Earlier this month, Judge Judith J. Gische of the Appellate Division of the Supreme Court of New York, First Judicial Department found that ACA Financial Guaranty Corporation, as bond insurer, must make future, post-confirmation principal and interest payments on municipal bonds issued pre-bankruptcy.  The Court required these payments despite the fact that the bonds were exchanged for new bonds and cancelled under the municipality’s chapter 9 plan.  The Court held that “neither the plan of debt adjustment nor the discharge of the bond debt in the bankruptcy proceeding changed the obligations under the parties’ contracts of insurance.”  This decision is an unequivocal win for holders of distressed municipal bonds wrapped by monoline insurance policies and makes clear that insurers must continue to extend coverage to bondholders after a municipal issuer files for chapter 9 and obtains a discharge of the bond debt in bankruptcy.  This outcome may impact negotiations and potential resolutions in Detroit’s chapter 9 case and other recent municipal bankruptcies and distressed scenarios, such as Puerto Rico.    See Oppenheimer Amt-Free Municipals v. ACA Fin. Guar. Corp., 2013 N.Y. App. Div. LEXIS 5688, at *4 (N.Y. App. Div. 1st Dep’t Sept. 3, 2013).

Background

This decision stemmed from the sale of approximately $200 million tax-free, toll road revenue bonds in Greenville, South Carolina issued by Connector 2000 Association Inc.  The bonds consisted of one fixed-rate series and multiple series of zero-coupon bonds.  The Issuer purchased insurance policies from ACA pursuant to which ACA guaranteed the payment of scheduled interest and payment obligations by the issuer in the event of a payment default.  Thereafter, Oppenheimer and other investors acquired a large number of the zero-coupon bonds with the corresponding wraps.  New York law governed the insurance wraps.

The Issuer defaulted on interest payments due on January 1, 2010, and filed for chapter 9 bankruptcy protection on June 24, 2010.  The Issuer subsequently missed another interest payment and a principal payment on some of its bonds.  Although the bankruptcy case effectively accelerated the claims on the bonds, ACA did not accelerate the insurance policies as permitted.  As a result, ACA only made insurance payments on account of the bond payments that had already come due.  The Issuer did not miss any payments on the zero-coupon bonds held by Oppenheimer.

On April 1, 2011, the Bankruptcy Court for the District of South Carolina confirmed the Issuers’ plan of debt adjustment, which called for the cancellation of the pre-bankruptcy bonds and the mandatory exchange of the old bonds for new bonds.  The confirmation order also discharged the Issuer from all pre-confirmation debts pursuant to section 944(b) of the Bankruptcy Code.  Following confirmation, ACA took the position that the plan relieved ACA of its payment obligations under the insurance policies because the plan cancelled the pre-bankruptcy bonds.  In response, Oppenheimer sought a declaratory judgment declaring that ACA was required to make payments on account of those bonds.  On July 23, 2012, Judge Charles E. Ramos of the Supreme Court of New York, New York County ruled in favor of Oppenheimer and entered an order declaring that “[ACA] is obliged to provide coverage for its claimed losses under the Secondary Marked Insurance Policies . . . .”  See Oppenheimer Amt-Free Municipals v. ACA Fin. Guar. Corp., 2012 N.Y. Misc. LEXIS 3905, at *46 (N.Y. Sup. Ct. July 23, 2012).   ACA then appealed the declaratory judgment.

Analysis

On appeal, the Appellate Division of the New York Supreme Court affirmed the lower court ruling and found that ACA must make payments on account of the pre-bankruptcy bonds when those payments came due for several reasons.  First, the Court found that the plain language of the insurance policies required ACA to “absolutely and unconditionally guarantee payment on the individual bonds in the event of the issuer’s nonpayment.”  The Court reasoned that the policies covered the risks of issuer insolvency and bankruptcy expressly and that “[t]hese are the very risks for which [ACA] received payment of premiums.”  The Court also noted that the policies were non-cancellable and did not provide for any exception in the event of bankruptcy.

Second, the Court concluded that the cancellation of the pre-bankruptcy bonds under the chapter 9 plan did not abrogate ACA’s obligations under its insurance policies.  The Court reasoned that “neither the restructuring plan, nor the issuer’s discharge of debt in the bankruptcy proceeding, changed the obligations under the parties’ contracts of insurance.”  While the Court acknowledged that the bankruptcy court had the power and jurisdiction to permanently enjoin claims against non-debtors such as ACA, the bankruptcy court did not issue such an order in favor of ACA in this case.

The Court also rejected ACA’s attempt to utilize a common-law defense to avoid coverage.  In this case, ACA relied “on the principle of law that a surety/guarantor is relieved of liability where, without its consent, there is any alteration of the underlying insured obligation.”  The Court found that this common-law defense has no application here.  The Court reasoned that the defense was inconsistent with the nature and purpose of the non-cancellable policies because “[n]oncancellability is consistent with and integral to the singular risk that the CBIs were clearly intended to cover, which is the insolvency or bankruptcy of the issuer.”  In addition, the Court distinguished the cases cited by ACA because none of the cases arose in the context of a bankruptcy proceeding.  The Court also reasoned that ACA did not have to bear any additional risk on account of the new bonds.  Instead, “the loss that is payable under the [policies] takes into account any partial value received by the bond holder from the issuer, which in this case would reflect and be equal to the value of the [new bonds]. This is different than the risk of insuring the [new bonds] … .”  For these reasons, the Court affirmed the declaratory judgment.

Conclusion

This case has implications for the municipal bond market given the numerous uncertainties facing bondholders following the City of Detroit’s historic chapter 9 filing.  In the case of Detroit, the City’s prepetition restructuring proposal contemplated that general obligation bonds would be treated as general unsecured claims and swapped out for new debt.  If Detroit adopts a similar approach in its plan of debt adjustment, bondholders could face significant haircuts.  However, holders of bonds that are wrapped pursuant to insurance policies governed by New York law can take comfort that the monoline insurers should be required to make regularly scheduled principal and interest payments on the covered bonds.  This is true even if Detroit cancels the bonds under a chapter 9 plan and obtains a discharge from all pre-confirmation debt.  Similarly, if the Commonwealth of Puerto Rico and its instrumentalities restructure their debt or otherwise trigger a non-payment event under insurance policies governed by New York law, bondholders have a strong argument that the applicable insurer must provide coverage for any claimed losses that result from the restructuring.