Raphael Janove is an associate at Eimer Stahl LLP, where he practices a wide variety of commercial litigation. Before joining the firm, he worked as an associate at Sullivan & Cromwell LLP in New York City and clerked on the U.S. District Court for the Eastern District of Pennsylvania and the U.S. Court of Appeals for the Third Circuit.
Although certainly not in the fiscal clear, Illinois finally approved a budget this past summer, narrowly avoiding default. As part of the budget legislation, the State also enabled the City of Chicago to securitize its sales tax. As a result, this past October, Chicago formed the Sales Tax Securitization Corporation (the “STSC”), which issued hundreds of millions of debt on December 14, 2017. Chicago transferred its right to present and future tax revenues to the STSC. In exchange, creditors lend money directly to the STSC, and the sales tax secures that debt. The STSC in turn gives the money it borrowed to the City of Chicago. Because STSC debt is viewed as a lower risk, bankruptcy-remote investment, and is thus rated AA or higher, the interest rate is substantially lower than if the debt was issued directly by the City of Chicago. The City estimates it will save tens of millions in interest payments by using the proceeds of the STSC arrangement to refinance existing debt.
Despite these recent developments, the specter of default or bankruptcy still looms in the background. Illinois cannot file for bankruptcy unless U.S. Congress enacts a new law, which might be similar to the Puerto Rico Oversight, Management, and Economic Stability Act, under which Puerto Rico is currently undergoing bankruptcy. Similarly, Chicago and other cities in Illinois cannot file for bankruptcy under chapter 9 of the Bankruptcy Code unless Illinois changes its state law. If a new bankruptcy law applies retroactively to impair secured creditors’ existing liens, these creditors may find some protection from the U.S. Constitution’s Takings Clause.
Although Congress may enact “uniform Laws on the subject of Bankruptcies,” U.S. Const. Art. 1 § 8 cl.1, “the bankruptcy power is subject to the Fifth Amendment’s prohibition against taking private property without compensation.” United States v. Securities Industrial Bank , 459 U.S. 70, 75 (1982) (citing Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555 (1935)). The Takings Clause prohibits the U.S. Government (and states and municipalities via the Fourteenth Amendment) from taking “private property . . . for public use . . . without just compensation.” U.S. Const. Amend. V.
Accordingly, this Article explores the Takings Clause of the U.S. Constitution, and how much protection that Clause may actually give creditors in the event Illinois or Chicago files for bankruptcy or otherwise restructures its debt. This Article first explains the basics of the Takings Clause in bankruptcy. The Article then discusses potential Takings issues that could arise if Illinois and Chicago filed for bankruptcy, and what the impact might be on creditors of Chicago’s new STSC.
I. A Three-Part Takings Framework, In and Out of Bankruptcy There are two types of takings. A physical taking—the actual physical appropriation of property—always violates the Takings Clause if the government does not pay compensation. Murr v. Wisconsin , 137 S.Ct. 1933, 1942 (2017). The second type—a regulatory taking—occurs when a government regulation goes “too far.” Id. (quoting Pennsylvania Coal Co. v. Mahon, 260 U.S. 393, 415 (1922)). Thus, if a law or regulation “denies all economically beneficial or productive use of the land,” it categorically is a regulatory taking. Id. (quoting Lucas v. South Carolina Coastal Council, 505 U.S. 1003, 1015 (1992)). But where regulations do not deny all economic value of property, courts apply the Penn Central balancing test, weighing three factors to determine whether the regulation amounts to a taking. These factors include: “the economic impact of the regulation, the owner’s investment-backed expectations, and the character of the government action.” Id. (citing Penn Central Transp. Co. v. New York City, 438 U.S. 104, 123 (1978)).
In other words, there is a three-part framework to understand general takings law: 1) appropriating private property is a categorical physical taking, 2) a regulation that denies all economic value of the property is a categorical regulatory taking, and 3) a regulation, even if it does not deny all economic value, may amount to a regulatory taking under the Penn Central balancing test.
Takings in bankruptcy also operates by this three-part framework, as illustrated by three leading Supreme Court decisions:
1) A Categorical Physical Taking ( Armstrong v. U.S.)
A secured creditor’s interest is private property subject to the Takings Clause. Securities Industrial, 459 U.S. 70 at 75. Therefore, when a government physically appropriates the collateral subject to a lien, it has taken the lienholder’s property, requiring just compensation. See Id. at 77 (quoting Armstrong v. U.S. , 364 U.S. 40, 48 (1960)) (“The total destruction by the government of all compensable value of these liens, which constitute compensable property, has every possible element of a Fifth Amendment ‘taking.’”); see Koontz v. St. Johns River Water Mgmt. Dist., 133 S. Ct. 2586, 2599 (2013) (“[T]he government must pay just compensation when it takes a lien—a right to receive money that is secured by a particular piece of property”). In Armstrong, because the U.S. Government physically took the secured parties’ collateral—the debtor’s inventory and equipment (unfinished hulls and ship-making material)—without just compensation, it violated the Takings Clause.
2) A Categorical Regulatory Taking ( Securities Industrial Bank)
If U.S. Congress passes a bankruptcy law that completely destroys an existing lien, that law is a regulatory taking because it strips all value from the lien. Securities Industrial, 459 U.S. at 78 (“[T]here is substantial doubt whether the retroactive destruction of the appellees’ liens . . . comports with the Fifth Amendment.”). In Securities Industrial, a recently enacted federal bankruptcy provision allowed consumer-debtors to avoid liens in certain household property. As a matter of constitutional avoidance, the Supreme Court construed the bankruptcy provision to apply prospectively only.
3) The Penn Central Balancing Test ( Radford)
Radford is an early example of what eventually became known as the Penn Central balancing test, which, as mentioned, asks whether a regulation goes “too far” to amount to a regulatory taking. In Radford, a bankruptcy law retroactively allowed farmers to reclaim their foreclosed property for the present value of the property, not the amount of indebtedness. This was a regulatory taking because “[t]he right of the mortgagee to insist upon full payment before giving up his security [is] the essence of a mortgage.” Radford, 295 U.S. at 580. Though Radford was decided in 1935, nearly fifty years before the Penn Central balancing test, its reasoning echoes the principles underlying Penn Central. See Radford, 295 U.S. at 580 (“Statutes for the relief of mortgagors, when applied to pre-existing mortgages, have given rise, from time to time, to serious constitutional questions. The statutes were sustained by this court when . . . they were found to preserve substantially the right of the mortgagee to obtain, through application of the security, payment of the indebtedness. They were stricken down . . . when it appeared that this substantive right was substantially abridged.”).
In sum, bankruptcy-specific takings jurisprudence matches takings jurisprudence generally. Therefore, to analyze the various alleged takings claims of the creditors, we must sort the takings into three groups. 1) Was it a physical taking of collateral? 2) Was it a regulatory taking that deprived all economic value of the lien? 3) If not all economic value was deprived by regulation, did the regulation go “too far” under the Penn Central test?
As applied to a hypothetical Illinois or Chicago bankruptcy, the physical-takings analysis would apply to all collateral existing at the time of the bankruptcy filing. Illinois could not use the bankruptcy process to appropriate this collateral without providing just compensation. Similarly, any sales tax revenue sitting in Chicago’s Sales Tax Securitization Corporation at the time of a bankruptcy filing would be protected from appropriation by Illinois or Chicago.
The regulatory-takings analysis would apply to the extent it prevents a secured creditor’s lien from attaching to post-petition collateral. This could happen if a new law enables Illinois or Chicago to retroactively apply 11 U.S.C. § 552(a), a bankruptcy-code provision that prevents nonstatutory liens from attaching to future collateral, or 11 U.S.C. § 943(b), which allows liens to continue to attach to a government debtor’s postpetition “special revenues” less the debtor’s “necessary operating expenses.” The regulatory-takings analysis would also apply to the extent Illinois or Chicago, by legislation or otherwise, decides to reallocate its revenues to different agencies or functions.
Unfortunately for secured creditors, the Takings Clause does not provide much relief as to the retroactive application of these provisions or any action or legislation that impairs liens as to post-petition collateral. Because this is not a complete regulatory destruction of a lien, the Penn Central balancing test would apply, and under this test, most likely there would not be a regulatory taking.
The good news for secured creditors with a valid takings claim, however, is that the claim should be treated more preferentially than an unsecured claim. While in a private bankruptcy, a restructuring plan cannot be confirmed if it violates the payment priorities of secured and unsecured claims, for a government-debtor, any plan would be unconstitutional if it does not pay “just compensation” to those with takings claims. Moreover, unlike a secured creditors’ claim, which only applies to a debtor subject to the security agreement, a secured creditor could have a Takings Claim based on the value of its collateral as to any government entity that appropriates the collateral, regardless of any agreement between these two entities.
With these basic principles established, I now turn to the actual debt and which bondholders may claim protection from the Takings Clause.
II. Illinois BondholdersThis past summer, after overcoming the Governor’s veto, Illinois passed a budget with some tax increases to enhance revenue. In late fall it issued more debt, allowing the State from going over the financial precipice for the time being. If, however, Illinois one day needs bankruptcy relief, and the U.S. Congress passes legislation to enable it to do so, here is what the Takings Clause might mean for the three main types of Illinois bondholders.
1) General Obligation Bondholders: Illinois has long issued general obligation, unsecured debt, including a recent $750 million issuance in December 2017. Because these bondholders have only a contractual right to payment backed by a pledge by the State to repay, they have no property rights and thus no Takings Clause protections. However, a creative argument might be made that general-obligation bondholders have a lien, security interest, or some other form of a property interest as to Illinois’ General Obligation Bond Retirement and Interest Fund or “GOBRI Fund.” This is a separate fund within Illinois’ Treasury. By statute, Illinois must transfer from its general funds to the GOBRI fund the amount necessary to pay the next interest and principal payments on general-obligation debt. The Governor is also required to include, as a part of the appropriation process, the funds necessary to pay the GOBRI fund. Thus, the GOBRI fund arguably functions as security or collateral, and thus the Takings Clause might limit or prevent Illinois from appropriating the amounts existing in the GOBRI fund at the time of a bankruptcy filing.
2) Build Illinois Bondholders: Illinois has also issued Build Illinois Bonds, with billions in outstanding debt, and the owners of this debt have explicit security interests. The State also has a separate fund within its treasury dedicated to paying this debt, called the Build Illinois Bonds Retirement and Interest Fund or the “BIBRI Fund.” These are dedicated tax revenue bonds, and the holders of these bonds actually have liens on the BIBRI fund’s assets. Because these bondholders have a security interest, the Takings Clause would protect them, at least as to prepetition collateral—whatever exists in the BIBRI fund when the bankruptcy petition is filed. To the extent Illinois would alter or renege on its commitment to transfer future revenues to the BIBRI fund, the Penn Central regulatory-takings analysis would apply to see if such action went “too far” to amount to a regulatory taking of postpetition collateral.
3) Special Revenue Bondholders: Special revenue bonds are not direct obligations of the State. Rather, various state agencies have issued their own secured debt, the security being the revenues these agencies derive. For example, the Illinois Sports Facility Authority, which finances sports facilities in Chicago, has some $414 million in outstanding debt. Its revenues consist of its share of state hotel tax revenues, which Illinois remits to the agency. Other examples include the Metropolitan Pier and Exposition Authority and the Railsplitter Tobacco Settlement Authority. The owners of these revenue bonds can look to the Takings Clause to protect the existing collateral—the assets of these agencies—to the extent Illinois tries to restructure its debt problems by raiding these agencies’ assets. However, the Takings Clause may not protect these security interests as to future collateral. As with the BIBRI fund bondholders, the Penn Central regulatory-takings analysis would apply to the extent Illinois decides to no longer remit tax revenues or any other financial support to these agencies.
As a final note, pension debt forms a large part of Illinois’ debt burden. Unfortunately, for the pensioners, the Takings Clause may not provide much protection as this is not secured debt. The Illinois Constitution’s “pension protection clause,” IL Const. Art. XIII § 4 states that pension obligations are an “enforceable contractual relationship, the benefits of which shall not be diminished or impaired.” As this is contractual and not a property interest, neither the Illinois Constitution nor the U.S. Constitution’s Takings Clause will be of much use. The Bankruptcy Power can generally impair contracts notwithstanding the U.S. Constitution’s Contract Clause. Securities Industrial, 459 U.S. at 80. However, political pressure may effectively treat pension obligations almost as favorably if not more favorably than secured debt.
III. Chicago’s Sales Tax Securitization CorporationIllinois collects tax revenues on its municipalities’ behalves, but then remits to them the portion of the tax revenue to which they are entitled. As part of the 2018 Budget, Illinois authorized Chicago and other municipalities to irrevocably transfer the portion of tax revenues they receive from the State. 65 Ill. Comp. Stat. 5/8-13-10(a). Chicago used this new legislation in October 2017, transferring its tax revenues to the newly created STSC. This transfer is deemed an “absolute conveyance” and “the transferring unit shall have no right, title or interest in or to the transferred receipts conveyed and the transferred receipts so conveyed shall be the property of the issuing entity.” Id. Furthermore, the creditors of the “issuing entity”—here, those who loaned money to Chicago’s STSC—receive a “statutory lien” in the transferred sales tax revenues. 65 Ill. Comp. Stat. 5/8-13-11.
Now, Illinois deposits tax revenue directly in the STSC instead of the City of Chicago. Though it has retained some of its tax revenues, Chicago has given 100% of its home rule sales taxes to the STSC, which are service and retailer occupation taxes. Chicago has also transferred to the STSC 100% of most of its tax revenue on grocery food, drugs, and medical appliances. However, the STSC will remit to the City any funds leftover after it services the debt and pays its own operating expenses.
In the event of a bankruptcy filing—whether by Illinois, Chicago, the STSC itself, or all three together—the STSC’s creditors could invoke the Takings Clause to protect their interests in the STSC’s assets. The creditors would have a valid takings claim at least as to the tax revenues at the STSC at the time of filing. While this prepetition collateral is protected, the situation is less clear as to future tax revenues.
The STSC creditors have a “statutory lien” as defined by the Bankruptcy Code, so 11 U.S.C. § 552 would not cut this lien off from extending into the future tax revenues deposited at the STSC. Thus, if the STSC itself filed for bankruptcy, the liens would continue in the future. Similarly, if Chicago filed for bankruptcy, the City probably could not prevent the tax revenues from continuing to flow to the STSC and being subject to the STSC creditors’ liens. The STSC received Chicago’s right to tax revenues as an “absolute conveyance,” and not “a pledge or other security interest.” 65 Ill. Comp. Stat. 5/8-13-10(a). Assuming this transfer constitutes an absolute sale (though perhaps Chicago’s interest in the tax fund residuals makes the transfer a security interest instead of sale), then these tax revenues would not be part of Chicago’s bankruptcy estate and not subject to a bankruptcy court’s jurisdiction. Thus, at least insofar as only the STSC or Chicago were to file for bankruptcy, the secured creditors’ liens would continue to attach to future tax revenues transferred to the STSC.
However, if Illinois files for bankruptcy, the STSC creditors may lose out on future tax revenues. These creditors have a statutory lien only as to the STSC’s assets, which consist of the right to receive tax revenues from Illinois. They do not have any security interests with Illinois; they at most have a promise. Under the Act authorizing the transfer of Chicago’s sales taxes, Illinois “pledge[d] to and agree[d] with” Chicago and the STSC to not impair the continued transfer of sales tax. 65 Ill. Comp. Stat. 5/8-13-15. However “[i] n no way shall the pledge and agreements of the State be interpreted to construe the State as a guarantor of any debt or obligation subject to an assignment agreement.” Id.
Therefore, if in bankruptcy, Illinois decides to alter the amount of sales-tax revenue that it remits to the STSC or cease doing so altogether—perhaps by repealing or enacting new legislation—the Takings Clause may not protect the STSC’s creditors. The STSC itself would have an unsecured claim against Illinois for its failure to fulfill its nonimpairment promise and any recovery on that unsecured claim would inure to the benefit of STSC’s creditors. But, the STSC creditors would not have a secured or takings claim as to the future tax revenues the STSC lost. Thus, even though Chicago may not be able to use bankruptcy to get its revenues back from the STSC, Illinois could use its own restructuring process to free up the tax revenues it promised to transfer to the STSC instead of Chicago.
In sum, like many purported “bankruptcy-remote” investments, STSC creditors should be aware that despite the securitization structure and the protections of the Takings Clause, this debt may not fully escape the reaches of a bankruptcy proceeding.
IV. What is “Just Compensation” in Bankruptcy? Going forward, those investing in Chicago or Illinois debt should be mindful that the Takings Clause may protect the value of their liens only as to their prepetition collateral. The Clause may not be of much use to ensure liens will continue to attach to postpetition collateral. That said, however, a takings claim is more valuable than most other bankruptcy claims.
Where an Illinois or Chicago creditor has a valid takings claim, they are entitled to “just compensation.” Although not completely settled, a “just compensation” claim in a bankruptcy proceeding should be treated more preferentially than an unsecured claim. For example, in the City of Detroit bankruptcy, the Bankruptcy Court confirmed a chapter 9 plan that excepted the takings claim from discharge. See In re City of Detroit , 524 B.R. 147, 270 (Bankr. E.D. Mich. 2014). The Court allowed the takings claim to continue post-bankruptcy because this “harmonizes chapter 9 with the Fifth Amendment while giving full effect to the principle that the Court should avoid interpreting chapter 9 in such a way that renders it unconstitutional.” Id. It reasoned that allowing the City to impair the takings claim would violate the Fifth Amendment because “[t]he taken property here is not the creditor’s unsecured claim in bankruptcy. . . . [T]he City took, or allegedly took, the creditors’ property.” Id.
This reasoning makes sense. If a municipality could make a takings claim unsecured, then the Fifth Amendment’s protections become meaningless. If the government takes a secured creditor’s collateral, and by doing so makes that creditor unsecured, then its lien was worthless. The creditor is in no better position than if it were unsecured in the first place. Thus, the Takings Clause would have provided no actual protection to that creditor’s property interest. Accordingly, creditors have a strong case that a takings claim should be treated as secured or at least is entitled to preferential treatment over an unsecured claim (such as an administrative expense).
V. ConclusionHopefully Illinois and Chicago will never need to resort to a bankruptcy filing, and the above discussion is purely academic. However, all creditors who deal in municipal and government debt should be aware of the protections of the Takings Clause and its limits. Its protections are not too meaningful as to postpetition collateral, but as to prepetition collateral, it prevents a government from taking that security without paying its full value. Accordingly, those who deal in municipal debt should not rely primarily on future receipts to secure the debt, but should ensure to maximize the amount and value of existing collateral to which their liens attach.
Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.
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