Restructuring Municipal Debt in India for Financial Sustainability
Harshitha Ulphas
LL.M. (Insolvency and Bankruptcy Laws), NALSAR University of Law & Indian Institute of Corporate Affairs (IICA)
Introduction
Municipal bonds have gained significant traction in India, with the country having 29 active municipal bonds listed on the NSE’s IBMX index. These debt instruments serve as a promising avenue for raising capital to fund crucial public infrastructure and service projects. Yet, while it may be tempting to view the debt obligations associated with these bonds as fool proof due to the sovereign backing of the issuer, such assumptions may prove imprudent. Challenges such as revenue generation shortfalls and project delays can cast doubts on the reliability of these obligations. However, perhaps the most looming threat lies in the potential for municipal corporation bankruptcy, a risk that cannot be ignored.
NSE’s index services subsidiary, NSE Indices Limited, made a debut on 24.02.2023 by unveiling India’s inaugural Municipal Bond Index, christened the Nifty India Municipal Bond Index, during a noteworthy SEBI workshop on Municipal Debt Securities held in Bengaluru. This pioneering index serves as a vigilant observer of the performance of municipal bonds emanating from Indian municipal corporations, spanning various maturity periods and boasting investment-grade credit ratings. Comprehensively curated, the index encompasses municipal bonds meticulously issued in accordance with the stringent guidelines delineated in the Securities Exchange Board of India Issue and Listing of Municipal Debt Securities Regulations of 2015. Presently, the index features 29 municipal bonds, collectively issued by 10 esteemed entities, all fortified with an AA credit rating[i]. The constituent bonds within the index are judiciously weighed and their significance is determined by their outstanding amount.
The Indian municipal bond market has undergone a remarkable renaissance since the enforcement of the Securities and Exchange Board of India (Issue and Listing of Municipal Debt Securities) Regulations in 2015[ii]. This resurgence is testament to a renewed governmental focus on municipal finance, thereby posing various benefits and threats. This paper seeks to delve deep into the above mentioned looming threat and concern with respect to its reliability, that is bankruptcy of the municipal corporation.
Municipal Bonds- The Concept
Before delving into the intricacies of the potential problem pertaining to bankruptcy of a municipal corporation, it is pertinent to understand the meaning of municipal bonds.
Municipal bonds serve as indispensable tools for financing public projects and utilities, orchestrated by government entities at the local level in India. These debt instruments beckon investors by extending the opportunity to lend funds to municipal corporations or associated bodies. In return, investors receive regular interest payments and the eventual reimbursement of their principal upon bond maturity.
These bonds come in two primary forms: General Obligation bonds and Revenue Bonds. The former deals with general development endeavours, drawing revenue from property taxes and revenue cess, while the latter earmarks funds for specific projects like educational institutions and water treatment facilities, leveraging revenues generated by these projects.
One of the alluring aspects of municipal bonds lies in their potential tax benefits, particularly the exemption of interest income from income tax.[iii] This feature renders municipal bonds particularly attractive to investors situated in higher tax brackets. However, the credibility of municipal bonds hinges upon the reliability of the respective government entities in repaying debts, underscored by investment-grade ratings bestowed by credit rating agencies. For instance, entities like the New Delhi Municipal Council and Navi Mumbai Bonds boast commendable AA+ ratings, affirming their creditworthiness.[iv]
The Securities and Exchange Board of India (SEBI) introduced revised guidelines in 2015 aimed at facilitating Urban Local Bodies (ULBs) or local government bodies in sourcing finances through municipal bonds.[v] These guidelines mandate various prerequisites, including ensuring the absence of negative net worth and prior defaults, as well as barring group companies, promoters, and directors enlisted in the wilful defaulters’ list published by the Reserve Bank of India (RBI).
However, despite initial issuance with sound ratings, the fluctuating financial performance of municipal corporations in the secondary market can impact bond prices. While robust performance may lead to price appreciation, faltering financial health could precipitate a decline in bond prices. Thus, vigilance and prudence remain paramount in navigating the municipal bond market landscape.
Understanding Municipal Finance in India
The historical context of municipal finance in India has been shaped by various factors, including the mounting fiscal strain of sovereign governments, increasing urbanization, and democratic decentralization. Reform initiatives in recent years have focused on structural, institutional, and regulatory changes across sectors to address these challenges. The late 1980s marked the beginning of significant developments in India, setting the stage for the first generation of reforms aimed at enhancing the financial empowerment of urban local bodies.
One key aspect of municipal finance in India is the development of a municipal bond market to finance urban infrastructure projects.[vi] The limited success of municipal bond markets in India, even a decade after the decentralization initiative through the 74th Constitution Amendment Act, has been a notable issue. Various problems and constraints have been encountered in developing the municipal bond market, hindering its full potential.
Efforts have been made to address these challenges and facilitate the growth of the municipal bond market in India. The reform initiatives adopted in recent years have focused on making urban local bodies financially sound and disciplined, with the aim of enabling the development of a robust municipal bond market.[vii] These initiatives are crucial for enhancing the financial capacity of urban local bodies and promoting infrastructure financing through the capital market.
Despite the challenges faced, there have been some positive experiences and lessons learned from the municipal bond market in India. Instruments issued by municipal corporations have mainly been through private placements, with subscriptions from various financial institutions and entities. Notably, issues have been made without state government guarantees in several cases, indicating a level of financial independence and creditworthiness among municipal bodies.
The development of the municipal bond market in India has also been supported by measures at both the central and state levels. Encouragement and support from state governments have played a role in promoting the growth of the market. Central-level reforms have been categorized into first and second-generation reforms, with the Constitution (Seventy-fourth) Amendment Act, 1992, recognizing urban local bodies as the third tier of government. While expectations for financial empowerment of urban local bodies have not been fully met, there is a recognition of the importance of fiscal decentralization in aligning with functional decentralization principles.
Therefore, the historical context of municipal finance in India reflects a complex landscape of challenges and opportunities. The development of a municipal bond market holds significant potential for financing urban infrastructure projects and enhancing the financial capacity of urban local bodies.[viii] While there have been constraints and limitations in the growth of the market, ongoing reform initiatives and lessons learned from past experiences provide a roadmap for further progress in municipal finance in India.
Challenges faced by Municipal Corporations
It is pertinent to note that the municipal corporations in India face several challenges that affect their ability to provide urban infrastructure and services effectively. Primarily, they often don’t have enough money to spend on building things like roads or running services like garbage collection. This makes it tough for them to keep up with the increasing demands from people living in cities. Plus, they rely heavily on money from outside sources, which can limit their independence and make it hard to keep going financially. Another issue is that many municipal corporations don’t have good systems for keeping track of money. Without this, it’s hard for them to make smart decisions about where to spend money and how to plan for the future.
Some of these specific challenges include:
- Weak Finances- Municipal corporations often struggle with limited funds, making it hard for them to invest in infrastructure projects and provide essential services to urban residents. They heavily rely on external sources of revenue, which impacts their financial independence and sustainability.
- Inadequate Information Systems- Many municipal corporations lack robust systems for collecting and analysing financial data. This makes it difficult for them to make informed decisions and plan their finances effectively.
- Difficulty Accessing Funds- Weak finances and inadequate information systems make it hard for municipal corporations to access funds from the capital market. The structure of urban governance in India also limits their ability to secure funds for infrastructure projects.
- Non-commercial Approach to Services- Municipal corporations often provide urban services at low costs, which affects their financial sustainability. They rely heavily on subsidies and struggle to generate enough revenue to maintain and expand essential services.
- Disparity in Revenue Sources- While tax revenues contribute significantly to municipal revenues, there’s a growing gap between tax and non-tax revenue sources. This disparity highlights the need for municipal corporations to diversify their revenue streams.
- Lack of Viable Projects- Municipal corporations face challenges in developing commercially viable water and sanitation projects. Without well-structured projects, they find it hard to attract investment from capital markets to address infrastructure needs.
In order to overcome these challenges, municipal corporations need to improve their financial management systems, enhance revenue generation mechanisms, and develop commercially viable projects[ix]. By doing so, the financial resilience of the municipal corporations can be enhanced equipping them to better serve the needs of urban residents.
Municipal Bonds and Bankruptcy Protection
In India, as discussed, municipal corporations face a bunch of problems that affect how well they can manage money and provide services in cities. In addition to the problems already discussed, getting money from banks or other big sources is also tricky for municipal corporations. They might not have enough money saved up, and the way cities are run in India makes it tough for them to borrow money from big markets.
Another big challenge is that municipal corporations often don’t charge enough for services like water or garbage collection to cover all their costs. This means they have to rely on help from the government or other sources to make ends meet, which can be tough. In addition to this, there isn’t much clear guidance on what happens if a municipal corporation runs out of money and can’t pay its debts. This can make things tough and uncertain for people who lend money to them because they might not get paid back.
Even though municipal bonds are seen as safe, there have been cases, like in Detroit in 2013. Before filing for bankruptcy, Detroit had released a range of bonds, including General Obligation bonds supported by taxation authority and Revenue bonds tied to revenue from particular projects. The city’s financial woes, arising from issues such as population decline and escalating pension expenses, led to a significant budget shortfall, prompting it to seek refuge in Chapter 9 bankruptcy in July 2013. Chapter 9 facilitated the restructuring of debts without requiring the city to sell off its assets, allowing negotiations with creditors overseen by the court. This ensured the development of a fair repayment strategy while safeguarding crucial services. Detroit successfully emerged from bankruptcy in 2014 following the approval of a financial restructuring plan by a federal judge.
However, India’s Insolvency and Bankruptcy Code (IBC) doesn’t have rules like Chapter 9 in the U.S., which worry about safeguarding people who invest in municipal bonds during bankruptcy. Even SEBI doesn’t offer guidance on what happens when municipalities go bankrupt or can’t pay back their debts. Regulators seem to trust that these municipalities will always pay back their debts because they’re part of the government, and they don’t want to interfere with how states run things. This is similar to what happened with Chapter 9 in the U.S. Initially, the law for municipal bankruptcy in 1934 was found unconstitutional because it interfered with states’ powers.[x] Congress changed the law in 1937, and it was held as constitutional in the case of United States v. Bekins.[xi]
Chapter 9 stands out due to its tailored design specifically for municipal bankruptcies, setting it apart from other bankruptcy chapters. It institutes an automatic stay, halting any associated claims or legal actions against the debtor. This stay provides crucial breathing room for the municipality to assess its financial situation without the added pressure of ongoing litigation.
Moreover, the provisions within Chapter 9 impose limitations on the court’s interference with the municipality’s powers during the bankruptcy proceedings. For instance, the court refrains from meddling with the municipality’s ability to borrow funds, recognizing the necessity of maintaining its financial autonomy, especially since the municipality represents a sovereign entity. Similarly, the court is barred from converting the proceedings into a liquidation process, preserving the municipality’s ability to continue operating and serving its constituents.
These restrictions are not arbitrary; rather, they are crafted to uphold the constitutional standing of Chapter 9 within the broader legal framework. Given that the municipality is considered a sovereign borrower, it is imperative to safeguard its autonomy and integrity throughout the bankruptcy process.
Consequently, within the Chapter 9 framework, the onus falls on the municipal debtor to propose a comprehensive plan to adjust its debt. This requirement underscores the proactive role expected of the municipality in navigating its financial challenges. Notably, creditors are barred from submitting their own plans under Chapter 9, emphasizing the municipality’s central role in devising a viable path forward.
This unique structure fosters an environment conducive to negotiation and restructuring, allowing stakeholders to collaboratively develop a sustainable debt repayment plan tailored to the municipality’s specific circumstances. This flexibility and collaborative approach are instrumental in addressing the complexities of municipal debt.
However, it’s crucial to note that Indian law lacks a similar guarantee or framework for municipal bankruptcies. This absence underscores the need for comprehensive legal provisions that offer municipalities the necessary support and guidance in managing financial crises effectively.
The problem gets worse because the rules for general bankruptcies in India don’t match up with the rules for municipalities. Municipalities are controlled by state governments (Entry 5, List II), while bankruptcy laws are made by the central government (List I). Each state has its own laws for how municipalities can borrow money, like issuing bonds. These laws say what the money can be used for and what kind of security the bondholders have. Some laws also say that municipalities have to keep money in a ‘sinking fund’ to pay back their debts. But it’s not clear if this money can be used for other things, like if the municipality wants to issue other kinds of bonds.
While there are some rules about who gets paid first if there’s a problem. But these are rare and might not apply in a real bankruptcy. Municipal bonds in India are seen as ‘secured’ debt, meaning there’s something valuable backing them up, like land or buildings. But the laws don’t say how important these claims are compared to other debts. The secured creditors are fifth in line to get paid back under Section 53 of the IBC, which has also been upheld in multiple cases, including the PVVNL v. Raman Ispat.[xii] However, this is the case for general bankruptcies, not for bankruptcies of municipalities. So it’s not clear what would happen if a municipality went bankrupt. For instance, in the U.S., bonds offered by Detroit were supposed to be paid back before other debts i.e they were to be paid as per highest priority, however, during bankruptcy, they were treated like other debts, causing problems for bondholders after the manager for Detroit concluded that bonds were unsecured in nature, thereby completely rejecting the contention on ad valorem taxes. The city had to restructure its debt to make things right with a lien on taxes from the city’s casinos[xiii]. This elucidates that India might face similar problems if a municipality goes bankrupt, however, unlike the U.S., there aren’t clear rules for how to fix it.
The restructuring in Detroit appears to echo the practices seen in certain Acts in India, where corporations pledge security for bondholders when issuing bonds. However, neither these Acts nor the IBC outline a clear process for negotiating or potentially restructuring the said municipal debt. This lack of clarity may unsettle bondholders, as municipal bankruptcies could encounter conflicting interpretations or insufficient legal frameworks governing municipal corporations and bankruptcy proceedings.
Additionally, some municipal corporations supplement sinking funds with specific escrow accounts to manage their debt. For example, the Pune Municipal Corporation maintains a ‘no-lien escrow account’ for debenture payments.[xiv] This illustrates that, structurally, municipal bond arrangements typically do not initially grant bondholders a claim on municipal property. Consequently, concerns related to liens may arise, as creditors may worry about recovering their investments in the event of bankruptcy.
Legal and Institutional Challenges
There are three primary concerns that need to be dealt with. Firstly, as per the article by Adam Feibelman and Bhargavi Zaveri-Shah[xv], that municipal finances in India are not doing well. For example, from 2007 to 2008, municipal revenues stayed at around 1% of the GDP, which is much lower than in other similar countries. Municipal bodies, like urban local bodies (ULBs), rely a lot on grants and loans from state governments. They haven’t been investing enough in important infrastructure projects. The pandemic has made this financial situation even worse. So, it’s likely that municipal debt will keep growing as municipalities try to find more money.
Secondly, India doesn’t give clear ways for dealing with municipal debt problems. If a municipality can’t pay its debts, there’s no clear plan for what happens to the people it owes money to, like bondholders, banks, employees, and vendors. On one hand, this could mean that powerful creditors might take control of public assets owned by the municipality, leading to privatisation. On the other hand, it means there’s no way to quickly recognize when a municipality is in financial trouble and try to fix it. The pandemic and the increasing amount of borrowing by municipalities make these problems even worse.
Thirdly, the usual way of restructuring debt for private companies doesn’t work for municipal bodies because they provide public services, and most of their work is meant for public use. Some other countries have laws specifically for dealing with distressed municipal bodies. One such is the already discussed, i.e Chapter 9 of the U.S. Bankruptcy Code. Chapter 9 has been used by over 100 municipal entities to deal with their financial problems, even though there has been significant opposition to it. It’s a rule-based process, but is flexible enough to deal with the complicated mix of financial and social problems that municipalities face. It also brings up important questions that should be talked about when dealing with financially troubled municipalities.
While it is essential to have a municipal debt restructuring mechanism owing to the significant municipal debt in the country, there are certain challenges that need overcoming. Some of them are:
- While bankruptcy laws are part of both central and state governments’ responsibilities, municipal governance falls under the State List. So, making a national bankruptcy law for municipalities will bring up complex questions about how much control states should have.
- The way the courts would have to get involved in a municipal bankruptcy is very different from how it works in other/ general bankruptcies, wherein mechanisms already exist for the latter. This could mean adding to the current laws about how bankruptcies are handled to include how municipal bankruptcies are to be dealt with.
- Concerns regarding what kind of help a municipality can get during a bankruptcy in terms of increasing taxes as a part of the Resolution Plan, sale of public property, potential for privatisation, etc. However, it is essential to note that these decisions usually made by the city government or state, not by a bankruptcy court or Adjudicating Authority in the Indian context.
Conclusion
In conclusion, the rise of municipal bonds in India, facilitated by the SEBI’s regulations and the introduction of indices like the Nifty India Municipal Bond Index, marks a significant milestone in municipal finance. However, amidst the promising avenues for infrastructure funding that municipal bonds offer, there lurks a looming threat of municipal corporation bankruptcy.
Municipal bonds, crucial for financing public projects, are attractive to investors due to their tax benefits and perceived security backed by government entities. Yet, the fluctuating financial performance of municipal corporations, coupled with the absence of clear legal frameworks for municipal bankruptcies, raises questions about the reliability of these investments.
Drawing parallels with the Chapter 9 bankruptcy framework in the U.S., it is evident that there is a need for tailored mechanisms to address municipal financial distress effectively. However, India’s legal landscape lacks such provisions, posing significant challenges for stakeholders in the event of municipal defaults. Furthermore, the complex interaction between central and state governments, coupled with the distinct nature of municipal finance, underscores the need for nuanced approaches to address bankruptcy concerns. While reform initiatives and lessons from international experiences provide valuable insights, navigating the legal and institutional challenges demands careful deliberation and collaboration among policymakers, regulators, and states.
In light of the severe impacts of the COVID-19 pandemic and the deteriorating state of India’s cities, the urgency to establish a clear municipal bankruptcy framework cannot be overstated. It is imperative to recognize the growing significance of municipal bonds as assets held by Indian households and to ensure adequate safeguards for investors amidst evolving financial landscapes.
Moving forward, policymakers must engage in prolonged negotiations with states, akin to the enactment of the GST framework, to address legal and institutional hurdles effectively. By fostering dialogue and pursuing comprehensive reforms, India can lay the groundwork for a robust municipal debt restructuring mechanism that aligns with the principles of fiscal decentralization, financial resilience, and investor protection.
References:
[i] NSE Portfolio, https://niftyindices.com/Portfolio/Nifty_IndiaMunicipalBondIndex_Portfolio.pdf.
[ii] SEBI, Securities Exchange Board of India, (Issue and Listing of Municipal Debt Securities), Regulations, 2015, https://www.sebi.gov.in/legal/regulations/sep-2019/securities-and-exchange-board-of-india-issue-and-listing-of-municipal-debt-securities-regulations-2015-last-amendment-on-august-03-2021-_34611.html.
[iii] Section 10(15)(vii), Income Tax Act, 1961.
[iv] Press Information Bureau, https://pib.gov.in/newsite/printrelease.aspx?relid=159951.
[v] Government of India, Guidance on use of Municipal Bond Financing for Infrastructure projects, (2017) https://www.pppinindia.gov.in/report/Guidance%20on%20use%20of%20Municipal%20Bonds%20for%20PPP%20projects.pdf_1685082702.pdf.
[vi] Soumen Bagchi, Financial Implications of Decentralisation: Issues Concerning Resource Mobilisation by Urban Local Bodies, Artha Vijnana, Vol XLII, No 4. (2000)
[vii] Gunja Kapoor, Padmaja Pati, Discussion Paper- Municipal Bond Market in India, (2017) https://pahleindia.org/wp-content/uploads/2022/12/Municipal-Bond-Market-in-India.pdf.
[viii] Soumen Bagchi, Financial Implications of Decentralisation: Issues Concerning Resource Mobilisation by Urban Local Bodies, Artha Vijnana, Vol XLII, No 4. (2000)
[ix] Gunja Kapoor, Padmaja Pati, Discussion Paper- Municipal Bond Market in India, (2017) https://pahleindia.org/wp-content/uploads/2022/12/Municipal-Bond-Market-in-India.pdf.
[x] US Courts, Chapter 9- Bankruptcy Basics, https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-9-bankruptcy-basics.
[xi] 304 U.S. 27 (1938).
[xii] PVVN v. Raman Ispat Private Ltd., (2023) ibclaw.in 81 SC.
[xiii] David A. Skeel Jr, What is a Lien? Lessons from Municipal Bankruptcy, All Faculty Scholarship, University of Pennsylvania Carey Law School (2015), https://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=2388&context=faculty_scholarship.
[xiv] Presentation by CMA Ulka Kalskar, Chief Finance and Accounts Officer at the Pune Municipal Corporation, https://www.thegpsc.org/sites/gpsc/files/session_b2_03_ms._ulka_pune_municipal_bonds.pdf.
[xv] Adam Feibelmen and Bhargavi Zaveri-Shah, Resolving Municipal Distress In India (2021), https://www.ibbi.gov.in/uploads/whatsnew/1d8b31fc65f7ac6f09a973be8f12f868.pdf.
