Restructuring

Contributed by Brian Wells
In a recent decision, Oppenheimer AMT-Free Municipals v. ACA Financial Guaranty Corporation, the New York Appellate Division, First Department, held that a monoline bond insurer (ACA) that insured bonds issued by a municipal toll-road operator that later petitioned for relief under chapter 9 of the Bankruptcy Code was not relieved of its policy obligations where the issuer’s chapter 9 plan of adjustment canceled the original insured bonds and provided a distribution of new bonds without the insurer’s consent.  The First Department found that the court-ordered restructuring could did not change ACA’s policy obligations and noted that the risk of insolvency and bankruptcy was precisely what ACA had agreed to insure.  The First Department also disagreed with ACA’s argument that its subrogation rights had been rendered worthless by the restructuring, finding that any partial value received by holders from the issuer, including the value of the replacement bonds, would reduce ACA’s policy obligations.
Connector 2000 and the ACA Policies
The ACA policies at issue covered certain bonds issued by Connector 2000 Association, Inc. to finance the construction of a 16-mile toll highway in Greenville, South Carolina.  This debt was “back loaded,” so that Connector’s servicing costs would ramp up over time as toll revenues were given a chance to grow (with the assumption that they would grow as projected).  Thus, while debt service was initially $3.5 million per year, by 2008 that figure would reach $9.7 million and, by 2038, $59 million.  By 2001 (three years after completion of the highway), Connector’s toll revenues were failing to match projections.  Holders found their bonds illiquid, which prompted a large block to purchase secondary market insurance policies from ACA.
The policies generally functioned as most any other municipal bond insurance policy would.  In the event that Connector did not pay a particular obligation (i.e., a principal or interest payment) in full on its due date, ACA agreed to pay promptly the amount of the shortfall to a custodian.  A condition to a bondholder receiving payment from ACA was that it assign to ACA, upon payment, all its rights satisfied by the policy payment (i.e., the missed principal or interest payment).  If the issuer’s obligations on the insured bonds were accelerated, the policies permitted ACA, at its option, to accelerate its policy obligations and redeem the bonds.  The policies also provided that they were “non-cancellable” unless a policyholder voluntarily surrendered its interest in the policy.  Notably, the policies purportedly did not give ACA any “control rights” (which include, for example, the right to direct the vote of the insured bonds in a chapter 9 proceeding) until, and only to the extent, it made a payment on the bonds.
Insolvency and Chapter 9
As the years passed, Connector’s traffic continued to disappoint.  By January 1, 2010, Connector defaulted on its bond payments and, on June 24, 2010, Connector petitioned for chapter 9 relief.  The bond trustee submitted a claim in the amount of all outstanding principal and accrued interest (but not unmatured interest) on the insured bonds.  The bond trustee also negotiated the terms of a plan of adjustment and, ultimately, voted for that plan on the bondholders’ behalf.  The plan, which the bankruptcy court confirmed, required that the bondholders exchange their original bonds for new bonds in a lower principal amount and with later maturities.  ACA apparently did not participate in the plan negotiation or confirmation process, and did not otherwise consent to this treatment of the bonds.
The Dispute and Decision
Soon after the bond exchange, the custodian notified ACA that a claim would be made on its policies.  In response, ACA asserted that – as a result of the bond exchange – its policy obligations had ceased to exist.  Upon learning of ACA’s position, the Oppenheimer AMT-Free Municipals fund, which had amassed a sizable position in Connector’s (ACA-insured) zero-coupon bonds, sought assurances from ACA that it would make payments on the policies when due (roughly between 10 and 20 years into the future).  ACA declined to answer and a declaratory judgment action soon followed.
ACA made a number of arguments as to why it did not have to make any payments on its policies, including that the plan of adjustment, on which ACA had not voted and to which it had not consented, had materially altered the insured Connector bonds.  As support, ACA pointed to cases providing sureties with a common law defense to liability where a debtor or creditor alters an insured obligation without the surety’s consent.  The First Department rejected this argument given that the “alteration” at issue was a restructuring effected through a court-ordered plan, unlike the cases cited by ACA, which involved only private agreements between a debtor and creditor to modify an insured interest.  The First Department noted that the singular risk covered by the policies was that of Connector’s insolvency or bankruptcy.  To allow a bankruptcy restructuring to vitiate ACA’s policy obligations, the court reasoned, would allow ACA to avoid paying for the very risk that it undertook to insure – and for which it received premiums.  Notably, the court declined to hold that this common law defense could not apply to monoline insurers under different circumstances.
ACA also argued that, after the exchange and cancellation of the original bonds, its subrogation rights were “nullified” because there were simply no rights to which it could be subrogated, and the policies did not contemplate subrogation to the replacement bonds.  Accordingly, ACA argued, the bondholders could not satisfy the condition to payment that they assign their rights under the bonds to ACA.  The First Department disagreed with ACA’s characterization of its rights.  It found the replacement bonds “meaningful” for purposes of “subrogation rights and/or offsets to payment” because ACA’s payment obligations would be reduced by any value given to the holders by the issuer – including the value of new bonds.  In particular, the First Department held that because ACA had sole control over whether and when to accelerate its policy obligations, it could do so at a time when it believed the value of the new bonds was high, thus reducing the loss payable under the policies.
Conclusion
After this decision, insurers must think carefully before acting on the assumption that they will be relieved of their policy obligations because of changes to the underlying bonds.  At least on the Oppenheimer facts, the First Department has shown reluctance to find an insurer excused from its policy obligations where the obligations that had been insured were changed through a chapter 9 plan of adjustment.