon for other creditors. The utility of this approach is, hopefully, a swifter bankruptcy process. Allowing the debtor to be in and out of bankruptcy quickly also reduces the costs of the process, especially with regard to professional fees. It is common with special-purpose bonds to have a prenegotiated bankruptcy, in which key creditors have agreed to the terms of a restructuring, although a few remaining unresolved issues are left to be addressed in the bankruptcy.

If the parties can’t reach agreement, the project debtor can always file a contested bankruptcy. A free fall bankruptcy without the support of the majority bondholders is the least desirable and most costly and time-consuming way to resolve debt problems, yet it is not uncommon.

The basic litmus test for restructuring an entity with special-purpose tax-free debt is no different from a standard restructuring; that is, will a sale/liquidation of the operating assets provide a better tax-adjusted recovery for creditors? Whereas most middle market bankruptcies today result in Section 363 sales and/or liquidations, it is not uncommon for nonprofit entities to have unencumbered collateral available to them both to help fund a restructuring and to provide liquidity for post-restructuring operations.

The distressed entity also needs to assess where it has leverage in negotiations with the indenture trustee, such as with lien perfection issues. Most critical is to be proactive in assessing the time horizon. To the extent the distressed entity has control of cash, it is imperative to ensure that it has sufficient funds to implement improvement initiatives and effectuate a restructuring, as bondholders rarely have the capacity to provide funds to recapitalize the business. The fact that the tax-free bondholders are frequently willing to reissue bonds with 30-plus year amortizations enhances the likelihood of finding feasible solutions.

What is critical in tax-free middle market restructurings is for the stakeholders to be solution-oriented and to build trust and transparency between them and the professionals early in the process. Since there are frequently more stakeholders than in a traditional middle market restructuring (with a vocal senior lender), it is not uncommon for tax-free middle market restructurings to move at a snail’s pace, comparatively, which can increase risk and professional cost.

Recent Restructurings

Some of the best outcomes result from collaboration among the distressed entity, its professionals, and bondholder professionals. Three recent examples of creative outcomes are:

KidsPeace (13-14508 et al). KidsPeace is a nonprofit organization that owns and operates an adolescent psychiatric hospital in Pennsylvania and has behavioral health operations in a number of other states. It had more than $60 million of bond debt outstanding in 2012. As a result of changes in reimbursement, some quality assurance issues, and a reduction in patient census, the entity was no longer able to meet its bond obligations, which were secured by all the enterprise’s revenues.

KidsPeace proactively hired a financial advisor for guidance on strategic alternatives and to present a liquidity and stabilization plan to the indenture trustee and its advisors. Three bondholders held more than 80 percent of the bonds. Other stakeholder constituents included the Pension Benefit Guaranty Corporation (PBGC) and trade creditors.

KidsPeace and its advisors had numerous meetings with the indenture trustee and its advisors. The initial steps involved determining, based on the changing patient landscape, reimbursement rates, and other factors, what modifications to the business model were needed to ensure long-term viability and what the resulting sustainable cash flow was likely to be. The indenture trustee and its advisors and the bondholders needed to evaluate whether the resulting cash flow model was acceptable in view of the likely sale value of the operations. During the prebankruptcy negotiation stage the company was able to successfully terminate the pension.

Ultimately, the indenture trustee and bondholders agreed on a restructuring of the bonds into two different series of bonds. The bondholder treatment was memorialized in a plan support agreement. KidsPeace entered bankruptcy without agreement from the PBGC or the trade creditors, but with the bondholders’ agreement, the major creditor was behind the plan of reorganization.

The bankruptcy ultimately took more than a year, but most of the hard work had been done prepetition. Eventually, the PBGC and the creditors’ committee agreed to consensual treatment. The plan vote by all impaired classes entitled to vote was overwhelmingly in favor.

KidsPeace emerged from bankruptcy in 2014 and is still successfully serving its mission today.

Chicagoland Jewish High School (11-19342). Chicagoland Jewish High School was the first and only high school exclusively serving the Jewish community in Chicago area. In 2007 it decided to build a new school building and issued about $30 million in bonds. The bonds were owned mostly by six mutual funds, but had a substantial retail component. The collateral for the bonds was the school revenues, a mortgage on the school building, and security interests in all of its other assets. The school had a separate endowment fund of around $6 million, but it was not pledged as security for the bonds.

The problem with the school’s finances was that the business model only called for one-third of the operating expenses and debt service on the bonds to be paid from school tuition revenue. The remaining two-thirds was to come from annual gifts and contributions. Although the school had a history of such pledge support, the recession of 2008 impacted gift-giving significantly, and within 18 months of the school dedication, the bonds were already in default.

The school offered the bondholders 35 percent of par to discharge the bonds, which they refused. The school building was worth more than the offer. Since the school was a nonprofit entity and its purpose was important to the community, the professionals, the school, and the bondholders worked hard to find a workable solution. They also determined that since there were no other real creditors with substantial claims, if it could be worked out, a bankruptcy case would be needed only to confirm the plan. Again, the negotiating bondholders, although a majority, could not bind those present to a restructured deal without a bankruptcy process.

Ultimately, the bondholders agreed to a complex two-tiered bond structure in which some of the bonds would be interest-paying currently to reflect the depressed gift support, but zero coupon bonds were added in anticipation of increased gifts in the future. The bondholders received around 70 percent of par in new bonds in the restructuring. The key to cementing the deal was that the $6 million endowment fund was pledged to the bonds, making the entire principal of the bonds virtually 100 percent secured.

Again, a plan support agreement was drafted and signed by the majority bondholders. The school was in and out of bankruptcy in five short months as a result of the prepetition work and the prenegotiated plan with the bondholders. The school repaid all of the restructured bonds in full three years later.

Regency Pointe. Regency Pointe is a 100-bed continuing care retirement community in northern Alabama. Unfortunately, the costs of operation were equal to its revenues, with the result that the $25 million in bonds that financed the facility had not been paid in seven years; in effect, bondholders were subsidizing the residents.

A single municipal bond fund owned all the bonds. With no cash flow to pay any debt service on the bonds, the central question was whether there was any purpose to operating the facility. Moreover, residents who had left the facility over the past seven years were due refunds of their entrance fees but were not likely to get any refunds for years since the occupancy load was dwindling due to the inability of locals to sell their homes since 2008 during the housing recession. The total deferred entrance fee refunds totaled more than $15 million. The bondholders had collateral in the revenues, a mortgage on the facility, and the other assets. The entrance fee refunds were unsecured. Yet, a bankruptcy case would surely be contested, with uncertain results.

It was determined that there were no prospects for occupancy increases unless the facility converted from an entrance fee business model to a rental model. To do that, the entrance fee refunds of all the departed residents and current residents had to be dealt with. The question was how to fairly apportion the bankruptcy risk between bondholders and residents.

Ultimately, the professionals developed a proposal in which the residents would be offered a cash payout of their entrance fees if they would agree to a sale of the facility. To ensure fairness in the discussions, the indenture trustee offered to pay for separate counsel to negotiate on behalf of the residents. It was ultimately agreed that the residents would get cash equal to 40 percent of their refunds due provided that 90 percent of residents agreed. It was put to a vote and 98 out of 99 residents agreed (the lone holdout eventually agreed as well). The residents were given leases enabling them to reside at the facility, if they wished, for the rest of their lives.

The facility was marketed, attracted a number of bids, and was ultimately sold in 2015. The residents were all cashed out. The bondholders received cash of about 65 percent of par for their bonds, and bankruptcy was avoided. Regency Pointe remains in operation under its new for-profit ownership.

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