05.16.14

In Parallel Universes. Two of the nation’s cities – one in California and one in Michigan – have each been in parallel federal courtrooms this week as part of their respective efforts to not just exit municipal bankruptcy, but also to put together and gain judicial approval of respective plans of adjustment that would provide for sustainable futures. Each is struggling with overwhelming pension debt, and each has achieved significant agreement from almost all its creditors on its respective plans for successfully exiting municipal bankruptcy. Yet they have proposed plans that are very different—especially on the issue of public pension system obligations—and whether—in two states where such obligations are constitutionally protected, they may be impaired. Nonetheless, U.S. Bankruptcy Judge Christopher Klein this week noted that Stockton’s public pension obligations are a “festering sore”—a sore, he added, which “We got to get in there and excise.” In contrast, Detroit and most of its retirees and pensioners have agreed to “haircuts” in the Motor City’s pension obligations—agreements incorporated in the city’s current plan of adjustment. These twin cases about the future of these cities and their respective plans—especially with regard to their daunting pension obligations—are certain to have significant repercussions for almost every state and local government because of the potential impact on the $3.7 trillion municipal bond market: decisions in these municipal bankruptcy cases could have a contagion effect by sharply raising the perceived threat to investors, thereby comparably raising the cost of capital finance for all states and local governments.

Taking Stock on Stockton, Day III. Whether and when Stockton can earn federal approval to emerge from bankruptcy must await another day. U.S. Bankruptcy Judge Christopher Klein, noting, yesterday, that “[D]uring some of (the questioning) I thought I was sitting in depositions,” nevertheless concluded “this is an important case, and I want everyone to have a fair opportunity. I will add a fifth day, but no more than a fifth day (which will be June 4th).” This week’s trial, which has been focused on the city’s sole objector to its plan of adjustment, has been complicated by Judge Klein’s willingness to consider whether or not its public pensions can be impaired. He has in the past rejected a contract impairment argument, noting that the constitutional prohibition against contract impairment does not apply in the bankruptcy arena—indeed, whether the city’s proposed plan can be fair and feasible if it exempts any haircut to its pensions. That consideration has been further evidenced by testimony this week by Charles Moore, who has served as an adviser to Detroit in its bankruptcy adjustment planning effort, who told the court this week that Stockton could afford to pay its holdout creditor, Franklin Templeton, more than pennies on the dollar, noting that the city’s proposed plan proposes giving other creditors significantly more than the proposed pennies on the dollar it has proposed to pay two funds managed by Franklin Templeton, adding that he views Stockton’s pension obligations as “high, growing and unpredictable,” adding: “If there is a willingness to pay, there is cash in the forecast to pay Franklin…The key point is willingness to pay.” While the city’s pending long-term fiscal plan proposes to amass strong cash reserves, along with contingency funding; Mr. Moore countered that once the city reached a level of financial health, all additional money would forever more filter into the contingency reserves, instead of paying down the Franklin bonds. That marked a significant contrast with Robert Leland’s testimony earlier this week. Mr. Leland, a financial adviser for Stockton, testified that the extra financial cushion was required for economic downswings, explain: “That’s when you want to be most protected,” adding that to realize a sustainable future, the city needed to be prepared to confront what he called a “daunting array of needs that the city has not funded.” But Mr. Moore, describing to the court the parallel challenges in the Motor City, also testified that Stockton’s apprehensions that reducing pension and post-retirement health care benefits might harm Stockton’s ability to recruit public employees, also testified that the loss of public employees had also been a concern in Detroit, where U.S. Bankruptcy Court Judge Steven Rhodes ruled in December that Detroit may legally reduce public pension benefits, despite Michigan’s constitutional protection of public pensions: “There was a strong belief that if anyone tried to touch accrued benefits that all the employees would leave. We have not seen that…” We’ve made sure we have a package that is going to attract employees going forward.”

The Billion Risks Ahead & The Fine Art of Municipal Bankruptcy. Even as efforts are proceeding in the State Capitol, Lansing, to put together a package of 11 bills to be incorporated as part of Detroit’s exit plan from municipal bankruptcy, U.S. Bankruptcy Judge Steven Rhodes yesterday in court commented during a hearing in his courtroom that he had heard that the state had promised to give Detroit some money — but only if the city could get him to approve its bankruptcy exit plan by the end of September. Noting that there were “a bazillion things that could happen between now and Sept. 30,” Judge Rhodes noted state lawmakers needed to understand he could not guarantee meeting such a deadline. The Motor City is currently scheduled to follow Stockton in July to trial to seek federal approval of its plan of adjustment—but Detroit’s case involves an unprecedented number and complexity of objections―numbers far exceeding the lone holdout, Franklin Templeton, in Stockton.  Yesterday’s hearing before Judge Rhodes had been originally scheduled to focus on the arguments of two bond insurers, Syncora and the Financial Guaranty Insurance Company that back Detroit’s shakiest debt — about $1.4 billion of certificates issued in 2005 and 2006 to raise money for Detroit’s pension system―with the city claiming the two have no valid claim in the bankruptcy, but that it has offered to accept 40 percent of the certificates as valid if the creditors in this group will vote for its overall plan of adjustment (which would be a small recovery, albeit far greater than Stockton has proposed for Franklin Templeton). Along with the two insurers are several European banks that bought certificates that were not insured. FGIC has responded with a counterclaim, arguing  its 2005 transaction with the city was legal—but that should Judge Rhodes find it was not, then Detroit’s pension system would be forced to disgorge the $1.4 billion and remit it back to the investors—an outcome which would virtually doom any successful exit from the nation’s largest municipal bankruptcy. In the courtroom yesterday, Judge Rhodes, after questioning Financial Guaranty’s lawyer about its counterclaim, said he would issue a written opinion later on whether the insurer could proceed. In addition, Judge Rhodes granted limited permission to FGIC’s request to determine whether investment bankers can improve on Detroit’s proposal to raise money connected to the city’s art collection, ruling that FGIC could work with officials of the Detroit Institute of Arts on evaluating artwork that the museum now has in storage; but Judge Rhodes barred the firm from removing any of the works on display to have them appraised and denied the creditors’ motion seeking detailed records of how the art came to be in the museum’s collection, and, reportedly, adding that FGIC could buy a ticket to the museum instead. The creditors are seeking to prove that the art is worth far more than the city and state of Michigan claim, which would, then, enable them to ruin the so-called “grand bargain” being crafted in Lansing—and upon which nearly all of the settlements the city has won with labor parties, including unions, retirees, and its two pension funds, have been built. In its statement issued after the ruling, FGIC said it, nevertheless, remains hopeful that alternative bids will remain on the table: “We were hopeful that the city would cooperate fully with the four parties that expressed in entering into transactions that would monetize the art, which could generate up to $2 billion…However, we are pleased the judge will hold the DIA to its commitment to allow access to the art not on display, and hopefully this ruling will not impair the alternative proposals. We maintain that the drastically undervalued DIA settlement under the ‘grand bargain’ places politics over the financial and legal realities of the situation and will almost certainly result in drawn-out litigation that no one wants.” Together, FGIC and Syncora could lose more than $1 billion under Detroit’s pending plan of adjustment.

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