A Musical Lessons Learned from Municipal Fiscal Distress

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February 19, 2014
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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.

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