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.”

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