D-Day in Stockton, California

October 30, 2014
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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.


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