The Tests of Exiting Municipal Bankruptcy

November 6, 2014

Visit the project blog: The Municipal Sustainability Project 

Is the Motor City Poised to Take Off? With U.S. Bankruptcy Judge Steven Rhodes poised to issue his ruling on the Motor City’s proposed plan of debt adjustment tomorrow afternoon, Detroit posted a proposed order which it hopes could serve as a template. Judge Rhodes will determine whether the plan’s proposed elimination of nearly $7 billion in debt it owes to its creditors and $1.7 billion it is proposing to invest in the city’s long-term sustainability and economic future is equitable and balanced. The 163-page proposed order [see a portion below] outlines the legal arguments in defense of the plan. A key issue for Judge Rhodes in rendering his decision will be whether the city’s 8th version of its plan, under which its retirees would benefit from higher recoveries than its other unsecured creditors, is fair and reasonable, attorneys argue, for several reasons. Among them are that bondholders, as sophisticated investors, or, as the city, in its proposed order, suggests: “It would be practically impossible to confirm a workable plan without discriminating among unsecured creditors because, with respect to the pension claims in particular, the city’s recovery will turn in large part on its ability to marshal the support of its residents in general and its retirees, employees and their labor unions in particular.” (Detroit’s plan proposes that its retirees would receive a diminution of benefits of about 5 percent, but the proposed, draft order omits a specific amount.) In its draft proposal, the city suggests that Judge Rhodes that “[C]ritical business considerations justify the differential treatment of pension claims,” including the need for the city to maintain a “stable and motivated” workforce, address the “expectations of creditors” under the Michigan Constitution, and the need to confirm a workable plan of adjustment. The city’s plan proposes, in contrast, that the Motor City’s unlimited-tax general obligation bondholders would receive for 74% of what they are owed, and limited-tax general obligation bond holders would receive roughly 34%. The holders of $1.5 billion of the city’s pension certificates of participation, who were the last holdout creditors in the case, are proposed to receive a 14% cash recovery supplemented by various real estate development deals, vacant land, and long-term leases on city assets. In suggesting verbiage for Judge Rhodes to use, Detroit’s attorneys suggested: “The reasonable expectations of creditors further demonstrate that the differential treatment of pension claims is fair and reasonable because, while many of the city’s institutional creditors affirmatively chose to invest in the city and possessed both the experience and sophistication necessary to evaluate the risks related to such an investment, individual holders of pension claims had no meaningful opportunity to protect themselves from such risk because they had little control over how much the city contributed to pensions, how pension assets were invested and how the retirement systems were operated.” With regard to Detroit’s perennial concerns about revenue, the draft, proposed order notes that because tax increases could be counterintuitive to economic revival, the city’s plan of adjustment instead proposes to raise “multiple” sources of new revenue―chief among those derived from the so-called “grand bargain,” under which $816 million in public and private funds are proposed to protect public pension benefits and ensure the retention of the Detroit Institute of Arts in the city as an independent trust. The draft notes that the proposed plan to reinvest $1.7 billion over the next decade into the city’s sustainable future will be critical to “arrest the reinforcing trends of population loss, declining property values and declining revenues if adequate services are restored, blight is remediated and the city becomes a more attractive place to live and work.”


The City of Detroit (the “City” or the “Debtor”) having proposed its Eighth Amended Plan for the Adjustment of Debts of the City of Detroit (October 22, 2014) ([as modified by the Modifications,] the “Plan” or the “Eighth Amended Plan”), a true and correct copy of which (without exhibits) is attached hereto as Appendix I [, as modified by errata notices/modifications (collectively, the “Modifications,” true and correct copies of which are annexed hereto as Appendix II])]; the Court having conducted a 24-day evidentiary hearing to consider confirmation of the Plan on August 18, September 2-5, September 8-9, September 15-18, September 29 to October 3, October 6, October 14-16, October 20-22 and October 27, 2014 (the “Confirmation Hearing”); the Court having conducted a hearing on July 15, 2014, at which 46 individuals who (i) filed objections to Confirmation of the Plan with the Court and (ii) appeared in the Chapter 9 Case pro se made presentations with respect to such objections to the Court (the “Pro Se Hearing”) and the Court having considered the arguments of such parties at the Pro Se Hearing; the Court having conducted hearings on certain On May 5, 2014, the City filed its Fourth Amended Plan for the Adjustment of Debts of the City of Detroit (May 5, 2014) (the “Fourth Amended Plan”), which version of the Plan was included in the contents of the solicitation packages distributed to creditors entitled to vote thereon. All capitalized terms used but not defined herein have the meanings given to them in the Plan. See Notice of Hearing to Individuals Who Filed Plan Objections (Docket No. 5264) (June 10, 2014). Legal issues related to confirmation of the Plan on July 16, 2014 and August 19, 2014; the Court having considered: (i) the testimony of the 41 witnesses called at the Confirmation Hearing, as well as the affidavits and declarations included among the 2,327 exhibits admitted into evidence at the Confirmation Hearing; (ii) the arguments of counsel presented at the Confirmation Hearing; (iii) the pleadings filed by the City in support of the Plan.


Plan B in San Bernardino? With final votes still to be tallied in San Bernardino, it appears voters narrowly rejected a measure, Measure Q, which would have modified the mechanism which determines how the bankrupt city pays police and firefighters (For Measure Q, the “no” vote led 55.32 percent to 44.68 percent for “yes” as of yesterday, a difference of 1,692 votes.): it means that San Bernardino will be mandated to continue to set public safety salaries based on the average of 10 cities of similar population instead of by collective bargaining—likely dealing a blow to the city’s efforts to put together a plan of debt adjustment to present to U.S. Bankruptcy Judge Meredith Jury, as the apparent rejection means San Bernardino will be required to pay at least $1.3 million more for police salaries this year than budgeted, according to City Manager Allen Parker. In addition, the vote could impose higher cost burdens on firefighters’ pay and on overtime and benefits that increase alongside base salary—all of which carry implications for putting together a revised municipal bankruptcy exit plan, not to mention relations between the city and its public safety employees. The heads of both the police and fire unions, as well as many of their supporters, released statements after the apparent defeat of Measure Q calling it a mandate for public safety to be a priority. San Bernardino fire union President Jeff English said the city must now focus on bringing more money into the city: “The defeat of Measure Q is strong signal to the mayor and city manager to scrap their ‘budget cuts only’ approach to fiscal management…It’s time for city leaders to immediately begin working on solutions that will generate new revenues and economic development for the city.” Similarly, Councilwoman Virginia Marquez, a longtime proponent of setting pay by collective bargaining, said economic development could accelerate now that City manager Parker had specialists in his office to bring in businesses. She has also received calls from prospective businesses herself, she said, but the budget remains a challenge: “These are challenging times,” she said. “I believe that public safety is a priority. We have to have some kind of law and order in the city to maintain stability, but (the level of spending) is just not sustainable. So we need to change the way we do business.” Now a council-appointed citizen charter committee is scheduled to meet a week from Tuesday to study possible charter changes—a daunting task, given that when it met last May, it had recommended five amendments, including the two that became Measure Q and Measure R. Measure R, which changes the city charter so that terminated city employees are no longer paid while they wait for an appeal of their employment, was, as of yesterday, ahead 54.76 percent to 45.24 percent. That likely change is scheduled to take place after the City Council approves a resolution to that effect, which will come after San Bernardino County certifies the results, according to the City Clerk’s Office. The county’s legal deadline to certify the results is December 2nd.

Taking Stock in Stockton: Moody’s yesterday opined that U.S. Bankruptcy Judge Christopher Klein’s ruling approving Stockton’s plan of debt adjustment, because it does not impair pension obligations, is a credit positive for the California Public Employees Retirement System―CalPERS, adding that it is likely to set a precedent under which public pensions will realize better treatment than other debt in California municipal bankruptcy cases: “The inclusion of pension cuts in Stockton’s bankruptcy exit plan, in and of itself, would not have materially impacted CalPERS’ financial health, because Stockton would have been obligated to pay a substantial termination fee…However, it would have stood as the first pension impairment in a California Chapter 9 bankruptcy and established a new landmark precedent.” Such a ruling would have increased the risk that other distressed California municipalities would file for bankruptcy in an effort to extract cuts to pension liabilities, which would have had a negative effect on CalPERS’ financial health. It would also have had longer-term negative credit implications because it would have critically damaged the notion that CalPERS is an arm of the state and therefor exempt from federal bankruptcy court jurisdiction, Moody’s said. “Favorable outcomes for CalPERS in the Stockton, CA and San Bernardino, CA bankruptcy proceedings lend further support to CalPERS improving financial profile because it reduces the likelihood that other CalPERS contracting employers will race to declare bankruptcy to reduce growing pension liabilities,” the report said. CalPERS is rated Aa2 by Moody’s, after an upgrade from Aa3 in July. The upgrade was based on the system’s improving credit profile of the retirement plan’s main sponsor, the State of California, as well as the steps taken by CalPERS to increase contribution rates in an effort to remediate its funding gap over time. Moody’s said in a previous report that while Chapter 9 filings will remain rare, Judge Klein’s oral ruling that pensions can be impaired will give other local governments more negotiating leverage with labor unions. Standard & Poor’s also said Stockton’s experience with municipal bankruptcy is unlikely to cause other municipalities to view Chapter 9 as an attractive option.


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