What Does it Take to Exit Municipal Bankruptcy?

September 30, 2014
Visit the project blog: The Municipal Sustainability Project

Taking Stock in Stockton. More than two years after Stockton sought federal bankruptcy protection and nearly 4 months since its bankruptcy trial over the city’s proposed plan of adjustment commenced last June, the city is poised to emerge as early as tomorrow, with U.S. Bankruptcy Judge Christopher Klein expected to announce his decision in federal court tomorrow. In anticipation, closed-session City Council special meetings have been scheduled for today and tomorrow at City Hall. When Stockton filed for federal bankruptcy two years ago in June, it was the largest city in the U.S. to seek such protection—until eclipsed by Detroit nearly a year later. The holdup—not dissimilar to Detroit’s—has been Stockton’s last major holdout creditor, Franklin Templeton Investments, with which there is, as yet, no agreement. That means that tomorrow’s decision could lead to either a confirmation of the city’s proposed plan of adjustment—letting the city begin to implement its recovery plan—or Judge Klein could reject the plan, in which case the city would be forced to go back to the drawing board to address any specific concerns that it can glean from Judge Klein’s decision—either with regard to the city’s public pension obligations, especially with regard to its obligations under California’s constitution and law to the California Public Retirement System or CalPERS (Last July, in federal bankruptcy court, Judge Klein said he “might very well conclude the CalPERS contract would be rejected and that its proposed $1.5 billion lien is not enforceable.”), or with its holdout creditor Franklin: might it have to recalibrate its offer to resolve some nearly $30 million in unsecured debt, because the court did not agree to a so-called cram-down in the city’s proposed plan of adjustment, under which it is proposing to repay only about $300,000? The most critical issue for Judge Klein, however, will be whether he finds the city’s plan to be fiscally sustainable—should he determine that the plan does not provide for a long-term recovery, he would have little choice but to send the municipality back to the drawing board. In preparation, the city has scheduled closed-door sessions for this afternoon and tomorrow morning, with the notices specifically referring to Stockton’s bankruptcy case, with tomorrow’s session scheduled to start just two hours after Judge Klein is scheduled to render his ruling in his federal courtroom in Sacramento.

Financing an Exit from Municipal Bankruptcy. Meanwhile, nearly halfway across the country, Detroit—whose municipal bankruptcy process has outpaced Stockton’s and could itself come to fruition in the next two weeks has gained the State of Michigan’s approval for a plan to issue $1.1 billion of municipal bonds as part of its municipal bankruptcy exit financing under its proposed plan of adjustment to raise resources to pay off several of its creditors—borrowings already approved by the Detroit City Council, as the city ramps up its efforts to recover from service insolvency and provide resources for investment into services that are part of the Motor City’s plan of adjustment—albeit, as with the entirety of the plan, the final nod will be up to U.S. Bankruptcy Judge Steven Rhodes. The approval came from the state emergency loan board, which is made up of three members of Gov. Rick Snyder’s administration, including the state treasurer or his deputy. The borrowings include a $325 million exit financing that will initially be completed via a private placement with Barclays, financed by means of an intercept on Detroit’s income tax revenues, including covenants which would mandate Detroit to keep income tax rates at a level sufficient to generate at least twice its debt service coverage, with the proceeds dedicated to pay off an earlier $120 million of a debtor-in-possession financing with Barclays. The city will also use some of the money for service improvements. In addition, the state approved another $777 million of bonds that will be structured as limited-tax general obligation bonds featuring a first-budget obligation—with a $55 million series to be used to pay off limited-tax general obligation bondholders, who settled for a 34% recovery on their $164 million claim, and an $88 million series to be dedicated to paying off holders of $1.5 billion of disputed certificates of participation (COPs)—with the revenues derived from the Motor City’s parking revenues and supported by a first budget obligation pledge and proceeds from the ad valorem tax levy. In addition, under its recent agreement to resolve holdout creditor Syncora’s objections to its plan of adjustment, a significant portion will be provided to Syncora Guarantee Inc., which holds $390 million of the COPs and reached a settlement with the city three weeks ago. Meanwhile, as the tempo accelerates, the Detroit Free Press reports that the Motor City and its last major holdout creditor, Financial Guaranty Insurance Co., are hashing out a settlement behind closed doors that would, if worked out, remove the most serious obstacle to Detroit’s successful exit from municipal bankruptcy.

Essential Municipal Services. U.S. Bankruptcy Judge Steven Rhodes yesterday decided he lacked authority to issue a restraining order to the City of Detroit to bar water shutoffs because of over delinquent bills. Judge Rhodes wrote that federal municipal bankruptcy law, or chapter 9, “strictly limits the courts’ power in a bankruptcy case,” and that there is no constitutional right to water. Judge Rhodes further wrote that moratorium would be a financial hit to the Detroit Water and Sewerage Department. And Judge Rhodes found that last point persuasive, writing that with the Motor City in bankruptcy and under intense pressure to make every operation in the city as cost-effective and efficient as possible, “the last thing it needs is this hit to its revenues.” In addition, noting the intergovernmental implication, Judge Rhodes wrote that Detroit and its neighboring counties of Wayne, Oakland, and Macomb counties are in the process of approving a new Great Lakes Water Authority under which Detroit would maintain ownership of the region’s water and sewer system but lease the pipes that largely serve the suburbs, in exchange for $50 million a year for 40 years dedicated to fixing aging water and sewer lines.

Hear Ye. Meanwhile, the Motor City’s days in court before Judge Rhodes have continued, with soon-to-depart Detroit emergency manager Kevyn Orr likely to be called to testify as early as today. Yesterday, Judge Rhodes pressed Ernst & Young financial consultant Guarav Malhotra to explain his main concerns with regard to the Motor City’s future fiscal sustainability if Judge Rhodes were to approve the city’s pending plan of debt adjustment. In response, Mr. Malhotra said the biggest risks included:
• whether the city’s pension systems would be healthy after the end of 10 years;
• whether new labor contracts would increase costs; and
• whether city financial staff would be able to take over managing Detroit’s cash, a job Ernst & Young has been doing.


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