Bankruptcy: To Be Eligible or Not to Be, that is the question.

October 5, 2015

Who’s on First in Atlantic City? There was a bankruptcy filing in Atlantic City yesterday: American Apparel is filing for Chapter 11 bankruptcy protection, a filing which came after the Los Angeles corporation reported that its U.S. retail stores will continue to operate and that its international stores are not affected, but a plan which would, pending approval by a federal bankruptcy court, erase more than $200 million in bonds held by the retailer in exchange for equity interests. Lenders will provide about $90 million in debtor-in-possession financing. The company’s board has approved the restructuring plan, which is expected to be completed in about six months—and then will await the court approvals. In contrast, there has been no municipal bankruptcy filing by Atlantic City, notwithstanding the continued silence from Presidential candidate and New Jersey Governor Chris Christie with regard to whether and when he might interrupt his campaign to sign financial relief provisions long since sent to him by the New Jersey legislature to authorize the city’s casinos to make payments in lieu of taxes over the next 15 years and reallocate the casino alternative tax to pay debt service on Atlantic City-issued municipal bonds. In the strange municipal leadership dilemma in which Mayor Don Guardian sits—awaiting action by an absentee Governor and not fully clear about the hydra-headed governance situation where the mostly absentee governor has appointed an emergency manager to act in an ill-defined role as a quasi co-mayor—Mayor Guardian nevertheless is focused on efforts to signally change the city’s fiscal dependence on casinos by diversifying the city’s economic base. Nevertheless, with a $101 million deficit and delayed FY2016 budget (adopted last week), in addition to a withering credit rating; Mayor Guardian has cut the city’s personnel by 400 positions, and worked with his Council to help plug the budget gap—even as he and his fellow elected Councilmembers await Emergency Manager Kevin Lavin’s expected second report, which is to include fiscal sustainability recommendations—recommendations in this strange, two-headed quasi municipal governance situation—and in which the missing Governor’s action will be critical. Notwithstanding his tenuous authority under New Jersey’s unique municipal bankruptcy laws, Mayor Guardian is not just sitting around twiddling his thumbs; rather he is focused on his city’s future, telling the Bond Buyer’s Andrew Coen: “I want to prepare my city for the next recession…Whether that is five or 10 years away, I want to make sure that we’re a lot more than just a resort town so that we become resilient.” That focus, especially since quasi hurricane San Joaquin opted to not vent its physical fury on the city, will be easier in the wake of New Jersey’s Local Finance Board approval of the city’s budget, which opened the way for Atlantic City to proceed with fourth-quarter tax bills and tax-lien sales for some big delinquent properties among current and former casino hotels.

The Anomalies of Municipal Bankruptcy. Hillview, Kentucky, the small (population under 10,000) home rule-class municipality in Bullitt County, Kentucky—a rural farming community just a hop, skip, and jump from Louisville, which filed for chapter 9 municipal bankruptcy in August—the first filing for a municipality since Detroit’s filing more than two years’ ago—might find its filing unavailing. Having ignored the electronically musically and sound advice of retired U.S. Bankruptcy Judge Steven Rhodes, who oversaw the largest municipal bankruptcy in U.S. history, Steven Rhodes, the small city could be digging itself into a deeper fiscal trough, even as it preps to argue before U.S. Bankruptcy Judge Alan C. Stout. Judge Stout will have to determine if the municipality’s filing was done in good faith, in addition to assessing the justifications. The municipality’s largest creditor, Truck America LLC, which has been awarded an $11.4 million judgment against Hillview (with the interest bring the growing amount of said award now up to $15 million) has filed an objection with the U.S, bankruptcy court, arguing the municipality is ineligible because its petition to the federal court which the municipality relied on to file for reorganization “suffers from a fatal flaw: it refers only to the now-repealed Bankruptcy Act.” The objection, which in a sense echoes earlier moody warnings from credit rating agency Moody’s that: “Generally, a municipality must prove that it is not paying its debts on time or is unable to pay the obligations as they become due,” a bar which the credit rating agency had noted would be difficult to overcome, as the municipality had the fiscal capacity to increase its property and occupational license taxes—not to mention the authority and ability to issue bonds to pay for losses in legal judgments, according to the credit rating agency. In its objection to the federal court, Truck America’s attorney wrote that Kentucky courts would likely require that the Kentucky Legislature amend state law (in this instance, §66.400), the Bluegrass State’s municipal bankruptcy statute, under which two municipal entities, both utility districts, have previously filed. Truck America, in its brief, also wrote that Hillview had not negotiated in good faith to settle its court-awarded $11.4 million claim over a contract dispute as required by the bankruptcy code, noting: “Hillview did not file Chapter 9 in good faith to adjust its debts, or to ameliorate bona fide financial distress…Rather, it admits to being ‘fiscally sound’ and filed this case for the specific purpose of minimizing the amount it will be required to pay one creditor—Truck America—on account of a judgment affirmed by Kentucky’s appellate courts,” adding that impairing a single creditor is not a legitimate municipal bankruptcy objective. Interestingly, in its filing, Truck America wrote that the municipality had not complied with Kentucky’s constitution—specifically the provision therein which requires that the state’s municipalities raise taxes in order to pay authorized indebtedness, such as a judgment, within 40 years. If that were not enough of a fiscal nightmare, last August, Hillview Mayor Jim Eadens said the city is exploring malpractice claims against its former attorney. He did not provide any details.

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The Seemingly Irreconcilable Challenge between Addressing Debt & Investing in the Future

September 11, 2015

Investing in Kids? S&P has lowered its ratings on the Michigan Finance Authority’s series 2011 revenue bonds to A from A-plus and series 2012 revenues bonds to A-minus from A-plus with a negative outlook—bonds issued by the MFA for the Detroit Public Schools, with S&P analyst John Sauter writing: “The district’s continued overall financial and liquidity deterioration is another contributing factor.” The bonds, which are payable from the repayment of loans made by the MFA to the Motor City’s school district—loans secured by all appropriated annual state aid to be received by the school district—which has irrevocably assigned 100% of its pledged state aid to the loans (and thereby to the authority’s bonds). The district’s 2011 obligation holds a first-lien pledge of state aid, and the 2012 obligation a second lien. The district’s limited-tax general obligation (GO) pledge also secures both obligations. The ratings reflect the strength and structural features of the district’s state aid pledge to its obligations. Mr. Sauter noted: “The downgrade is based on severe declines in the district’s enrollment, and subsequently, pledged state aid available to pay debt service.” DPS’ credit downward trajectory appears to reflect continued fiscal stress as indicated by significant growth in DPS’ accumulated operating fund balance deficit from FY2014 and ongoing declines in enrollment—declines which pressure operating revenue, as well as the perception that DPS lacks the capacity to reverse the negative operating trend. But the rating also takes into consideration the weak economic profile of the City of Detroit (B3 stable), DPS’ substantial debt burden, and an operating budget constrained by high fixed costs. Absent enrollment and revenue growth, fixed costs will comprise a growing share of DPS’s annual financial resources and potentially stress the sufficiency of year-round cash flow. The unholy combination of falling revenue, rising costs, and credit downgrades can raise the cost of borrowing money—creating a vicious cycle that erodes the fiscal capacity to invest in Detroit’s future taxpayers. Michigan law prohibits its school districts from raising property taxes for operating funds over 18 mills on non-homestead properties; thus, many districts have cut spending, laid off teachers and other staff and eliminated some school programs. DPS has been under the auspices of a state emergency manager for several years and has about $483 million in debt. The district’s enrollment was once well above 100,000 students, but now is about 47,000. Former state superintendent of Public Instruction Mike Flanagan wrote earlier this year in a report to education appropriation subcommittees as he was leaving his post that cash needs could force Detroit Schools to refinance even more debt. The downgrade affects both costs and reputation: for Detroit, its ability to leverage families to move into the city is inherently dependent upon the reputation of its public school system.

Planning Debt Adjustment. When a municipality is in bankruptcy, it is forced to juggle thousands upon thousands of issues relating to constructing a plan of debt adjustment with its creditors that will secure the federal court’s approval—a process made ever more difficult with the approach of elections. This adds stress—and confusion—as could be observed in San Bernardino in the wake of a brief welter of confusion yesterday when a tentative contract agreement already reported to U.S. Bankruptcy Judge Meredith Jury was abruptly pulled off the City Council agenda—a contract with the city’s general unit, which represents some 357 employees who are not in another union, such as police or management. Nevertheless, the contract is now set for the Council to review in closed session at the city council’s meeting scheduled for a week from Monday—in this instance, a contract with regard to leave policy for the city’s employees, who have been working under a contract which expired June 30th as they negotiated with the city for a new contract. The need for a revision arose in the wake of the city’s implementation of one part of its 2012 bankruptcy plan — freezing leave which had accrued before August 2012, when the city filed for bankruptcy protection. That meant that by this year, many employees wound up with negative leave balances—a situation which a city official described to the Council as “very detrimental to the employees.”

Debt Restructuring Outside of Bankruptcy. If you can imagine an NFL football game without any referees or under-inflated footballs, you can begin to imagine the chaos triggered by the release in Puerto Rico this week of its quasi plan of debt adjustment—a plan which, unsurprisingly, calls for its municipal bondholders in each of the nation’s 50 states to accept less than they are owed. The U.S. territory has $13 billion less than it needs to cover its debt payments over the next five years—and that is even after taking into account the proposed spending cuts and measures to raise revenue in the newly proposed plan. Puerto Rico officials estimate that the island will have only $5 billion of available funds to repay $18 billion of debt service on $47 billion of debt, excluding obligations of its electric and water utilities. The projected debt-funding shortfall is after anticipated savings from the consolidation of 135 public schools, reductions in health-care spending, additional subsidy cuts and reductions in payroll expenses. So now, in an unrefereed, unprecedented fiscal process, Puerto Rico’s fiscal team plans to present its investors with a debt-exchange offer in the next few weeks. It also intends to seek a moratorium on principal payments. And it will not have long: the whistle will blow by the end of the year, leaving the unenviable challenge and task of seeking to get all the creditors on the field quickly: Puerto Rico is on course to run out of cash by the end of this calendar year unless it can refinance its debt—or as non-football BlackRock analyst Peter Hayes yesterday put it: “They have a real solvency issue…They have a liquidity crisis on their hands that grows very dire by the end of the year.” And the fiscal threat and challenge was exacerbated by S&P’s dropping of Puerto Rico’s tax-backed debt to CC from CCC-, and removal of the U.S. territory’s ratings from CreditWatch, where they had been placed with negative implications July 20. The outlook is negative. With the near certainty of a default or restructuring—or fiscal event, there is an increased likelihood of either a missed debt service payment or a distressed exchange which would resemble a default. Gov. Alejandro Garcia Padilla stated that if Puerto Rico’s creditors are unwilling to partake in restructuring negotiations, Puerto Rico would have no alternative but to proceed without them even if it involved “years of litigation and defaults.”

Herding Angry Sheep. In a television address, Gov. Padilla yesterday announced the appointment of a team of debt restructuring experts to negotiate with Puerto Rico’s creditors—a process which would be unprecedented as those creditors run from some of the world’s most sophisticated to tens of thousands of individual municipal bondholders in each of the nation’s 50 states—and a process which, absent action by Congress, might more resemble gladiators in a coliseum than the kinds of overseen negotiations which took place under the aegis of U.S. Bankruptcy Judge Steven Rhodes in Detroit. Adding to the uncertainty, the report on which such negotiations is premised is technically only a recommendation. Try and imagine a football game not only without referees or under inflated balls, but also without agreed upon rules. That report projects Puerto Rico’s treasury will exhaust its liquidity by November—and only until then if Puerto Rico takes extraordinary measures to preserve cash. Unlike a non-governmental corporation—Puerto Rico has no ability to act unilaterally: actions require legislative and gubernatorial action and concurrence. Moreover, it is not just Puerto Rico, but also the Puerto Rico Government Development Bank (GDB)–which is projected to exhaust its liquidity before the end of calendar 2015. And there are dozens and dozens of municipalities at growing fiscal risk (Puerto Rico’s municipalities cannot file for Chapter 9 bankruptcy protection, and a local debt-restructuring law enacted in June 2014 was thrown out by a federal judge in San Juan.). But, like in football game, there is a clock: and it is already running: we know that Puerto Rico will not have fully sufficient fiscal resources in FY2016 to make payment on its scheduled tax-supported debt, including its General Obligation (GO) debt, so that for creditors, it is almost as if the music for a game of musical chairs has already started. The report released this week forecasts a total central government deficit as a whole, including the general fund, GDB net revenue, COFINA, federal programs, and Puerto Rico Highways & Transportation Authority (HTA) net revenue, in fiscal 2016 of $3.2 billion, or about 16 percent of expenditures, including payment of debt service; it projects only a $924 million surplus available before payment of debt service. That is, it appears, as in musical chairs, that there simply will be insufficient fiscal capacity to meet the obligations to pay $1.8 billion of GO and GO-guaranteed debt service (GO debt service alone is $1.2 billion), much less total central government debt service, including GO debt, of $4.1 billion. Or, as Mr. Hayes wrote: “We rate all Puerto Rico tax-backed debt at the same ‘CC’ level, except for Puerto Rico Public Finance Corp. (PFC) debt, which is currently in default and rated ‘D,’ reflecting the report’s projection of limited liquidity to meet all debt service before the end of calendar 2015, including GO debt service, and the report’s recommendation to enter restructuring discussions with all tax-backed debt holders.”

The Hard Choices Forced by State or Local Fiscal Distress

eBlog

August 28, 2015

The Distressing Costs of Municipal Debt Adjustment. For a municipality, state, or—in this case, U.S. territory in serious fiscal distress, without access to bankruptcy so that the options for ensuring sufficient cash to provide essential services are at risk, just the costs of structuring a plan to return to a fiscally sustainable future can be daunting. Indeed, early reports indicate Puerto Rico has already spent as much as $60 million over the last two years as it nears its deadline for proposing a quasi-plan of debt adjustment in this twilight zone where there is neither a U.S. bankruptcy court nor any other official arbiter to adjudicate whatever proposals Governor Padilla ends up proposing next week to address Puerto Rico’s unpayable $72 billion in accumulated debts. Moreover, of course, the meter is still running—each day consuming more legal and consulting fees that leave less and less for upset creditors, public services, and the island’s bondholders in every state of the U.S. Fabulous Matt Fabian of Municipal Market Analytics tersely sums up the dilemma: “It’s an incredibly complex restructuring, with a lot of different investor groups, a lot of different securities and moving parts.” Puerto Rico’s public power utility and its creditors face a Tuesday deadline on a restructuring plan for its $9 billion of debt or an agreement that keeps discussions out of court will expire. Nevertheless, as the nation’s preeminent municipal bankruptcy wizard Jim Spiotto noted, the investment in these outside professionals could be critical to providing a way out for the commonwealth that will improve the economy and make its debt sustainable: “The analysis part is important in addressing it in an effective way, so that the money you spend is well spent, because you’re going to need a recovery plan that is going improve the situation, grow the commonwealth, and, thereby, improve the situation for everyone.”

What Options Does Congress Have? Even as Puerto Rican leaders are perusing options to sort out its overwhelming debt, the Congressional Research Service has offered Members of Congress options, “Puerto Rico’s Current Fiscal Challenges,” it could act upon in response to Puerto Rico’s fiscal crisis ranging from backstopping its debt to authorizing the U.S. territory access to municipal bankruptcy. The report notes that the U.S. government “has generally been reluctant to offer direct financial assistance to individual states in fiscal distress, although Congress at times has adjusted technical parameters of federal programs to provide direct or indirect support for states…The independence of state governments to set their own fiscal paths has been linked to an expectation that those governments take responsibility for the consequences of their fiscal decisions.” Under the dual sovereignty of our form of government there are constitutional limitations on any federal authority.  Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, and the former Territory of Florida all recorded bankruptcies in the period running up to and through the great Panic of 1837. By 1841, 19 of the then 26 states, as well as two of the three U.S. territories had issued municipal bonds and incurred state debt—debt on which these aforementioned states and Florida defaulted. Ironically, the majority of state debt was owed to parties outside the U.S., primarily Europe. Nevertheless, the state debts were largely paid off in full by the late 1840s, notwithstanding that no direct sanctions were enacted to force repayment.

In this new report to Congress, the CRS author noted that Congress could:

• amend the current Chapter 9 bankruptcy law to allow access to Puerto Rico’s public corporations and municipalities; or,
• backstop Puerto Rico’s debt, which would help reduce its borrowing costs (noting that this has been done in the U.S. and elsewhere, usually contingent on budgetary or structural reform requirements.)

CRS also reported that the U.S. government guaranteed Mexico’s government debt in 1994-1995, as well as provided indirect credit support to some states in the 1930’s through 1950’s via the Reconstruction Finance Corp., noting, for example, the RFC “acted as an intermediary in helping to roll over $136 billion in debt for the State of Arkansas” after Arkansas had defaulted on its debt in 1933. The report also suggested Congress could waive the Jones Act for Puerto Rico—a significant unfunded federal mandate which requires ships operating between U.S. ports to be owned by U.S. citizens or companies, to have been constructed in the U.S., and to be operated by U.S. citizens. The CRS report also noted that Congress, as it did for the District of Columbia in 1995, could call for a financial control board. Finally, the CRS report notes that whilst Congress has traditionally been reluctant to provide assistance to states overwhelmed by fiscal storms, it has not been reluctant after natural storms—mayhap timely given yesterday’s memories of the federal assistance granted to Louisiana in the wake of Hurricane Katrina—and, Congress provided both direct and indirect support for New York City in the wake of its fiscal crisis in 1975.

First Chapter 9 since Detroit. Hillview, Kentucky City Attorney Tammy Baker has described the small city’s filing for federal bankruptcy protection as “a very difficult decision” for the city’s elected leaders, but, because of the mounting interest costs from a court judgment against the city, costing it more than $3,700 a day, she notes: “The city really ended up with no choice…With the interest accruing at that rate, it’s just really going to be impossible for the city to pay that judgment.” Counselor Baker has advised the Bond Buyer that the Kentucky municipality, which has filed for municipal bankruptcy, does not intend to restructure its municipal bond debt as part of its plan of debt adjustment. Hillview, the first municipality to file for bankruptcy since Detroit, filed its petition in order to halt payments it owes of thousands of dollars in accruing interest in the wake of an $11.4 million judgment against it—or, as Counselor Baker described it: “What the [municipal] bankruptcy has allowed is breathing room for the city…The interest has been stopped.” The effective halt on the interest payments offers breathing room for the small municipality to develop a plan to address the breach of contract judgment it lost to Truck America Training LLC. Its plan of debt adjustment will have to address some $1.39 million in debt it owes on outstanding general obligation municipal bonds Hillview issued in 2010, and $1.78 million as part of a 2010 pool bond issued on its behalf by the Kentucky Bond Corp. However, in her email to the Bond Buyer, Counselor Baker wrote: “The city does not intend to restructure any bonds through the filing…In fact, we are of the belief that such a restructuring could not be done.” In describing why the city filed its abrupt municipal bankruptcy last week, Ms. Baker noted: “The main reason the city filed for bankruptcy is to halt the crushing interest [of] $3,759 daily from accruing while we develop a plan.” While the filing might provide some instant r-o-l-a-i-d-s for the small municipality, it comes not only with the kinds of costs Puerto Rico is experiencing, but also in terms of borrowing costs: S&P last Friday dropped the municipality’s credit rating five notches to B-minus from BB-plus, and placed the lower rating on CreditWatch with negative implications pending a determination by the federal bankruptcy court on the city’s petition—the lower rating appears to have already translated into at least a ten percent increase to the cost of capital borrowing for Hillview—which, in its petition to the federal bankruptcy court, estimated its liabilities as high as $100 million versus assets of $10 million.

Municipal Default & Consequences

August 6, 2015

Default & Its Consequences. Puerto Rico is in uncharted fiscal and physical territory in the wake of its default, and now faces a severe physical and fiscal drought. Lacking the protections to ensure the ability to provide essential public services under municipal bankruptcy, the drought threatens to syphon off already insufficient resources—almost certainly forcing further defaults—a fiscal situation which will make the island’s cost of borrowing increasingly prohibitive. Put another way, further credit downgrades could pose a serious challenge to Puerto Rico’s post-crisis recovery. With nearly 13 percent of the island under an extreme drought, the U.S. territory’s public utility will be providing water only every third day, raising the total facing 48-hour cuts in service to 400,000, as Puerto Rico’s main reservoirs continue to shrink, according to the island’s water and sewer company. Last month was the fourth-driest month on record in San Juan since 1898. Now the drought has forced some businesses in Puerto Rico to temporarily close—closures which will further erode critical tax revenues, including recently increased sales and use tax revenues. But the island’s travails will have widespread fiscal reverberations: if Puerto Rico fails to make interest payments on its $72 billion public debt, pension funds across the U.S. could find themselves unable to meet their own payment obligations. Thus, even as Congress has slipped out of town without any consideration of what threatens to become a much more national financial crisis, tens of thousands of Americans in Puerto Rico are facing an immediate issue—one with potential serious health and safety consequences—and one which even a simple debt restructuring, were Puerto Rico’s bondholders to agree to it — would not resolve the fiscal and increasingly physical challenge. Absent some intervention, the U.S. territory, with a population of 3.6 million, assumes that each and every person on the island would need to pay $1,400 a year — 9 percent of Puerto Rico’s per-capita income — just to cover this year’s $5 billion principal and interest payments on the debt.

Advice and Consent. Wayne County Executive Warren Evans told his fellow commissioners yesterday that agreeing to a consent agreement is Wayne County’s only option for resolving its financial emergency: “It’s the only rational option…It keeps power in the county’s hands.” Mr. Evans’ remarks came as he and his colleagues must opt for one of four options under Michigan law: a consent agreement, mediation, appointment of an emergency manager, or Chapter 9 municipal bankruptcy. Mr. Evans added, yesterday, that Michigan State Treasurer Nick Khouri had told him earlier in the day that the county could be released from a consent agreement as early as next April. Commissioner Burton Leland, D-Detroit, said the panel’s realistic choices are limited. “There are really only a couple of options,” he said. “Bankruptcy and emergency manager aren’t really options.” Commissioners have until 5 p.m. today to make their decision—with the most radical to, in effect, remove themselves and hand over power and governance authority to an unelected emergency manager. For his part, the County Executive made clear he would prefer a consent agreement: such an agreement, he said, would spell out specific budgetary reforms the county would have to meet, adding that power is only a tool—and one he would not necessarily need to use if cost-saving contracts with Wayne County’s labor unions could be negotiated, noting: “I would much rather negotiate contracts with our unions than impose them…Because I have the hammer doesn’t mean I drop it.” Leaders of Wayne County’s public unions asked commissioners to consider how their decision might impact workers before they vote, with Edward McNeil of AFSCME testifying: “You commissioners were asking (Executive Evans) if the consent agreement would take away your power…If you go with a consent agreement, you take away our power to sit down and negotiate (a contract) on equal footing.” The issue confronting the elected leaders is how they can address a $52 million annual structural deficit—a deficit caught between the Scylla of a $100 million drop in annual property tax revenue since 2008 and the Charybdis of the county’s desperately underfunded pension system: Wayne County’s primary pension plan is 45 percent funded and has a liability of $910.5 million, based on the latest actuarial valuation. Officials currently project Wayne County’s deficit could reach $171.4 million by FY2019 absent immediate fiscal steps.

Rolling the Fiscal Dice. Standard & Poor’s Monday cut Atlantic City’s general obligation credit rating three notches to BB, citing uncertainty over whether the fiscally stressed municipality can meet its fiscal obligations this year, with S&P analyst Timothy Little commenting that Atlantic City confronts short-term fiscal risks from the “lack of a clear plan” to plug an estimated 2015 deficit of $101 million, adopting a 2016 fiscal budget and achieving tax collection projections. Mr. Littler noted: “The downgrade reflects continued uncertainty regarding the long-term fiscal stability and recovery of the city as it responds to increasing liabilities from tax appeals and an eroding tax base… [it] reflects our view that the city is more vulnerable to nonpayment since our last review given that three months have passed without additional clarity on how the city will propose to resolve its long-term financial challenges.” The downgrade came as the city—rather than awaiting tonight’s GOP debate—instead is frustrated by the delay in action by Gov. Chris Christie. Atlantic City Revenue Director Michael Stinson made clear that Atlantic City not only has met its August debt payments, but also that he expects a balanced budget to be achieved in early September, provided Gov. Christie signs legislation to implement a state fiscal package which would provide the city with additional revenue. Mr. Stinson added that Atlantic City was successful in selling some $40.5 million in Municipal Qualified Bond Act (MQBA) bonds last May to pay off a state loan and that tourism has been up this summer, noting: “There has been nothing negative happening to the city since we issued those bonds in May…A downgrade at this point is unwarranted.” But S&P’s Little wrote that although Atlantic City was able to address immediate financial and liquidity pressures through the MQBA bonds, the future ability of Atlantic City to the municipal bond market remained more of a gamble, adding that since the release last March of a 60-day report from the city’s emergency manager Kevin Lavin, there has been no clarity on potential payment deferrals. Indeed, on July 1st, Mr. Lavin said that all options are on the table with a potential municipal bankruptcy filing not ruled out—in effect reemphasizing the confused governance situation with regard to his role and relationship with Mayor Don Guardian, leading Mr. Little to note: “The lack of clear and implementable reforms to restore fiscal solvency without payment deferrals or debt restructuring remains uncertain as the city continues to operate in a difficult fiscal environment.”

Is Municipal Bankruptcy a Dirty Word? Moody’s, in a decidedly unmoody examination, today wrote that the nation’s city and county leaders no longer consider municipal bankruptcy to be taboo; rather, they said, fiscally distressed cities and counties in those states which authorize chapter 9 municipal bankruptcy are increasingly likely to consider it a viable option, based upon their examination of recent municipal bankruptcies, adding that “The number of general government bankruptcies following the recession remains low, but is still remarkable compared to the long-term experience of the U.S. municipal market since World War II.” They noted that four of the five largest municipal bankruptcy filings in U.S. history have been made in a little more than three years, a record they attributed to a slow recovery from the Great Recession, but also to changing attitudes about debt. But they also noted that the successful recovery from municipal bankruptcy by municipalities such as Central Falls, Jefferson County, and Detroit—in addition to the willingness of investors to come back to defaulting cities like Wenatchee, Washington could further help change municipal investors’ perceptions with regard to default and bankruptcy: “In the apparent absence of a severe or prolonged capital markets penalty, it is not surprising that various governors, mayors, and other local government officials have come to consider bankruptcy as a potentially realistic and effective option for restructuring liabilities.” The magnificent seven also noted that while these municipal bankruptcies have gained wider acceptance and appear—at least so far—to have worked; they have been less friendly to municipal bondholders, noting especially that pensions have been largely protected, whilst municipal bondholders have taken steep cuts, adding: “A more frequent use of bankruptcy by distressed credits does not in and of itself alter our overall stable outlooks for the state and local government sectors, but it does underscore how the recent recession has resulted in significant pockets of pressure, ongoing challenges of balancing rising fixed costs against anti-tax sentiment and a tighter budgetary ‘new normal’ that is less resistant to new shocks…We expect that bankruptcy and default will remain infrequent among rated local governments and consequently expect no change to our broad distribution of municipal ratings.”

How Does One Define “Essential Public Services” for a Municipality in Distress?

July 31, 2015

Securing a Safe & Sustainable Fiscal Future. Michigan Gov. Rick Snyder yesterday affirmed his declaration that Wayne County is in a financial emergency—an affirmation almost certain to trigger a partial state takeover of the county—a county which encompasses not just Detroit, but also 33 other cities and 9 townships. In his statement yesterday, Gov. Snyder said: “Officials have taken steps to begin addressing the county’s crisis, but there can be no disputing that a financial emergency exists and must be addressed swiftly and surely to ensure residents continue to receive the services they need and deserve and the county can continue its economic recovery.” The decision immediately started a stopwatch which will give the Wayne County Board until next Thursday to choose among four options offered under Michigan law to municipalities in financial emergencies:

• municipal bankruptcy;
• a consent agreement with the state;
• authority to request a neutral evaluator; or
• an emergency manager.

Wayne County Executive Warren Evans has said he has been hoping for a consent agreement to fix the county’s finances: such an agreement would spell out specific budgetary steps and reforms the county would have to undertake and complete to address the county’s $52 million structural deficit. Wayne County has been caught between a rock (significant declines in property tax revenues, estimated to be as much as $100 million annually since 2008) and a hard place: its underfunded public pension system. The county is confronted with an accumulated deficit of $150 million. Should the county opt for entering into a consent agreement, such an option would give Wayne Count broader authority to impose reforms on expired labor contracts and would leave the bulk of the restructuring under local, rather than state control. But, as some of the county’s commissioners warn, a consent agreement could instead lead to a preemption of local authority and a state takeover—as happened to Wayne County’s largest city: Detroit. Perhaps Wayne County Commission Chairman Gary Woronchak described it best: “We have a difficult decision ahead of us, because we have to choose from one of these four options…They may seem simple on their face, but there are little trap doors along the way that we should well be aware of while we’re making this decision.”

Stopping the Fiscal Bleeding & Financing Essential Public Services. Wayne County’s Treasurer is getting ready this fall to auction off as many as 30,000 properties: a record number of tax delinquent properties, nearly half of which were eligible for foreclosure years ago. About $193 million is owed in taxes and fees on the 30,000 Wayne County foreclosures, including $95 million in debt on properties that had more than five years in unpaid bills. Of that record number, nearly half are delinquent on their property taxes for five or more years: Michigan law provides for foreclosure after three years of nonpayment. As in Detroit’s experience, failure to foreclose creates a double whammy: first, an ever-growing erosion of assessed property values and collected property taxes in neighborhoods, and an ever-increasing cost and burden to the county to foreclose: this year, the Treasurer’s office is trying to foreclose on Wayne County’s vast majority of tax delinquent properties. To get some idea of the scope, over the last seven years, Wayne County has taken 108,500 properties to auction. A key issue, of course, is tax delinquencies: when the patient is bleeding, it is critical to stanch the flow, because, as Wayne County Chief Deputy Treasurer David Szymanski wrote in an email to The Detroit News: “Payment of these delinquent taxes is essential to support essential government services.” Wayne County is scheduling a first round of tax auctions in September, which is when foreclosed properties will be sold for the full debt owed—with whatever is not sold re-offered the following month.

Shared or Different Fiscal Destinies? Robert Frost, in his wonderful poem “Mending Walls,” wrote “good fences make good neighbors,” and so it is that Detroit and Wayne County are more than neighbors—as Detroit is in Wayne County. But even as Wayne County is in a financial emergency, Moody’s yesterday upgraded the City of Detroit one notch to B2 from B3, with a positive outlook, reporting that its upgrade reflects Detroit’s improved financial position following its exit from municipal bankruptcy. Moody’s added that the upgrade incorporates management’s continued improvement of city financial operations and signs of economic development in the city—even as it pointed out the city’s ongoing population loss, persistent tax base weakness, and taxable valuation declines—declines which it projects will continue over the near-term.

How Does on Define “Essential Public Services”? Perhaps the single most critical value of municipal bankruptcy is the immediate protection of a city or county’s ability to ensure the provision of essential public services while its sorts out its debts under the ever watchful scrutiny of a federal bankruptcy judge—certainly a part of the great apprehension in Puerto Rico is that, absent such a judicial protection, those in most dire need and who have the least legal or fiscal resources will be ill-equipped to compete with the hedge funds. But that raises a hard question: just what are essential public services? In San Bernardino, that question is front and center as the city, with an 18.9% unemployment rate, has determined, by a 4-2 Council vote, to appropriate $250,000 to keep a job center open for at least another two months as it appeals the state’s decision to reject the Mayor and Council’s request for funding—that is, $250,000 that the bankrupt city does not have. Nevertheless, the vote affirms the city’s decision to keep the doors of opportunity open for some 138 individuals currently enrolled in training programs or on-the-job-programs, to close out grants, and to otherwise wind down the agency. One can appreciate how hard it would be to draw the fine line between what is essential and what is not. San Bernardino Councilmember Rikke Van Johnson, in the majority of those voting to keep the city’s 40-year-old program on temporary life support said: “It’s integral, if we’re going to move out of this bankruptcy, that we keep our assets that will aid us in getting out of bankruptcy…and that’s what the San Bernardino Employment and Training Agency will do.” While the city’s workforce development attorney, in a seven-page opinion for the Council, wrote that she believes the city will be reimbursed most or all of the money, there was little certainty whether that would, in fact, happen as well as the growing expense—even as the city faces ever-growing bills over the next twelve to eighteen months from the prohibitive costs of municipal bankruptcy. Already San Bernardino has had to cut public safety, outsource jobs, and agree to a settlement under which its retirees will lose some $40 million in health benefits. Councilmembers Fred Shorett and Jim Mulvihill, who voted against the funding, wondered whether and how the decision might affect the city’s case in the U.S. bankruptcy court before Judge Meredith Jury—including with regard to the city’s fiscal discipline, noting: “We’re in bankruptcy because previous councils refused to say no.”

As we have written before, the exceptional complications of democracy and municipal bankruptcy—as provided under certain state authorizations of municipal bankruptcy, such as Alabama and California—create singular civic challenges—challenges that are about governing—and in sharp contrast to municipal bankruptcies in states such as Michigan and Rhode Island, where the Governor appoints an emergency manager or receiver and the mayor and council are barred from any role or governance responsibility—as are the voters and taxpayers. So it was perhaps unsurprising this week to note that the San Bernardino community came out in force for the meeting to determine the fate of the agency, an agency which, over the last four years has served about 48,000 people through job training, placement, and other services.

Cadena de Eventos. With the Congress off in the hinterlands and having spurned any action to provide Puerto Rico or its municipalities any access to municipal bankruptcy, the U.S. territory is on the brink of setting in motion a chain of events (cadena de eventos) which will take us into a state and local bankruptcy twilight zone—as tens of thousands of creditors will be caught up in unrefereed negotiations about how to restructure Puerto Rico’s $72 billion debt—with the triggering event the almost certain default of the Puerto Rico Public Finance Corporation, for which the legislature has not appropriated the requisite $58 million necessary for the utility to make payment to its bondholders tomorrow. That the default will happen should hardly come as a surprise: Governor Alejandro Garcia Padilla made clear last month that Puerto Rico cannot repay its obligations and sought a delay in debt payments—even as he hopes to propose a debt-restructuring plan by September 1st. The non-payment at issue, defined as a moral obligation bond—as opposed to full faith and credit—because it is dependent on a legislative appropriation—is more like the first granules in an avalanche that offer the briefest of warnings of what could follow. Nevertheless, with the Public Finance Corp. having (technically) until the end of business on Monday to make the payment, Puerto Rico tomorrow will enter into an uncharted and unprotected fiscal future—a future lacking the protections of a U.S. bankruptcy court to ensure the provision of essential public services—and a future in which those most at risk—such as Puerto Rico’s retirees and poorest U.S. citizens—will be least equipped to achieve a fair outcome or a sustainable fiscal future. Puerto Rico’s largest pension fund, according to Moody’s, could deplete its assets by 2020: it has 0.7 percent of assets to cover $30.2 billion of projected costs, according to financial documents. The PFC default will not be the only one tomorrow: other Puerto Rican debt payments due tomorrow include $91.5 million of principal and interest on Municipal Finance Agency bonds repaid with payments from San Juan and other towns—in addition to $252 million of principal and interest on debt backed by the island’s sales-tax levy. There are also Government Development Bank bonds due tomorrow (The bank, which lends to the commonwealth and its municipalities, has $140 million of municipal bonds maturing $29 million in interest payments due, according to data compiled by Bloomberg.) Perhaps forgotten in this telescoping of fiscal events is that Puerto Rico and its instrumentalities are not just facing default, but also a perilous slope of capital borrowing costs: costs which have increased by close to one-third.

Public Service Delivery Insolvency

July 30, 2015

Securing a Safe & Sustainable Fiscal Future. With a violent crime rate more than 500% of the U.S. national average, but empty city coffers, San Bernardino’s municipal bankruptcy filing was critical to stanching not just its credit, but also its ability to protect its citizens. A critical purpose of the federal municipal bankruptcy law, after all, is to preserve the ability of a city or county to continue to provide essential public services. Ergo, notwithstanding its bankruptcy, it appears that the City of San Bernardino could be a step nearer a more secure future, with all the ramifications that would have for assessed property values, in the wake of its announcement yesterday that after more than two years’ of watching its police officers leave the force and the city, city negotiators and the police union said they had agreed on a new contract, albeit one subject to ratification by the City Council. The San Bernardino Police Officers Association yesterday reported an overwhelming vote in support of the new pact, with their spokesperson noting: “We also anticipate that the deal…will hopefully keep men and women on the force from exiting the city of San Bernardino.” U.S. Bankruptcy Judge Meredith Jury, at a hearing on the city’s municipal bankruptcy yesterday, praised the two sides for reaching the pact and a mediation judge for helping broker it, noting: “It is an incredibly important step… It is a very big step, and I hope the city votes in favor next week.” Judge Jury added she hoped it would end adversarial court filings by the police union, which has been one of the city’s main creditor challengers in her courtroom, albeit Judge Jury added that she did not expect the adversarial nature of the fire union to change at all: “Obviously that’s not going to happen….” After the hearing, Mayor Carey Davis said the deal was “very favorable” to the city, while City Attorney Gary Saenz said it was a milestone in efforts to turn around the city: “This is a very good deal for the city and a very good deal for the police, but most of all, it’s a very good deal for the citizens of San Bernardino…The Police Department and the city are once more on the same side, and police will have the stability to improve the crime rate that many people, in the survey we did as part of the strategic planning process, identified as one of the main issues in the city.” The agreement, if ratified by the Council, would replace the current terms imposed by the city two years ago in January—terms which police officers believe have contributed to the high rate of turnover. Nevertheless, the agreement, even though praised by Judge Jury in her courtroom, will not go unchallenged: even though it means the city’s plan of debt adjustment before the federal bankruptcy court will—if the agreement is ratified by Council—be modified to incorporate the agreement; it is a change that would likely come at further expense to the bankrupt city’s municipal bondholders—creditors already slated under the city’s plan to only receive one penny on each dollar they are owed. Bondholders’ attorney Vincent Mariott yesterday testified before Judge Jury he was concerned by the slow pace with which he claimed San Bernardino has provided documents, especially with regard to those which purport to defend the city’s plan proposal to, in a manner similar to Stockton, make disproportionately deep cuts to creditor bondholders—or, as attorney Mariott put it: “We’re of course entitled to a full understanding of why the city believes that wiping us out is necessary…We do need the city to be more responsive than it has been to date.”

Resecuring Fiscal Sustainability. Motown is fixing for its amazing comeback, planning to issue its first sale of municipal debt on August 19th—with an estimated issuance of $245 million in municipal bonds, with the proceeds of the sale dedicated to repayment to Barclays for the $275 million loan which marked the final key step which secured Detroit’s exit from the largest municipal bankruptcy in U.S. history. Mayor Mike Duggan yesterday said the new bonds are essential to improving Detroit city services—and have earned an upgrade to A from Standard & Poor’s, adding: “If you had said six months ago there was any chance the city of Detroit could be borrowing with an investment-grade credit rating, people would have thought that was very unlikely…But it gives you an indication of how far we’ve come in a short period of time.” S&P awarded the grade, with a stable outlook, to the Michigan Finance Authority’s Local Government Loan Program revenue bonds, e.g., bonds issued on behalf of Detroit and based on a first-lien pledge of the city’s income tax. In addition, the bonds are secured by a limited-tax general obligation pledge. The upgrade, according to the city, could mean savings of as much as $2.5 million annually and $20 million in interest costs over the life of the Motor City debt. The financial recovery bonds were originally privately placed with Barclay’s Capital Inc., in December as the city made its exit from Chapter 9. The savings highlight the exceptional role the State of Michigan has taken—in stark contrast to the states of California and Alabama, for instance—especially in view of Detroit’s own S&P B rating— five grades below the lowest invest-grade rating. The improvement also reflects the remarkable revenue turnaround: Detroit’s tax revenue has been rising for the past four years, The improved rating also reflects an intriguing wrinkle: the bonds are secured by Detroit’s municipal income tax—tax revenues in this instance which will bypass the city treasury and go directly to a trustee so that the tax proceeds must first be dedicated only to pay bondholders, even going so far as to provide, under the terms of the bond documents, for daily deposits as tax revenue is collected—or, as S&P’s credit analyst Jane Ridley describes it: “The ‘A’ rating isn’t based on the credit of the city itself…It’s based on the strength of the revenue pledge and the income stream. It doesn’t really stay in the city’s hands at all. It’s designed to be immediately taken by the trustee for the benefit of bondholders.” Gov. Rick Snyder, in April, signed into law legislation giving bondholders a statutory lien on the city’s income-tax revenue as way to ease Detroit’s first post-Chapter 9 return to the capital markets. The law also gives the bonds an intercept feature, sending income tax revenue first to a bond trustee who will extract enough to cover debt service and send the rest to the city. Put another way by the ever insightful Lisa Washburn, a managing director for Municipal Market Analytics, Detroit’s overall creditworthiness is unlikely to change until it posts 1) several years of growth and stability in tax revenues, 2) increasing investment in the city, and 3) a stable city government which can improve city services, adding: that will be a multi-year process.” The proceeds of the municipal bonds here will be dedicated to financing key priorities, including the overhaul of its financial management system and the Detroit Fire and Police department fleets.

Referring to the sale at an MSRB seminar Tuesday, Kevyn Orr, Detroit’s former emergency manager who guided the city into and out of municipal bankruptcy, kidded the Board: “I hope you buy early and I hope you buy often.” Under the original agreement, Barclays was to hold the taxable debt for up to 150 days in a variable-rate mode, and the city was to refund the bonds publicly in a fixed-rate mode. The loan was extended by 90 days in May. Of the $275 million, $38 million of the taxable proceeds paid off the banks that acted as counterparties on the city’s interest-rate swaps. Another chunk of proceeds financed new information technology as well as other capital and operating upgrades. The city floated $1.2 billion of bonds in December to pay off creditors, but none of the debt was floated on the public markets. It was directly placed with creditors and participants, though they are securities that can be traded on the markets.

Remembering Motown & Public Service Delivery Insolvency. Reminiscing yesterday about his service in Detroit and its truly remarkable turnaround, Mr. Orr—at the MSRB—said that as the city plummeted into municipal bankruptcy,
• 9-1-1 response time to the highest priority police and emergency medical calls averaged 45 minutes to an hour;
• tax collection was at 65%; 75% of parks were closed; and
• 72 water main breaks occurred in one day last August.
Or (not a pun), as he noted, the noted rhythm guitar playing and now retired (but volunteering his musical and peerless services in Puerto Rico) U.S. Bankruptcy Judge Stephen Rhodes called the U.S.’s largest municipal bankruptcy a “service-delivery insolvency.” But, as he reported yesterday: “Detroit’s a much better credit than it was two years ago,” and he has few qualms about its fiscal future and sustainability: “We built enough of a surplus…They should be fine.”

Too Little, Demasiado Tarde? U.S. Treasury Secretary Jacob Lew Tuesday warned that a failure by Congress to help Puerto Rico resolve its debts may hit the retirement portfolios of average Americans. Secretary Lew’s statements came as Congress was fleeing Washington for its long summer vacation—a departure just days before Saturday’s potential default. Sec. Lew endorsed federal legislation to grant the commonwealth the same access to an orderly municipal bankruptcy regime as every state, noting it was critical to prevent a chaotic and protracted resolution of Puerto Rico’s fiscal challenges—warning that a default would be costly, not just for Puerto Rico, but also the U.S. In an epistle to Senate Finance Committee Chairman Hatch (R-Utah) (and not to Chairman Charles Grassley (R-Iowa), Chairman of the Senate committee of jurisdiction, the Senate Judiciary Committee), he wrote: “The continued deterioration of Puerto Rico’s economic and financial conditions has the potential to further harm retiree investment portfolios across the country…A significant portion of Puerto Rico’s debt is still held directly by individual retail investors or indirectly through the municipal bond funds they own.” On Saturday, long after Congress will have left Washington, D.C. until after Labor Day, $36.3 million of bonds sold by Puerto Rico’s Public Finance Corp. become due. Puerto Rico’s legislature has not appropriated the requisite funds to settle that payment. Because Puerto Rico has not transferred cash to its Public Finance Corporation (PFC) trustee ahead of Saturday’s August 1 debt service payment, the likelihood increases there will be a technical default, or, in Spanish, an incumplimiento technico, a step ahead of what could become the U.S. territory’s first payment default on Tuesday if sufficient funds have not been advanced by the end of this week—a default, which as our ever astute market observers at MMA have already observed: “[E]nhances the political viability of additional defaults everywhere else.”

June 30, 2015

Is Puerto Rico at the Tipping Point? Puerto Rico Gov. Alejandro García Padilla yesterday praised a report, “Puerto Rico—a Way Forward,” by Anne Krueger, Ranjit Teja, and Andrew Wolfe—which calls for a comprehensive solution to Puerto Rico’s problems, including debt restructuring. The report, which Puerto Rico commissioned, calls for fiscal adjustment, structural reforms, and debt restructuring. As for the latter, the authors say that even after Puerto Rico took major revenue and expenditure measures, there would be large financial gaps. These would peak at about $2.5 billion in fiscal 2016 and generally decline to about $0 in fiscal 2024. By comparison, the total commonwealth government debt service in fiscal 2016 is slated to be about $3.6 billion. The report notes: “Debt relief could be obtained through a voluntary exchange of old bonds for new ones with a later/lower debt service profile. Negotiations with creditors will doubtlessly be challenging.” They make clear the general obligation as well as other commonwealth government debt should be restructured. The authors also call for negotiations on the public corporations debt and for the federal government to make the corporations eligible for Chapter 9 bankruptcy.

The report warns that Puerto Rico will need to seek relief from principal and interest payments falling due from 2016 to 2023; however, it also warns that any restructuring of general obligation, or central government debt, would set a precedent as “no U.S. state has restructured (such debt) in living memory,” and any such attempt would face legal challenges—even as it made clear there are limits with regard to how much more expenditures can be cut or taxes raised. Or, as Adam Weigold, senior portfolio manager at Eaton Vance, put it last Friday: This coming week “is the tipping point:” Puerto Rico’s debt problems could lead to a reduction in government services. Nevertheless, Reuters noted that the island is not contemplating a partial or full shutdown of government services. With some of Puerto Rico’s creditors, restructuring negotiations are already underway: late last week, Puerto Rico officials and creditors of the island’s electric power authority were apparently close to a deal which would avoid a default on a $416 million payment due the day after tomorrow, and, with other payment deadlines looming, Gov. Padilla and his staff said they would begin looking for possible concessions on all forms of government debt.

The key takeaways from the report:

  • This is a problem years in the making;
  • The problems are structural–not cyclical;
  • This is a “vicious cycle” where unsustainable public finances are feeding uncertainty and low growth;
  • “failed partial solutions argue for a comprehensive approach;
  • “[the]single most telling factor is that 40% of the adult population — versus 63% on the mainland — is employed.” Why? Because the minimum wage; local overtime, paid vacation, benefits are too costly to the governments—and to the 147 municipalities; local welfare benefits are more generous than the minimum wage.
  • Public sector debt has risen each year–reaching 100% of GNP by the end of FY’14;
  • “If federal obstacles could be overcome, there is no reason why Puerto Rico could not grow in new directions…”

June 29, 2015

More Trouble in River City. A critical issue for any municipality is an audit; that is even more the case when a city or county files for bankruptcy: it provides that outside review important to the city’s taxpayers, the federal bankruptcy court, and the municipality’s creditors. While an audit, technically, is not necessarily required by San Bernardino’s charter committee, City Attorney Gary Saenz had warned that failure to have those audits by the deadline would be “devastating for the city.” City Manager Allen Parker had agreed, last spring, with council members who said its absence in the city’s plan of debt adjustment would allow San Bernardino’s creditors to attack the plan before the federal court as unprepared and undeserving of bankruptcy protection. Notwithstanding that apprehension, Deputy City Manager Nita McKay has now confirmed the audit has not been completed, and, obviously, not been included in the city’s plan of debt adjustment. Worse, the city’s accounting firm, Macias, Gini and O’Connell LLP, not only has missed repeated deadlines, but had also requested nearly half a million dollars—more than double its original cost estimate given to the city—to complete it. Unsurprisingly, the attorney representing San Bernardino’s municipal bondholders had charged in U.S. Bankruptcy Judge Meredith Jury’s first hearing earlier this month that San Bernardino had failed in its duty to the court and the city’s creditors by not even disclosing that its plan of debt adjustment did not mention the missing audits—either in its submitted plan or in its testimony before the court. Nor, the attorney charged, had the city proposed a hearing date at which Judge Jury could consider the adequacy of San Bernardino’s financial disclosure statement. For her part, Judge Jury has noted that a bankrupt entity normally would have proposed such a date to keep momentum in the case. Instead, Judge Jury set the hearing date for October 8th. The problem appears to lie not just with the city’s auditor, Macias, Gini and O’Connell LLP accounting firm, but also with the city’s own transparency and at least perceived competency. While there is every indication San Bernardino staff have been responsive to every request from the auditor—according to the auditor; as late as last Thursday, the firm’s audit managers gave the city staff a new list of outstanding items—a list city staff described as one which “contains 29 items, 24 of which have not been requested before the time of the meeting…For eight of these items, they could not articulate what it is that they are requesting, i.e. ‘changes to General Fund accounts receivable resulted in additional testing being needed for $3.7 million. Sample to follow.’” San Bernardino Councilmember Fred Shorett at the end of last week stated the seemingly obvious: the city might need to consider starting over with a new firm, even though that would present difficulties: “This sounds as though this auditing firm is incompetent or (not) working…Giving no responses to you and coming at us with requests at the eleventh hour is not acceptable. This whole situation needs review. I’m very concerned that this firm has some kind of agenda that is not helpful to us.” Councilman Rikke Van Johnson also questioned the firm’s motives. “Sounds as if they are playing us and trying to get more money!” he wrote. The auditing firm is surely on notice that, despite its 13th hour demands for a significant increase in payments for a job not done, it is requesting said increases as, now, one of many creditors in bankruptcy—it will not be paid one hundred cents on the dollar—but its integrity and competence, as well as the failure of the city to oversee—or disclose—the absence seem hardly likely to curry respect from Judge Jury.

Is Puerto Rico at the Tipping Point? With the increasing likelihood that Congress will continue to ignore the U.S. territory of Puerto Rico’s looming insolvency—or even give Puerto Rico the ability and authority to offer its 147 municipalities access to chapter 9 municipal bankruptcy, Puerto Rico Governor Alejandro García Padilla stated:  “My administration is doing everything not to default…But we have to make the economy grow…If not, we will be in a death spiral.” Gov. Padilla has now conceded the commonwealth cannot likely pay its nearly $72 billion in outstanding debts, warning the island is in a “death spiral,” but, unlike any other U.S. corporation, denied access to the federal bankruptcy courts.

Puerto Rico needs to restructure its debts and should make reforms, including cutting the number of teachers and raising property taxes, a report by former International Monetary Fund economists on the Caribbean island’s financial woes said. Gov. Padilla, and senior members of his staff said last week that they would probably seek significant concessions from as many as all of the island’s creditors, which could include deferring some debt payments for as long as five years or extending the timetable for repayment: “The debt is not payable…There is no other option. I would love to have an easier option. This is not politics, this is math.” Gov. Padilla is also likely to release a new report today by former IMF economists, who were hired earlier this year by the Puerto Rico Government Development Bank to analyze Puerto Rico’s economic and financial stability and growth prospects—a report concluding that Puerto Rico’s debt load is unsustainable. The report suggests a municipal bond exchange, with the new bonds carrying “a longer/lower debt service profile,” noting that: “There is no U.S. precedent for anything of this scale or scope.” The report is not solely focused on Puerto Rico, however, but also seems aimed at the White House and Congress—neither of which appear to be willing to devote time or resources on these events affecting hundreds of thousands of Americans, although both New York Federal Reserve leaders and United States Treasury officials have been advising the island’s government in recent months amid the worsening fiscal situation.

Said report, according to Reuters, recommends structural reform and debt restructuring, writing: “Puerto Rico faces hard times…Structural problems, economic shocks, and weak public finances have yielded a decade of stagnation, out-migration, and debt… A crisis looms.” The report recommends restructuring of Puerto Rico’s general obligation debt, as well as suspending the minimum wage and reducing electricity and transport costs, noting the U.S. territory must overcome a legacy of weak budget execution and opaque data.

Seemingly overwhelmed by its staggering $73 billion debt load and faltering economy—and with its Government Development Bank running out of cash, Puerto Rico this week has a number of municipal bond payments coming due—even as its public power utility, PREPA, is in talks to avoid a possible default. The report warns that Puerto Rico will need to seek relief from principal and interest payments falling due from 2016 to 2023; however, warning that any restructuring of general obligation, or central government debt, would set a precedent as “no U.S. state has restructured (such debt) in living memory,” and any such attempt would face legal challenges—even as it made clear there are limits with regard to how much more expenditures can be cut or taxes raised. Or, as Adam Weigold, senior portfolio manager at Eaton Vance, put it last Friday: This coming week “is the tipping point:” Puerto Rico’s debt problems could lead to a reduction in government services. Nevertheless, Reuters noted that the island is not contemplating a partial or full shutdown of government services. With some of Puerto Rico’s creditors, restructuring negotiations are already underway: late last week, Puerto Rico officials and creditors of the island’s electric power authority were apparently close to a deal that would avoid a default on a $416 million payment due the day after tomorrow, and, with other payment deadlines looming, Gov. Padilla and his staff said they would begin looking for possible concessions on all forms of government debt.

The ever perceptive Mary Walsh Williams of the New York Times this morning notes “Puerto Rico’s municipal bonds have a face value roughly eight times that of Detroit’s bonds.” That is, as she wrote, Puerto Rico’s fiscal meltdown and inability to access U.S. bankruptcy courts could have fiscal implications for cities and counties throughout America, writing: “Its call for debt relief on such a vast scale could raise borrowing costs for other local governments as investors become more wary of lending. Perhaps more important, much of Puerto Rico’s debt is widely held by individual investors on the United States mainland, in mutual funds or other investment accounts, and they may not be aware of it. Puerto Rico, as a commonwealth, does not have the option of bankruptcy. A default on its debts would most likely leave the island, its creditors, and its residents in a legal and financial limbo that, like the debt crisis in Greece, could take years to sort out.” She writes that Puerto Rico must set aside as much as $93 million each month to pay the holders of its general obligation bonds — a critical action, because Puerto Rico’s constitution requires that interest on its municipal bonds—payments which go to citizens in every state in the U.S.—be paid before any other expense, adding that “No American state has restructured its general obligation debt in living memory.” The government’s Public Finance Corporation, which has issued bonds to finance budget deficits in the past, owes $94 million on July 15. The Government Development Bank — the commonwealth’s fiscal agent — must repay $140 million of bond principal by Aug. 1.

Here Come da Judge. It turns out that even though Congress appears determined to bar Puerto Rico from access to the U.S. Bankruptcy Court, Puerto Rico is creating its own wise investment, this month hiring retired U.S. Bankruptcy Judge Steven W. Rhodes, who presided over the largest municipal bankruptcy in U.S. history in Detroit’s 18 month municipal bankruptcy. In addition, Puerto Rico is also consulting with a group of bankers from Citigroup who advised Detroit on a $1.5 billion debt exchange with certain creditors. The ever electronically and musically perceptive Judge Rhodes told Ms. Williams that Congress needs to go further and permit Puerto Rico’s central government to file for bankruptcy — or risk chaos, telling her in an interview: “There are way too many creditors and way too many kinds of debt…They need Chapter 9 for the whole commonwealth.”

June 25, 2015

Not My Problem. A unique characteristic of the United States and federalism is dual sovereignty, making the U.S. and its kind of federalism unique among all nations. In the field of bankruptcy, it means Congress lacks Constitutional authority to even grant authority to states to file for bankruptcy; similarly, the federal government cannot grant municipalities such authority—except by means of authorizing states to, as is done under chapter 9. Unsurprisingly, then, not only do not all states authorize municipalities to file for municipal bankruptcy, but among those that do, virtually no two provide such authority the same way. Moreover, as we have noted, not only the differing statutes, but also the state role in those states where municipalities have filed for chapter 9 municipal bankruptcy, has been profoundly different. Key issues have related not only to whether, under such state authorizing legislation, the state asserts authority to preempt local authority by means of the appointment of a receiver or emergency manager—appointments which have meant suspension of any authority for the elected leaders of a city or county, but also the role of the state in contributing in some way to the development and implementation of an ensuing plan of debt adjustment—the plan which must be approved by a U.S. bankruptcy court for a city or county to successfully exit bankruptcy. U.S. Bankruptcy Judge Thomas Bennett keenly noted the precipitate role of the State Alabama in leading to Jefferson County’s bankruptcy, while in Michigan, Gov. Rick Snyder gradually began coordinating with key bipartisan leaders of Michigan’s House and Senate in making critical contributions to Detroit’s plan of debt adjustment—granted with some exceptionally innovative and creative contributions by U.S. Chief Judge Gerald Rosen. So it is that, unlike municipal bankruptcy in any other country around the world, states not only have a role under the U.S. Constitution, the federal municipal bankruptcy law, but also the unique politics and leadership within each state.

Ergo, mayhap ironically, California appears to be set on the Alabama model—spurning the more constructive roles taken by Rhode Island, Michigan, New Jersey, and Pennsylvania. If anything, that message appeared to be reinforced yesterday when Gov. Jerry Brown offered no positive reinforcement to San Bernardino’s Mayor Carey Davis in his quest to the state capitol in Sacramento. Mayor Davis, notwithstanding the absence of any affirmative state role in the municipal bankruptcies of Vallejo or Stockton, nevertheless had made the long trip just in case.

It was time and resources, scarce commodities for a city in bankruptcy, apparently for naught. Gov. Brown’s response, according to the city, was no. The key issue – ironically in the midst of the surge of the so-called sharing economy – was sharing vital public services. Or, as Mayor Davis’ chief of staff, Christopher Lopez, put it: the “cornerstone” of San Bernardino’s plan of debt adjustment pending before U.S. Bankruptcy Judge Meredith Jury is contracting out for some services, including fire protection. Specifically, the city has pressed for the 110-year old California state agency Cal Fire to submit a bid for providing fire services to San Bernardino—part of the city’s plan to contract out such services, and something the city has repeatedly sought to pressure Cal Fire to provide. Given the lack of any response, the delegation yesterday sought a prod from Gov. Brown—a prod which produced, apparently, not even a spark, or, as Mr. Lopez put it: “Governor Brown’s office has recently made San Bernardino aware that Cal Fire will not provide a proposal and that our additional requests will not be considered.” In contrast, the San Bernardino County Fire Department and a private firm, Centerra, have each submitted proposals to provide San Bernadino’s fire services—bids which the city guesstimates could save it as much as $7 million annually. Having struck out on the fire front, the Mayor and delegation then sought assistance on other key items on their list, including some relief from a potential California Public Employees’ Retirement System penalty, the threatened decertification of the San Bernardino Employment and Training Agency, a loan, help with the dissolution of the city’s redevelopment agency, and clarification on its tax agreement with Amazon. They went home empty-handed.

Send for Batman! In most instances, in the case of a potential drowning, a lifeguard at least throws a buoy, but in the wake of Wayne Count Executive Warren Evans’ request for Michigan state intervention, Standard & Poor’s put the county’s speculative grade rating on CreditWatch with negative implications yesterday. The downgrade will increase costs for the fiscally struggling county; the harder question is what S&P’s actions might mean to the many municipalities, including Detroit, within its boards. Jane Ridley, S&P’s analyst, wrote: “The CreditWatch placement reflects our expectation that with the onset of actions under Michigan Act 436, the county could lose some of the autonomy currently held by the CEO and his staff.” Ironically, Mr. Evans’ June 17th request was intended to enable the county to enter into a consent agreement with the state (please not the stark contrast with the seeming lack of any intergovernmental commitment in California, above) to enhance Wayne County’s authority to deal with labor contracts and other pending issues critical to the county’s fiscal sustainability—and, as state officials have made clear, municipal bankruptcy or even the appointment of an emergency manager is not only not in the picture, but also Michigan state officials almost immediately made most clear that municipal bankruptcy is not only not in the picture, but also that they perceive Mr. Warren’s request as a positive, constructive step towards resolution of Wayne County’s fiscal challenges. Nonetheless, in its warning, S&P noted that under Michigan law, if the county’s request were approved by the state for a financial review, the Wayne County board would be faced by four options: a consent agreement; appointment of an emergency manager; a neutral evaluation; or it could pursue a Chapter 9 bankruptcy filing, with Ms. Ridley writing: “In our view, the county’s request for financial review does not signal the start of filing for bankruptcy, but rather a step in its stated goal of using all possible tools to regain structural balance…However, given the uncertainty associated with these four options—as well as the potential for a prolonged time frame to make additional meaningful structural changes while this process is underway—we have placed the rating on CreditWatch,” adding that its actions reflect apprehensions Wayne County’s autonomy in its restructuring could be diminished if an emergency manager is ultimately named: “In our view, this could mean that making the significant, meaningful adjustments necessary could be delayed or adjusted, which would have an impact on the county’s long-term financial health.” If, instead, Wayne County retains control over its restructuring, as seems to be not only its intent, but also the state’s impression, S&P noted it could remove the rating from CreditWatch and assign a negative outlook, reflecting the long-term budget pressures the county is facing. Interestingly, in light of the discussion re: federalism above, Ms. Ridley notes that S&P views the appointment of an emergency manager as more risky due to the loss of autonomy—a loss the credit rating agency notes which could lead to a credit rating downgrade: “Notwithstanding the uncertainty of the county’s near-term management control, without the county’s clear, demonstrable progress in the next year to regain structural balance and reduce its sizable pension burden, we could lower the rating…In addition, should Wayne County’s liquidity position deteriorate significantly, we could lower the rating.”

Trying to Balance its Budget. The Puerto Rican Senate is currently considering the U.S. territory’s FY2016 budget—a balanced budget, like every state in the U.S., albeit unlike any Congressional budget in modern times, which the House adopted and sent to the Senate early this week, and which includes austerity measures to improve Puerto Rico’s fiscal health. As passed, the House budget estimates $9.8 billion in revenues, and proposes $9.55 billion in spending. The House proposed $674 million in spending cuts, with much of the savings to anticipate the territory’s increasing debt service costs and public pension obligations; the House cut nearly 60 percent off the Puerto Rico Development Bank’s budget request of $700 million—with the bank facing potential insolvency later this summer when some $4 billion in debt it issued begins to become due. The House Chairman of Committee on Treasury and the Budget, Rep. Rafael Hernández Montañez, noted the development bank could be forced to restructure its debt, but that the House-passed budget would be sufficient to ensure Puerto Rico would not default on any of its general obligation or G.O. bonds, albeit, he warned that if the U.S. territory’s development bank encounters difficulties in meeting its obligations and is forced to restructure its debt, there might have to be some delay in setting aside the proposed funding in the House-adopted budget to meet pending general obligation bond payments—warning that the alternative would be a government shutdown—an alternative he made clear would be devastating to the island’s economy.

In the Fiscal Twilight Zone. Even as Puerto Rico’s elected leaders have been pressing to address the U.S. territory’s overwhelming debts—and hedge funds have mounted an expensive lobbying and advertising campaign with full page adds—“No Bailout for Puerto Rico”—in the Wall Street Journal as part of a heavily financed lobbying blitz in the U.S. Congress to bar granting Puerto Rico the same authority provided to every state in the U.S., or even broader authority so that the U.S. Bankruptcy courts could act to ensure the continuity of essential public services while overseeing the development of a plan of debt adjustment; Congress so far has been seemingly paralyzed—and it is focusing its attention in a diverting way, so that Puerto Rico’s Governor, Alejandro García Padilla, is urging Congress to act on pending legislation to give the U.S. territory access to municipal bankruptcy authority—and not divert its focus to the issue of potential statehood. The urgency came this week in the face of continued inaction by the House Judiciary Committee, but, instead, a hearing yesterday by the House Committee on Natural Resources Subcommittee on Indian, Insular and Alaska Native Affairs on proposed legislation to authorize a means for Puerto Ricans to determine what legal options might be available for its citizens to opt for statehood. Even with the U.S. territory nearing a potential default and insolvency, Chairman Don Young (R-Alaska) had scheduled the hearing earlier this month to consider legislation proposed by Rep. Pedro Pierluisi (D-P.R.) to authorize a U.S. sponsored vote to be held in Puerto Rico within one year of its enactment: the vote suggested in the bill would be solely on the question with regard to whether Puerto Rico should become a state—a status which, were it to be adopted, would render Puerto Rico not only able to authorize its 147 municipality’s the option to file for chapter 9 municipal bankruptcy, but also make the state-to-be eligible for billions of dollars in additional annual federal funding. Rep. Pierluisi stated: “I don’t seek special, different or unique treatment…I don’t ask (for Puerto Rico) to be treated any better than the states, but I won’t accept being treated any worse either. I want only for Puerto Rico to be treated equally. Give us the same rights and opportunities as our fellow American citizens, and let us rise or fall based on our own merits. Because I know that we will rise.” He testified of his apprehensions that, absent statehood, he worried there would be a continuing exodus of intelligent workers to the U.S. mainland in search of full rights available in the 50 states. Puerto Rico Attorney General César Miranda, testifying on behalf of Gov. Padilla, urged Congress to focus on the immediate, “truly dire” situation: Puerto Rico’s “state of fiscal emergency,” telling the Committee that diverting attention to the issue of authorizing a mechanism for considering statehood should await resolution of the island’s most crucial issue: granting bankruptcy authorization rights to the island: “We have the capabilities to come across and bring the island to a brighter condition…We need to have an instrument to deal with the debt that we are carrying now. That is why we support extending Chapter 9 to Puerto Rico.”