The Expensive Challenge of Finding the Right Outcome in Municipal Bankruptcy

September 9, 2014
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Fourth Lap. Detroit continued to cull through its list of twenty-five planned witnesses in the hearings on the city’s bankruptcy plan of adjustment yesterday, with a key—and depressing—focus on the state of the city’s technology and information systems. Beth Niblock, a former information technology chief for the city of Louisville, who was recruited earlier this year by Mayor Mike Duggan, testified that the city’s information technology is “generations behind” current standards, noting, for instance, that employees send emails, but emails that never arrive in the recipient’s inbox. Drawing a devastating image for U.S. Bankruptcy Judge Steven Rhodes of the city’s computers, software, and email system, Ms. Niblock testified the city’s systems are also extremely susceptible to cybersecurity attacks, adding that the system is so out-dated that it hampers the city’s ability to issue paychecks, collect taxes, communicate internally, and dispatch police and firefighters: “It is fundamentally broken or beyond fundamentally broken…In some cases fundamentally broken would be good.” Emergency Manager Kevyn Orr and the city’s legal team has been using this portion of the trial to justify the plan’s proposal not just to obtain the federal court’s approval to eliminate some $7 billion of Detroit’s obligations, but also to approve the plan’s proposal to reinvest more than $1.4 billion in services, including basic information technology. Her testimony followed the carryover of the city’s chief restructuring consultant, Chuck Moore of the firm Conway MacKenzie, who began last Friday explaining to the court ways Mr. Orr’s plan would improve and reshape the city government, testifying that eliminating waste, fraud, and inefficient spending is crucial to ensure that the city’s proposed plan of adjustment is successful. In response to Judge Rhodes’ questions about whether the plan really offers an achievable plan to improve basic services, Mr. Moore testified that the cash budgeted to improve city services over 10 years must be spent responsibly, noting carefully: “Just because the money exists doesn’t mean it can be spent…It has to be justified.”

Is there a Right Balance? Municipal bankruptcy is rare in the U.S., part of the reason that municipal bonds issued by state and local governments are perceived as such a safe bet: the default rate is just 0.23%. Notwithstanding, for those bondholders in that category, part of their struggle in Detroit’s bankruptcy trial is to recover what they might view as a more equitable share of what they are owed. Unlike a non-municipal corporate bankruptcy—where the corporation can simply be extinguished and its assets equitably distributed; the challenge in municipal bankruptcy is infinitely more challenging: how does one put together a plan to adjust that debt in a manner that will not only be accepted by a federal bankruptcy court, but also will stand the test of time by proving that said plan will provide for a sustainable future for that city? In Detroit, the city foundered under unpayable debts—debts estimated at $18 billion or $26,000 per Motor City resident. Kevyn Orr, the city’s state-appointed emergency manager, has proposed a plan of adjustment to the court to eliminate that debt—but also to try and determine the magic amount in that same plan requisite to try and ensure that Detroit can not just eliminate its debt, but actually have a viable future. Fabulous Matt Fabian of Municipal Market Advisors wisely notes that Mr. Orr’s plan—if approved by the federal bankruptcy court—would help Detroit’s balance sheet—but not its income statement. The city, which already taxes itself more than any other city in Michigan, and which—at least under its plan—will invest in 20th century technology to more effectively collect the revenues it is owed; nevertheless faces declining revenues and a continuing likely decline in assessed property values. It will not be competing with other big cities across the country on a level playing field. Revenues from casinos are down, property values are likely to be re-rated (see chart), and future state fiscal assistance would seem uncertain at best. This is the hard test over the next thirty days before U.S. Bankruptcy Judge Steven Rhodes: does this proposed plan by the city put the Motor City’s finances on a viable path for a sustainable future.

The Extraordinary Cost of Municipal Bankruptcy. While Judge Rhodes is struggling to determine whether to approve or disapprove Detroit’s proposed plan to adjust its debts—paying less, in some cases far less, than it owes to its creditors, but struggling to find some resources to invest so that the city can have a sustainable future; the legal and accounting costs are mounting. For instance, Jones Day, the law firm from which Kevyn Orr was drawn, and his colleagues involved in the case has already, according to fee examiner Robert Fishman, submitted bills to Detroit for just over $26 million, according to Mr. Fishman’s most recent report, which was made public yesterday. Mr. Fishman’s supplemental report adds $3 million in fees and nearly $83,000 in expenses billed in March by Jones Day, the former law firm of Detroit’s state-appointed emergency manager, Kevyn Orr. The addition of the March numbers brings Jones Day’s total billing from July of last year to last March to $25.1 million in fees and $1 million in expenses. It also brings the total price tag for all of Detroit’s professional services in the historic case and reported so far by the fee examiner to about $55 million. Nevertheless, Mr. Orr has said he hopes the final cost will not reach the hundreds of millions of dollars. Jefferson County, Alabama (please see below), which was the largest municipal bankruptcy before Detroit sought federal bankruptcy protection, spent only about $25 million on its two-year case. Experts expect that Mr. Fishman’s next quarterly reports will demonstrate a sharp upsurge in costs to Detroit’s taxpayers, because of the heavy workload by the Jones Day team and other consultants both to prepare for and help shepherd the city through the current trial to determine if the federal court will accept the current proposed plan of adjustment—and the trial is projected to last another five weeks.

Slapping at SWAPs. Wall Street bankers, golfing with frequent pit stops for alcoholic beverages, and the sale of exotic financial instruments were a volatile combination that played a key role in plunging Jefferson County, Alabama into what, before Detroit, was the largest bankruptcy in American history. Swaps, or interest-rate transactions between two so-called counterparties in which fixed and floating interest-rate payments are traded—especially when such financial arrangements are undertaken without a sophisticated municipal advisor held to a legal standard of putting the municipality’s best interests ahead of her or his own—were central to what the former Republican Chairman of the House Financial Services Committee described to me as a criminal endeavor. Thus, as in Detroit, both sewers and swaps involved sophisticated financial advisors preying on municipalities in fiscal straits—ending in prison for the former Mayor of Detroit and bankruptcy for his city. In Bermingham, U.S. District Judge Abdul Kallon has rejected motions by two ex-JPMorgan bankers to dismiss the pay-to-play case against them involving Jefferson County, Alabama’s sewer deals and swaps, rejecting several motions by former bankers Charles LeCroy and Douglas MacFaddin, including a request for partial summary judgment based on the contention that the federal court lacked jurisdiction over the interest rate swap transactions. Messieurs LeCroy and MacFaddin had also filed a request with the court seeking permission to file another motion to dismiss the case based on lack of jurisdiction due to the five-year statute of limitation—a request which Judge Kallon also rejected. In addition, Judge Kallon rejected a motion by Mr. LeCroy for partial summary judgment based on the contention that at least one claim by the Securities and Exchange Commission (SEC) against him should be barred because of the statute of limitations. The SEC is seeking declaratory relief, a permanent injunction enjoining the defendants from violating federal securities laws, and disgorgement of profits or proceeds as a result of their conduct. In his decision, Judge Kallon noted: “[Mr.] LeCroy relies primarily on his own self-serving declaration to support this contention, and he has consistently asserted his Fifth Amendment right at his depositions when asked about his work history and securities dealings after he left J.P. Morgan Securities…This court will not allow LeCroy to convert the [Fifth Amendment] privilege from the shield against compulsory self-incrimination which it was intended to be, into a sword.” The SEC filed suit in 2009 claiming that Messieurs MacFaddin and LeCroy violated multiple securities laws as managing directors at JPMorgan; the former bankers agreed with certain Jefferson County Commissioners to pay more than $8.2 million to close friends who either owned or worked at local broker-dealers, but had no official role in selling the county’s sewer bonds in 2002 and 2003, according to the SEC complaint. The payments, undisclosed at the time, were to ensure that JPMorgan won $5 billion in underwriting and interest rate swap transaction business from Jefferson County. Jefferson County exited from municipal bankruptcy last December, but the case is being appealed.


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