U.S. Bankruptcy Court Approves Stockton’s Plan to Exit Municipal Bankruptcy & What is the Role of States in Municipal Bankruptcy?

October 31, 2014

Visit the project blog: The Municipal Sustainability Project 

Taking the Final Stock in Stockton. (From our special correspondent in the courtroom yesterday afternoon in Stockton, Chris McKenzie, the extraordinary Executive Director of the California League of Cities) In a proceeding lasting just over two hours, U.S. Bankruptcy Court Judge Christopher Klein rejected the claims of the remaining holdout creditor, Franklin Templeton Investments, and approved the city of Stockton’s proposed Chapter 9 Bankruptcy Plan of Adjustment. The judge detailed the various classes of creditors and the extent to which they would be paid. He specifically refused to categorize the $32 million Franklin unsecured claim as a separate class, leaving it in a class of even larger unsecured claims, effectively rejecting Franklin’s claim of discrimination. The court previously ruled that roughly $4 million of Franklin’s $36 million claim was secured. Earlier this month on Oct. 1, Judge Klein ruled that federal bankruptcy law preempted California law and made the city’s contract with CalPERS subject to impairment by the city in the Chapter 9 proceeding. Today the judge said that contract was inextricably tied to Stockton’s collective bargaining agreements with various employee groups. Further, he stressed how in reality this amounts to a triangle of contracts because the employees are third party beneficiaries of Stockton’s contract with CalPERS. Contrary to Franklin’s assertion that CalPERS is the city’s largest creditor, the Judge said that the employees are Stockton’s largest creditor, citing ample evidence that their benefits and salaries have been substantially reduced. In response to Franklin’s assertion that the employee’s pensions were given favorable treatment in the Plan of Adjustment, the judge detailed all the reductions since 2008 (not just since the filing of the case in 2012) that have collectively ended the prior tradition of paying above market salaries and benefits to Stockton employees. This includes loss of retiree health care,  reductions in positions, salaries and employer pension contributions, and approval of a new pension plan for new hires, The judge said any further reductions, as called for by Franklin, would make city employees “the real victims” of the proceeding. Judge Klein also referred to the U.S. Supreme Court’s decision in N.L.R.B. v. Bildisco and Bildisco, 465 U.S. 513 (1984) in which the court held that collective bargaining agreements should receive greater deference from impairment in bankruptcy proceedings than other executory contracts. The judge explained how Stockton and its employees previously approved collective bargaining agreements with substantial reductions in costs, and the city was not proposing to further reduce those agreements in light of the substantial reductions that had already been approved. Citing an earlier disclosure by the city of over $13 million in professional services and other costs only through the end of May, Judge Klein also commented that the high cost of Chapter 9 proceedings should be an object lesson for everyone about why Chapter 9 bankruptcy should not be entered into lightly.

Reading Stockton’s Tea Leaves. S&P’s Chris Morgan, after the decision, wrote “The leaders of distressed U.S. municipalities will continue to pursue other options before setting in motion the long and costly process that bankruptcy implies,” even as Mr. Morgan reported that S&P believes that the “implications of Stockton’s exit from bankruptcy will be modest.” Nevertheless, he called attention to Judge Klein’s warning to other cities about the costs of bankruptcy and that it is an area of the fiscal, municipal twilight zone which should not “be entered into lightly.” As of last May, Stockton had paid lawyers and other advisers nearly $14 million, according to its court filings. Now the city, which will begin its exit from bankruptcy once Judge Klein sets a date―mayhap before the end of the year, will be able to focus on its future. As approved by the federal court, the city’s plan of adjustment provided for a $5.1 million contribution for canceling retiree health benefits. One key—both to putting together its plan of debt adjustment, but also to its future—was the voter approval last year to increase the city’s sales and use tax to 9 percent, a level expected to generate about $28 million annually, with the proceeds to be devoted to restoring city services and paying for law enforcement. Moody’s, in its reading of the potential implications of yesterday’s decision, wrote that Judge Klein’s ruling could set up future challenges from California cities burdened by their retiree obligations to CalPERS, with Gregory Lipitz, a vice president and senior credit officer at Moody’s, noting: “Local governments will now have more negotiating leverage with labor unions, who cannot count on pensions as ironclad obligations, even in bankruptcy.” A larger question, however, for city and county leaders across the nation will be the potential implications of Judge Klein’s affirmation of Stockton’s plan to pay its municipal bond investors pennies on the dollar while shielding public pensions.

The Role of the States in Municipal Bankruptcy. In our federalism system—and under the current version of chapter 9 municipal bankruptcy signed into law by the former Governor of California, former President Ronald Reagan, states play a unique role. No municipality, after all, may even file for federal bankruptcy protection—unlike any other corporation—unless authorized by state law. But states also play a role in either helping municipalities not to need access to federal bankruptcy protection—or, sometimes the opposite―as U.S. Bankruptcy Judge Thomas Bennett wrote in the case of the nation’s second largest municipal bankruptcy: “The loss of this unencumbered revenue source was rooted in the inability of the state of Alabama and its Legislature to properly enact a statute…All those who attribute Jefferson County’s bankruptcy case and Cooper Green’s plight only to conduct and actions by the county are ill-informed…The state of Alabama and its legislators are a significant, precipitating cause. Both before and after filing its Chapter 9 case, the county’s revenue-seeking activities with Alabama have been to no avail.”(In Re Jefferson County, United States Bankruptcy Court, N.D. Alabama, Southern Division, December 19, 2012.)

21 States do not provide access to Chapter 9 Bankruptcy, and 16 States set conditions for eligibility; and 12 States provide blanket authorization: Georgia explicitly denies access to municipal bankruptcy (GA Code 36—80-5); the following states do not authorize municipal bankruptcy: Alaska, Delaware, Hawaii, Indiana, Kansas, Maine, Maryland, Massachusetts, Mississippi, New Hampshire, New Mexico, North Dakota, South Dakota, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin, and Wyoming. But beyond the issue of eligibility, as Judge Bennett noted in the case of Alabama—and now a new study from the Chicago Federal Reserve finds, states can have precipitating roles as well as preventative roles (think New Jersey and North Carolina). In the study, the Windy City Fed determined that Michigan’s decade-long policy of repeatedly cutting local aid to help deal with its own fiscal problems has helped drive some of its local governments into fiscal crisis, the Chicago Fed says in a new report:

While economic downturns clearly put pressure on state and local governments alike, in Michigan’s case they have also added volatility and uncertainty into the revenue relationships between state and local governments. Because of changes to Michigan’s statutory revenue sharing program and tax code, local government officials have become increasingly uncertain that statutory revenue sharing will reach pre-2003 levels. Local governments in Michigan may be forced to adjust what their services programs can deliver because of expected lower amounts of state aid over the medium term and possibly the long term. Meanwhile, Michigan localities’ latitude to maintain their own programs with their own revenue sources is seemingly limited by law.

In its report, the author, Martin Lavelle, a senior associate at the Detroit branch, examined the trend of state revenue sharing to local governments in Michigan over the past decade as part of a larger look at how local governments nationally have struggled with state aid cuts, noting that in Michigan, local governments have faced cuts since at least 2003, when the state’s recession began, finding that the cuts helped drive several local governments and school districts into fiscal crisis, so that today the state not only hosts the largest municipal bankruptcy in history (followed, in order by Jefferson County, Orange County (Ca.), San Bernardino, and Stockton), but also where many of the state’s local governments (and school districts) are under state-controlled emergency management. Mr. Lavelle writes that problems tied to state aid cuts are aggravated by constraints on municipal authority to raise their own revenue―the key issue U.S. Bankruptcy Judge Bennett noted in the Jefferson County case. Mr. Lavelle writes: “While economic downturns clearly put pressure on state aid and local governments alike, in Michigan’s case they have also added volatility and uncertainty into the revenue relationships between state and local governments…Local governments in Michigan may be forced to adjust what their services programs can deliver because of expected lower amounts of state aid over the medium term and possibility the long term.” The study notes, interestingly, that the state’s local governments are among the most dependent on state aid in the country, with 43.3% of their budgets funded by the state, according to the Federal Reserve—indeed, fifth highest in the nation, trailing Vermont, which crowns the list, with 66.2% of local governments’ budgets funded by the state. But it is also timing: Mr. Lavelle notes that Michigan’s local governments have received less revenue from the state every year since 2003, with state revenue sharing as a percentage of state spending from state resources dropping to 56.3% last year, down from its peak of 64.3% in 2002 (Michigan distributes state aid according to two formulas, one based on the state constitution and one based on state statute). Mr. Lavelle found that while the constitutional aid has remained fairly flat since the early 2000s, the statutory aid has “fallen sharply.” (Due to the 1978 Headlee constitutional Amendment, local governments in Michigan are among the only municipalities in the nation which confront limitations on revenue, levies, tax rates, and assessment limits, even when property taxes are declining.) Even though a new formula (the City, Village, and Township Revenue Sharing program) is scheduled to take effect in 2015, Mr. Lavelle noted it, too, is “likely to fall short of fully restoring statutory revenue sharing funds to levels before Michigan’s one-state recession.” On the scholastic side, Mr. Lavelle found that Michigan’s reliance on state sales and use tax revenues added to municipal fiscal problems, because Michigan’s school operating budgets’ reliance on state sales tax revenue created cyclical misery by reducing local school aid in economic downturns: “While this program shifts the responsibility for funding education…to the state, it also exposes local education funding to any budget difficulties the state may experience…After Michigan’s recession began in 2003, state revenue sharing to local school districts decreased. And despite Michigan’s economic rebound since mid-2009, local school districts remain fiscally challenged, in part because of recent spikes in teacher retirement costs.”

Mr. Lavelle’s report does not examine the remarkable, bipartisan role of Michigan’s legislative leaders and its governor in fashioning and adopting—in an election year—the so-called Grand Bargain that involved a pioneering state role and substantial state injection of revenues that came to act as a fulcrum towards the Motor City’s hopes to follow Stockton out of bankruptcy next week. No report has tracked the virtually absentee role – or mayhap contributory role – of the State of California, now the unproud home to the country’s third, fourth, and fifth largest bankruptcies in U.S. history.

Exiting Municipal Bankruptcy

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

Stockton Exits Municipal Bankruptcy. U.S. Bankruptcy Judge Christopher Klein this afternoon approved Stockton bankruptcy plan of debt adjustment, saying he was “satisfied that [its] plan of debt adjustment has been proposed in good faith.” His decision comes 28 months after the financially desperate city first declared itself to be insolvent. The federal judge said he would not issue written findings, but he allowed the parties to request additional findings. In issuing his approval, the federal judge in effect protected the California Public Retirement System (CalPERS) from taking any haircut, while imposing steep cuts on the city’s lone holdout creditor Franklin Investments—so a very different plan than Detroit, where U.S. Bankruptcy Judge Steven Rhodes is scheduled to announce his opinion next week. In his ruling, Judge Klein noted that employees have already agreed to pay cuts and other concessions, and that retirees were stripped of their medical plans. If the city were to reduce its pensions to free up cash for Franklin Templeton, workers and retirees would, he said, be “the real victims.” In the Motor City’s plan, accepted by its retirees, there are modest cuts in the retirement pensions and steep post-retirement health care cuts. Unlike Detroit, Stockton, despite the green light from Judge Klein, did not propose any reductions in its payments to CalPERS. Indeed, in his ruling this afternoon, Judge Klein noted that the real creditors impacted in such a ruling would be the city’s retirees, who gave up retiree health care benefits valued at more than a half-billion dollars during the bankruptcy. A status conference will be convened in Judge Klein’s courtroom at 11 am on December 10th.

Judge Klein’s ruling brings to an end a trial that began last May 12th—and rang up some $10 million in legal fees. The city reports says it saved $2 billion through agreements with creditors, employee groups, and retirees in putting together its final plan of debt adjustment that was reached before the start of the trial. The city gained Judge Klein’s confirmation today despite never reaching a settlement with Franklin Templeton Investments, which lent the city $35 million in 2009. Stockton’s plan of adjustment to exit bankruptcy called for Franklin to receive only a $300,000 repayment of $32 million in still-outstanding unsecured debt. Judge Klein this afternoon said he was not persuaded by Franklin’s argument that it was being treated unfairly in the city’s bankruptcy exit plan, overruling objections from investor Franklin Advisers that it was being unfairly treated in the city’s bankruptcy exit plan, noting he would enter judgment on the adversary part of the proceeding (concerning value of Franklin’s secured claim). Stockton’s attorneys will have drafted a proposed conference order and adversary proceeding judgment by next week. In the plan, the city’s retiree health care claim is set at $545 million, but Judge Klein said he would consider motions on adjusting the amount. In one area of continuing disagreement—the fee issue, Stockton and Franklin disagree, with Franklin arguing that all fees be disclosed in detail and city saying (notwithstanding what Judge Rhodes has done in his Detroit case). Chapter 9 does not provide for court oversight of the fees unless the parties request it. Judge Klein said §Sec 429 of the federal bankruptcy code requires statements from attorneys, but it does not apply to Chapter 9 municipal bankruptcy cases. §43(b) applies to disclosure of future payments, not past, despite disclosures made by Stockton last May of its fees and expenses. Stockton’s leaders were thrilled with this afternoon’s decision, which they said will enable the city to move forward after years of financial crisis: “We are on a more stable financial footing,” said City Manager Kurt Wilson, adding that police officers and other city employees have been leaving Stockton, in part because of uncertainty over their pensions and the city’s financial troubles. He believes the exodus will now stop: “That’s going to be a very big help for us.”

Left uncertain is whether Franklin Templeton Investments, with whom there is a nearly unbridgeable chasm over some $32 million in unsecured debt―will appeal. That loan was to finance construction of a fire station, upgrade the city’s police communications center, and build parks and streets at a time when the city’s finances already were careening toward disaster when the loan was made in 2009―on which the city’s now federally approved plan will mean Franklin will receive only about $300,000, or less than 1 cent on the dollar—in stark contrast to the city’s plan’s commitment to 100 cents on the dollar to the California Public Employees’ Retirement System of CalPERS. Nor is it clear how municipal credit rating agencies will react: In the wake of Judge Klein’s earlier oral opinion, credit rating agency Moody’s termed it “a positive sign for investors (in state and local municipal bonds) that pension obligations will not be given preferential treatment over debt in a municipal bankruptcy,” with Moody’s adding that it could prompt other stressed municipalities to “consider bankruptcy as a way of trimming unaffordable and growing pension burdens.”

Combatting Blight. Louis Aguilar of the Detroit News, this morning provided us with a bird’s eye view of a new and innovative version of the sharing economy, writing about how the “war on blight” has spread beyond Detroit into Hamtramck and Highland Park—cities within Detroit’s boundaries, and could soon expand to other Michigan cities. The two cities are undertaking their first comprehensive attempts to count the number of blighted properties within their boundaries. Like Detroit, the two municipalities have lost tens of thousands of residents, so they each have dozens and dozens of burned-out homes and abandoned buildings—sites which have become havens for squatters, crime, and unpaid property taxes—and where assessed property values have disappeared. Highland Park, where Henry Ford built his first auto plant in what was then known as the “City of Trees” today counts part of that former Model T plant amongst its estimated 3,000 empty buildings in the city―which make up nearly 50% of the structures left. The bleak fiscal shape of the two municipalities’ treasuries have made even the task of counting their respective abandoned homes and buildings beyond reach—but now, thanks to generous grants from the Kresge and Skillman foundations, and a Detroit startup company that invented something called “blexting,” such a goal is now obtainable; so last week, Highland Park and Hamtramck teamed up with the Motor City Mapping project, which paved the way for 20 workers to go out with camera phones and tablets and survey every parcel in each city. The funding was provided by the foundations, with support from the nonprofit Data Driven Detroit and Detroit-based business Rock Ventures. The Motor City Mapping project was conceived by startup Loveland Technologies, which has been exploring ways to digitize Detroit’s property information and make the data available to the public. Blexting (blexting) was used in the historic Motor City Mapping project (www.motorcitymapping.org), which surveyed all 380,000 properties in the City of Detroit, using the app to take photos of every parcel and answering a series of questions about each — about 6,700 in Hamtramck and 6,600 in Highland Park. The program, to be run by the Michigan State Housing Development Authority, will work in Detroit, Ecorse, Hamtramck, Highland Park, Inkster, and River Rouge in Wayne County as well as Adrian, Ironwood, Jackson, Lansing, Muskegon Heights and Port Huron.

D-Day in Stockton, California

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

D-Day: Taking the Final Stock in Stockton. U.S. Bankruptcy Judge Christopher Klein is set to gavel his court back into session this morning, where he is expected to either confirm Stockton’s plan of debt adjustment and restructuring proposal, permitting the city to exit municipal bankruptcy, or reject it. Today’s decision—on which we will rely on two extraordinary on site witnesses, could end the California city’s 28 month effort to pull itself back from insolvency towards a sustainable future. The key, remaining issue relates to the city’s lone remaining holdout creditor, Franklin Templeton Investments, with whom there is a nearly unbridgeable chasm over some $32 million in unsecured debt― debt to Stockton to finance construction of a fire station, upgrade the city’s police communications center, and build parks and streets at a time when the city’s finances already were careening toward disaster when the loan was made in 2009―on which the city’s plan proposes to pay about $300,000, or less than 1 cent on the dollar—in stark contrast to the city’s plan’s commitment to 100 cents on the dollar to the California Public Employees’ Retirement System or CalPERS. Unsurprisingly, Franklin has disparaged the city’s plan, telling the court it does not meet the bankruptcy test of fair and equitable (see Franklin’s statement immediately below), especially compared to the agreements Stockton reached with other creditors, and in the wake of Judge Klein’s opinion on the first day of this month—a verbal ruling in which he made clear, for the first time, notwithstanding the California constitutional protections for public employee pensions, those protections are preempted by the federal, chapter 9 municipal bankruptcy law—a ruling prompted by Franklin’s legal protest.

CalPERS had argued that California cities should be legally bound to use all their assets to pay pension debt before reducing retirement benefits, but Judge disagreed, noting that California’s state’s public employee retirement law “is simply invalid in the face of the U.S. Constitution.” Nevertheless, the practical effect of Judge Klein’s oral ruling is uncertain. What is in the balance is the annual $29 million in pension payments in Stockton’s proposed plan of adjustment. In a larger sense, the issue could cause reverberations far beyond Stockton’s city limits. In the wake of Judge Klein’s earlier oral opinion, credit rating agency Moody’s termed it “a positive sign for investors (in state and local municipal bonds) that pension obligations will not be given preferential treatment over debt in a municipal bankruptcy.” The agency added that it could prompt other stressed municipalities to “consider bankruptcy as a way of trimming unaffordable and growing pension burdens.” In contrast, Stockton city officials have said an exit from CalPERS would have disastrous consequences for Stockton. As for Stockton’s repayment proposal to Franklin, no one has said publicly whether negotiations between the city and the investment firm have been held since the last court date.

In its own statement to the federal bankruptcy court, the firm wrote:

“Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund loaned $35 million to the City of Stockton in 2009. Stockton defaulted in repayment of that loan and subsequently sought to adjust its debts in a bankruptcy case under chapter 9 of the United States Bankruptcy Code.

“Franklin has participated in the bankruptcy case as a creditor. Our focus always has been and continues to be on doing what is in the best interest of the investors in the Franklin funds holding the Stockton debt at issue. Many of those investors are individuals and retirees who rely on us to protect the value of their investments and provide retirement income.

“On October 1, the Bankruptcy Court issued an important decision in Stockton’s case. Agreeing with Franklin, Judge Christopher Klein held that, under U.S. bankruptcy law, Stockton’s pension liabilities may be impaired as part of a bankruptcy plan of adjustment, just like all of Stockton’s other debts. The decision confirmed Franklin’s position that all of Stockton’s liabilities should be addressed in its bankruptcy and is consistent with Franklin’s claim that Stockton’s plan fails to treat Franklin fairly and equitably.
“Franklin urged the Bankruptcy Court to make that ruling because Stockton has proposed an unfair and discriminatory plan of adjustment. Stockton’s plan provides for pensions to be paid in full and other unsecured creditors to be paid between 50% and 100%, while Franklin’s unsecured claim is to be paid less than 1%.

“This proposal violates the Bankruptcy Code’s prohibition against unfair discrimination and fails the Bankruptcy Code’s requirement that Stockton provide Franklin with a reasonable recovery paid over time from Stockton’s future revenues. In light of the Bankruptcy Court’s ruling, it is clear that Stockton cannot wipe out Franklin’s claim through a negligible 1% payment while choosing to pay in full its much larger pension debts.
“In fact, the evidence establishes that Stockton can pay substantial amounts to Franklin even if it leaves pensions untouched. Had Stockton chosen to do so, it could have avoided the delay and expense of litigation. Instead, Stockton ignored that evidence and proposed just a small, one-time payment to us. As a result, we had no choice but to resist confirmation in order to stand up for the individuals who have entrusted us with their savings.

“We continue to desire a cooperative partnership with Stockton in which our claim will be repaid over time as Stockton recovers, just as the claims of other creditors and pension holders are to be paid over time from future Stockton revenues. We are hopeful that the Bankruptcy Court’s decision will prompt Stockton to offer a more realistic plan that provides a fair and equitable recovery for our fund investors, as required by the Bankruptcy Code.”

Trading Lots in the Motor City. Detroit Mayor Mike Duggan and Detroit Public Schools Emergency Manager Jack Martin have announced an agreement to eliminate some $11.6 million in debt the school system owes the city in return for the transfer of 77 vacant school buildings and lots. Almost in parallel universes, Michigan had taken control of both Detroit and its public school system—in significant part because of the systemic fiscal scourge created by the city’s significant population decline (its school population dropped by more than 66%). Under the terms of the agreement, Detroit will forgive the debt—consisting mostly of electric bills owed to the city, in exchange for the school system turning over 57 vacant schools (31 secured and 26 unsecured) and 20 vacant lots (where schools once stood). Mayor Duggan said: “This agreement is great for our neighborhoods and DPS school children…It allows DPS to put all of its energies into its core mission, which is to educate our children. It also recognizes that the city is better suited to addressing the important issue of neighborhood blight and redeveloping these properties in a way that is in harmony with the surrounding community,” adding that, under the terms of the agreement, the city “will take [ownership of] between 10 and 12 buildings and move in a timely manner to demolish them,” with plans to tap $4.3 million in Neighborhood Stabilization Program funds that could be used to raze those structures by next summer. Mayor Duggan said: “Each property that has a good playground will be assessed by Parks and Recreation…If they are well maintained, the rec department will make them available to the neighborhood.” As for the vacant schools, the Mayor added the city will not rush to raze all of them: “There may come a day when more people move back into the city,” adding that between 14 and 16 will be secured for future use. As for the school system, Mr. Martin notes that the grand swap will remove $12 million in its liabilities, albeit he still must address 20 other vacant schools which are not part of this agreement, and that it could mark a key step in his efforts to get the system out of debt and state control: the district’s deficit was $127 million as of the end of its most recent fiscal year in June, according to the state. Since the State of Michigan asserted control over DPS in March of 2009, the district has closed 100 school buildings. The district has been leasing and selling property since 2005 and had more than 100 properties on the market. Now facing a $127-million deficit, DPS has shut dozens of buildings over the years as its enrollment declined. In 2002-03, the district had more than 156,000 students; current projections are at about 47,100 students.

Actuarially Challenging. Last month a class action suit was filed by a Detroit retiree, apparently a frequent filer, against the city’s actuary, Gabriel Roeder Smith and Co., for its work advising the city’s (and Wayne County’s) general pension fund. The suit alleges that consultants used faulty assumptions that contributed to underfunding that some say helped drive the city into bankruptcy. (Gabriel, Roeder, Smith & Company is a national actuarial and benefits consulting services firm that focuses on services in the public sector, with clients in every state except Maine, Massachusetts, New Jersey, and Montana.) In the suit, Detroit retiree Colleta Estes, filed in Wayne County Circuit Court, Ms. Estes accused GRS of using a misleading methodology to calculate contributions, and of allowing trustees to spend money they did not have. Now that Detroit is bankrupt, the pension fund is short, benefits are being cut and one of the system’s roughly 35,000 members, Ms. Estes contends the firm used faulty methods and assumptions that “doomed the plan to financial ruin.” GRS has served as the Motor City’s actuary for 75 years. The suits (three) seek recompense outside of the bankruptcy with regard to services rendered by GRS to three public employee retirement systems. GRS’s actual clients – the retirement systems – did not initiate the lawsuits; instead, the named plaintiffs are participants in the retirement systems. The plaintiffs previously brought lawsuits against trustees of the retirement systems and other service providers to the retirement systems. The suits claim GRS helped cause the fiscal mess “by negligently, willfully, recklessly, wantonly and repeatedly committing gross errors and failing to exercise due care and skill in providing actuarial services to the plan, and in failing to promptly discover and disclose those errors to the trustees, (thereby) defendant Gabriel Roeder breached its duties to the plan.” The litigants also claim the General Retirement System “knowingly acted in concert with the plan trustees to further their self-interest, and by agreeing to allow an underfunding scheme, which has greatly impaired the system’s financial soundness, the plan is one of the nation’s worst performing public pension systems.” GRS still works with Detroit’s two pension funds. Members of the Detroit police and fire retirement system have filed a similar lawsuit, as have members of the Wayne County employees’ fund, according to the New York Times. Ms. Este’s lawsuit asks to have the pension plan made whole.

The Process of Emerging from Municipal Bankruptcy

October 28, 2014

Visit the project blog: The Municipal Sustainability Project 

Paving the Way to Exit Bankruptcy. Detroit made its closing arguments for federal court approval of its proposed plan to exit municipal bankruptcy and invest some $1.7 billion in its future in its final day in its historic bankruptcy trial yesterday, with its lead bankruptcy attorney Bruce Bennett testifying: “The end really is in sight,” and that “The city has settled with all the major economic players,” as he asked U.S. Bankruptcy Judge Steven Rhodes for his approval of the city’s eighth version of its proposed plan of debt adjustment and reinvestment in a sustainable future—or what the city termed its $1.7 billion blueprint for Detroit’s revitalization, with Mr. Bennett seeking to make the case why its pending plan is fair to creditors and fiscally feasible or sustainable—the keys to the kingdom as it were. For, to approve the pending plan of debt adjustment, Judge Rhodes must find it to be both fair and feasible. Judge Rhodes took a final opportunity to press lawyers about the feasibility of the plan, asking the Motor City’s lead lawyer, Bruce Bennett, to identify the most critical risks that could prevent Detroit from implementing its debt adjustment and fiscal recovery plan—to which Mr. Bennett responded that if Detroit Mayor Mike Duggan and the Council deviated from the plan put together by former emergency manager Kevyn Orr and his team—but approved by the Mayor and Council: “The worst thing that could happen is if the $1.7 billion (the portion of the plan for investment in Detroit’s future) is misused or perceived to be misused…Either would be an enormous problem.” He said the plan of adjustment is feasible and concluded that raising taxes to pay off debts was not workable, in part because the city has reached its legally allowable property tax rate: “It’s frankly easy to decide taxes should not be increased. The harder question is, should taxes be reduced?” In response to questions with regard to the so-called “Grand Bargain,” Mr. Bennett told the court there were rumors and speculation that other potential methods of monetizing the Detroit Institute of Art were available, but he said there was no other way than the grand bargain to generate the kind of funding the state and city found here, adding that a sale could not have guaranteed it, and would have damaged the museum’s reputation. He added that any loans using the art as collateral would have proven too costly for the city to take on, even if they would have been legally permitted, adding that the federal municipal bankruptcy law does not require a municipality to sell assets to pay off debts.

Lonely on the Bench. If Judge Rhodes next week approves Detroit’s plan, the city will attempt to end its bankruptcy prior to the Nov. 27 Thanksgiving holiday, Mr. Bennett told Judge Rhodes yesterday. To meet that deadline, Kevyn Orr testified Detroit would need to obtain exit financing in place: The city plans to raise $275 million. As part of its pending plan of debt adjustment, the city proposes an agreement with Barclays Plc to arrange the exit financing, key to its proposed $1.7 billion investment to remove blight and improve everything from police and fire protection to public transportation. Judge Rhodes yesterday told the courtroom he has not decided whether or not to approve the city’s proposed plan of adjustment, related creditor settlements, or the exit financing. On his lonely shoulders falls the task of determining whether the plan is fair and feasible―and whether to accept or overrule objections of the remaining holdouts. Judge Rhodes has scheduled a hearing for November 7th to announce his decision. He also told the court that in the wake of his announcement, he may hold one final hearing to hammer out the exact wording of the written order needed to formally approve the plan.

Good Faith? A sometimes forgotten issue in  determining whether a city can emerge from bankruptcy is whether it acted in good faith in putting together its plan of debt adjustment—another item Judge Rhodes must consider. So Judge Rhodes devoted part of yesterday’s final hearing for the city to focus on whether it acted in good faith in fashioning its plan. In response, Mr. Bennett told the court there was “ample evidence that the city’s intent…has been to restructure its indebtedness and frankly revitalize this municipality…We are certainly looking for the maximum protection possible” for officers sued as a result of their actions on the job. Judge Rhodes inquired whether those lawsuit settlements could be impaired, referring to police misconduct lawsuits stayed during the bankruptcy, but adding he wished for more of an explanation of how fair and equitable are applied among different classes, including, specifically, what the city proposed to do about its §1983 cases, cases involving citizens with claims against police officers over mistreatment, wrongful imprisonment, etc., asking Mr. Bennett: “Fair and equitable, what does it mean?…We need to know what your intent is before we can determine whether it’s consistent with the law….We need to review the whole issue of what the plan intends to do with respect to 1983 claims against officers in their individual capacity.” In response, Mr. Bennett, after a break to do his requested “homework,” testified that that higher bar pushed the city to settle higher to avoid the risk of losing at appeal.

Only the Lonely. Municipal bankruptcy involves not just huge creditors, but thousands upon thousands of individual creditors—some of whom received their day in court yesterday. Detroit retiree John Quinn told Judge Rhodes he should be in a special class of creditors because of steep pension and benefit cuts, describing the city’s pending plan of debt adjustment as unfair and legally defective. He testified that Detroit’s General pension fund “doesn’t send me money every month for generosity…I get the money because they owe me. They have a fiduciary obligation to pay me my pension.” Judge Rhodes followed up: “Some people’s reduction is less than yours, so their pension payment is more than yours. Should they be in a separate class too? Where’s the line?” A second objector, Mike Karwoski, testified he would be supportive of the plan if it did not include a controversial plan to recoup excess interest paid into the optional annuity savings fund accounts of general city workers, arguing the recoupment is “illegal and unjust.”

Federal Law Versus a State’s Constitution. Judge Rhodes yesterday pressured Detroit’s bankruptcy attorneys to justify why the city’s bankruptcy exit plan proposes better treatment for pensioners than financial creditors. In a discussion of the complicated math underpinning the city’s financial projections, Judge Rhodes noted that the Motor City’s retirees could eventually get all their pension cuts restored if the city’s pension investments perform well over the next several years, leading him to query Mr. Bennett: “Tell me why that isn’t a 100% recovery.” In response to which, Mr. Bennett replied: “The math gets a little tricky here.” The exchange underscores the importance of the unfair discrimination issue in Detroit’s bankruptcy. Although all major creditors have struck settlements, bond insurers Syncora and Financial Guaranty Insurance Co. (FGIC) argued earlier in the case that pensioners were getting extraordinarily favorable treatment—certainly far better than the bond insurers—albeit less than they are guaranteed under Michigan’s constitution. Civilian retirees are to receive a 4.5% cut to their monthly checks, the elimination of cost-of-living-adjustment (COLA) increases and a claw back of excessive annuity payments. Police and fire retirees are to receive a COLA reduction from 2.25% to 1%. The reductions were agreed to be based upon retirees’ votes to accept the cuts, as well as a 90% reduction in their health care benefits. So Mr. Bennett responded: “Having a consensual agreement with the workforce” helps the city put together a plan of adjustment that works—leading Judge Rhodes to ask if that was much of a meaningful portion of the plan. Mr. Bennett said the plan measures it in dollars and sense, but Judge Rhodes asked what about the people who ratified the constitutional protection?—in effect asking if the state’s constitution should not carry some weight: “I was thinking about it in terms of the judgment of the people who ratified the Constitution that’s reflected in this special callout. Is that something worth considering? On this point of unfair discrimination, to what extent is it appropriate for the court to take into account the fact that the Michigan Constitution does single out pension claims for something―whatever it is, it’s more than other creditors? What weight is that to be given?” Mr. Bennett noted that the city’s final version of its plan is largely amicable, and marks a “very remarkable” one given the tumultuous negotiation period with retirees, insurers, bondholders, and unions, noting: “We had litigation with everybody about something.”

Will Detroit’s Plan Work: The Skinny Edge of Feasibility? Even as Detroit had its final day to seek U.S. Bankruptcy Judge Steven Rhodes’ approval of what is now its eighth and final plan of debt adjustment, it is hard to imagine how—even after more than a year of immersing himself in the city’s fiscal and financial detritus—Judge Rhodes, who is, after all, a federal bankruptcy judge—not an elected city leader, municipal analyst, etc. could really ascertain whether the current plan—mostly configured by a Washington, D.C. corporate, rather than a municipal bankruptcy attorney, who has never been an appointed or elected city leader—can actually lay the foundation for a sustainable future for the city. The plan, after all, cannot change either the city’s mismatch between its huge land size versus its vastly diminished population—imposing disproportional burdens on its emergency response and public safety resources against a much smaller tax base than comparably sized cities, or its deeply troubled public school system. Chapter 9 has allowed—if Judge Rhodes provides a favorable nod next week, Detroit to shed $7 billion of debt—and, critically, to provide for $1.7 billion in investment in a different future for the Motor City. Mayhap Martha Kopacz, who, along with the wizard of NYC, Dick Ravitch, served as advisors to Judge Rhodes, put it best, testifying before Judge Rhodes she believes the $7 billion debt reduction and nearly $1.7 reinvestment plan is feasible, but expressed apprehension that neither Detroit leaders, nor Kevyn Orr’s bankruptcy team have devoted enough time, until recently, to the Motor City’s restructuring city operations. In addition, she expressed great concern over the city’s pension system, telling the court: “They (referring to the city) could wake up with a bad nightmare, not unlike what they’ve been through with this pension system to get to this point.” In response to Judge Rhodes’ queries about the fiscal and economic impact and feasibility of the recent settlements the city has reached with its last holdout creditors, Ms. Kopacz warned the settlements have pushed Detroit to the “skinny end of feasibility.”

Let’s Get Going! With the Stockton municipal bankruptcy decision expected this week, and Detroit’s next week, San Bernardino’s pension obligation bond creditors, Ambac and EEPK, are running out of patience. The two have submitted a motion to U.S. Bankruptcy Judge Meredith Jury to try and impose a deadline of next March for the much slower moving case in southern California. The city filed for chapter 9 bankruptcy protection on August 12, 2012, nearly a year before Detroit, and two months after Stockton. Now the two creditors are pressing the court to set a deadline for San Bernardino to submit a final plan of debt adjustment:

“By this motion Ambac Assurance Corporation (“Ambac”) and Erste Europäische Pfandbrief- und Kommunalkreditbank AG in Luxemburg (“EEPK,” and together with Ambac, the “POB Creditors”) respectfully seek an order of this Court fixing a deadline for the City of San Bernardino to file its plan pursuant to 11 U.S.C. §941. Setting a deadline for the City to file its plan of adjustment is warranted at this juncture. The City has negotiated with its major creditor groups and has made sufficient progress towards understanding its financial situation to be able to formulate a plan of adjustment. The time has come to fix a deadline for the City to file a plan and proceed to the plan phase of this case. On the one hand, fixing the deadline may provide the City and its creditors with additional incentive to settle. On the other hand, in the event uniform creditor support is not obtained, further delays detrimental to the City and its creditors will be minimized.”

Judge Jury has scheduled a hearing for arguments on the motion for next month, likely appreciating next week’s municipal elections, involving both governance issues—especially Question Q—and potential changes in the city’s elected leaders. To date, San Bernardino has held extensive settlement discussions with all of its major creditors through a court-ordered confidential meditation, not dissimilar to those overseen by U.S. Judge Gerard Rosen in the Detroit case; however, the only substantive agreement reached to date has been with the California Public Employees’ Retirement System or CalPERS—an agreement whose terms are confidential, but which have resulted in the city’s resumption of pension obligation payments to CalPERS. EEPK and Ambac are, respectively, the holder and insurer, of $50 million in pension obligation bonds issued by San Bernardino to refund the majority of the city’s then unfunded actuarial accrued liability under its employee retirement plans administered by CalPERS—of which Ambac insures about $14 million. San Bernardino has not resumed payments to the Ambac and EEPK, even though the proceeds of the original pension obligation bond issuance were turned over to CalPERS, according to the filing. In its filing, the two creditors did note that even though their negotiations with the municipality have not been productive—ergo the filing with the federal court—the two added that “unlike with the fire union, they have not been acrimonious.”

The Obstacles to Exiting Municipal Bankruptcy

Visit the project blog: The Municipal Sustainability Project
Paving the Way to Exit Bankruptcy. The Detroit City Council yesterday approved a crucial bankruptcy settlement that could pave the way for the demolition of Detroit’s downtown Joe Louis Arena to make way for a new hotel—in effect blessing the agreement worked out under the auspices of U.S. Judge Gerard Rosen behind closed doors between the Motor City and its last major holdout creditor, Financial Guaranty Insurance Co. Detroit Council President Brenda Jones, who testified less than three weeks ago in support of the plan of adjustment, was the only member to oppose the deal. Council President Jones did not describe her reasons for opposing the agreement before casting her vote, telling her colleagues she was “not proud of this settlement.” She has previously questioned the value of the Joe Louis property and who would be responsible for oversight of the hotel development. Under the settlement, downtown Detroit’s west riverfront would be transformed with a new hotel, residential and retail complex on the site of Joe Louis Arena, and its parking garage. The agreement also proposes to provide FGIC with about $74 million in cash from bonds the city will issue. In addition, FGIC and the municipal bond debt holders it insures are to receive another $67 million in bond proceeds—and FGIC, the city’s last remaining major holdout creditor, reversed its opposition to the city’s plan of debt adjustment awaiting U.S. Bankruptcy Judge Steven Rhodes approval—or disapproval—the week after next. Nevertheless, Detroit corporation counsel Melvin (Butch) Hollowell yesterday said the FGIC settlement signals a near-end to the largest municipal bankruptcy in the nation’s history: “This really puts a capstone on the remaining creditors in this chapter 9 file.”
Politics, Municipal Bankruptcy, & Governance. For San Bernardino’s elected leaders, November has become juggling season: the city has to juggle its efforts to put together a debt adjustment plan that will gain the approval of U.S. Bankruptcy Judge Meredith Jury if it is to emerge from municipal bankruptcy; it must undergo elections—and not just elections to municipal leadership, but also election measures—especially, in this instance, on Measure Q, a challenge to a provision in the city’s charter to reform Charter Section 186, a guarantee unique among California cities: a legal requirement that police and firefighters’ salaries be exactly the average of what 10 other California cities with a population between 100,000 and 250,000 pay for those positions. Those 10 cities vary by year, but the way they are selected ensures, in practice and previous experience, that base pay is the average pay of midsized cities. That significantly complicates the San Bernardino’s ability to structure a plan of adjustment—it is almost like the obstacle imposed by the uncertainty with regard to whether it can subject its pension obligations to a haircut—with the federal bankruptcy courts saying yes—and the California constitution and the state’s massive public retirement authority, CalPERS, saying no. It is like being between a double rock and hard place. The cost of police salary increases required by the city Charter §186 will surpass $1.3 million for the 2014-15 year, according to City Manager Allen Parker. That includes only base salary, but overtime and some benefits will also increase proportionally, Mr. Parker said in a statement, adding: “The salary increases are mandatory and are not based upon employee performance, the City’s financial condition, or departmental performance measurements,” adding that: “Of the cities chosen under the Police Safety Unit employees, four (4) are served under contract by the Los Angeles County Sheriff’s Department and three (3) are Northern California cities.” The delicate timing of the election comes as the city’s negotiations with the fire union, according to assertions it has filed with the federal bankruptcy court, have come to a halt—so, in effect, the significant legal meter is running at great cost to the city—and its fiscal future—but it is hamstrung in the nonce. §186 requires the city and union to alternately strike names from a list of California cities with a population between 100,000 and 250,000 to find the salaries, but there is no clear legal map what the alternative is if the fire union opts not to participate in that process. Moreover, because, in effect, §186 mandates salary increases, the city—in order to comply with the unfunded mandate―is likely to compel the city to slow down hiring — a slowdown which could adversely affect service levels and overtime. Currently, San Bernardino’s charter is the only one in the Golden State that mandates police and firefighter salaries be set with a formula such as §186.
Ruling Ahead. U.S. Bankruptcy Judge Christopher Klein is scheduled to issue his opinion on the City of Stockton’s proposed plan of debt adjustment next Thursday. Judge Klein, who at the beginning of this month ruled that, notwithstanding California’s state constitutional protection of municipal retirees’ pensions, federal bankruptcy law preempted the state bar—in effect offered the city the option of modifying its plan of adjustment to give a haircut to its pension payment obligations to the California Public Retirement System (CalPERS). Nevertheless, the city has remained opposed to any such reductions out of apprehension that any such retirement reductions would adversely affect city’s ability to retain and recruit workers. Stockton’s main remaining holdout creditor, Franklin Templeton Investments, is seeking to recoup more of the $35.1 million in bond debt the city owes than what is proposed under Stockton’s current plan of debt adjustment—in effect asking the city’s bondholders to share a disproportionate risk. Franklin Templeton has urged Judge Klein to reject Stockton’s plan. Unlike Solomon, Judge Klein does not have the option of cutting the baby in half: he can either approve or disapprove the city’s plan of adjustment, albeit Stockton Assistant City Manager Liz Warmerdam said Judge Klein’s earlier ruling could offer other California municipalities cities “more options” than they now have to address fiscal crises. In California, however, there is fear that taking on CalPERS as a means to avoid or get out of municipal bankruptcy risks significant legal costs that cities can ill afford in what is already a horrendously expensive process—pitting Davids against the CalPERS Goliath, and creating a costly delay in cities’ efforts to reorganize their way out of bankruptcy. There is also a competitive apprehension: in the wake of its 2012 bankruptcy filing, Stockton experienced an increase in crime in the wake of laying off police and leaving positions vacated by retirements unfilled.

The Hurdles to Exiting Municipal Bankruptcy

October 23, 2014

Visit the project blog: The Municipal Sustainability Project 

The Skinny End of Feasibility? The trial portion of Detroit’s municipal bankruptcy concluded yesterday with Martha Kopacz, an independent financial expert hired by U.S. Bankruptcy Judge Steven Rhodes to review the feasibility of the Motor City’s plan of debt adjustment and investment in the city’s fiscal, sustainable future, endorsing the city’s eighth, and likely final version of its debt adjustment plan, but warning that elected officials need to be on board for the plan to work. Ms. Kopacz testified she believes the $7 billion debt reduction and nearly $1.7 reinvestment plan is feasible, but expressed concern that neither Detroit leaders, nor Kevyn Orr’s bankruptcy team have devoted enough time, until recently, to the Motor City’s restructuring of city operations. In addition, she expressed great concern over the city’s pension system, telling the court: “They (referring to the city) could wake up with a bad nightmare, not unlike what they’ve been through with this pension system to get to this point.” In response to Judge Rhodes’ queries about the fiscal and economic impact and feasibility of the recent settlements the city has reached with its last holdout creditors, M. Kopacz warned the settlements have pushed Detroit to the “skinny end of feasibility.” Even though she was brought in to serve as a special advisor to Judge Rhodes, Ms. Kopacz demonstrated her own independence in criticizing the speed with which the inimitable rhythm guitar leader of the Indubitable Equivalents―Judge Rhodes―has managed and processed the biggest municipal bankruptcy in American history, testifying that speed can be a “two-edged sword…In a little over a year, the city has gone through a massive restructuring process and will have significantly (slashed debt)…Everybody in the city needs to get on the same page relative to what the plan is post-bankruptcy. Right now, the official budget doesn’t include anticipated spending that is really, really critical.” Ms. Kopacz concluded the city’s plan was feasible—testifying the city will likely be able to provide basic services and meet its obligations “without significant probability of default―” according to local reports from the courtroom, a critical element if Judge Rhodes is to approve the city’s pending plan, but she stressed that Detroit needs a larger and better-trained workforce and commitment from its elected leadership to carry out the massive restructuring: the post-bankrupt Detroit, she told the court, could find itself “on the edge” when it comes to servicing debt and managing operations. Closing statements in the trial are set to begin on Monday, and Judge Rhodes said he intends to deliver a decision in open court during the week of November 3rd, whence he will opine whether the plan treats creditors fairly and was crafted in good faith, issues which Ms. Kopacz did not consider in her analysis. On some of the key elements:

  • Debt Obligations: Referring to Detroit’s debt obligations, Ms. Kopacz testified: “I do believe we are on the edge of what the city can reasonably be expected to be able to service in the future.” Reminding the court that in the city’s plan of adjustment, the plan proposes borrowing $275 million from Barclays in an exit financing to pay off creditors and improve services. An inability to do the Barclays deal, however, she warned, “could have caused the plan to tip into infeasibility: The debt is a means to an end, and based on the projections the city can service that.”
  • Pension Obligations: In response to Judge Rhodes’ queries with regard to Detroit’s projected 6.75% return rate for Detroit’s two pension funds, Ms. Kopacz testified the assumption rate was reasonable, but added she would “”make it 5% if I ruled the world,” warning that, without careful monitoring, the city could find itself facing mounting pension debt again: The city’s leaders “could wake up with a bad nightmare, not unlike what they’ve been through with this pension system to get to this point.”
  • Restructuring Initiatives: Ms. Kopacz warned the Motor City officials will need to put more effort into its restructuring initiatives: “There has not been, until recently, as much energy put into restructuring operations…It’s not in the budget, and there’s not a robust implementation plan behind it.”
  • The speed of the bankruptcy: She noted the exceptional celerity with which Detroit’s bankruptcy has proceeded, but warned that this could prove to be a “two-edged sword:” telling the court that while the plan eliminates some $7 billion in municipal debts, much less effort has been devoted to the Motor City’s fiscally sustainable future: “Because the focus has been on the bankruptcy and the speed in getting that done, there has not been until recently as much energy put into restructuring the operations of the city…Functionally, the city operationally was broke…I believe the emergency manager had to pick one of two options. The focus was on delivering, not fixing, the operations. That was one way the speed cut against necessary, long-term things which will now have to be accomplished outside of the bankruptcy, which could be more difficult to achieve than inside the bankruptcy with the power of the emergency manager.” She noted that a longer process might also have allowed creditors to gain a deeper understanding of the city’s finances and allow Detroit’s leaders to develop broader, multi-party agreements: “I think we would have been able to reach settlements where maybe we weren’t as close on that continuum of feasibility as we are today.”
  • Municipal Revenue Projections: She testified that Mr. Orr’s revenue projections for Detroit—that is the revenues that are the foundation for the city’s reinvestment in its future — which some have warned are unrealistic — are largely reasonable, adding that, if anything, the projected annual growth rate of 2% for income taxes may even be conservative. (The plan projects that state revenue aid is expected to stay flat, while casino tax revenues are projected to decrease, at least in the near term.) She testified that the low amount of funding set aside for contingencies is a “continuing concern,” but added that the amount did not make the plan infeasible.
  • State Oversight: Ms. Kopacz testified that the creation of a fiscal review committee to oversee Detroit’s finances for up to 20 years will play a key role in the plan’s feasibility: “The existence of the financial review commission, the oversight commission, I think is a very positive, qualitative factor in ensuring that the city conducts itself in such a way that ensures or helps to ensure the commitments of the plan are going to be met.”
  • New collective Bargaining Agreements: Ms. Kopacz testified she would have preferred a more “robust negotiation” around work rules, as part of her overall apprehension that the city’s focus on speed in getting out of bankruptcy focused on fixing the city’s balance sheet―not its operations, advising: “The plan of adjustment is a giant change management exercise.”

Getting Ready to Close. With the historic trial’s closing arguments scheduled for Monday morning, Judge Rhodes yesterday closed the session by advising the parties: “[Y]you should argue whatever you think you need to argue and we’ll deal.” Detroit’s lead attorney Bruce Bennett said he could trim his three-hour closing. Two individual objectors want 30 to 45 minutes each. Barbara Patek of the biggest police union says her closing will be 10 to 15 minutes if there is one. Ron King of the Retirement Systems says 15 to 20 minutes at most.

Politics, Municipal Bankruptcy, & Governance. As San Bernardino continues its efforts to emerge from municipal bankruptcy, it—as in Detroit and Stockton—has had to go through elections, a complication that does not occur in other kinds of corporate bankruptcies, so that it adds many layers of complications. In San Bernardino, it is not just elections to municipal leadership, mayor and council races, but also measures—so that early next month city voters will go to the polls on Measure Q, a challenge to a decades-old provision in the city’s charter to reform Charter Section 186, a guarantee unique among California cities: a legal requirement that police and firefighters’ salaries be exactly the average of what 10 other California cities with a population between 100,000 and 250,000 pay for those positions. Those 10 cities vary by year, but the way they are selected ensures, in practice and previous experience, that base pay is the average pay of midsized cities. Needless to write, for a city in the midst of trying to structure a plan of adjustment to emerge from municipal bankruptcy before U.S. Bankruptcy Judge Meredith Jury, the city and its fiscal circumstances are anything but average, so that a committee of citizens chosen by the City Council and Mayor decided this year to ask voters to replace that formula with collective bargaining. San Bernardino Mayor Carey Davis, whose signature voters will see on the ballot argument for Measure Q, warns: “Firefighters and police make up a huge part of the budget, even now when we’re down 100 officers: That high pay prevents us from hiring more officers.” The election, coming in the midst of the city’s trial in federal bankruptcy court, comes as the fiscally struggling municipality is exploring realignment of how its emergency services are delivered—but, in effect, transfixed between California law and federal bankruptcy law.

El Futuro? Caught in a legal twilight zone between a rock and a hard place, the Commonwealth of Puerto Rico’s planned municipal bond sale from the Puerto Rico Infrastructure Finance Authority (PRIFA) could trigger—or avert—a default, but, because the island is a territory, not a municipality; it has no access to federal bankruptcy protection. The planned sale, under the aegis of its recently enacted Debt Enforcement and Recovery Act, under which public corporations are authorized to restructure their debt, will depend upon legislative ingenuity. Under legislation that could be introduced in the island’s legislature as soon as this week, PRIFA, would be authorized to issue more than $1 billion of bonds―enough to refinance debt owed to the Government Development Bank by the Puerto Rico Highways and Transportation Authority, which is subject to the new law. The legal conundrum would be whether this would suffice to prevent a default by the island’s transportation authority—and at what interest rate. It also raises issues with regard to whether the infrastructure authority would have the same ability to service the debt or maintain the excise taxes serving as source of payment, and whether the bond would need bondholders’ approval.

Justifying One’s Exit from Municipal Bankruptcy

October 22, 2014
Visit the project blog: The Municipal Sustainability Project

Nearing Home? U.S. Bankruptcy Judge Steven Rhodes yesterday outlined several issues he would like to see addressed in the city’s closing arguments, advising the Motor City’s lead attorney, Bruce Bennett, that he would like him to discuss the section of the federal bankruptcy code, chapter 9, which addresses the “reasonableness of fees,” and “how it can work here.” In addition, Judge Rhodes instructed Mr. Bennett that he should specifically note which settlements the federal court is being asked to approve and whether the court needs to approve the city’s exit financing. Judge Rhodes also requested that the city “spend as much time as you think is necessary on the issue of the justification for the discrimination among the classes of unsecured creditors, adding that “At the same time, however, while you do that, I want to indicate to you that I’m less concerned about the numerator and denominator than I am about the business side, the business justification side of that analysis.” That guidance came after Judge Rhodes had previously queried Kevyn Orr on the related issue of the State of Michigan’s role: “What advice would you give to the Financial Review Commission with respect to its responsibilities?” Mr. Orr testified that the new state commission needs to understand how to improve public safety in Detroit; it will need a deep understanding of redevelopment plans; it will need a means to ensure keeping Detroit within its budget; and he told the court the staff of the commission will need a comprehensive understanding of Detroit’s human resources challenges. Earlier, yesterday, Ernst & Young consultant Guauray Malhotra testified that he believes Detroit’s cash position in the future will be “sufficient” to operate and meet its debt obligations, testifying that the Motor City’s planned exit financing issue with Barclays is now likely to be $275 million, down from $325 million: “It is the city’s view to borrow less because of the overall cost of that financing that has to eventually be paid.” Martha Kopacz, an independent financial expert hired by Judge Rhodes to review the feasibility of the plan, is expected to testify today, on what could be the last day of the trial, with closing statements set to begin next Monday.

The Last Hurdle? As Detroit’s bankruptcy trial winds down, the federal court yesterday devoted most of its time focusing on the details of the city’s recent, federally mediated settlement with its final, major holdout creditor, municipal bond insurer Financial Guaranty Insurance Co., with Detroit emergency manager Kevyn Orr and an Ernst & Young financial consultant testifying with regard to additional details about the agreement—an agreement which provides for significant real estate and cash, including the current site of the Joe Louis Arena, where the Detroit Red Wings skate, located on prime riverfront Detroit land adjacent to the Motor City’s convention center—sites which will be developed by FGIC into a 300-room hotel with condominiums and retail space. Under the cash part of the deal, FGIC is expected to recover approximately 13% on its $1.1 billion claim against the city, receiving $141 million from proceeds of a note issue and $20 million in settlement credits. Judge Rhodes asked Mr. Orr to estimate the monetary value of the real estate portion of FGIC settlement, noting: “Ultimately I’d like you to testify either what the value of the real estate is FGIC has an option to acquire here, or tell me the city doesn’t think it’s necessary for the court to have that to determine the reasonableness of the settlement.” After taking a break to confer with his attorneys, Mr. Orr came returned to the stand and said the Joe Louis Arena currently had either no value or even “negative” value, and that its worth would only be realized after it was demolished and the new project built—leading Judge Rhodes to follow up: “[T]he city’s position is that the costs associated with attempting to market all of that property either equals or exceeds what the city could sell it for in the market?” In response, Mr. Orr testified “Yes…Because you have to demolish it. You have to remediate it, so that’s true, your Honor,” going on to describe the federally mediated resolution with the city last major holdout creditor as a “peace accord, more or less” which Mr. Orr believed would bring some certainty to the bankruptcy exit process—and save Detroit significant legal fees, because, as part of the agreement, Detroit will drop the suit it filed at the beginning of the year seeking to invalidate the $1.5 billion of certificates of participation insured by FGIC and Syncora Guarantee Inc., adding that if the insurer had succeeded in its countersuit on the COPs or on its objection that the city’s plan unfairly discriminated against it, then the Motor City would have had to in Mr. Orr’s words, “hit the rest button and go back to plan development…It would have been fairly catastrophic from my perspective.” The Detroit City Council is expected to vote today or tomorrow on the FGIC agreement, which, because it was put together under Michigan’s state emergency management law, means that even if the council rejects it, officials can go to the state emergency loan board for its approval.

Let there be light! The old adage is necessity is the mother of invention, so it was yesterday in Judge Rhodes’ courtroom that one of Detroit’s consultants, Gaurav Malhotra, testified the Motor City will be getting into the metal scrapping business to help finance the city’s recovery by salvaging millions of pounds of copper from thousands of its moribund streetlights. As the city replaces lights over the next seven years with brighter lamps which use less power, it expects to collect as much as $25 million through sales of the copper it excavates and recovers from the older lines. Mr. Malhotra told Judge Rhodes he estimated there could be as much as 13.5 million pounds of copper, worth about $40 million, in the old streetlight system—not an inconsiderable sum to incorporate into Detroit’s revised, eighth—and presumably final—plan of debt adjustment, with the guesstimated $40 million pledged to help finance the plan’s proposed decade-long rebuilding plan—whilst at the same time shining light on some of the city’s dimmest lit and most blighted neighborhoods in a critical effort to reduce violent crime.

Copping a Lower Credit Rating. Moody’s on Monday lowered its ratings on the Motor City’s $1.5 billion of certificates of participation or so-calls COPs to C from Ca, writing that the city’s recovery or debt adjustment plan’s proposed settlements with insurers would put recoveries well below 35%. The drop came in the wake of Detroit’s settlement with holdout creditor Financial Guaranty Insurance Co. last week with regard to FGIC’s insurance on some $1.1 billion of COPs—and in the wake of its warnings at the beginning of this month that it might downgrade the debt depending on the terms of any settlements with either FGIC or the city’s then other and similar holdout creditor, Syncora. In the wake of the two resolutions, worked out under the closed door federal ministrations of U.S. Judge Gerard Rosen by means of agreements involving cash and downtown real estate, estimates are that the cash recovery for the two insurers will in the range of about 13 percent of their claims against the city, leading Moody’s analyst to note: “Reported terms of the FGIC settlement, along with the Syncora settlement terms laid out in the city’s Seventh Amended Plan of Adjustment (now updated to the Eighth to incorporate the more recent settlement with FGIC), support our expectation of a recovery rate falling well below the 35% to 65% recovery rate range that would be consistent with a Ca rating.” The Detroit City Council has already voted to approve the agreement with Syncora, and is scheduled to take up the proposed agreement with FGIC later this week. Should the Council reject the newer agreement, the Mayor could seek approval from Michigan’s state emergency loan board.

Harried in Harrisburg. Harrisburg, Pennsylvania, which opted out of filing for federal bankruptcy protection and has slowly crawled out of fiscal distress under a debt recovery plan approved by the Commonwealth Court of Pennsylvania plan last September, nevertheless continues to confront recovery stumbles and remains under the state’s Act 47 program for distressed municipalities. Yesterday, its Treasurer, Timothy East, became the state capitol city’s second treasurer to resign in two months. Mr. East, who had filed for personal bankruptcy in 2011—a filing which is still open, told the city’s Patriot-News he was unsure whether city officials could get him bonded. The City Council had approved Mr. East over five other candidates late last month to serve out the remaining 15 months of his predecessor’s—a predecessor who had resigned after the Dauphin County District Attorney charged him with stealing money from two nonprofits: Lighten Up Harrisburg, a program designed to fix street lights, and the gay-and-lesbian advocacy group Equality Pennsylvania. In addition, the Dauphin County District Attorney had subsequently filed an additional theft charge in connection with $2,750 that went missing from a political action committee for which he was treasurer—with the former treasurer reportedly claiming to authorities he used the money for personal college and medical expenses, according to court records. Mr. East’s personal financial issues were not subject to scrutiny by the city when he applied, because background checks only require notice of any criminal records. In his application, Mr. East had not disclosed the information with regard to his personal finances. Harrisburg officials briefed the City Council last week about his personal finances. Harrisburg, Pennsylvania’s 49,000-population capital, narrowly avoided municipal bankruptcy last year by crafting a financial recovery plan which erased more than $600 million of debt. A city’s treasurer, because she or he needs to be bonded, may create a risk that insurance companies may be leery of approval in instances where a treasurer has already declared personal bankruptcy—especially in this instance, where the abrupt departure of Harrisburg’s former city treasurer, John Campbell, also meant the city had to get re-bonded—already a costly and precarious undertaking in light of the capitol city’s near bankruptcy and receivership. Harrisburg had secured a bond for the city, but now awaits hearing back from insurance companies in the wake of the trials and tribulations of Mr. East. In his job interview with the city late last month, Mr. East counted among his skills that he understood cash management operations, tax collection, and proper system controls, according to the Patriot-News, and he said he thought his most important leadership quality was the ability to inspire others. His personal bankruptcy filing was dismissed last year after he fell short on his required payments, but his attorney was successful in getting it reinstated last January. In Harrisburg, the city treasurer is a part-time position which pays $20,000 a year.