Following a bankruptcy filing, the liens securing such revenue bonds are at risk of being terminated by Section 552(a) of the Bankruptcy Code, unless one of three exceptions applies.  Specifically, Section 552(a) generally does not terminate (i) “statutory liens”; (ii) liens on “special revenues”; or (iii) liens on the “proceeds” of prepetition collateral. 

In its opinion, the Third Circuit analyzed the application of each of these three exceptions to multiple different revenue streams serving as collateral for municipal bonds, ultimately concluding that neither the “statutory lien” nor the “special revenue” exception applied to any of the relevant revenue streams.  

However, the Court concluded that the exception for “proceeds” of prepetition collateral might apply to at least some of Chester’s bonds, and remanded to the bankruptcy court for further proceedings on that issue. While the matter has returned to the bankruptcy court for further review, this ruling has the potential to limit collateral for secured lenders unless they tailor the drafting of municipal liens to comply with the provisions of Section 552 of the Bankruptcy Code as well as this key Third Circuit ruling.

In 2009 and again in 2017, the City of Chester, Pennsylvania issued bonds secured by various revenue streams. These included the below revenue streams, which the Third Circuit referred to collectively as “Pledged Revenues”:

• “Slot Machine Revenues”:an annual slot machine license operation fee that the State of Pennsylvania collects pursuant to the Pennsylvania Race Horse and Development Gaming Act from a Harrah’s casino located in Chester, and a portion of which the State then pays to the City;
• “Table Game Revenues”:a “local share assessment” that the Gaming Act requires the casino to pay to the State on account of its table games, and a portion of which the State distributes to the City;
• “Additional City Consideration”:a sum that the Harrah’s casino agreed by contract to pay to the City, based on the casino’s monthly gross revenue from both table games and slot machines; and
• “Host Community Revenues”: fees paid to the City by a waste incinerator operator pursuant to an agreement that authorized the operation of a waste incinerator in the City.

The bonds were issued pursuant to two City ordinances enacted in 2009 and 2017, respectively. The 2009 ordinance provided that the Slot Machine Revenues were “irrevocably pledge[d]” to the bondholders. At the same time, Chester executed a “Contribution Agreement,” which granted a security interest in the Slot Machine Revenues. Similarly, the 2017 ordinance authorized the issuance of additional bonds, which were secured by an “irrevocable pledge” of Slot Machine Revenues, Table Game Revenues, and Host Community Revenues. The 2017 ordinance mandated the creation and execution of a Trust Indenture “under which the Bonds will be issued and secured.”

In November 2022, the City filed for chapter 9 bankruptcy protection in the U.S. Bankruptcy Court for the Eastern District of Pennsylvania. The City then commenced an adversary proceeding against the 2009 and 2017 bondholders, alleging that the liens securing their bonds did not extend to postpetition revenues because of Section 552(a) of the Bankruptcy Code.

As previously reported here, the Bankruptcy Court found for the City, ruling that Section 552(a) had in fact terminated the bondholders’ liens on all of the relevant revenues as of the time of the bankruptcy filing. The bondholders sought and obtained authorization to appeal this ruling directly to the Third Circuit.

Section 552(a) of the Bankruptcy Code

Section 552(a) of the Bankruptcy Code generally terminates most security interests in property acquired by a debtor after the date of the bankruptcy petition. There are three main exceptions to Section 552(a), which permit a prepetition lien to continue to attach to property acquired after the commencement of the bankruptcy case if:

• the prepetition lien is a “statutory lien”;
• the pledged revenues qualify as “special revenues” as defined in the Bankruptcy Code; or
• the postpetition collateral constitutes “proceeds” of prepetition collateral.

On appeal, the Chester bondholders argued that each of these three exceptions applied to the Pledged Revenues.  The Third Circuit addressed each exception in turn.    

“Statutory Lien” analysis

First, because Section 552(a) by its terms applies only to a “lien resulting from any security agreement,” Section 552(a) does not apply to a statutory lien that results from a statute rather than an “agreement.”  The Bankruptcy Code defines a “statutory lien” as one “arising solely by force of a statute on specified circumstances or conditions.”¹

On appeal, Chester’s bondholders argued that they had such a statutory lien arising from the two separate ordinances governing the 2009 and 2017 bonds.  The Third Circuit conceded that both ordinances did in fact “contain lien-creating language.”  However, the Third Circuit nonetheless concluded that each ordinance failed to create a statutory lien, because the liens granted by the ordinances “depend[ed] on the subsequent lien-creating language” in the related agreements.

Specifically, in the case of the 2009 ordinance, the Third Circuit held that the lien granted by the ordinance was dependent on the related “Contribution Agreement” through which the City “contributed” a portion of the Slot Machine Revenues to the relevant bondholder. The Third Circuit based that conclusion on the fact that the ordinance (i) “directed” the City to execute the Contribution Agreement and (ii) required the City to contribute Slot Machine Revenues to that bondholder “in accordance with the terms and provisions of [that] Contribution Agreement.”

In the case of the 2017 ordinance, the Third Circuit held that the lien granted by the ordinance depended on the related Trust Indenture governing the 2017 bonds, because the ordinance (i) “authorize[d] the execution and delivery of . . . the Trust Indenture” and (ii) provided that the Trust Indenture may “remove” any revenue streams from the Pledged Revenues “if necessary or desirable.”

Although the Third Circuit held that the particular relationship between the relevant ordinances and agreements in this case defeated the existence of a statutory lien, the Third Circuit did not go as far as the Chester Bankruptcy Court or some other courts in suggesting that a statutory lien and a contractual security interest can never co-exist on the same collateral.  In the absence of such a per se rule, the Third Circuit’s opinion should therefore leave room for litigants in future cases to argue for the co-existence of a statutory lien and a contractual security interest under different governing documents and different facts. 

“Special Revenues” analysis

Second, Section 928(a) of the Bankruptcy Code overrides Section 552(a) with respect to security interests in “special revenues.”  Section 902(2) of the Bankruptcy Code in turn defines “special revenues” to include “special excise taxes imposed on particular activities or transactions,” among other categories of “special revenues.”² However, the term “special excise taxes” is not defined in the Bankruptcy Code, and judicial guidance on the meaning of that term is limited. 

On appeal, Chester’s bondholders argued that each of the Slot Machine Revenues, Table Game Revenues, and Additional City Consideration qualified as “special excise taxes” protected from the application of Section 552(a).  In each case, the Third Circuit rejected those arguments.  

With respect to both the Slot Machine Revenues and the Table Game Revenues, the Third Circuit concluded that the relevant revenues constituted “fees” rather than “taxes,” and therefore could not qualify as “special excise taxes.”  In reaching this conclusion, the Court treated the issue of whether the relevant revenues constituted “taxes” as ultimately a question of federal law.  It then relied on federal caselaw defining a “tax” as “a pecuniary burden laid upon individuals or property for the purpose of supporting the government,”³ as opposed to a “fee,” which is a “charge . . . for a ‘benefit’ granted to the payor that is ‘not shared by  other  members  of  society.’”⁴ The Court concluded that both the Slot Machine Revenues and the Table Game Revenues qualified as “fees” under these definitions, because the casino paid them in exchange for “a benefit—operating slot machines and table games—not shared by other members of society.”  In addition, although state law was not dispositive, the Court noted that some of the applicable state statutes distinguished between taxes and fees, and referred to these charges as “fees,” reinforcing the conclusion that they constituted “fees” rather than “taxes.” 

With respect to the Additional City Consideration, the Third Circuit simply noted that the casino’s obligation to pay this consideration arose by contract, and that contractual obligations have long been held not to constitute “taxes.”

“Proceeds” analysis

Finally, Chester’s bondholders argued that Section 552(b)’s “proceeds” exception to Section 552(a) applied to the Pledged Revenues.  Section 552(b) permits prepetition liens to continue to attach to property acquired by the debtor after the commencement of the bankruptcy case if the postpetition property constitutes “proceeds” of prepetition collateral and the applicable security agreement provides for a lien on such proceeds. 

In the Bankruptcy Court, Chester’s bondholders argued that Section 552(b) applied because any postpetition Pledged Revenues constituted “proceeds” of their prepetition security interest in Chester’s right to receive such revenues. The Bankruptcy Court rejected this argument, holding that the applicable security agreements granted security interests only in the Pledged Revenues themselves, not in the right to receive such revenues.

The Third Circuit remanded this portion of the Bankruptcy Court’s decision. In the Third Circuit’s view, the Bankruptcy Court had not adequately addressed broad language in the 2017 Trust Indenture that granted the 2017 bondholders “a security interest in all of the right, title and interest of the City in and to the [Pledged] Revenues,” rather than only a security interest in the Pledged Revenues themselves. On remand, the Third Circuit instructed the Bankruptcy Court to “consider the issue of proceeds in light of this language.”

However, the Third Circuit also noted that the effect of even this broad contractual language could be mooted if the Bankruptcy Court chooses on remand to follow the reasoning of the U.S. District Court for the District of Puerto Rico in In re Fin. Oversight & Mgmt. Bd. for P.R., 385 F. Supp.3d 138 (D.P.R. 2019) (“Andalusian”), where the Puerto Rico District Court suggested that the Section 552(b) “proceeds” exception did not apply where the amount of the relevant postpetition proceeds was not determinable as of the bankruptcy date.

• The municipal bond market relies on the three major exceptions to Section 552(a)’s lien termination provisions to assess the bankruptcy risks associated with revenue bonds. The Third Circuit’s Chester opinion provides some potentially useful guideposts for analyzing the application of the three major exceptions to Section 552(a).
• In particular, with respect to the Bankruptcy Code’s “special revenues” exception, the Third Circuit provided some guidance on the difference between “special excise taxes” and “fees,” although it remains to be seen how feasible this distinction will be to apply in practice. Furthermore, the Third Circuit’s analysis focused only on the “tax” element of the term “special excise taxes.” The Court provided no guidance on what distinguishes an “excise” tax from other types of taxes, nor on what makes a particular excise tax “special.” Those issues therefore remain potential areas for future litigation.
• With respect to both the “statutory lien” and the “proceeds” exceptions, the Third Circuit employed a fact-specific analysis rather than establishing per se rules.
  • In the case of the “statutory lien” exception, the Court held that the relationship between the particular ordinances and agreements at issue negated the existence of a statutory lien, but did not go so far as to state expressly that a statutory lien and a consensual lien can neverco-exist on the same collateral.
    • Moreover, although the Court held that the statutory liens were ineffective because they “depended” on certain provisions of the related agreements, the fact that the liens “depended” on the agreements does not necessarily mean that they actually “arose by force of” the agreements rather than “solely” by force of the applicable ordinances. Both the ordinances and the agreements included separate lien-creating language, and the contractual language that the Court specifically identified as defeating the statutory liens related more to the nature and flow of the relevant revenue streams than to the actual creation of the liens. As a result, another court might reasonably have concluded that the statutory liens themselves “arose” independently of the lien-creation language in the applicable agreements and “solely by force of” the relevant ordinances, and there may be room for future courts to interpret the Bankruptcy Code’s “statutory lien” definition to accommodate financings involving statutory liens and security agreements.
  • On the issue of whether postpetition revenues constitute protected “proceeds” of a prepetition “right to receive” such revenues, the Court similarly rejected any per se rule as to whether an interest in a revenue stream comes with an attendant right to payment separate from the stream itself. Instead, the Court emphasized that “the correct approach is fact-intensive: Did the security agreement actually convey a right to be paid, or did it only convey the revenue itself?” Although the Third Circuit seemed to suggest that the broad language in the 2017 Trust Indenture probably did convey a security interest in the right to receive revenues, it left it to the Bankruptcy Court to address that issue in the first instance.
  • The Third Circuit’s fact-specific, non-categorical approach to these issues suggests that municipal market participants cannot rely on broad assumptions about the enforceability of statutory liens or liens on “proceeds.” Instead, they must carefully scrutinize the structures of particular transactions and the language of governing documents in order to assess whether liens on municipal revenues are likely to survive in a bankruptcy. Ultimately, the input of experienced legal counsel may be necessary in order to accurately assess the bankruptcy risks associated with a particular transaction or structure.
• In addition, the Third Circuit left open the possibility that the Bankruptcy Court on remand could adopt the reasoning of the Puerto Rico District Court’s Andalusian decision to limit the Section 552(b) “proceeds” exception only to “proceeds” determinable as of the date of the bankruptcy filing.  Broader adoption of Andalusian could be an unwelcome development for secured creditors, as it could effectively negate the Section 552(b) exception in many cases.  Market participants should therefore carefully monitor the treatment of Andalusian on remand, and in any subsequent appeal back to the Third Circuit.      
• The Chester ruling has the potential to limit secured lenders’ ability to collect on what they intended to be valid collateral.  Therefore, lenders should give close scrutiny to the drafting of their liens, the provisions of Section 552 of the Bankruptcy Code, and Chester and other critical court rulings.

Authored by Casey Servais, Ivan Loncar, Doug Mintz, Lary Stromfeld, and Tom Curtin.