The Unique Roles of Mediators in Municipal Bankruptcy

Getting Ready to Rumble. With the San Bernardino City Council poised to be briefed and then vote tomorrow on the city’s proposed plan of debt adjustment, so that it may be submitted to U.S. Bankruptcy Judge Meredith Jury prior to her deadline of May 30th, Paul Glassman, an attorney for San Bernardino yesterday, in court, told Judge Jury San Bernardino “hopes it can reach an agreement by the plan filing deadline with the unions…The city also has begun negotiations with other non-safety unions — and hopes to reach agreements with whatever groups it can before the plan filing deadline.” Almost as if in a two-ring circus, even as the Mayor and Council are prepping for tomorrow’s vote, the outlines of the battle amongst the city’s creditors that Judge Jury will opine upon are already emerging. Indeed, Monday’s status hearing in the U.S. Bankruptcy court did not come out well for some of the owners of San Bernardino pension obligation bonds, who suffered a key defeat. In a reprise of the struggles between bondholders and public pensions which characterized critical issues in the Stockton and Detroit bankruptcies, Judge Jury ruled against their argument that the pension obligation bonds should be treated no differently than San Bernardino’s obligations to the California Public Employees’ Retirement System (CalPERS), which San Bernardino plans to honor. The hearing, to consider Erste Europaische Pfandbrief- und Kommunalkreditbank AG and Ambac Assurance Corporation’s complaint filed last January seeking equal treatment as creditors with CalPERS—a hearing where the pension bond attorneys pointed to a court validation ruling the city obtained prior to issuing the pension bonds in 2005, focused on the issue with regard to San Bernardino’s argument that the pension bonds represented simply a refinancing of its unfunded liability to CalPERS; as a result, they had argued, it was not new debt, so that it did not require voter approval. The bank’s lawyers argued that any payment of San Bernardino’s obligations to CalPERS required equivalent payment to the holders of the city’s pension obligation bonds: “The bondholder pension obligation portion and the CalPERS pension obligation portion are separate portions of a single indivisible pension obligation owed by the debtor under the retirement law and CalPERS contract.”

Judge Jury, however, demurred, responding that she does not think the bonds and payments to CalPERS are a single obligation which should be treated the same in municipal bankruptcy: “Although maybe it is a concept I don’t fully understand, it does seem the retirement law is a source granting the city the right to issue POBs.” Judge Jury said she was wrestling with the awareness that, if POBs were not treated on par with pensions and bondholders were to be treated differently (e.g. take a haircut), the city could confront greater barriers in the future issuing municipal bond debt for its public pension obligations: “The city wants the opportunity to protect against uncertain fluctuations with CalPERS by issuing bonds…Both sides wanted this transaction, so it could happen.” Nevertheless, Judge Jury said the central issue was whether San Bernardino’s pension payments and bond payments were a single obligation. She opined they are not: “It is important that the remedies (for curing default) are different…That is enough for the court to be satisfied that it can’t be considered the same obligation,” adding that she does understand the importance of her ruling and the impact on the municipal bond market in California. Nevertheless, Judge Jury granted the motion to dismiss without leave.

The issue with regard to whether pension obligation bonds issued by a municipality ought to have exactly the same status as the CalPERS UAAL is, as one colleague puts it: “ridiculous,” suggesting that if we were to ask anyone (creditor, rating agency, or debtor) whether a refinancing is a separate and different debt issue that stands on its own….they would each give the same answer. The bond insurer in this case tried to push that, mayhap forgetting the status and uniqueness of CalPERS. The insurer questioned whether CalPERS is truly a creditor in the first place…as opposed to a conduit…receiving funds, investing them, and then paying it out to the retirees: “They cannot lose money and they cannot make money. They are a product of state law. The real creditors are the retirees…” much as Judge Christopher Klein had written in his confirmation opinion with regard to Stockton.

The Unique Roles of Mediators in Municipal Bankruptcy. Perhaps because of his electrical rhythm, U.S. Bankruptcy Judge Steven Rhodes made an invaluable contribution to the annals of municipal bankruptcy through his appointment of U.S. District Judge Gerald E. Rosen to serve as a mediator in Detroit’s municipal bankruptcy. So too, U.S. Bankruptcy Judge Christopher Klein swore by the invaluable U.S. Bankruptcy Judge Gregg Zive, who served as a mediator for him—and has now accepted a similar position in San Bernardino, where Ron Olinor, who represents the San Bernardino police officers’ union, noted yesterday: “I like everything the city has done so far today,” noting that the mediation process headed by U.S. Bankruptcy Judge Gregg Zive is bearing fruit: “Judge Zive is very much involved…We have been on the phone with Judge Zive twice today. He will be reaching out to you at the appropriate time. It has been a long road. There are many reasons on the city’s part and sworn officers’ part to make a deal…We have a deadline, thank you for that — we will know where the city is at after the plan is filed.”

Financial Armageddon. Wayne County, one of the nation’s largest counties, which surrounds Detroit, also confronts many of the same fiscal stresses which brought the Motor City into municipal bankruptcy: plummeting property taxes are putting its deficit on track to swell to $200 million by 2019, from $159.5 million in 2013, according to Fitch; Wayne County’s pension assets are $910 million less than promised payouts, and its post-retirement health care is underfunded by $1.3 billion—or, as one analyst put it: “When we look at Wayne County’s tax base, its budget, its balance sheet, it looks eerily similar to the city of Detroit’s problems.” Indeed, three months after Wayne County Executive Warren Evans warned of possible “financial Armageddon” in the face of the county’s looming budget deficit, Mr. Evans is proposing to reduce wages, end post-retirement health-care benefits for future retirees, and reductions in pension benefits. Moody’s has moodily reduced Wayne’s credit rating to junk status, and Fitch has noted that the county’s jail debt may be “particularly vulnerable,” as officials sort out its finances: should Wayne County file for municipal bankruptcy, its $200 million municipal bonds backing an unfinished, 2000-bed jail in downtown Detroit would likely go unpaid. Officials halted construction in 2013 amid cost overruns. For his part, Mr. Evans said in the County’s recovery plan released last month that if his recommendations are implemented, the county can plan a new jail. Whether finishing the partially built facility is the answer, however, remains an “open question,” according to his report. Mr. Evans has proposed changes to cut $53.4 million from spending; meanwhile the county’s efforts to negotiate wage and benefit reductions with unions are showing little signs of progress. The county’s largest union, AFSCME Council 25, reports its members have already taken pay cuts. Gary Woronchak, Chairman of the Wayne County Commission, states the county’s debt payments are safe: there is “no chance” of vendors or bondholders not being paid. Should the county’s fiscal conditions deteriorate, Chairman Woronchak believes the most likely outcome would be a consent agreement, in which county officials and the state would agree on measures to resolve the crisis, adding that, unlike in neighboring Detroit, even though Governor Snyder could appoint an emergency manager, that step would not be needed, because, he says, the financial challenges are manageable and municipal bankruptcy “is not in the realm of what’s going to happen.” Indeed, almost like Romulus and Remus, Detroit’s long-term recovery from municipal bankruptcy might irretrievably now be dependent upon Wayne County’s avoidance of going into municipal bankruptcy.

Going to School on Debt. After really trying to give Gary a chance, and less than a month after the city’s School Board fired its school district’s interim chief financial officer, the Indiana legislature—in a state which does not specifically authorize municipalities to file for municipal bankruptcy―is trying to finalize new state legislation which would allow the state to take over the city’s school system. It would, if the final details are worked out, mark the first use of an emergency manager to assume responsibility for a local entity. The statutory language authorizing a state takeover is expected to incorporate specifics with regard to the process for selecting an emergency manager, as well as the scope of authority such a manager would have—or, as Dennis Costerison, a lobbyist for the state’s public school system described it for the Bond Buyer: “It will be a first, and it will be very interesting…We’ve never had a district go this far before.” The bill authorizes the Distressed Unit Appeals Board or DUAB to oversee the new emergency management process. The DUAB was created in 2008 to help distressed local governments deal with property tax revenues losses, but, so far, has only managed a few units. Under the legislation, DUAB will hold a public hearing on the Gary district’s finances. The state board will then select three financial managers, and the Gary school board will choose one of them. The manager will have a year’s tenure. The legislation authorizes the DUAB authority to “delay or suspend” a school the district’s principal and interest payments on loans from the Indiana Common School Loan Fund and recommend to the state board of finance that it make an interest-free loan with a six-year maturity. Micah Vincent, chair of DUAB and general counsel and policy director for the Indiana Office of Budget and Management, said the board has yet to work out the fine print of the takeover. Mr. Vincent hopes to fine tune the plan over the next month; DUAB will hold the public hearing this summer.

Mr. Vincent noted the board will be looking at other states’ programs, including that of Michigan, which is considered to have a relatively strong emergency management program. An emergency manager will likely begin his or her tenure with a comprehensive audit of all areas of the school district from “bookkeeping to bill paying,” according to Mr. Vincent, who declined to comment on whether the process or the emergency manager would have the ability to restructure bond debt, but noted that the current law only allows for the restructuring of state loan debt. The school corporation has $30.5 million of direct debt. That includes $13.8 million of general obligation bonds, and $16.4 million of state loans. It has another $44.3 million of underlying debt from Gary Building Corp. mortgage bonds. Its debt service fund had a negative ending balance of $349,000 as of fiscal 2013, an improvement from the $669,000 deficit in 2012 but down from the $2.4 million positive balance in 2009, bond documents show.

Gary, a city of 78,000, just 25 miles from Chicago, is a municipality which has experienced severe fiscal problems related to its population decline and property tax caps—in addition to nearly a 50 percent reduction in state school aid over the last five years—indeed, today Gary has among the highest number of charter schools in the state, whilst the city’s public school system has experienced nearly a 40 percent decline—meaning that by this month, the system’s general fund balance had fallen to $6.6 million in the red by 2013, a severe reversal from the $9.3 million surplus the school system recorded in 2009. State property tax reform exacted a severe toll: when enacted in 2008, the school system’s general fund was barred from receiving any property tax revenues and forced to rely entirely upon state aid. And as if such fiscal misery was not enough of a challenge for municipal leaders, voters last week rejected a referendum that would have raised additional revenue. But the academic road map in Gary is likely to only become more challenging: the state’s newly adopted budget includes provisions to modify Indiana’s state school funding formula to make funding more closely follow students: that is a change that could have the effect of cutting state aid for lower income, urban school districts, but increasing fiscal assistance for suburban districts which are experiencing increased enrollment.

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