Skeel: What is a Lien? Lessons from Municipal Bankruptcy

From the Introduction:

As the initial shock of Detroit’s bankruptcy filing has worn off, and the parties have attempted to tackle the major issues that stand in the way of a successful reorganization, an unlikely issue seems to keep coming up: what exactly is a lien? In ordinary bankruptcies, this question is not much in dispute. The parties may disagree on the value of the collateral securing the principal lender’s security interest, but it generally is clear whether the lender or other creditors do indeed have a property interest or its equivalent.

Not so in Detroit. Some of Detroit’s general obligation bondholders believed that their bonds could not be restructured, due to Detroit’s promise to use its “full faith and credit” to assure repayment. Even after it became clear that ordinary GO bonds are simply unsecured claims in bankruptcy, the holders of “unlimited tax” GO bonds insisted that they have a lien on Detroit’s ad valorem taxes, and this lien must be recognized in bankruptcy. The beneficiaries of Detroit’s two major pensions have insisted that they too are fully protected, due to a provision in the Michigan constitution stating that accrued pensions cannot be “diminished or impaired.”  In 2006, Detroit entered into a swap transaction designed to stabilize the interest rate it paid on bonds that were issued to plug a gap in its pension funding. The swap transaction was restructured three years later to give the counterparties a lien on Detroit’s casino revenues. This transaction too has raised lien-related issues.

One of the objectives of this Article is simply to sort through these issues, and to determine which of these creditors do have liens or lien-like protection. Answering this question will require an exploration of two related sets of concerns. First, what is the relationship between liens and lien substitutes—such as priorities and exceptions from bankruptcy’s automatic stay? As similar as liens and priorities are, the bankruptcy laws have long drawn a sharp distinction between state-created liens, which are honored in bankruptcy; and state-created priorities, which are not. We will want to consider why this is so.

The second question is the question in my title: what is a lien? The dictionary defines a lien as the “right to take and hold or sell the property of a debtor as security or  repayment for a debt.” Not a bad definition, but whether a purported lien actually is a lien is not always clear, especially in the municipal context. Shortly before the little town of Central Falls, Rhode Island filed for bankruptcy, the Rhode Island legislature passed a statute giving general obligation bondholders a lien on all of a municipality’s ad valorem taxes and general revenues—that is, on nearly all of the municipality’s revenues. Blanket liens are hardly unheard of; most small businesses and many large ones have lenders who have a security interest in most or all of their assets. Yet despite using the language of liens, the Rhode Island statute seems to function more like a priority rule than a traditional lien. The breadth of the statute raises the question whether a court should decline to honor a statutory lien if it does not serve the functions of a traditional lien.

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