The Absences of Fiscal Balances

May 4, 2018

Good Morning! In this morning’s eBlog, we note the deepening road towards insolvency of the Harvey, Illinois; then we turn south to consider the potential adverse municipal fiscal impacts were the State of Georgia to enable the de-annexation of the small city of Stockbridge. Finally, we journey back to Puerto Rico, where House Natural Resources Committee Chair Rob Bishop is headed for a first-hand assessment of the ongoing fiscal and physical challenges and federal emergency assistance still needed. 

An Absence of Fiscal Balance? In the Land of Lincoln, Illinois, where the state’s courts have heard requests for municipal bankruptcy relief; but where chapter 9 municipal bankruptcy is not authorized; relief appears only to have been granted when not challenged. Under 65 Illinois Comp. Statute 5/8-5-1, smaller municipalities may, if not home rule jurisdictions, seek judicial relief. Under the state’s Local Government Financial Planning and Supervision Act (50 Ill. Comp. Stat. 3200) a municipality with a population under 25,000 suffering a “fiscal emergency” may, after securing a two-thirds vote of the governing body, petition the state to establish a financial planning and supervision commission to address such “fiscal emergency.” Ironically, Harvey, with a population of 25,282, just exceeds that level—some 1,052 Illinois municipalities have less than 25,000 residents. Now, with the municipality unable to meet its police and fire pensions, Illinois Comptroller Susana Mendoza is holding up more than $1 million in state funds the town is owed—under Illinois statutes which authorize the state to withhold tax revenues a municipality is slated to receive if it does not make the required payments into its police and firefighter pensions: the funds withheld go right into the pension fund instead of town services—which, in the case of Harvey, amount to about $1.4 million, leading to, as we have previously noted, the town’s announcement that it will lay off nearly half of its police and fire department. Making the fiscal situation more dire, the city’s Mayor, Eric Kellogg, has been banned for life from the municipal bond market for misleading investors; the municipality appears to be in a chronic pattern of underfunding its public safety pension funds, even as its operating budget chronically spends more than the revenues it brings in. Ergo, as we have written, under Illinois’ Public Act 96-1495, the Comptroller may be compelled to withhold state tax revenues, which would traditionally be in order to ensure pension payments are made to a municipality which has failed to make full pension payments for years.

In a situation which risks compromising public health and safety, Harvey has laid off nearly half its police and fire force—even as it has warned it might not be able to make payroll—especially with inadequate municipal fiscal resources now being rerouted to oppose the state actions in court.

It being Illinois—and an election year—Gov. Bruce Rauner has been uncharacteristically silent about the brewing fiscal catastrophe. The godfather of chapter 9 municipal bankruptcy, Jim Spiotto, has joined with the exceptional Chicago Civic Federation in drafting legislation, the Local Government Protection Authority, which includes a provision to:

  • establish an oversight board,
  • set up a clear procedure for dealing with a stressed city, and
  • allow filing for Chapter 9 municipal bankruptcy. (Legislation which has, to date, gained no traction in the legislature.)

Harvey Town Attorney Bob Fioretti reports: “We are going to find some solution, if possible,” signaling that the municipality was still negotiating with its police and fire pension funds, but warning that, if those discussions falter:  “Layoffs will occur. But the safety of the population is key, and that will continue.”

Mayhap ironically, Illinois adopted its pension law eight years ago as a way to ensure smaller municipalities would stop shorting their pension fund contributions—provisions upheld the week when a judge affirmed that the Illinois comptroller was within the state law to withhold the revenue. Thus, while the Comptroller’s Office issued a statement that it “does not want to see any Harvey employees harmed or any Harvey residents put at risk…the law does not give the Comptroller discretion in this case: The Comptroller’s Office is obligated to follow the law. This dispute is between the retired Harvey police officers’ pension fund and the city of Harvey.”

Nor does Harvey appear to be an isolated case: According to an analysis by Amanda Kass, a researcher at the University of Chicago, there are 74 police or fire pension funds in Illinois municipalities with similar unfunded pension liabilities—leading Chicago Civic Federation President Laurence Msall to note: “If they ignore the law and don’t make the contribution as Harvey has, then yes, those municipalities all around the state have ability to seek an intercept of state revenues that would otherwise come to the municipality.”

The complicating factor for Harvey is, however, not just that it has had years of decline and corruption in government, but also with declining assessed property values and very high property taxes, the municipality has a shrinking set of fiscal options—or, as Mr. Fioretti puts it: “We have an aging population, a declining population, a fixed-income population, and our revenues aren’t even being collected from the real estate taxes. We’re below 50 percent for the year on those collections,” noting that the delinquent real estate tax money is costing the town $12 million this year.”

Uneasy Fiscal Options. While Mr. Msall notes that the State of Illinois helped create the fiscal mess by setting up the pension funds and setting all of the pension levels; now, he notes, Illinois must either dissolve Harvey’s pension into the state fund, or put together an emergency financial team to sort through the wreckage of this and other distressed towns—adding: “Let’s create a board that could be independent with real financial expertise to guide these local governments, not to push them into [municipal] bankruptcy: The best path forward for Harvey is independent oversight that could sort out why they’re not making their financial reports on a regular basis.”

The Cost of Municipal Annexation. Municipalities across Georgia could face higher borrowing costs if the state government enables the “de-annexation” of about half of one small city, that city being Stockbridge, one settled in 1829 when the Concord Methodist Church was organized near present-day Old Stagecoach Road—and, especially, when Stockbridge was granted a post office on April 5, 1847, named for a traveling professor, Levi Stockbridge, who had passed through the area many times before the post office was built. Albeit that heritage remains a matter of some dispute: others contend that the city was named after Thomas Stock, who was State Surveyor and the Georgia State President in the 1820s. The small municipality was incorporated as a town in 1895 and, subsequently, as a city on August 6, 1920. Now, however, more change might be on the way, especially if Georgia Governor Nathan Deal signs into law Senate bills 262 and 263—bills which, if enacted, would de-annex just over half of Stockbridge’s assessable residential and commercial property. Why? Because proposed SB 263, an Act to incorporate the City of Eagles Landing, provide a charter for the City of Eagles Landing; provide for a referendum; provide for transition of powers and duties; provide for community improvement districts; and repeal conflicting laws would effectively have disconcerting fiscal impacts on City Hall in Stockbridge, which was financed with municipal revenue bonds. Neither of the two bills apportions the revenues involved between the to-be two entities—a requirement which, according to some legal experts, is based upon precedent-setting court cases before the U.S. Supreme Court and Georgia when the boundaries of a governmental entity are changed.

Thus, unsurprisingly, during the Georgia Municipal Association’s Georgia Cities Week last week, Stockbridge officials and representatives of the Eagle’s Landing effort held separate meetings with Gov. Deal.  Stockbridge City Attorney Michael Williams described their session as “very productive: The Governor said he would consider the series of points we made…I’m certainly taking him at his word that he will.” Nevertheless, the municipality is hedging its fiscal bets: it has hired three outside law firms to challenge the laws if Gov. Deal approves them.

Should that happen, however, the much reduced City if Stockbridge would still would be obligated to pay off about $13.02 million of privately placed Urban Redevelopment Agency lease-revenue bonds, and $1.5 million of water and sewer notes issued through the Georgia Environmental Facilities Authority—municipal bonds owned by Capitol One Public Funding LLC. Unsurprisingly, the Romulus and Remus of Eagles Landing have expressed no eagerness to help make those payments: sharing only goes so far. The lease-revenue bonds, issued in 2005 and 2006 for projects including funding to purchase land and build city hall, backed by general fund revenues and the city’s taxing power, if needed, even though the city does not currently impose a property tax.

Also unsurprisingly, Jim Spiotto’s firm, Chapman and Cutler LLP, which represents Capital One, wrote to the city a day after the General Assembly ended its session last month, warning it could face potential litigation: “SB 262 and SB 263 infringe Capital One’s constitutional rights under the contracts clause of the U.S. Constitution and the Georgia Constitution by taking away a significant source of the security and source of repayment for the bonds that was contractually bargained for by the bondholders,” Chapman and Cutler partner Laura Appleby wrote to the City Attorney. Unless the bonds are properly apportioned between Stockbridge and Eagle’s Landing, and the [municipal] bondholders have the benefit of the full security that they were originally promised, Ms. Appleby wrote, “We have serious concerns regarding the ability of [Stockbridge] to continue to pay debt service on the bonds because it will have lost a large portion of its ad valorem tax base.”

Jonathan Lewis, Capital One Public Funding’s president, has written to Gov. Deal also requesting a meeting, writing: “The failure of SB 262 and SB 263 to provide for the apportionment of the [municipal] bonds between the City of Stockbridge and, if formed, the City of Eagle’s Landing, is not only an inequitable result for the City of Stockbridge, it is an infringement on Capital One’s constitutional rights under the contracts clause of the U.S. Constitution and the Georgia Constitution, as it removes a significant portion of the security and source of repayment for the bonds…Capital One has come to trust that the State of Georgia will take those actions required to maintain, preserve, and protect the pledges made by its municipalities to their bondholders…Permitting SB 262 and SB 263 to become law would no longer allow us to rely in the State of Georgia [based] on the bedrock public finance principle of non-impairment,” adding that such a “de-annexation” would impair Capital One’s municipal bonds and “create new, unprecedented risks for existing holders and prospective purchasers of State of Georgia local debt.” Mr. Lewis last week also communicated to Georgia Municipal Association Executive Director Larry Hanson, whose organization is made up of 521 municipalities, that if enacted, the de-annexation would require all lenders to Georgia municipalities to “consider, and price in, the potential loss of security from future de-annexations,” because the legislation does not apportion Stockbridge’s outstanding debt: “GMA’s members would bear the burden of this new, Georgia-specific risk in the form of higher interest costs: “The uncertainty created by such a shift sets a dangerous precedent and could produce additional negative unintended consequences as lenders consider municipal financing opportunities within the state.”

Who’s on First? Chairman Rob Bishop (R-Utah) of the House Natural Resources Committee, the committee of jurisdiction for U.S. territories, yesterday confirmed he would got to Puerto Rico to meet with island leaders to assess the recovery in the wake of Hurricane Maria’s devastation, noting: “This trip will allow me to better understand the ongoing challenges and the emergency assistance that is still needed.” He is scheduled to meet with Puerto Rico’s non-voting Member of Congress, Jenniffer Gonzalez, as well as Chairman Jose Carrion of the PROMESA Board as part of an effort the Chairman described as a “first hand look at recovery efforts,” pointing out that, in his view, it would be irresponsible for Governor Rosselló, who apparently the Chairman had not advised of his visit, not to implement the government reforms ordered by the PROMESA oversight board—making clear the fiscal gulf between the two leaders, with the Governor observing that Chairman Bishop, with his demands in favor of a dialogue with creditors, seems to be supporting the causes of the territory’s municipal bondholders over the U.S. citizens of Puerto Rico.

Unlike chapter 9 municipal bankruptcy, wherein state laws create a process—where permitted—for a municipality; there are many fiscal chefs in the kitchen in Puerto Rico, with growing questions with regard to the limits of their respective legal authority under the PROMESA law. A key issue, the final decision with regard to the implementation of cuts to the pension system and the labor reform may yet take a few months. The fiscal stakes, however, especially on an island where there has been a steady stream of college graduates and young professionals moving to the mainland—leaving behind  disproportionate number of older, retired Puerto Ricans, increasingly creates a greater and greater fiscal imbalance. That is now front and center in the wake of the Board’s proposed 10 percent average reduction in pensions—a proposal Gov. Rosselló has rejected, but, as one commentator noted, it is the Board which holds all the cards. The challenge is in interpreting the PROMESA Board’s authority to use its fiscal plans to provide “adequate funding” to Puerto Rico’s public pension systems: under the proposed fiscal plan, the Board cut in pensions would not begin until FY2020—giving time for the PROMESA Board to submit to U.S. Judge Laura Taylor Swain a quasi-plan of chapter 9 debt plan of debt adjustment by the end of this year.

It is not that the Governor believes pension should be off the table—after all, he had recommended a 6% reduction last year; thus, there remains some chance that the government and the Board could reach an agreement and avoid the heavy costs of fighting the fiscal issues out before Judge Swain. Indeed, as we saw in San Bernardino, those back door negotiations between the government and creditors can save an awful lot in lawyers’ fees—or, as former U.S. Bankruptcy Judge Gerardo Carlo-Altier put it: “The ideal thing would be for the Board, the government, and the groups of creditors to reach an agreement in advance and go together to court.”

A key sticking point appears to be the Board’s insistence of labor reforms: under its proposed plan, the Puerto Rico Legislature should approve the labor reform by the end of this month, so that the seven-day reduction for vacation and sick leave would take effect immediately. The elimination of the protections against unjustified dismissal, the mandatory Christmas bonus, and work requirements for the Nutrition Assistance Program (NAP) are proposed for next January—with the PROMESA Board estimating that, absent the enactment of such labor reforms, including: such as employment at will, reductions in sick and vacation leaves, and non-mandatory Christmas bonus; the government of Puerto Rico would stop receiving $330 million within the next five years. They estimate another $ 185 million to cuts in pensions—all of which has led the PROMESA Board to project that, absent the adoption of the reforms proposed in the five-year fiscal plan, Puerto Rico’s economic growth and capacity to finance its public debt service would fail.

Who Will Govern? Are there too many fiscal cooks in the kitchen? In Central Falls, Rhode Island: there was one individual in charge of steering the small city, aka Chocolateville, out of bankruptcy. Similarly, in Detroit, Governor Snyder named Kevyn Orr as Emergency Manager—effectively suspending the governance authority of the Mayor and Council during the pendency of the city’s chapter 9 proceedings until U.S. Bankruptcy Judge Steven Rhodes approved Detroit’s plan of debt adjustment. Yet, in Puerto Rico—a territory which is neither a state, nor a municipality; there are a multiplicity of actors—including, now, Chairman Bishop, the Governor, the Legislature, and the PROMESA Board—a Board which Constitutionalist Professor Carlos Ramos González of the Inter-American University Law School believes, even given the power conferred upon it by Congress over Puerto Rico’s elected government, is uncertain with regard to its own authority to implement the structural reforms it favors—or, as he has noted: “Nobody wants to be blamed for cutting pensions: in all the chapter 9 municipal bankruptcy cases, there were pension reductions,” adding that, as we saw especially in the case of Detroit, the issue of equity is challenging: how to make those cuts without plunging many retirees into poverty—a problem of even greater resonance on an island experiencing an outflow of its young professionals, so that the demography already risks insufficient revenues to meet a clearly growing demand.  

Then there is a second challenge: while PROMESA appears clear in its grant of authority to the Board to certify the fiscal plan, it appears to lack any authority to implement it on its own. Unlike Central Falls, Detroit, San Bernardino, or other chapter 9 plans of debt adjustment approved by U.S. Bankruptcy Courts; the current PROMESA statute does not authorize a federal court to control Puerto Rico’s legislative process: there is a separation of powers issue.  Nevertheless, in the wake of the approval of the fiscal plan, the PROMESA Board is trying: it has submitted a preliminary labor reform draft to the Puerto Rico Legislature, where Senate President Thomas Rivera Schatz has invited PROMESA President José Carrión III to defend the proposed changes and cuts—an invitation, however, which has not been accepted.  

Former Governor Aníbal Acevedo Vilá, who lectures for a Separation of Powers class at the Law School of the University of Puerto Rico, finds it self-evident that the Legislature will not give way to the Boards proposed labor reforms, noting: “I think the Board has a very weak case in terms of imposing the labor reform. It has a better case in other measures, because they are directly tied to Puerto Rico’s fiscal crisis.” Similarly, Governor Rosselló usually quotes §205 of the PROMESA Act, which refers to the fact that the Board can make “recommendations to the Governor or the Legislature on actions the territorial government may take to ensure compliance with the Fiscal Plan, or to otherwise promote the financial stability, economic growth, management responsibility, and service delivery efficiency of the territorial government.” While Carlo Altieri adds to the debate §108, which, regarding the general powers of the Board, warns that: “Neither the Governor nor the Legislature may— (1) exercise any control, supervision, oversight, or review over the Oversight Board or its activities; or (2) enact, implement, or enforce any statute, resolution, policy, or rule that would impair or defeat the purposes of this Act, as determined by the Oversight Board.”

Indeed, an attorney for the Governor, Richard Cooper of Cleary Gottlieb, noted: “Congress did not grant the Board the power to pass laws or appoint or replace government officials…it left the government of Puerto Rico the capacity and responsibility to make the law (as long as it is consistent with the adopted fiscal plan and adjustment fiscal plan) and manage the government, with all that it entails.” Indeed, in an earlier ‘who’s in charge dispute,’ when the PROMESA Board tried to appoint a trustee to monitor the Puerto Rico Electric Power Authority (PREPA), alleging that PROMESA recognizes it as representative of the “debtor,” Judge Swain stated that no section of the PROMESA law granted the Board power with regard to the “the implementation of those (fiscal) plans and budgets,” instead comparing the statute Congress adopted in the 1990’s creating a fiscal control board over Washington, D.C. with PROMESA. She concluded that the Board has the task of establishing the “rails” for the “territorial government” to move “towards credibility and fiscal responsibility.” Indeed, the Congressional Record appears to make no reference to the power of the Board to impose structural governmental reforms—just as Congress lacks any authority to impose such on a state—especially in a nation where it was the states which created the nation, rather than vice versa. Rather, the Congressional debate on Puerto Rico reflected an emphasis on the power of the PROMESA Board to restructure the debt, which is the main burden of Puerto Rico—and, in Congress, Republicans and Democrats have expressed no interest in amending the act, either to strengthen or soften the powers of the Board.

For his part, Chairman Bishop believes that the act allows the Board to implement structural reforms and that it would be an irresponsible attitude of the Puerto Rican government to block them. That indicates there could well be intriguing fiscal and governmental discussions this weekend—albeit it seems most certain that, as Gov. Rosselló has made clear: “We are not going to allow an imposed Board to dictate the public policy of Puerto Rico.”

Notwithstanding their differences over the extent of the powers of the PROMESA Board, Gov. Rosselló and the Board are not at complete odds: they appear to have made common cause before regarding the case of Aurelius investment group and the Electrical Industry and Irrigation Workers Union, the main union of PREPA, to defend the constitutionality of the appointment of the Board members, because six of the seven were proposed by the Congressional leadership; rather, Gov. Rosselló’s administration has limited itself to challenging actions of the Board, not its existence—even as one of his predecessors, former Governor Acevedo Vilá, noting that, even under the colonial situation and the doctrine of Insular Cases decided a century ago by the U.S. Supreme Court, which has repeatedly validated the so-called “plenary powers” of Congress in Puerto Rico, the government of Puerto Rico must challenge the existence of the Board as a violation of the U.S. Constitution under the theory that “to the extent that Board has executive and legislative powers, even under the Insular Cases, it is unconstitutional,” adding that: “Even when organizing the territories, Congress has to guarantee a minimum system of separation of powers.”

The Puerto Rico Debt Tango. While the PROMESA Oversight Board and Gov. Rosselló are engaged in a complicated dance over future debt payments and policy, their complicated dance steps are not dissimilar: In successive versions of a fiscal plan that the Governor submitted to the Board in January, February, March, and last month; the Governor said the amount of debt Puerto Rico should carry should be determined through a comparison with debt medians in the 50 mainland states—quite similar to the Board’s certified plan.  Like the Governor’s proposed fiscal plans, the board certified plan has a comparison to the medians for the 50 states and to the 10 states with the highest levels of four measures of debt. The Board certified plan stated: “The implied debt capacity and expected growth in debt capacity in debt capacity must be sufficient to cover both the payments due on the restructured debt, and all payments due on future new money borrowings.” Accordingly, the aggregate debt service due on all fixed payment debt issued in the restructuring of the government’s existing tax-supported debt should be capped at a maximum annual debt service level: “The cap would be derived from the U.S. state rating metrics, and specifically what Moody’s [Investors Service] calls the ‘Debt Service Ratio.’” (The debt service ratio is defined as ratio of total debt payments due in a year divided by a state-government’s own source revenues.)

Under such a construct, it would appear that Puerto Rico could pay about $19 billion of the roughly $45 billion that the central government and its closely related lending entities owe, according to the plan’s exhibit 26. In the same exhibit, the PROMESA Board alternately suggests that one should use an average of a set of four measures of debt capacity and not just own-source revenues. Using this composite measure would mean that Puerto Rico should pay back about $10.7 billion in outstanding debt. But the Board plan notes this would be optimistic for a promised level of payments, rather, it reports, the fixed amount committed to should be cut by 10% to 30% to allow for “implementation risk.” It suggest that 20% should be used and the coupon be adjusted to 5%. These would lead to Puerto Rico committing to pay 19% of its debt—adding: “Any additional cash flow above the maximum annual debt service cap applied to the restructured fixed payment debt that is generated over the long-term from successful implementation of the new fiscal plan could be dedicated to a combination of contingent ‘growth bond’ payments to legacy bond creditors, debt service due on future new money borrowings needed to fund Puerto Rico’s infrastructure investments, and additional ‘PayGo’ capital investment to reduce the government’s historically out-size reliance on borrowing to fund its needs, among other purposes.”

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