Municipal Bankruptcy–Constitutional Challenges

February 8, 2016. Share on Twitter

“Progress is our most important product.” As former California Governor and President Ronald Reagan used to say in ads he did for General Electric, progress matters—especially for San Bernardino, the city in municipal bankruptcy longer than any other in U.S. history. San Bernardino, in its latest filing in U.S. Bankruptcy Court for the Central District of California, has reported progress: the bankrupt city has reached a tentative settlement agreement with pension bondholders in its Chapter 9 municipal bankruptcy, having reached a tentative agreement with the creditor holding its pension obligation bonds with regard to how the debt would be treated in the city’s plan of debt adjustment, reporting the agreement was reached last month and that it was working on document terms, which remain confidential for now. As in the Detroit bankruptcy, the role of a judicial mediator is proving invaluable. In this instance, Nevada Bankruptcy Judge Gregg W. Zive, appears to be playing a critical role in confidential mediation with the city, bond insurer, and bondholder—mediation which has been ongoing for nearly a year, according to the filing. San Bernardino had been planning to pay $655,000 plus interest on nearly $50 million in pension obligation bonds held by a Luxembourg-based bank (Erste Europaische Pfandbrief-und Kommunalkreditbank AG—EEPK), which had been at the forefront of opposing the city’s proposal to adjust more than $150 million in claims.

When San Bernardino first filed its plan of debt adjustment and its disclosure statement last May 29th, after nearly three years in bankruptcy, the plan had drawn objections from both Ambac Assurance Corp. and EEPK—with Ambac the bond insurer on the pension obligation bonds held by EEPK. Under the previous terms of San Bernardino’s plan of debt adjustment, holders of the $50 million of unsecured pension obligation bonds (POB) claims would have received payments of $655,000 plus interest over time, and holders of general unsecured claims between $130 million and $150 million would have received a pro rata share of $1.3 million after the plan became effective. But last December, in a filing with the U.S. bankruptcy court, Ambac Attorney Paul Kreller had questioned how the city was able to decide on what he termed its “draconian” plan of only paying 1 percent owed on the pension obligation bonds and general unsecured claims when its financial disclosures were what he termed so “murky.”

The disclosure of the agreement followed a unanimous vote by the new City Council to approve a settlement ending disputes involving more than $40 million in claims with the city’s firefighters, a move the city said it expected would advance its proposed plan of debt adjustment to exit municipal bankruptcy. As adopted, the settlement resolves nine years’ of claims against San Bernardino. It includes paying the firefighters $2.7 million to resolve claims over changes to the city’s pension policy and to settle lawsuits the firefighters pressed against the city after it filed for Chapter 9 bankruptcy protection. The agreement also provides for the firefighters’ union to be treated as an unsecured creditor which would receive $140,000, or 1 percent, on a $14 million claim in the city’s plan of debt adjustment. Amended disclosures documents are now due March 30, rather than Feb. 10, with opposition filings due April 13. The status hearing was postponed from Feb. 10 to April 27 at 1:30 p.m.

Puerto Rico in the Twilight Zone. While Puerto’s Rico’s Governor and other state and local elected leaders await U.S. House Speaker Paul Ryan’s (R-Wisc.) anticipated deadline of April 1st with regard to what authority or plan the House will settle upon with regard to the U.S. Territory, Representatives for Puerto Rico report the Territory intends to pursue its recently proposed debt exchange with holders of tax-supported debt. In the category of, when it rains it pours, moreover, Puerto Rico Gov. Alejandro García Padilla last Friday announced the declaration of a public health emergency over the mosquito-borne Zika virus, with 22 confirmed cases to date, including a pregnant woman. The virus, which has been particularly linked to microcephaly on newborns, or abnormal brain development, poses a threat not just for Puerto Rico residents, but also on its operating budget. In issuing his executive order, Gav. Padilla noted: “Our main objective is to ensure the security of Puerto Ricans, inform about the necessary prevention measures, following the recommendations of health experts.” The Health Department will hold an event today at the Puerto Rico Convention Center to provide local health professionals with more information not only on Zika, but also dengue and chikungunya, which are also carried by the same mosquito linked to Zika — the aedes aegypti. The Consumers Affairs Department has also ordered a temporary price freeze on products that help in preventing and fighting the disease. From the territory’s fiscal perspective, the public emergency constitutes a double fiscal whammy: it will impose significant, unbudgeted costs—even as it risks discouraging tourists from visiting the islands. The Centers for Disease Control & Prevention (CDC) recently issued a Zika-related travel alert on the Caribbean region, warning pregnant women and those planning to become pregnant against travel to the affected areas, including Puerto Rico. The government’s service line, 3-1-1, will be taking calls to provide information about the virus and log complaints about mosquito breeding sites.

The Commonwealth has repeatedly asked Congress to provide it or its authorities with restructuring capabilities, such as Detroit, Jefferson County, and San Bernardino have under Chapter 9 municipal bankruptcy; however, there has been little progress to date. Under the restructuring plan Puerto Rico announced last week, creditors holding $49.2 billion of tax-supported debt would be asked to exchange it for $26.5 billion of new, mandatorily payable so-called “Base Bonds” and $22.7 billion of Growth Bonds. There would be no interest payments on the Base Bonds until fiscal year 2018 and no principal payments until fiscal year 2021. In addition, the so-called Growth Bonds would only be payable if Puerto Rico were to surpass conservative revenue growth projections through real economic growth: the first payments on the Growth Bonds, if possible, would commence a decade after the close of the exchange offer. If Puerto Rico were to experience growth consistent with the U.S.’s projected growth over the next three decades, the creditors would be able to recover the full amount of their principal investments. Annual payments on the Growth Bonds would be capped at 15% of the commonwealth’s revenue. If it all worked, Puerto Rico’s debt service-to-revenue ratio on tax-supported debt would fall by more than 50 percent from its current 36% level.

Ms. Acosta Febo, President of the Puerto Rico Government Development Bank, said she and other commonwealth officials have had more conversations with creditors in the wake of last week’s meeting when the idea, which lays out a broad allocation of how much each class of creditor would receive, was proposed. At the same time, Puerto Rican leaders have also been trying to finalize a separate agreement with creditors for about $9 billion of Puerto Rico Electric Power Authority debt: a previously missed deadline for Puerto Rico’s lawmakers to pass legislation required under the potential agreement has been extended to next Tuesday. The negotiations have led Moody’s to be unmoody in noting that the extension of negotiations “suggest a consensual debt restructuring is still possible.” ‘Possible’ is increasingly the key term, as Puerto Rico officials have said that without solutions from those negotiations or Congressional action, the territory will default on its next major round of municipal bond payments due July 1st.

It Ain’t Over Until It’s Over. Jefferson County, prior to Detroit, the largest municipal bankruptcy in U.S. history, is finding that exiting municipal bankruptcy can take longer and be more trying (a pun) than getting into bankruptcy. Now the county will have to, some more than two years after its exit from municipal bankruptcy, appear before the 11th U.S. Circuit Court of Appeals to argue, once again, the soundness of its plan of debt adjustment – and why that plan should remain in force to protect bondholders. Jefferson County had asked to appear before the panel to appeal U.S. District Judge Sharon Blackburn’s ruling in September 2014, a ruling in which Judge Blackburn denied the county’s motion to strike down an appeal by a group of local ratepayers of the Jefferson County’s sewer system—ratepayers who have challenged Jefferson County’s plan of debt adjustment. The county had argued unsuccessfully that the ratepayers’ appeal was moot, because the bankruptcy plan was largely consummated in December 2013, when $1.8 billion of sewer system refunding warrants were sold to write down $3.2 billion of outstanding debt. Jefferson County’s attorneys believe an oral argument could be of assistance for the federal appellate judges, noting: “The constitutional, statutory, and equitable principles involved in this appeal are particularly important to governmental entities that may consider Chapter 9 relief now or in the future, as well as to the municipal debt market.” The 11th Circuit Court of Appeals has accepted numerous documents and court cases, including friend of the court briefs from municipal market organizations and Chapter 9 bankruptcy appeal rulings in Detroit and Stockton, California.

The challenge here is constitutional—and goes to the core of federalism. The Jeffco ratepayers are alleging the Jefferson County’s plan of debt adjustment violates the Tenth Amendment to the U.S. Constitution, under which powers not delegated to the United States by the Constitution are reserved to the States, respectively, or to the people. Thus, they contend, a provision in Jefferson County’s court-approved plan of debt adjustment could allow the federal bankruptcy court to set sewer system rates to service Jefferson County’s debt—a key provision in the city’s approved plan of debt adjustment because it guaranteed protection for the county’s municipal bondholders who participated in the 2013 refunding agreement—and allows the federal bankruptcy court in Alabama to maintain jurisdiction over Jefferson County’s plan of debt adjustment as long as the debt remains outstanding. Judge Blackburn, however, was troubled by the provision when she denied Jefferson County’s motion to dismiss the ratepayers’ appeal. Although Judge Blackburn said some parts of the county’s bankruptcy confirmation order “may be impossible to reverse,” she said the portion which cedes the county’s future authority to set sewer rates to the bankruptcy court is not one of those. Jefferson County has argued that the bankruptcy court is only a forum for bondholders to enforce the plan and related contracts, and not to set sewer rates.

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