The Challenging, but Critical Role of Schools in Municipal Fiscal Sustainability

eBlog

February 27, 2014
Visit the project blog: The Municipal Sustainability Project

Blueprint for the Motor City’s Future. Detroit’s Coalition for the Future of Detroit Schoolchildren, the Motor City’s 36-member community commission assessing how to better serve the city’s children—and facing a March 31 deadline, has now achieved consensus that a single governing authority should oversee the nurturing of Detroit’s 119,000 school-age children―regardless of where they attend public school―or, as two members confirmed to the Detroit Free Press yesterday: “There is consensus on that because one of the things we have to have are some clearly defined educational objectives for all our children…You can’t have the Detroit Public Schools having one academic achievement design, and the Michigan Education Achievement Association another, and charters having something else. If you have a child that attends school in Detroit, regardless of entity, there are certain academic standards that should apply universally. How you address those may be up to you, but the standard itself should apply unilaterally.” The coalition’s challenge is brutal: In the Motor City today, there are 97 Detroit Public Schools (DPS), about 100 charter schools, and 15 schools in the Education Achievement Authority (the district for Michigan’s lowest-performing schools). According to DPS officials, the city has about 20,000 more seats than students, and about half of Detroit’s school-age children attend charter schools. DPS has been run by a state-appointed emergency manager for six years and has been paying down its $169.5-million deficit, using part of the per-pupil allotment it receives to educate children. At the same time, the school district’s special needs population has more than doubled. And, the system confronts paralyzing debt obligations: “Fifteen percent of our state allocation right off the top goes to debt service,” according to one commission member, who, reminding us of our own arithmetic, helpfully computed: “That’s $53 million a year, so you have an inherent deficit right there, because that $1,200 per child that comes off your per-pupil allocation which doesn’t do anything to address our kids’ needs.” Because, as in most of the nation’s cities and counties, governance of the cities and counties is different than governance of the respective school systems, the challenge in Detroit is not only with regard to determining whether there ought to be just a single school oversight authority, but also how it relates to the city or county—the bodies, after all, which not only are charged with raising the revenues to finance the capital and operating budgets of the school systems, but also have to rely on the perception and performance achieved by the schools to attract families into the city—a matter of signal import for assessed property values, not to mention a city or county’s future fiscal sustainability. Thus, the Detroit coalition’s challenge to try and come up with a plan to transform a district that has been dysfunctional for more than a decade, consistently carries major debt, spends a significant part of its per-pupil funding to pay down that debt, and has graduated generations of students who are not ready for college or work is a matter of great import for Detroit’s future. Thus, unsurprisingly, Mayor Mike Duggan, who has been crystal clear he would not be involved in fixing the schools, said in an interview with the Free Press that he stands ready to “do what the group wants me to do.” Mayor Duggan has made clear, however, that even if he does not have any desire to run the school system, he does, according to a second commission member, want to appoint the governing authority. Mayor Duggan also understands – and has taken pains to explain to Coalition members—the politics, telling the members whatever final recommendations they make, he will have to sell to Governor Snyder and state legislators. As the wonderful Free Press columnist Rochelle Riley wryly wrote: “To say that this is the most important post-bankruptcy work the city will face is an understatement. Duggan’s vision and the fate of Detroit’s neighborhoods will rest with the adults who are now children in the city’s schools.”

Spinning for Municipal Bankruptcy: In the Red or Black? Atlantic City reveled yesterday when it learned that despite Gov. Chris Christie’s budget proposal to keep state municipal aid flat in the coming year, the Gov. has proposed an exception for the fiscally strapped municipality, which is slated to receive $16.2 million in municipal aid, according to figures released yesterday by the Department of Community Affairs―$3 million less than what Atlantic City received last year, when the city also received $13 million in Transitional Aid that was needed to avoid a “worst case scenario” property tax increase last March. Atlantic City will again receive about $6.3 million in total formula aid; it will also receive some $10 million in Consolidated Municipal Property Tax Relief Act aid, which is used for distressed municipalities―assistance the city did not receive last year. In addition, Chris Filiciello, Atlantic City Mayor Don Guardian’s chief of staff said the deadline to apply for more Transition Aid is March 16th: “It’s just one piece of the puzzle the mayor is trying to put together to keep property taxes as low as possible.” The state assistance news came even as continued governance uncertainty remains: yesterday, former Detroit emergency manager Kevyn Orr, previously drafted by Michigan Governor Rick Snyder to take Detroit into and then out of the nation’s largest municipal bankruptcy in history, and now tapped by Gov. Christie to determine whether Atlantic City should file for municipal bankruptcy, told Bloomberg News that it would be inappropriate for him to talk about whether Atlantic City was a “shoo-in” for bankruptcy: “You know, nothing is shoo-in. But first of all I’m not the principal on Atlantic City. Kevin Lavin is the principal. He is the emergency manager. I’m just a counselor, a consultant in Atlantic City.” However, Mr. Orr then explained that while the conditions in Detroit and Atlantic City are very different, “the underlying issue for both of them is the current state of affairs is probably not sustainable. So it does take some intervention on a receivership basis to correct that and hopefully that will happen on a consensual basis.” Mr. Orr did not explain what he might have meant in terms of any distinction between municipal bankruptcies and “receivership,” and Kevin Roberts, a spokesperson for Gov. Christie, called it “misleading” to emphasize Mr. Orr’s use of the word “receivership,” given that Mr. Orr earlier declined to say the Atlantic City was a shoo-in for bankruptcy. Moreover, Mr. Orr’s continued, unclear role vis-à-vis Atlantic City Mayor Don Guardian—and the potentially contagious credit risk to other municipalities in New Jersey due to the signal change in state policy towards distressed municipalities remained a matter of confusion clouding the city’s future sustainability.

Cloudy Forecast for Municipal Bankruptcy. House Judiciary Committee Chairman Bob Goodlatte (R-Va.) yesterday released a statement noting that “Chapter 9 of the Bankruptcy Code could provide predictability, transparency, and stability to a Puerto Rican municipal bankruptcy…It also could serve as a framework within which parties could come to the negotiating table and reach a consensual restructuring. That said, [municipal] bondholders purchased Puerto Rican bonds at a time when chapter 9 was not an option. Proposals to retroactively impact investors’ rights should be reviewed with care and caution.” Puerto Rico and its agencies have $73 billion of debt, most of which has traded at distressed levels for more than a year on concern that the island won’t be able to repay. The main electric utility is negotiating with creditors in what may become the largest municipal debt-restructuring ever. Moody’s Investors Service said in a Feb. 19 report that there’s a high probability that the commonwealth will default on its general obligations within two years. For their part, Puerto Rico officials are in favor of extending to the island the option of bankruptcy, which municipalities on the mainland already have. States do not have the ability to file for bankruptcy, and the bill wouldn’t apply to Puerto Rico’s general-obligation bonds. Melba Acosta, president of Puerto Rico’s Government Development Bank, testified that bankruptcy protection may help the island get out from under its obligations and revive the economy: “Addressing fiscal problems associated with Puerto Rico’s public corporations is not only a necessity from a public welfare and safety perspective…It is a critical piece of any strategy for long-term economic growth, fiscal sustainability and prosperity in Puerto Rico.”

Nevertheless, Chairman Goodlatte’s absence from the hearing appeared to cast doubt on whether the House would act on pending legislation to amend the U.S. Bankruptcy Code to allow government-owned corporations in Puerto Rico to reorganize through Chapter 9 municipal bankruptcy. The legislation under consideration is aimed at ameliorating this situation and providing a last resort remedy for municipalities in Puerto Rico, assuming Puerto Rico authorizes its municipalities to file for bankruptcy—making it consistent with the original purpose of Chapter 9: Chapter 9 was the last resort for municipalities that were suffering severe financial distress and, for the most part, had exhausted other available, less drastic methods of resolution. The proposed bill would amend §101(52) of the Bankruptcy Code so that it provides: “The term ‘State’ includes Puerto Rico and, except for the purpose of defining who may be a debtor under Chapter 9 of this title, includes the “District of Columbia.” Thus, the bill has a narrow, simple and straightforward purpose: to permit Puerto Rico, if it so chooses, to authorize its municipalities to file for Chapter 9. Yesterday’s witnesses testifying before the House Judiciary Committee’s subcommittee on regulatory reform, commercial and antitrust law, which has jurisdiction over bankruptcy law, mostly expressed strong support for the bill, the Puerto Rico Chapter 9 Uniformity Act of 2015, which is sponsored by Democrat Pedro Pierluisi and has bipartisan support on the island―but some major funds invested in Puerto Rico bonds oppose it. If enacted, the bill would allow issuers such as the cash-strapped Puerto Rico Electric Power Authority to formally reorganize under court supervision, something it cannot do under current federal law. Rep. Pierluisi introduced the bill last year, but it went nowhere. John Conyers (D-Mich.), of Detroit, and the full committee’s ranking member, called the current exclusion of Puerto Rico from Chapter 9 access “inexplicable,” whilst John Pottow, an attorney and professor at the University of Michigan, testified the bill is a “long overdue” technical correction which is narrowly-tailored to grant Puerto Rico the authority already given the states to determine whether and under what conditions its political subdivisions can file for federal bankruptcy. Professor Pottow said that the federal court’s decision to strike down the local Recovery Act served as “an invitation” to seek this exact remedy. Robert Donahue, a managing director at Municipal Market Analytics, told the panel that the bill poses no systemic risk and reduces the likelihood Puerto Rico will ask for outside help to meet basic needs for its citizens: “This is the best option among a limited set of unattractive options;” however, Thomas Mayer, a lawyer who represents funds managed by Franklin Municipal Bond Group and OppenheimerFunds, Inc. said the bill should be killed in favor of a receivership, because, he testified municipal bankruptcy hurts bondholders, because it is slow and unpredictable.

Advertisements

Citizens’ Great Stakes in Municipal Bankruptcy

eBlog

February 26, 2014
Visit the project blog: The Municipal Sustainability Project

Blueprint for the Motor City’s Future. The newly retired judicial architect of Detroit’s fiscal future, Judge Steven Rhodes—honored yesterday in the Motor City along with his colleague, U.S. Chief District Court Judge Gerald Rosen and former emergency manager Kevyn Orr―noted: “The residents of the city had a great stake in the outcome of the case, a personal stake, each and every one of them…This is something that we in the bankruptcy court are totally unfamiliar with.” Judge Rhodes also cited another key element or outcome of the historic case, noting that, at his urging, Detroit’s bankruptcy reorganization spurred an agreement between city and suburban leaders to regionalize the governance of Detroit’s water and sewerage department (of which one component remains unfinished): “We have to find a way to build upon the momentum for regional cooperation …I think that is essential to the ultimate success of the city, and the region and the state.” Judge Rhodes, without his electric rhythm guitar, nevertheless made clear he was “very optimistic and enthusiastic about the city’s future: All of the ingredients for success are there. The balance sheet has been fixed.” Judge Rhodes, as well as his two colleagues, also discussed their concerns and shared thoughts about the broader topic of fiscal sustainability, with Judge Rhodes noting he remains “deeply concerned” ― in the wake of his experience in the Motor City approving reductions in pensions and health insurance for more than 32,000 Detroit retirees ― about the unfunded pension liabilities of other cities, suggesting Detroit and other cities need to consider moving away from costly pension plans and transition employees towards 401(k)-style defined contribution retirement plans. Judge Rhodes cited publicized estimates that cities and counties have unfunded pension liabilities ranging between $1 trillion and $4 trillion: “It flies largely under the radar and it doesn’t get a lot of attention and it doesn’t get a lot of management, and I’m deeply concerned about that…Because that’s money cities don’t have that they have promised to their retirees, and I think that solution across the country, and including in Detroit, has to be at some point defined contribution (plans).” The retired bankruptcy judge’s remarks, which drew protests outside the event, reflected on the Motor City’s federally approved plan of debt adjustment, under which non-uniform retirees will receive reductions of a minimum of 4.5 percent, while police officers and firefighters realized reduced COLAs―with the reduced benefits scheduled to begin showing up in retirees’ pension checks in March. The plan of adjustment does retain a hybrid pension plan under which new employees contribute more to their retirement.

Judge Rhodes suggested Detroit missed a chance to exit the traditional defined benefit pension business altogether—a reflection with which Mr. Orr did not concur. Mr. Orr, asked whether it was a missed opportunity for the city, said: “I don’t think so…Our general services pensions are modest, $19,400 (per person) on average.” (Police and firefighters receive pensions that average about $25,000 a year, but they are not eligible to collect Social Security like other retirees.) Under its plan of adjustment, as approved by the federal bankruptcy court, Detroit was able to reduce its $3.13 billion unfunded pension liability by 54 percent to $1.45 billion through reduced benefits and the 20-year “grand bargain” infusion of $816 million in contributions from state taxpayers, private foundations, and donors of the Detroit Institute of Arts donors. The approved plan provided for significantly greater savings through its profound cuts in promised retiree health insurance benefits―from $4.3 billion to $450 million.

Taking Final Stock in Stockton. “We have spent the last several weeks finalizing dozens of complicated legal and real estate documents and making preparations for thousands of checks that must be issued for the effective date…The stigma of bankruptcy is lifted and we can move our city forward toward recovery,” Stockton City Manager Kurt Wilson said yesterday, as the California city formally exited municipal bankruptcy—nearly one thousand days after filing for federal bankruptcy protection in July of 2012. Stockton’s route to exiting municipal was profoundly different than Detroit’s, as there was no state takeover; rather the elected leaders, as in Jefferson County, Alabama’s municipal bankruptcy, remained in charge and accountable to the citizens throughout the process—and, as in Alabama—despite, rather than with any assistance—such as was provided to Detroit and Central Falls from their respective states. U.S. Bankruptcy Judge Christopher Klein had lifted the stay preventing Stockton from exiting bankruptcy last month on January 20th, saying during a hearing that Franklin Templeton was not likely to win on its appeal of his decision. Manager Wilson said Stockton has developed a long-range financial plan for the duration of the agreements in its approved plan of debt adjustment, some of which extend out to as far as 2053. Thus, today marks a successful $2 billion municipal financial restructuring. Mr. Wilson and the city’s legal team will be in Judge Klein’s courtroom today for what is expected to be a routine conference updating the status of Stockton’s case, noting that the work in the city over the past three weeks to put the city’s plan of debt adjustment approved by Judge Klein into effect has been “heroic,” adding it has involved dozens of people, “not only people working on behalf of the city, but also people working on behalf of creditors. These are incredibly complicated transactions, and we were doing all of them and trying to get them completed on the same day.” Mr. Wilson said Stockton gave top priority to the 1,100 retirees who gave up some $544 million in lifetime medical benefits as their part or contribution in helping Stockton put together its plan of debt adjustment—with the final agreement providing the retirees a $5.1 million payout instead. Checks were mailed to retirees at the beginning of the week, with Mr. Wilson noting: “We’ve heard very clearly from some retirees that every day of delay has been a hardship…We made those a priority over everything else. They are ahead of everybody else.” Nevertheless, the city’s long municipal bankruptcy still will have another chapter: Franklin Templeton, the financial behemoth which had lent Stockton $36 million for a variety of projects in 2009, but which will receive only $4 million under the city’s approved plan of debt adjustment, is appealing Judge Klein’s decision to the 9th U.S. Circuit Court of Appeals—albeit, the appeal will not affect Stockton’s implementation of its restructuring plan. Mr. Wilson did note that few will discern any bright line etched in the sand of the precise moment in time when Stockton becomes a formerly bankrupt city; nevertheless, he remarked, it is a significant milestone: “We understand we’ll be under the microscope for every financial transaction we make for the next few decades…You’d be hard-pressed to find another city that has a handle on its finances going forward the way we do.” He added that it will be incumbent upon the city to make difficult spending choices going forward, even to deny increasing expenditures on universally popular services if those financial outlays do not fall within Stockton’s long-range economic projections: “In the past, the city sometimes made financial decisions based upon how worthy a cause was…The city used to make decisions where if something was worthy, just do it. We’re no longer in a position to just do it…We have to either make it fit into our model or reduce some other expenditure to get there. That will be difficult for people who say, ‘Hey, we’re out of bankruptcy.’ The reality is, where we were before bankruptcy was an unstable place.”

Hard Choices. San Bernardino, unlike Detroit, has no state-appointed emergency manager to make hard choices about the city’s difficult road to bankruptcy recovery—nor can it count on any assistance from the state. Nevertheless, it does appear that City Manager Allen Parker’s team might have the fiscally stressed city on the verge of a significant turnaround―a turnaround that marks a signal change in fiscal direction critical to the city’s hopes of completing and submitting its plan of debt adjustment to the federal bankruptcy court in three months—and to the city’s future sustainability. As Mr. Parker notes: “We stopped the bleeding…Revenue just exceeded — just by a bit — what we projected, and we were able to contain costs, so we’re on schedule to finish the year in the black.” Thus, the San Bernardino City Council has unanimously approved adjustments to the city’s budget—adjustments which are projected to actually provide for a small surplus, in part made possible by the politically difficult choice to shut three of the city’s five pools to the public this summer. However, as Assistant City Manager Nita McKay notes, even with the hard choices, the city’s successful efforts to balance its budget is different than in a normal, municipal budget process, because it relies upon the city’s chapter 9 filing as a key protection to prevent creditors from suing the city for money owed to them: “It is important to note that the city’s balanced General Fund budget for the fiscal year is made possible because the city is under the protection umbrella of Chapter 9 bankruptcy.” Moreover, City Manager Allen Parker warned there is as much as $15 million the city “hasn’t figured out how to pay yet.” With the ever-approaching May 30th deadline for the city to file its plan of debt adjustment with U.S. Bankruptcy Judge Meredith Jury, the city reports its sales and use tax revenue is expected to continue to climb to the highest level since 2006-07, which, along with property tax and administrative civil penalty revenue increases, are projected to provide the city $1.3 million toward $2.8 million in expenditure increases—leaving a surplus of about $113,000, with no reserves, according to budget documents. San Bernardino lists $5.2 million in “salary savings,” or money budgeted for positions that are now vacant. It is now trying to fill some of those positions, particularly police and firefighters, Ms. McKay said. Nevertheless, San Bernardino confronts significant budget burdens, including some $2 million for increased firefighter overtime, unanticipated, because, according to Mr. Parker, there was a three month delay before cuts to the Fire Department that were supposed to take effect last July 1st actually became effective. The city also approved general fund increases of $600,000 for 36 new police vehicles, $190,000 in part-time hours for the Parks and Recreation Department, $25,000 for Code Enforcement and $12,000 for the city treasurer’s office. The Council rejected, 4-3, a motion to add $60,000 to keep the other three pools open—notwithstanding a councilmember’s argument that these pools are the type of quality-of-life issues residents depend on a city for and that attract businesses, with Councilmember Valdivia noting the affected pools would be in minority areas. But, in rejecting the motion and noting the chapter 9 hanging over their heads, Councilman Fred Shorett responded that while a good argument could be made to keep pools open, and to reverse any of a number of cuts to “sacred cows” the city has made during bankruptcy; San Bernardino needed to put money toward paying deferred costs and emerging successfully from bankruptcy, adding: “I can balance my budget, too, if I don’t pay my cable bill or my gas bill or my electric bill.” In a sobering note, Councilmember Valdivia had requested staff to provide his colleagues with a summary of the municipal bankruptcy costs the city has accumulated since it filed for federal protection nearly three years ago: more than $9.3 million. Without those bankruptcy-related services, the city would have to pay significantly more than $9 million as creditors came after it, said Parker and City Attorney Gary Saenz.

Municipal Blueprints for Fiscally Sustainable Futures

February 24, 2014
Visit the project blog: The Municipal Sustainability Project

Blueprint for the Motor City’s Future. Detroit Mayor Mike Duggan will submit his proposed budget to the Detroit City Council today—some two months earlier than usual, because the Motor City’s post-bankruptcy budget approval process is more rigorous. Nevertheless, few expect the city’s first post-bankruptcy budget to stray far from the $1.1-billion spending plan included in a three-year budget emergency manager Kevyn Orr cobbled together last year. Nevertheless, there will be a fundamental change: the Mayor’s budget not only must be approved by the Council, but also by the Michigan Financial Review Commission—a key provision in the adoption of the so-called “Grand Bargain” which not only became the fulcrum for the city’s plan of debt adjustment, but also created a signal change in the state-Detroit relationship, making the new state oversight commission ultimately responsible for approving the city’s budget. That means that the city’s first post-bankruptcy budget must be submitted 100 days before the next fiscal year, which is now March 23rd―a signal change from prior years when Detroit, like most cities across the country, simply had to adopt its budget before the new fiscal year, which used to be July 1. Nevertheless, City Council President Pro Tem George Cushingberry Jr. does not anticipate the new, state level of review will create too much of a burden, noting: “We’ll all be on the same wavelength overall,” albeit, that is somewhat of an understatement, because, as Councilwoman Raquel Castaneda-Lopez puts it: “We’re restricted by the plan of adjustment,” the blueprint U.S. Bankruptcy Judge Steven Rhodes approved to give Detroit federal blessing to exit from municipal bankruptcy. Moreover, yesterday, Detroit CFO John Hill reported at the monthly meeting of the new Financial Review Commission that Detroit’s adjusted revenues are coming in close to targets. According to the Motor City budget adopted last year, Detroit’s departmental expenditures for the 2015-16 fiscal year are estimated to include $315 million for police, $143 million for the fire department, $10 million for the mayor’s office, and $7 million for the city council. On the revenue front, the city expects to be over anticipated revenues, notwithstanding lowered assessed values on homes in many neighborhoods citywide from 5% to 20% this year. With those reduced assessments, Detroit had anticipated receipt this year of $102 million in property tax revenues; however, CFO Hill advised the Mayor and Council that greater taxpayer confidence that the city has addressed demonstrated concerns about the integrity of its assessment process has resulted in a signal bonus: because homeowners appear to feel that their properties are more accurately valued, more are paying their taxes, and the city now expects it will receive a minimum of $114 million. Mr. Hill advised the Council that he is now projecting property taxes will reap some $254 million, $10 million less than was projected in the city’s plan of debt adjustment or exit plan—a shortfall to which Mr. Hill attributed a number of causes, including a higher number of workers in the city being paid on contract, rather than as employees―meaning their municipal income taxes are not withheld.

Fixing Cities’ Income Leaks. Detroit Mayor Mike Duggan yesterday reported he is working with Michigan state legislators and Gov. Rick Snyder, as well as mayors of more than 20 cities around the state, on a critical issue: collecting municipal income taxes. Detroit, which has the broadest tax base of any city in the nation, has income taxes as its largest single source of revenue—about 21 percent; yet it suffers from a singular problem: non-collection—especially with regard to commuters—both with regard to those coming into the city, but also residents who commute out of the city. These non-collections have meant a shortfall of as much as 50 percent of what was owed. Thus, Mayor Duggan is focusing on changes in state law to force suburban companies to withhold income taxes on residents of cities that levy income taxes. In addition, the Mayor reported there are discussions about how to collect income taxes on Detroit residents who live in the city, but claim suburban addresses, in many cases to avoid paying auto insurance rates that Mayor Duggan says average about $3,600 a year per household, generally double what is charged the average suburban driver.

Making the Fiscal Grade? Even as the Motor City is moving forward towards solvency and fiscal sustainability, there are harder questions with regard to its public schools, whose debt burden is considered key to the district’s revival and survival—and, of course, to Detroit’s future. Thus, the Coalition for the Future of Detroit Schoolchildren, a group which is crafting recommendations for Michigan Gov. Rick Snyder on options to reconstruct the system’s fiscal foundations has made clear that one option might be municipal bankruptcy. The Coalition is seeking to put together formal recommendations to submit to Gov. Rick Snyder by April Fool’s Day—an ambitious effort which likely will be as critical to Detroit’s fiscal future as the school system’s. The Detroit Public School System (DPS) currently faces an annual debt service total of around $56 million a year―the equivalent of about $1,200 per student—an unsustainable level. In an interview with the Detroit News last week, one of Gov. Snyder’s advisors said one possible legislative proposal would be for the state to authorize the creation of a new debt-free district for DPS―with the debt being serviced by an outstanding levy until it matured; nevertheless, the advisor, John Walsh, told the News that the Governor had been adamant about ruling out municipal bankruptcy as an option—an option, in any event—which may not be pursued under Michigan’s law absent the governor’s approval. Currently, DPS carries roughly $2.1 billion in debt, of which some $1.6 billion are in unlimited-tax general obligation bonds, secured by Michigan’s School Bond Qualification and Loan Program, with another $325 million by long-term state aid revenue bonds, secured by an intercept feature on state aid; and $108 million is in the form of loans from the Michigan School Loan Revolving Fund, according to Moody’s.

A Bridge Not Too Far. The U.S. Supreme Court yesterday, without comment, said it will not review a June appeals court decision concerning a new Detroit-Windsor bridge, removing another hurdle to the publicly financed span’s scheduled completion in five years—effectively allowing to stand a U.S. Sixth Circuit Court of Appeals ruling which upheld the Federal Highway Administration’s approval of the Delray neighborhood in Detroit as the preferred location for the U.S. side of a new bridge crossing to Canada. Opponents of the bridge claimed the FHWA had violated the National Environmental Protection Act, Administrative Procedures Act, principles of environmental justice, and other federal laws. U.S. District Judge Avern Cohn in 2012 had dismissed the lawsuit by the Latin Americans for Social and Economic Development, Citizens with Challenges, Detroit Association of Black Organizations, and other community groups — along with the Detroit International Bridge Co., which owns the privately held Ambassador Bridge and wants to build one next to it. Yesterday’s decision comes five days after Canada and the U.S. reached an agreement in which Canada will put up the hundreds of thousands of dollars to build a U.S. Customs plaza at the New International Trade Crossing and be repaid through tolls. The $2.1 billion bridge is to be two miles from the Ambassador Bridge and could open as early as 2020—it is expected to handle as much as one third of all U.S.-Canadian trade. Last June, the U.S. Coast Guard had issued a required permit for a publicly owned bridge from Detroit to Canada — clearing another key hurdle in the high-profile project.

Tense Futures & Pasts. San Bernardino City Manager Allen Parker thinks things might be looking up, reporting that, at mid-year, San Bernardino might well be on the verge of a significant turnaround: it has reached the middle of its fiscal year with a balanced budget. While that might not seem a cause for celebration for most cities, it appears to signal a change in fiscal direction fundamental to this city’s future sustainability. Mayhap equally importantly, it appears to signify that the municipality has avoided backsliding as the costs of putting together its plan of adjustment to halt the fiscal bleeding and other unexpected costs have imposed extraordinary challenges the its precarious margin for budget balance to its current fiscal year budget. Mayhap Mr. Parker puts its most aptly: “We stopped the bleeding…Revenue just exceeded — just by a bit — what we projected, and we were able to contain costs, so we’re on schedule to finish the year in the black.” That is a marked change from a year ago—a time when the city seemed to be on the down fiscal escalator, with its then midyear budget review demonstrating the city’s budget was balanced only by omitting $22.9 million in deferred payments. In contrast, now the city appears to have cleaned its balance sheet with regard to its California Public Employees’ Retirement System (CalPERS) obligations, and, perhaps of greater significance there is, as Manager Parker puts it: “[N]othing hidden in (the budget).” That is not to write that the future path to fiscal solvency and a painless exit from municipal bankruptcy will be easy: Mr. Parker happily reports that “The 12 months (of fiscal year 2014-15) have been solved,” but “[T]he Plan of Adjustment has other difficulties.” The rocky fiscal road ahead will require a fiscal plan to come up with nearly $200 million in needed infrastructure improvements, funds to meet expected increases to CalPERS payments, and more. Thus the Council convened a public review of the full fiscal year budget last evening to invite public input and comment—especially with regard to four changes: to approve increases in estimated revenues in the amount of $1.3 million in the General Fund; to approve increases in appropriations in the amount of $1.3 million in the General Fund; to approve budget transfers in appropriations in the amount of $1.46 million; and to approve increases in appropriations in the amount of $593,936 in the Traffic Safety Fund for the purchase of police vehicles. Longer term—in our dawning age of shared services, Mr. Parker reports the city is actively looking at outsourcing services—a challenge that has proven hard for the city in past attempts—but one, especially in the face of fire overtime costs—that will be defining for its fiscal future.

The Ineluctable Challenge of Weighing a City’s Past Versus its Future

eBlog

February 20, 2014
Visit the project blog: The Municipal Sustainability Project

Electronic Musical Chords. Nathan Bomey of the Detroit Free Press yesterday did a terrific interview with U.S. Bankruptcy Judge Steven Rhodes, with Judge Rhodes telling him he never believed the City of Detroit had to choose between paying its creditors or reinvesting in services. Judge Rhodes noted that cuts to Detroit’s pensioners and bondholders were necessary, but said that without a feasible plan to place the city on a financially sustainable path, retirees and financial creditors would have fared worse down the road, so, he said: “[T]he goals of satisfying the interests of creditors and satisfying the interests of the residents in my view were never in conflict…In fact, they were symbiotic. In order for creditors to be repaid, there had to be a vital city:” Please note I have taken the liberty of highlighting some of Judge Rhodes’ responses, as they seem especially insightful.

QUESTION: Do you think Detroit’s collapse was an isolated incident or does it portend a broader crisis of some sort?
ANSWER: It was in some senses unique to Detroit and in some senses a part of a national phenomenon. The part that’s national is the economic factor of it, the decline of manufacturing generally in this country and the migration of what manufacturing remains really out of the Rust Belt.
Q: And our unique amount of mismanagement and perhaps even corruption?
A: We did have obviously one corrupt mayor. It’s hard for me to judge how much of the city’s issues are directly attributable to that.
Q: You chose Judge Rosen to be your mediator. What was the reasoning behind that?
A: I was convinced of the importance of mediation and a mediated and negotiated settlement to the prompt disposition of the case. And I also felt that the prompt disposition of the case was essential to the city’s revitalization.
So I felt it was necessary to appoint the strongest possible mediator that I could. And I felt that Chief Judge Rosen had all of the necessary qualities. Weight of office. Weight of personality. Commitment to the city. Personal and professional contacts. Political contacts. He was the right person.
Q: Early on you set a really expeditious pace for the case.
A: I didn’t really perceive of it as expeditious. I perceived of it as what was necessary given the circumstances of the case.
Q: Is it accurate to say that you prioritized the health and welfare of the people of Detroit over the repayment of creditors?
A: Everyone in the state had a personal stake in the outcome of the case. Even more specifically, in order for any plan to be feasible, the city had to develop a plan by which it could deliver municipal services adequately.
So the goals of satisfying the interests of creditors and satisfying the interests of the residents in my view were never in conflict. In fact, they were symbiotic. In order for creditors to be repaid, there had to be a vital city.
Q: By the time Detroit filed for bankruptcy, were pension cuts inevitable?
A: Inevitable’s a pretty strong word. I would say very highly likely.
Q: People blamed Kevyn Orr and perhaps even you for cutting pensions. But in reality, the promises to pay those pensions had been broken many years ago.
A: The city did not have the resources in its pension plans to fulfill its obligations to pensioners. There really never was much dispute about that.
Q: But from a legal perspective it wasn’t a difficult call for you?
A: That’s true. We in bankruptcy impair contracts all day, every day. That is what we do.
Q: No municipal bankruptcy judge had had to decide that question or been willing to decide that question. Was there hesitancy that you’re going to be the first?
A: There was always going to be lots of groundbreaking in the Detroit case. It is certainly true that there was not a lot — or sometimes even any — precedent for the legal decisions I had to make.
Q: Former Mayor Kwame Kilpatrick’s $1.4 billion debt deal, executed in 2005 and 2006, was a disaster for the city. Was it the point of no return financially?
A: Yes. I have said the city should have filed for bankruptcy then and perhaps even before then.
Q: The governor has said he was always representing each individual person in Detroit. Was democracy suspended in Detroit?
A: The people lost the ability to have the direct impact that they have when there’s a mayor and a City Council in charge when the emergency manager was appointed. That’s a taking away of democracy to that extent.
Q: But you never felt that the law was unconstitutional obviously.
A: I did not. And really, primarily for the reasons that Gov. Snyder identifies. The democratically elected Legislature passed this law. The governor signed it. The city is an arm of the state. And it is always subject to state law.
Q: One of the most surprising moments of the bankruptcy was when you killed the second swaps settlement. There was a gasp in the courtroom. Did you hear it?
A: I can’t say that I did. But I was not surprised that they were surprised.
Q: Your relationship with Detroit emergency manager Kevyn Orr seemed complicated. At times you chided him. But also you’ve praised the job that he did. What is his legacy in Detroit?
A: I hope his legacy is that he took on an enormous and some might say impossible challenge and met that challenge with grace, dignity, professionalism, and proficiency. Of all of us who were challenged by Detroit’s insolvency, he had the most challenging and difficult job of all.
Q: How much credit does Gov. Snyder get for authorizing the bankruptcy?
A: A lot of people maintain that it was a very courageous thing for him to do and that it was something his predecessors were not willing to do and did not do. From an economic or fiscal perspective, it doesn’t seem to me it was a very hard decision. As I’ve said, it should have been made a long time ago. Politically, on the other hand, I’m sure it was hard for him.
Q: When did you first hear about the concept of the grand bargain?
A: I remember Judge Rosen sketching it out for me in the broadest details after he had the parties on board in concept, but I’m not sure I can tell you precisely when that was.
Q: Mr. Orr has said he was skeptical at the beginning. Some people withheld judgment. What was your initial reaction? Did you think it was doable?
A: I had no basis to judge that other than the optimism that Judge Rosen was exuding. He was optimistic about it from the beginning, and so was I.
Q: It’s well established at this point that cities cannot be forced to sell assets in municipal bankruptcy.
A: Yes, that’s true.
Q: What would have happened had Kevyn Orr decided selling DIA property was necessary?
A: I would have needed to be persuaded.
Q: Because you said in your opinion the DIA and the attorney general would be more likely to prevail if there was to be an argument over this in court.
A: Not only was I persuaded of that, I was also persuaded of the necessity of maintaining the DIA and the art in the DIA intact to assist in the city’s revitalization.
Q: There were many who said we should prioritize pensions or services over keeping an admittedly wonderful art collection. How did you balance that from a philosophical and judicial perspective?
A: I understood that perfectly well. But here’s the thing about bankruptcy. Bankruptcy requires shared sacrifice. And the deeper truth than that immediate one that they were trying to express is simply this: Without a revitalized city, any pension promises that the city might make would be impaired.
A revitalized city was essential to any long-term promises that the city might make to any creditor, including the pensioners.
Q: Were there nights where you thought, I am going to have to cram down something here?
A: Oh yeah. I believed that until the last creditor settlement. Until FGIC and Syncora settled — those were the last two — I assumed and believed that they would not settle and that I would have to consider the city’s request to cram down the plan over their objections.
Q: Syncora in particular waged an extremely aggressive campaign against the city. At one point you even told both sides to stop using war analogies because it had gotten so intense. What did you make of their strategy?
A: They argued zealously, but they always did it with civility. And their arguments were well argued, well structured, well organized, well presented. They were really good lawyers. So I had no problems with the zealousness with which they advocated their position.
Q: Of course at the end of the case, when they attacked the ethics of the mediators, you were extremely upset.
A: I was. I felt that was totally unjustified. And I struck it, and I was prepared to consider sanctions until they apologized for it.
Q: How close did you come to sanctions?
A: Well, I would have been interested in what they had to say on why they shouldn’t have been sanctioned. But I felt like sanctions should be given very serious considerations and not minor sanctions either.
Q: How taxing was this case for you personally?
A: There were obviously times when it was extremely taxing for me personally. It was, for stretches and sometimes long stretches, very intense.
Q: We were all at news conferences where Judge Rosen was present and in some ways he was much more visible as a mediator than a lot of people expected. Were you worried about that at all?
A: Judge Rosen is a political animal in a way that I totally am not. So I had complete faith and trust in his political judgments as to what he felt he needed to do to fulfill his obligations as a mediator.
When I appointed him and he agreed to be appointed, I told him that his deliverable to me was a confirmable plan of adjustment in this case and he delivered that.
Q: How much did you coordinate with Judge Rosen during the case and how much did you know about what was happening in mediation?
A: At the beginning of the case, we agreed on two basic principles. The first was, I would keep pedal to the metal in litigation, and he would keep pedal to the metal in mediation, and we would run them in parallel with one important exception. If he recommended to me that I let off on the gas and apply the brakes to litigation, I would do that. I would follow his recommendation when he thought that would facilitate settlement.
There were also times when he thought it would facilitate mediation for me to advance litigation and to hold a hearing and to ask the hard questions of the lawyers to get them to realize what the strengths and weaknesses of their case were. I would do that.
Q: Did the city need $1,000-per-hour attorneys to run this case?
A: The question is for me whether their fees were reasonable or not and I’ve made my judgment about that.
Q: They could have made more money elsewhere, right?
A: I assume. The rates that they charged were in some senses for them below market rates because they did discount the ultimate fee that they charged to the city in many different ways. The city’s lawyers brought to the case an expertise that is very rare in this country.
Q: Did you believe that the city needed to account for the DIA’s value in some capacity in the plan? Could the city have executed a plan of adjustment without someone accounting for the value of the museum?
A: It did. The plan we have takes no account of the value of the art. So the answer to that question is yes. It gets back to the fact that what the city does with its property is entirely its own decision and not one that the bankruptcy court can exercise any control over whatsoever.
Q: Then the natural question is, was there a false crisis in the sense that the DIA was never really in trouble?
A: Well, the question you’re raising really is at what point in the process from beginning to end could or should that issue have been resolved.
If I had decided early in the case and teed up the issue of whether the art was in play or not, would we have gotten $816 million in a grand bargain? I’m not sure about that.

The Motor City’s Future. Michigan Governor Rick Snyder is considering options for the state to provide debt relief for the cash-strapped Detroit Public Schools (DPS)—a system with an estimated $55 million annual cost to finance its accumulating debt. Governor Snyder has proposed a $75 million distressed schools fund as part of his 2016 executive budget as part of a plan to help financially struggling school districts across the state, telling the legislature: “We are still evolving in terms of the best way to implement the entire program, but there are districts that need substantial readjustments in terms of their finances…I’d like to start establishing a reserve fund for financial resources to do the restructurings…I don’t view this is a bailout, but only where we’re truly solving problems in the long term.” Such a fund would be designed to help DPS cover debt payments, or shifting shift DPS into a new district, with the remaining bonds being serviced with an outstanding levy. The Governor’s strategy director, John Walsh, however, told the Detroit News: We’re not talking about [municipal] bankruptcy — the governor has been very clear about that…We have to find a method that will recognize that they can’t bear the weight [of their debt].” Because the school system is not part of Detroit’s budget, its financial distress was not addressed in the Motor City’s plan of debt adjustment—nor was it part of the so-called “Grand Bargain,” they magic elixir to the city’s obtaining U.S. Bankruptcy Judge Steven Rhodes’ blessing of its largest in U.S. history municipal bankruptcy exit plan. Nevertheless, it is difficult to imagine a more critical criterion to the Motor City’s future than the recovery and financial and educational stability and competence of its school system. It will be key not only to any hope of reversing the unprecedented decline of the city’s population, but also to its future. In Detroit, the challenge is especially daunting: according to the Ann E. Casey Foundation KidsCount report, Detroit continues to have more children living in extreme poverty than any of the nation’s 50 largest cities: More than 59 percent of Detroit children lived in poverty in 2012, the most recent year for which data is available—an increase of 34 percent since 2006. It is, in some ways, a microcosm of the state, where one in four children live in extreme poverty, according to the report—itself an increase of 35 percent over six years, to nearly 25 percent―a devastating percentage which some attribute to steep cuts to social services. The other side of such decreases, one may observe, imposes a double whammy: huge increases in burdens on the City of Detroit―reports of child abuse and neglect increased 77 percent in Detroit from 2008-12, with about 15 percent of Detroit children living in homes that have been investigated by child protection workers: confirmed neglect or abuse increased 40 percent. The death rate for young people ages 1-19 increased 14 percent between 2004 and 2012, mostly because of increased homicide and suicide among teenagers―and a devastating and discouraging message to families with children that might be considering moving to Detroit. Fortunately, the Casey Foundation report showed improvements in some measures of well-being:
• The number of children in out-of-home care decreased 71 percent in Detroit, and 33 percent statewide.
• Births to teens aged 15-19 decreased 13 percent in Detroit, and 16 percent across the state.
• The number of fourth-graders scoring “not proficient” in reading declined 24 percent in Michigan, and 16 percent in Detroit, from the 2008-09 school year to the 2013-14 school year.
The Motor City’s public school system carries roughly $2.1 billion of debt, of which approximately 75% is unlimited-tax general obligation bonds secured by Michigan’s School Bond Qualification and Loan Program. Another $325 million is long-term state aid revenue bonds, secured by an intercept feature on state aid; and $108 million is in the form of loans from the Michigan School Loan Revolving Fund, according to Moody’s Investors Service. In 2013, fixed costs, including debt service and retirement costs, made up 35% of operating revenue and were expected to grow at least 3% or more in fiscal 2015, according to Moody’s, which maintains junk ratings and a negative outlook on the district. The Detroit School District faces a $170 million deficit in fiscal 2015.

Don’t Rush to Bankruptcy Judgment. A week after pushing Detroit neighbor Wayne County, Mich. to junk territory, credit rating agency Standard & Poor’s analyst Jane Ridley yesterday wrote it is premature to “start treating Detroit’s neighboring municipality as if it were about to file for municipal bankruptcy: As we recently saw in Detroit, bankruptcy is a significant issue, with serious potential repercussions for bondholders. We take very seriously any possibility of bankruptcy, but we don’t want to rush to judgment before letting the process to take its course.” Nevertheless, Ms. Ridley wrote S&P could change its view of the likelihood of municipal bankruptcy if Michigan were to appoint an emergency manager, based upon the experience of the accelerated transition from Gov. Snyder’s appointment of Kevyn Orr to Detroit’s filing for federal bankruptcy protection…if past is prologue: “While many consider it a positive step to bring in a third party who has powers to make changes, such as the Emergency Manager option, given Detroit’s recent experience and very rapid move to bankruptcy, our view on the county’s trajectory could well change with the appointment of an emergency manager.” Last Friday S&P downgraded Wayne to BB-plus from BBB-minus, with a negative outlook―costing the county its final investment-grade rating; Moody’s moodily had at the beginning of the week dropped the county three notches to junk. The respective downgrades came in the wake of newly elected County Executive Warren Evans’ warnings when he took office last month that Wayne County is on a trajectory to run out of cash by August 2016 and that municipal bankruptcy or state takeover are on the table without major financial fixes.

Tense Futures & Pasts. For every municipality in severe fiscal distress, the challenge between the past and the future—between public pension obligations versus capital investment for a sustainable future can best be described as a nightmare. For instance, in Stockton, as U.S. Bankruptcy Judge Christopher Klein opined, notwithstanding the Golden State constitution, the federal chapter 9 municipal bankruptcy law trumps the state constitution protection of public pension contracts. So there was a legal basis—as there is, with, presumably, U.S. Bankruptcy Judge Meredith Jury’s acquiescence―but there is a harsher reality. Not only are there unique attributes to California’s CalPERS public retirement system vis-à-vis municipalities, so that, for instance, had Stockton, in its proposed plan of debt adjustment, opted to include reductions in pensions; CalPERS would have cut pensions a little more than half for current retirees and employees in order to avoid having other California municipalities being forced to subsidize Stockton: CalPERS had no authority under state law to cut by a lesser percentage. Even as it was—and is in San Bernardino, which faces a similar quandary with regard to its public pension obligations to CalPERS—any action to cut pensions would likely have rendered Stockton far less competitive in its ability to attract qualified recruits to its public safety departments—a critical factor for cities in distress which, more often than not appear to have disproportionate rates of violent crime—a vital issue to address in any plan of adjustment or municipal bankruptcy recovery plan. So, for example, San Bernardino ranks as a city with one of the highest violent crime rates in California, should the city, as part of its developing plan of adjustment, opt to impair its CalPERS contract, technically employees would have 6 months to find another CalPERS job (state law)—under California law such individuals would be deemed “legacy” or “classic” employees: that would enable their retention of their current pension formulas with their new employer; however, if they were unable to find another job until after 6 months, they would then be deemed a “new” employee in CalPERS and take a significantly reduced pension benefit. This complex state-local dilemma narrows—an understatement—a California city’s options. In San Bernardino, the city had already lost 100 police officers due to compensation reforms prior to its filing for municipal bankruptcy protection—even though, on too many days, the city has been in Code Blue―that is, only responding to crimes in progress. It is, thus, nearly impossible to contemplate what would the impact on the city’s public safety would be were it to propose—as part of its plan of debt adjustment due in May to Judge Jury—adjustments in its public pension obligations. Would the city risk losing another 100-150 police officers? What would be the chances of the city to attract highly qualified replacements? What might be the impact on families—either those weighing whether to stay—or, much less, those who might be considering moving to San Bernardino? This is part of the intractable imbalance in municipal bankruptcy between a city’s obligations to its municipal bondholder creditors—vital capital, after all, and its employees and retirees: to its most critical goal in putting together its plan of debt adjustment: to transition back to service solvency. But as one reader aptly notes: “creditors don’t care about this fact and don’t understand it…the need, for a municipality, to be a viable employer is critical to ensuring service solvency.” That can be especially true in the Golden State, where, currently, it takes 100 applicants to get a single police officer.

Unappealing Options. Jefferson County, Alabama Commissioner George Bowman and several litigants who filed an appeal of the decision approving the county’s municipal bankruptcy plan of debt adjustment on behalf of ratepayers on the county’s sewer system yesterday wrote Alabama Gov. Robert Bentley and Attorney General Luther Strange requesting they intervene in the appeal of Jefferson County’s municipal bankruptcy case, writing that the Governor and Attorney General should “do their job to protect the public interest by joining in the existing appeal.” Commissioner Bowman said they hope to meet with Governor Bentley and the AG to discuss a number of issues raised in the appeal, including their apprehensions with regard to the plan’s proviso that the federal court oversee implementation of the plan — and sewer system rate increases — for the next 40 years. The appeal promises to add to the hefty price tag for Jefferson County taxpayers: Jefferson County has already expended close to $30 million for its bankruptcy—a price that is certain to veer upward with the appeal. In their appeal, the litigants claim the federal oversight violates Alabama’s rights in violation of the U.S. Constitution. Commissioner Bowman opposed the County’s decision to file for municipal bankruptcy protection in 2011; he also voted against the county’s plan of adjustment or exit plan which U.S. Bankruptcy Judge Thomas Bennett approved a year ago last December—a plan which authorized Jefferson County to issue $1.8 billion of sewer refunding warrants to write down the county’s debt, and exit what was, at the time, the largest municipal bankruptcy in U.S. history. Commissioner Bowman complains that the federally approved plan of adjustment burdens some of Jefferson County’s poorest citizens with 40 years of sewer system rate increases which he believes they will be unable to afford, warning that over the next forty years rates will increase 471% to service the sewer refunding warrants that have been issued. U.S. District Judge Sharon Blackburn has previously rejected the claim by Jefferson County that because the plan of debt adjustment has already been implemented the appeal is moot; Judge Blackburn made clear she has discretion to overturn various provisions in the plan of adjustment—both issues on which Jefferson County has appealed to the 11th U.S. Circuit Court of Appeals.

Underwater in Puerto Rico. Moody’s has downgraded Puerto Rico’s general obligation rating to Caa1 from B2, reporting that the territory’s anemic growth is harming tax revenues—imperiling the Commonwealth’s liquidity. The gloomy, if moody assessment comes as the U.S. House Judiciary Subcommittee on Regulatory Reform, Commercial and Antitrust law readies its hearing next Thursday on draft federal legislation to allow Puerto Rico government-owned corporations to restructure their debts under Chapter 9 municipal bankruptcy. The hearing comes amid increasing apprehension that the Twilight Zone for U.S. territories—which are neither states nor municipalities—leaves them no options for bankruptcy protection—unlike every other corporation in the U.S. The Commonwealth of Puerto Rico has said that while it supports amending Chapter 9, it fears that waiting for Congress to act could be like waiting for Godot. Moody’s downgrade now drops the island lower than S&P’s and Fitch’s most recent reassessments. Moody’s Caa is used for state and local bonds in “poor standing and subject to very high credit risk.” Moody’s analysts Ted Hampton and Emily Raimes wrote in yesterday’s report that tax revenue shortfalls, because of sluggish economic growth, may harm the Commonwealth’s liquidity; they noted that General Fund revenues have been coming in 2.5% below projections through the first 7 months of the fiscal year: “In view of still anemic economic trends, the revenue gap could widen after April income tax payments…Puerto Rico’s Economic Activity Index as of December was down 1.4% on a year-over-year basis.” The dynamic duo also noted apprehension about Puerto Rico’s ability to issue new debt to would shore up liquidity, adding that Puerto Rico anticipates a 35% increase in debt service in FY 2016―even more daunting will be the subsequent years as rising debt service requirements impose an ever increasing burden―noting that the Commonwealth’s debt burden is high compared with U.S. states: Puerto Rico’s adjusted net pension liability was 223% of revenues compared with a U.S. state median of 60% of revenues: “Downgrades of some ratings to Caa2, a notch below the commonwealth’s GO rating, reflect the vulnerability of pledged revenues to a constitutional provision that provides a claim in favor of general obligation bondholders.”

A Musical Lessons Learned from Municipal Fiscal Distress

eBlog

February 19, 2014
Visit the project blog: The Municipal Sustainability Project

Electronic Musical Chords. U.S. Bankruptcy Judge Steven Rhodes, the rhythm guitar-playing member of the Indubitable Equivalents who oversaw the largest municipal bankruptcy in U.S. history in Detroit, completed his judicial—but not musical—career yesterday with some reflections on lessons learned from the historic case. Speaking on Detroit’s WDET “Detroit Today” show, Judge Rhodes reflected on a concern that U.S. Bankruptcy Judge Thomas Bennett, who oversaw the Jefferson County municipal bankruptcy, has mentioned: what is the role for a citizen and taxpayer of a city or county going through municipal bankruptcy? In the interview, Judge Rhodes said he invited citizens to speak in his courtroom on multiple occasions during the case, because he wanted to hear their input: “It wasn’t just show. It wasn’t just me trying to persuade people that I’m fair…I have to say that from a legal perspective, it was not a particularly difficult decision…I was genuinely interested in what their concerns were and how I could possibly deal with them, if I could. So that was important to me.”

With regard to one of the most profound issues that arise in these historic cases—a city or county’s future fiscal sustainability versus its past obligations—Judge Rhodes remarked it was an easy legal decision to authorize pension reductions in Detroit’s bankruptcy, even though he still felt compassion for the Motor City’s retirees and citizens who suffered because of the city’s financial collapse and water shutoffs. Nevertheless, the electric rhythm guitar-playing judge affirmed that his groundbreaking ruling last December 3rd to give then Detroit emergency manager Kevyn Orr the authority to reduce the city’s pension obligations was prudent—notwithstanding Michigan’s Constitution, which describes public pensions as a contractual obligation that cannot be cut—an issue that had been primed for challenge at the 6th U.S. Court of Appeals in Cincinnati—as well as the 9th U.S. Court of Appeals in California in the parallel Stockton municipal bankruptcy case; however, neither appeal was pursued. These cases, which have pitted bondholders against public pensioners, in effect pit a city or county’s accrued liabilities against its costs for investing in its future. The greater the accrued liabilities, the higher the interest rate potential municipal bondholders will demand—in effect risking putting a city or county in a vicious cycle where its costs of long-term investment in its future economy and infrastructure are greater than other cities and counties. It risks becoming less competitive and confronting a stagnant or declining population at risk of credit downgrades.
Judge Rhodes also noted his frustration during the bankruptcy proceedings last year when Detroit began shutting off water to delinquent ratepayers, including too many people who could not afford to pay: “It weighed on me very heavily…I was concerned that the city’s response was not adequate. Now, that inadequacy, however, was not something I had any jurisdiction over and I tried to make that clear.” Nevertheless, Judge Rhodes admitted he used his powerful courtroom stage to pressure Detroit—remember, a city at the time having just—after more than a year, reverted to its own elected leaders, into altering its course. Mayor Mike Duggan assumed control of the department from Emergency Manager Orr, issued a temporary moratorium on shutoffs, and distributed information about assistance that was available to low-income citizens before resuming the shutoffs in a more targeted manner.

So Long. In his electronic swan song, as it were, Judge Rhodes said he had been “hoping” the news media would file an official motion seeking to broadcast live audio of court hearings in the historic municipal bankruptcy, but it never happened; he also noted the path-breaking role played by the chief mediator he had appointed, U.S. Judge Gerald Rosen, whose now famous cocktail napkin diagram became the grand bargain that connected the dots between the Detroit Institute of Arts, reduced public pension cuts, bipartisan leadership by Governor Rick Snyder and the state’s House and Senate bipartisan leaders, and non-profit foundations―the dramatic electrical key that triggered pledges of the equivalent of $816 million over 20 years to the grand bargain, and retirees approving the agreement by voting to accept cuts—or, as Judge Rhodes described it: “The work that Judge Rosen and his team did on the grand bargain was absolutely miraculous and unprecedented, not only in the history of bankruptcy but in the history of mediation, as far as I know…They went outside of their roles as mediators to go out and solicit money to solve the city’s problem. And that was enormous.” Finally, in a cautionary note, Judge Rhodes reiterated previous statements he had made that former—and now imprisoned―Mayor Kwame Kilpatrick’s $1.4 billion pension debt deal in 2005 “should have been a red flag,” because it “was structured to be an intentional evasion of the legal debt limits that municipalities are by state law required to stay within. It was too innovative. It was too creative.” That was the point in time, the Judge noted, when Detroit should have filed for bankruptcy.

The Devastating Costs of Municipal Bankruptcy. In a year which commenced with scholars Bo Zhao and David Coyne of the Boston Federal Reserve asking if U.S. state and local governments are on a fiscally sustainable path—and where we have observed, as newly retired U.S. Bankruptcy Judge Steven Rhodes does above―the difficult stresses between commitments of the past versus securing investment for the future―we now learn that he California Public Retirement System (CalPERS) has—to date—expended some $7 million in legal fees to two law firms representing the state public pension system attorneys in the Vallejo, Stockton, and San Bernardino municipal bankruptcies. Yet, as Ed Mendel, who covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune, wrote, the costly legal representation was ineffective, at best. U.S. Bankruptcy Judge Christopher Klein ruled that CalPERS pensions can be cut in bankruptcy. In the case of the Vallejo municipal bankruptcy, the city, in its plan of debt adjustment, did not seek to reduce its pension obligations; further south, San Bernardino has reached an agreement with CalPERS to protect public pensions. At times in the Stockton case, Judge Christopher Klein verbally jabbed the CalPERS attorney, Michael Gearin (of whom it was noted at one point that he was “bellowing and pawing the sidelines”), as if, in Mr. Mendel’s words, “he were an over-blown nuisance of questionable relevance.” Judge Klein, in his 54-page written ruling confirming Stockton’s plan of debt adjustment and successful exit from municipal bankruptcy, wrote: “As CalPERS does not guaranty payment of municipal pensions and has a connection with a municipality only if that municipality elects to contract with CalPERS to service its pensions, its standing to object to a municipal pension modification through chapter 9 (bankruptcy) appears to be lacking.” Yet, after Judge Steven Rhodes held, in approving Detroit’s plan of debt adjustment bankruptcy, that pensions can be cut; CalPERS joined unions in an appeal with the 6th U.S. Circuit Court of Appeals, arguing that CalPERS is an “arm of the state,” not a city-run plan like Detroit―thus arguing it is protected under chapter 9 municipal bankruptcy law. But in his ruling, Judge Klein held that Stockton has contracts with unions and CalPERS, finding that what he called the “third leg” of the triangle―the relationship between CalPERS and active and retired employees―is not a contract, but rather a “third-party beneficiary relationship,” adding that contrary to the widespread “myth” that CalPERS was Stockton’s largest creditor, it was rather a “small-potatoes creditor” and “pass-through conduit” only owed administrative expenses. Instead—or rather—Judge Klein noted the substantive pension debt is owed to employees and retirees, adding that nothing about state structure or procedure “necessitates” CalPERS. [Golden State law does not require that city employees have pensions: in California, municipalities may choose other pension providers: private, county, or the creation of their own system.] Nevertheless, once a city contracts with CalPERS, there can be a bear trap situation: two state laws sponsored by CalPERS, which do not apply to county or city retirement systems, make the prospect of leaving CalPERS prohibitive and especially challenging: California law bars rejection of CalPERS contracts in bankruptcy; the other state law places a lien on the property of a city that terminates its CalPERS contract in bankruptcy, second only to wages, that enforces immediate payment of future pension obligations. Moreover, on termination, CalPERS sharply escalates future pension costs by dropping its investment earnings forecast of 7.5 percent a year from a diverse portfolio to a bond-based 2.98 percent, ensuring payment, because employer-employee contributions cease. Thus, in the Stockton case, had the city—as part of its bankruptcy exit plan―sought to exit CalPERS, the debt or unfunded liability due immediately on termination of its CalPERS contract would have skyrocketed from $211 million to $1.6 billion—an amount Judge Klein likened to a “poison pill―” if the city tried to move to another pension provider. Nevertheless, in his oral and written opinions, Judge Klein held that the threat of a CalPERS termination lien forcing a $1.6 billion payment was a “toothless tiger” in a chapter 9 municipal bankruptcy, finding that the CalPERS lien is unenforceable in municipal bankruptcy, because the federal law “authorizes the avoidance of liens that are not perfected or enforceable at the time of the commencement of the case.” Judge Klein wrote that states cannot modify federal law, citing a Texas law allowing a school bankruptcy if state bonds were protected, which was overturned by the courts. Another “myth,” Judge Klein noted, is that because the Stockton plan to cut debt and exit bankruptcy leaves pensions intact, employees and retirees are “not sharing the pain” with bondholders. In addition to pay cuts, however, Stockton replaced its retiree health benefits valued at $545 million with a $5 million lump sum payment.
Stockton negotiated approval of its debt-cutting plan with all of its unions and its largest bondholders. A lone holdout, Franklin, received $4.35 million (the value of its weak collateral: two golf courses) for $36 million in bonds, a return of 12 percent. Franklin, planning an appeal, contended the Stockton plan’s failure to cut the municipality’s largest debt, pensions, is unfair and not proposed in “good faith.” Bondholders filed a similar objection to San Bernardino’s agreement with CalPERS to avoid pension cuts. Indeed, the situation in San Bernardino has previously caused greater headaches for CalPERS. San Bernardino had filed an emergency bankruptcy, which the city had claimed was urgent to keep making payroll, and subsequently took the unprecedented step of stopping payments to CalPERS for the rest of the fiscal year. After resuming regular CalPERS payments, however, San Bernardino is seeking to catch up on its skipped payments, some $13.5 million plus fees and interest—something which must be addressed by its approaching Memorial Day deadline set by U.S. Bankruptcy Judge Meredith Jury for the city to propose its plan of debt adjustment. In San Bernardino’s case, the stoppage of payments to CalPERS gave the state agency grounds to terminate its San Bernardino contract; yet that might have resulted in pension cuts, something CalPERS is battling to avoid in the municipal bankruptcies―a state, after all—which now leads the nation in the category.

Accountability, Transparency, & Governance Issues in Municipal Bankruptcy

eBlog

February 13, 2014
Visit the project blog: The Municipal Sustainability Project

Balancing & Transparency in Municipal Bankruptcy. U.S. Bankruptcy Judge Meredith Jury has ordered a settlement between San Bernardino and the California public retirement system CalPERS to be made public, with Judge Jury stressing the importance of transparency as a major theme at a status conference with regard to San Bernardino’s municipal bankruptcy. Judge Jury also stressed the importance of community input as the city puts together a plan to exit bankruptcy—its so-called plan of debt adjustment. It is another signal too of how different the public process of scrabbling together a plan of debt adjustment can be in Alabama, California, or other states where a city’s elected leaders are responsible—instead of, as in Michigan or Rhode Island, where the state appoints a receiver or emergency manager. Or, as Mayor Carey Davis said: “Your input matters. Without it, we wouldn’t have the ability to take the city in the direction you want it.” In fact, even as San Bernardino leaders are working against an ever faster approaching May 30th deadline to submit its plan of debt adjustment to Judge Jury, the city is simultaneously seeking to be open and public with its citizens and taxpayers. Thus, San Bernardino convened the first and second of a series of town hall meetings Wednesday and last night to discuss a long-term strategic plan with residents. The challenge for the city’s elected leadership is juggling: how to avoid putting the cart before the horse. On Wednesday night, an attorney representing the holder and insurer of $50 million of San Bernardino’s pension obligation bonds, stated the lateness of these meetings was “distressing: Faced with a fast approaching deadline to file a plan, one would have expected the City to create a strategic plan and begin outlining the terms of its bankruptcy plan expeditiously…And yet, months after the [federal bankruptcy] Court set its deadline for the city, creditors recently learned that the City still lacks what it itself describes as a ‘strategic plan.’” Unsurprisingly, the attorney said he was present to request two actions: for San Bernardino to open its plan of debt adjustment development process to public participation, and for creditors to be allowed to present the court with contested legal issues before or alongside San Bernardino’s process of confirming the plan of adjustment. In a sense, what the attorney is proposing is parallel to what Judge Jury has already mandated with regard to the city’s fire union. Nevertheless, even as the city is struggling internally to cobble together its plan under a nearing federally-imposed timeline, it is also juggling with other, complicated deadlines: There are four appeals pending in the U.S. District Court; in addition, the pension bond creditors—Ambac Assurance Corporation and the Luxemburg-based corporation EEPK—have filed suit against San Bernardino, claiming that paying the CalPERS pension obligation portion of the city’s debt legally requires paying the pension obligation bondholder portion equally. It is a kind of a reprise with the trying balancing act about which U.S. Bankruptcy Judge Christopher Klein wrote last week vis-à-vis Stockton. But the discussion also demonstrates the irony—especially say, compared to Detroit—with San Bernardino’s bankruptcy attorney Paul Glassman noting that the attorney for the city’s creditor was arguing for greater transparency, but making such an argument based on a presentation officials made to the public at a City Council meeting, adding that San Bernardino is committed to involving the public. Mr. Glassman added that one could be of the impression that the San Bernardino creditor here was seeking to become more of an obstacle than facilitator, because, by suggesting more litigation, it could appear to reasonable persons more like an attempt to distract the city and prevent it from making its federally imposed deadline: “This appears to be a somewhat cynical attempt to overwhelm the city with litigation… (and) cause chaos and distraction in the case,” adding he was confident the city would timely file its plan of debt adjustment with the U.S. bankruptcy court. At the session, attorneys representing the police union and a retirees’ committee both received permission to file briefs responding to the pension bondholder representatives’ arguments, claiming that they do see the struggle as one of Main Street against Wall Street—or as attorney Steven Katzman, who is representing retirees put it: “My clients have made significant concessions here…(and) there’s a lot of unhappy retirees who are facing significant hardships…as a result Wall Street hasn’t had their healthcare cut.” In this dynamic setting,

Judge Jury pronounced her satisfaction with San Bernardino’s transparency at this point, except with regard to an agreement between the city and CalPERS, noting that some parts of the agreement—including that the city will pay the full amount it owes CalPERS, about $14 million, over two years—had already been released to the public. Because of that, the city’s argument that it would be misleading to release the agreement without the context of the full Plan of Adjustment did not, according to the judge, make sense―she gave the city until March 26th to submit the full agreement in public court records, along with any desired explanation of context—a date which appears to be consistent with the city’s progress: City Attorney Gary Saenz said he hoped a draft of the city’s full plan of debt adjustment would be publicly presented to the City Council with all the necessary context by then.

Based upon the two nights of public meetings, the next steps with regard to how to incorporate and implement the direction ahead will be the task of a “core group” with further input from residents, followed by the steady development of a “strategic plan” city leaders say they intend to use to develop the city’s plan of debt adjustment, but also to guide the city for years to come. The city has scheduled two more such community input meeting for the end of this month.

The Extreme Costs of Municipal Bankruptcy. Meanwhile, in the frigid north, the noted rhythm guitar playing U.S. Bankruptcy Judge Steven Rhodes yesterday determined that the Motor City’s $178 million bankruptcy tab for its outside legal and accounting advisors is reasonable considering the case’s complexity, the city’s “extreme financial challenges,” and substantial discounts given by law firms and consultants. The judicial announcement yesterday could mark one of the final chapters of Detroit’s historic municipal bankruptcy—and Judge Rhodes’ illustrious career: he is set to retire this month. Nevertheless, the extraordinary legal and accounting costs―which will be nearly $200 million the city is unable to dedicate to its future, came almost simultaneously with the announcement the Detroit water and sewer system is considering major rate increases to offset flat revenues as it prepares to transition into a new regional authority created as a key step during the city’s work to successfully put together its now approved plan of debt adjustment. Under the plan, Detroit residents could be hit with not just the costs of the legal bills, but also a nearly 17% increase in sewer rates, with suburban customers facing an average 11.3% increase in water rates under proposed increases the Detroit Water and Sewerage Department released yesterday, albeit the board of water commissioners still needs to approve the rates. The rate increases are aimed to offset lower-than-expected revenues due to flat or declining water sales and delinquent payers, including some financially troubled suburbs, according to reports—and come just a week after Judge Rhodes filed a court document noting that additional mediation sessions have been set for the city and suburbs to hammer out remaining disputes in the creation of the Great Lakes Water Authority. As much as Judge Rhodes might wish to retire, his ability to create electronic rhythm will likely be tested: Oakland Executive L. Brooks Patterson and Macomb County Executive Mark Hackel have complained about the rate increases, lower-than-expected revenues, and the department’s lack of financial transparency. The agreement calls for Macomb, Oakland, and Wayne counties to lease for at least four decades the bulk of the water and sewer department, with Detroit retaining control of the Motor City’s infrastructure. In return, the counties would pay Detroit $50 million a year in lease payments, money that the city can only use for system upgrades. Nevertheless, Judge Rhodes appears optimistic that the fees served their purpose, as he noted: “The city is now on a path to success precisely because of the expertise, skill, commitment, endurance, personal sacrifice, civility and proficiency of all of the professionals in the case, including most certainly those whose fees are subject to review in this opinion.” As high as the fees were, the Judge’s order for mediation between the city and all attorneys and other professionals who worked for the city in December produced discounts from all the key parties—saving the city millions of dollars. In his 48-page ruling, Judge Rhodes wrote that his findings reflect numerous complex issues in the case and the final consensual agreements crafted largely in court-ordered mediation, adding: “In its eligibility opinion near the beginning of the case, the court made detailed, and frankly, depressing findings about the city’s fiscal and service delivery insolvency…Those findings reflected the awesome challenges that the professionals in the case faced, embraced, met and overcame. They understood from the beginning the profound personal stake that each of the 700,000 residents of the city of Detroit had in the outcome of their work…But now is the time to appreciate and credit that accomplishment and all of the effort and skill of those professionals in achieving it. The city is now on a path to success precisely because of all the professionals in the case, including most certainly those whose fees are subject to review in this opinion.” The law firm Jones Day earlier defended its total bill of $7.9 million as “entirely reasonable” and argued it was one of the few firms capable of handling “cutting edge” issues posed by the biggest municipal bankruptcy case in U.S. history: the firm agreed to a 24% reduction in the fees it intended to charge Detroit taxpayers—with Jones Day attorney Heather Lennox telling the federal court Detroit stands to realize an estimated $10 billion or more in economic benefits, and that her firm helped Detroit slash total liabilities by about 50 percent, unsecured liabilities by 75 percent, which lets Detroit avoid a projected $3.9 billion deficit over the next decade—and, according to Counselor Lennox—enabling Detroit to reinvest $1.7 billion over the next decade on public safety and other services. Among the top paid professionals were: investment banking firm Miller Buckfire, $22.82 million; restructuring firm Ernst & Young, $20.22 million; and operational restructuring firm Conway MacKenzie, $17.28 million.

What Is a Territory to Do? Resident Commissioner Pedro Pierluisi, Puerto Rico’s Representative in Congress, yesterday announced he had secured 10 additional cosponsors of H.R. 727, the Puerto Rico Statehood Admission Process Act, a bipartisan bill to provide statehood to Puerto Rico as of January 1, 2021―once a majority of the electorate in Puerto Rico votes in favor of admission in a federally-sponsored vote―giving the bill 61 cosponsors—48 Democrats and 13 Republicans. In a November 2012 referendum in Puerto Rico, sponsored by the local government, voters soundly rejected Puerto Rico’s current territory status and expressed a clear preference for statehood. H.R. 727 would authorize a vote to be held in Puerto Rico within one year of the bill’s enactment—that is, no later than the end of 2017. The ballot would consist of a single question: “Shall Puerto Rico be admitted as a State of the United States?” In 2014, at Pierluisi’s initiative, and over the objections of the Governor of Puerto Rico and his allies, Congress enacted a $2.5 million appropriation to enable Puerto Rico to conduct the first-federally sponsored vote in its history, so long as certain conditions are met. Under H.R. 727, the admission vote authorized by the bill may be funded with the $2.5 million that Congress approved. This is appropriate because a straightforward vote on admission clearly satisfies the conditions that the federal government established in the appropriations law. Commissioner Pedro Pierluisi this week re-introduced legislation that would empower the government of the U.S. territory of Puerto Rico to authorize one or more of its government-owned corporations, if they were to become insolvent, to restructure their debts under Chapter 9, the municipal bankruptcy provisions of the U.S. Bankruptcy Code: the Puerto Rico Chapter 9 Uniformity Act. As proposed, the bill would deem Puerto Rico to be a “State,” “except for the purpose of defining who may be a debtor” under Chapter 9. Here, the intent appears to be that, if approved, Puerto Rico would be authorized to authorize its public utilities or instrumentalities to file for municipal bankruptcy protection. The action comes in the wake of multiple investment firms which own Puerto Rico’s municipal bonds suing Puerto Rico in U.S. federal district court, arguing that its enacted Recovery Act violates both the U.S. Constitution and the Puerto Rico Constitution—and last week’s U.S. district court decision holding that the Recovery Act is preempted by the U.S. Bankruptcy Code and is therefore invalid under the Supremacy Clause of the U.S. Constitution. Now, as Commissioner Pierluisi put it: “In the wake of the district court’s decision, it is more clear than ever that Congress should act swiftly to amend the U.S. Bankruptcy Code to empower the government of Puerto Rico to authorize its insolvent government-owned corporations to restructure their debts under Chapter 9. If Congress does not act, government-owned corporations in Puerto Rico will be left without any legal framework-at either the federal or territory level-to adjust their debts.”

Rethinking Tax Systems & The Importance of Revenues

eBlog

February 11, 2014
Visit the project blog: The Municipal Sustainability Project

State of the Motor City. Yesterday was a day of another round of voting to round out Detroit’s process of filling a vacancy on its City Council—with the Council yesterday narrowing the list of candidates sixteen to two after seven rounds of voting: the finalists are Janee’ Ayers, a 33-year-old union leader, and Debra Walker, a community organizer and retired Chrysler executive. Yesterday’s voting was done in public, so Councilmembers did not have an opportunity to speak in private between votes. Councilmember George Cushingberry, who admitted to cutting a deal ahead of last year’s vote for council president, attempted to call a recess so members could speak privately; however, Council President Brenda Jones rejected the request, hinting that such conversations would violate Michigan’s open meetings act. The next round will be early next week, after the Council completes interviewing Ms. Ayers and Ms. Walker a second time—after which a final vote is anticipated. The next round became necessary after the Council was unable to obtain the requisite super-majority of six members yesterday to settle upon either of the two candidates—and that was in the wake of four rounds of voting at yesterday’s public meeting to narrow the field to two finalists. In the subsequent three rounds, the votes for the two aspirants remained the same, so an impasse was declared. The job pays about $76,000. Councilmember Cushingberry after the session said he has no problem with open government, but the Council’s fear of breaking the open meetings act has hamstrung the appointment process, because members are hesitant to talk freely about the issue in public meetings, claiming the council is “severely constrained by this damn act.” While he told the Detroit Free Press he would switch his vote, other members said they would go into the next interview phase with a less rigid stance. Candidate Ayers, who attended the session, said her experience as elected vice president of Metro Detroit AFL-CIO and as a tutor for children would be an asset to the council: “I build bridges, I problem solve and I can get along with everybody…I don’t do anything in order for somebody to know my name. It’s all about what happens to benefit the people.” For her part, Ms. Walker, who lives in Corktown in District 6, said she is humbled to be among the final two candidates: “If they’re looking to truly get a candidate that can work with the entire council and bring the depth and breadth of energy and experience and ideas, then hopefully they would recognize that individual to be me.”

Raising Revenues. Moving swiftly after Judge Francisco A. Besosa of the United States District Court in San Juan, Puerto Rico, last Friday ruled that Puerto Rico’s Recovery Act violated federal law―and enjoined commonwealth officials from enforcing it, Gov. Alejandro García Padilla of the Commonwealth of Puerto Rico—under pressure to realize more than a 10 percent increase in tax revenues―has proposed a major overhaul of the island’s tax system in an effort to reduce tax evasion and promote economic growth—key steps if the territory is to avert fiscal failure. The Governor is proposing to move to a VAT or value added tax system, under which the system would move to taxing consumption from its current significant reliance on individual income taxes (please see pie chart below—as well as the chart at the bottom to assess how the Commonwealth’s year-to-year revenues have changed), stating: “With this tax system overhaul we can help direct the island’s revenues towards the future and ensure that we will borrow less, pay our current debts, and pay down the debt previous administrations committed to without the appropriate means for repayment.” Under his proposal, the commonwealth’s income tax would no longer apply to those earning less than $40,000 annually—as opposed to today’s $20,000 trigger. Under the proposal, Puerto Rico’s 7% sales and use tax would be replaced by a 16% VAT tax, according to Government Development Bank President Melba Acosta Febo. Under such a system, value added taxes are charged at each stage of an item or product’s path to the final purchaser—as opposed to a traditional state or local sales tax, which is only applied at the final transaction. The government hopes the move to a more European type of revenue system will help pump up critically needed new revenues, but will also address significant tax evasion. Last year, the government expanded its sales and use tax base and increased corporate income tax rates—and halted its projected reductions in corporate excise taxes—the second largest source of revenues. Puerto Rico’s corporate tax collections increased sharply last year, while individual and non-resident withholding tax collections fell. Gov. Padilla—in pressing for the significant tax changes noted: “We currently have a tax system that penalizes work and productivity while encouraging evasion…It is inefficient and unfair. The current system punishes the middle class and the poor who work so hard to provide for their families,” noting that last year only 12,000 taxpayers filed tax returns for $150,000 and up in income—something which appears in sharp contrast to the island’s many luxury cars and beautiful homes—raising concerns that many taxpayers are significantly underreporting their income—a door that will be shut, under the revised system used by most European countries as it is likely to mean significantly reduce tax avoidance, according to what Puerto Rico’s Treasury Secretary Juan Zaragoza Gómez told The Bond Buyer. Under the VAT tax, prescription medications, groceries, rents, mortgages, and public higher education charges would be exempt. Under the switch, the government predicts it will achieve significant savings, because it will not have to process 850,000 tax returns.