The Hurdles to Exiting Municipal Bankruptcy

October 23, 2014

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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.

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