Lessons of Municipal Bankruptcy

Veterans’ Day, 2014

Visit the project blog: The Municipal Sustainability Project 

Unsung Contributors. Unlike the municipal bankruptcy resolutions in Jefferson County, Central Falls, Vallejo, Ca., and Stockton, Ca.; Detroit’s successful exit was the product of an intricate web of intergovernmental governance that involved not only all three layers of government in the country, but also the judicial, legislative, and executive branches. One might think that unsurprising given that the federal bankruptcy judge to whom the case was assigned, Judge Steven Rhodes, the electric rhythm guitar player of the Indubitable Equivalents clearly appreciated the importance and value of contributors coordinating together to make extraordinary music. One of Judge Rhodes earliest actions in Detroit’s municipal bankruptcy case was to select U.S. District Chief Judge Gerald Rosen to fill a unique role—sort of a plenipotentiary ambassador at-large to think and act way outside the box—but almost always behind closed doors—to fashion not only unexpected partners, but also unexpected coalitions. Now Marion Walker of the Detroit Free Press has done us a marvelous rendition by writing about Judge Rosen’s own impressions, about which he spoke on Sunday at Christ Church in Grosse Pointe at the church’s Rector’s Forum Lecture Series, noting: “Detroit is a good stock. I’m confident.” Judge Rosen spoke for nearly an hour about the behind-the-scenes events—events in which he played an unprecedented and largely unsung leadership role—but the role which in the end became the lynchpin which allowed the Motor City to successfully exit bankruptcy―including the grand bargain, which saved art at the DIA and saved many city retirees from deep cuts originally planned for their pensions. According to Ms. Walker, Judge Rosen spoke of the selection of Judge Rhodes as the presiding judge for the case, and how municipal bankruptcies are the only time in federal cases where the judge is not decided through a random draw process―explaining how it was tradition that the chief judge for the federal circuit court would call the chief judge of the federal district court (Judge Rosen in this case) for a recommendation with regard to whom should handle the proceedings: “Things were happening very quickly as Detroit was careening toward bankruptcy…There was, I believe, about 8 weeks of cash left. It was pretty obvious to me that (bankruptcy) was, unfortunately, going to happen. Judge Rhodes and I have known each other a long time. Without diminishing the skills or abilities of any of the other bankruptcy judges, in my mind, there was really only one guy who could do this, by virtue of his experience, case management, intellect and sharp focus.” According to Ms. Walker, Judge Rosen then shared a story from later in the mediation process involving a phone call with Darren Walker, president of the Ford Foundation, at Walker’s New York office, and how Mr. Walker announced to him that Ford would be making its largest-ever donation,  $125 million, to the grand bargain, to contribute to Detroit’s future—and to ensure the preservation of the world famous Detroit Institute of Art, as well as protect the most vulnerable of Detroit’s retirees: “I almost fell out of my chair…And that was the first moment where I thought ‘you know, this thing may get some legs.’” Indeed, as Judge Rosen noted, that moment—a moment which seemingly grew from a doodle he had made on a blank piece of paper with two boxes, one labeled foundations, the other pensions, osmosis seemed to take over: $100 million from the Kresge Foundation, $40 million from the Knight Foundation―in all, the doodles translated into $370 million in foundation commitments. Like a fox to the chase, Judge Rosen met with Michigan Governor Gov. Rick Snyder—a meeting which produced its own indubitable equivalent, as the Governor and bipartisan legislative leaders fashioned together what became known as the grand bargain. On Sunday, Judge Rosen noted that his conversation with Gov. Snyder included a question and answer portion where people sought his opinion about the Motor City’s ability to lead itself following the bankruptcy. One participant, Judge Rosen reported, simply wanted to applaud him and others involved in the process for getting the job done, telling the Judge: “Thank you in proving that men of good will can come together and move mountains.” To which, the Judge appended in his inimitable style: “Amen to that with only one amendment, which is: ‘and women.’”

Reading Detroit’s Tea Leaves. In the wake of Judge Rhodes’ affirmation of Detroit’s plan of adjustment, there are questions for state and local leaders across the country with regard to:

• What lessons ought to be learned?
• How are the tensions between cities’ and counties’ pension obligations, especially in states where state constitutions appear to guarantee those pension commitments, to be balanced against a city or county’s promise of full faith and credit to its general obligation bond holders?
• Will the federally approved plans in Stockton and Detroit actually work to guarantee sustainable futures for these respective municipalities?

Time will, of course, tell. An eminent panel of experts, next week at the NLC Congress of Cities in Austin Texas, will offer some acute and insightful perspectives and experience—as well as a guidebook for municipal leaders. In the nonce, two of the major rating agencies have offered divergent views of the ruling: Moody’s has termed Detroit’s plan of debt adjustment approved by Judge Rhodes to be a credit negative for holders of the State of Michigan general obligation bonds. Moody’s Genevieve Nolan wrote that approval of the plan was negative for municipal investors, because it reinforces favorable treatment of pension claims over other unsecured claims. The firm’s analysts have fretted the Motor City case raised more questions than answers for investors, especially those who hold Michigan debt, and revealed their vulnerability in a bankruptcy court setting, with Ms. Nolan writing: “Confirmation of the plan is a credit negative for investors of Michigan general obligation bonds, not only because the pledges were impaired, but also owing to the lack of a ruling on the strength of the pledges.” Standard & Poor’s, in contrast, opines that the lack of legal precedent means the outcome will not affect its general obligation or GO municipal bond ratings. The ever insightful Richard Ciccarone, president and chief executive officer of Merritt Research Services LLC, yesterday told the Bond Buyer: “Detroit clearly indicates the sympathy the courts and the public will have to provide a fair deal for retirees and from that standpoint, it means that for bondholders to think they’re at the top of the heap and that’s all that matters is a dangerous way to think…There’s a natural tension there, but that tension is not really a clear and present danger until there’s a significant dose of fiscal stress.” In contrast, S&P analyst Jane Ridley, while acknowledging the favorable treatment of pension obligations over bond debt in Stockton and Detroit, wrote that the lack of legal precedents and the small number of municipal bankruptcies make it difficult to generalize about the treatment of GO bonds in a Chapter 9: “In our view, the Detroit and Stockton situations will likely not set a precedent – however high profile and attention-grabbing they may be – and we shouldn’t universally apply the lessons learned to all GO-bond debt ratings.” Ms. Ridley noted that “the most important outcome” from Detroit’s creditor settlements is the wide gap in treatment of pensions versus municipal bonds, as well as the “very different” settlements for LTGO, ULTGO. and pension obligation bondholders…Given the nature of a Chapter 9 bankruptcy, we expect that most municipal creditors will continue to settle, as was the case in Detroit, rather than risk a bankruptcy court decision…While a trend could be developing where local governments in bankruptcy favor bondholder haircuts rather than pension reductions, we believe that Detroit’s and Stockton’s bankruptcies remain too small a sample size on which to base widespread ratings changes.”

Municipal Recovery. The harder post-municipal bankruptcy question is with regard to recovery—a question which, ironically, has sparked a related issue: will the successful outcomes in Central Falls, Jefferson County, Vallejo, etc. lead other cities and counties to file for federal bankruptcy protection? In response, at least one advisor affirms, at least in the case of Michigan: “They all should be looking at it,” according to Pat O’Keefe, chief financial officer of restructuring firm O’Keefe and Associates: “The big issue is always the retirement benefits, and a shrinking population of retirees that are supporting it…I’m not a big fan of bankruptcy, because it’s costly and uncertain, and for businesses it’s uncertain, but when you’re dealing with residents who aren’t going anywhere, you’ve got to take a close look at it….Arguably there’s a certain cleansing that takes place in the bankruptcy process in terms of legacy liabilities…One could argue that Detroit is in a much better position to attract municipal bond financing, which is the lifeblood of every community.” But on the central issue with regard to whether Detroit’s plan will in fact provide for a sustainable future, Mr. Ciccarone notes: “Despite Judge Rhodes’ ruling that the plan presents a feasible path to long-term recovery, some experts warn that the depth of Detroit’s challenges and the uncertainty of future population growth threaten the recovery…They’ve still got a heavy load of legacy costs and it’s still going to be expensive to run the government…I think it’s really hard when you look at the numbers to say they’ve done enough to be on the path to recovery.” S&P, in its report, also cautioned that the city could have a hard road ahead. “Although the roadmap is set out in the plan of adjustment, it will still likely be difficult for the city to continue making the kinds of changes that will lead to the cost savings it needs to be operationally balanced…We believe that achieving this is the only way that Detroit will be able to stay out of bankruptcy in the future.” The eminent godfather of chapter 9, Jim Spiotto, the managing director of Chapman Strategic Advisors, commented that Detroit’s treatment of its general obligation municipal bond holders and, to a lesser extent, its revenue bond holders, could end up costing the city millions in increased borrowing costs over the years: “As the judge said from the beginning, it’s the long-term survival and reinvestment in Detroit that’s the most important thing…He wants to make sure that you’ve got that survivability; make sure that there is a not a repeat, which is extremely important, because another bankruptcy for Detroit could be significantly more difficult and painful.”

Public Trust. Former San Bernardino Councilman Robert Jenkins, who had won a special election to the San Bernardino City Council in July of 2011, but was charged while still in elected office 13 months ago in Riverside County with 30 felony and misdemeanor counts―leading to his failure to win reelection last November―has pled guilty in an alleged Internet stalking case involving his ex-boyfriend and another man. His plea bargain will result in a sentence of 180 days. The charges against Mr. Jenkins included stalking and identity theft related to placing personal ads directing sex partners to the home and work of an ex-boyfriend and that ex’s boyfriend. His charges carried a maximum potential sentence of 14 years and four months for the felonies and 12 years for the misdemeanors, which he could still face if he violates parole. His case had wound through hearings and closed-door negotiations since then—seemingly parallel to the city’s municipal bankruptcy. Mr. Jenkins was a special education teacher until he let his certification lapse last year. Under the decision, Mr. Jenkins also must pay $14,795 in restitution to the victims in the case.  Judge Rafael Arreola, in sentencing the former city elected leader, told Mr. Jenkins: “You’re probably very fortunate,” adding that elected officials have increased responsibilities.

Rolling the Municipal Dice. Atlantic City casinos would pay the municipal government $150 million annually over two years, according to a plan proposed by New Jersey Senate President Steve Sweeney to revitalize the tottering city’s finances. The state-administered Casino Reinvestment Development Authority would also direct as much as $30 million annually to cover Atlantic City’s debt payments. According to the proposal by Sen. Sweeney, the plan would require schools and the municipality to make $72 million in unspecified cuts: “One of the things we don’t want is for Atlantic City to become Detroit…Combined between schools and the municipal government in Atlantic City, it costs $377 million a year. That’s not sustainable.”’ Atlantic City, which lost its title as the second-largest U.S. gambling hub, has withered as surrounding states add casinos and erode what had been its primary economic engine. About 70% of all taxes collected there come from casinos, according to Moody’s. Sen. Sweeney made his proposal in anticipation of tomorrow’s summit to try to address the city’s future—a summit at which potential U.S. Presidential candidate Gov. Chris Christie and gaming executives will all participate.

Balancing Public Pension Obligations vs. Essential Public Services. The Grand Wizard of municipal bankruptcy, James Spiotto, with whom I worked for many years to ensure passage of chapter 9 and its signing into public law under President Reagan, has written a typically short piece, “How Municipalities in Financial Distress Should Deal with Unfunded Pension Obligations and Appropriate Funding of Essential Services” for the Willamette Law Review to discuss what a financially distressed city, town, or county “must do” to survive a financial crisis and how to develop a viable public recovery plan. He notes that “A practical approach is critical and must be based on a determination of what pension benefits and obligations are sustainable and affordable.” He warns that restructuring that “does not provide for adequate public services will be doomed to failure.”    He adds that: “Since our nation’s birth, units of local government have faced six panics, thirty-eight recessions and four depressions, the last being the Great Depression of the 1930’s and the Great Recession of 2008.” Somehow the women and men who have and continue to lead cities, counties, and towns have persevered through the hardest times by helping to make hard choices and leading the way to constructing solutions.

D-Day in Stockton, California

eBlog
October 30, 2014
Visit the project blog: The Municipal Sustainability Project

D-Day: Taking the Final Stock in Stockton. U.S. Bankruptcy Judge Christopher Klein is set to gavel his court back into session this morning, where he is expected to either confirm Stockton’s plan of debt adjustment and restructuring proposal, permitting the city to exit municipal bankruptcy, or reject it. Today’s decision—on which we will rely on two extraordinary on site witnesses, could end the California city’s 28 month effort to pull itself back from insolvency towards a sustainable future. The key, remaining issue relates to the city’s lone remaining holdout creditor, Franklin Templeton Investments, with whom there is a nearly unbridgeable chasm over some $32 million in unsecured debt― debt to Stockton to finance construction of a fire station, upgrade the city’s police communications center, and build parks and streets at a time when the city’s finances already were careening toward disaster when the loan was made in 2009―on which the city’s plan proposes to pay about $300,000, or less than 1 cent on the dollar—in stark contrast to the city’s plan’s commitment to 100 cents on the dollar to the California Public Employees’ Retirement System or CalPERS. Unsurprisingly, Franklin has disparaged the city’s plan, telling the court it does not meet the bankruptcy test of fair and equitable (see Franklin’s statement immediately below), especially compared to the agreements Stockton reached with other creditors, and in the wake of Judge Klein’s opinion on the first day of this month—a verbal ruling in which he made clear, for the first time, notwithstanding the California constitutional protections for public employee pensions, those protections are preempted by the federal, chapter 9 municipal bankruptcy law—a ruling prompted by Franklin’s legal protest.

CalPERS had argued that California cities should be legally bound to use all their assets to pay pension debt before reducing retirement benefits, but Judge disagreed, noting that California’s state’s public employee retirement law “is simply invalid in the face of the U.S. Constitution.” Nevertheless, the practical effect of Judge Klein’s oral ruling is uncertain. What is in the balance is the annual $29 million in pension payments in Stockton’s proposed plan of adjustment. In a larger sense, the issue could cause reverberations far beyond Stockton’s city limits. In the wake of Judge Klein’s earlier oral opinion, credit rating agency Moody’s termed it “a positive sign for investors (in state and local municipal bonds) that pension obligations will not be given preferential treatment over debt in a municipal bankruptcy.” The agency added that it could prompt other stressed municipalities to “consider bankruptcy as a way of trimming unaffordable and growing pension burdens.” In contrast, Stockton city officials have said an exit from CalPERS would have disastrous consequences for Stockton. As for Stockton’s repayment proposal to Franklin, no one has said publicly whether negotiations between the city and the investment firm have been held since the last court date.

In its own statement to the federal bankruptcy court, the firm wrote:

“Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund loaned $35 million to the City of Stockton in 2009. Stockton defaulted in repayment of that loan and subsequently sought to adjust its debts in a bankruptcy case under chapter 9 of the United States Bankruptcy Code.

“Franklin has participated in the bankruptcy case as a creditor. Our focus always has been and continues to be on doing what is in the best interest of the investors in the Franklin funds holding the Stockton debt at issue. Many of those investors are individuals and retirees who rely on us to protect the value of their investments and provide retirement income.

“On October 1, the Bankruptcy Court issued an important decision in Stockton’s case. Agreeing with Franklin, Judge Christopher Klein held that, under U.S. bankruptcy law, Stockton’s pension liabilities may be impaired as part of a bankruptcy plan of adjustment, just like all of Stockton’s other debts. The decision confirmed Franklin’s position that all of Stockton’s liabilities should be addressed in its bankruptcy and is consistent with Franklin’s claim that Stockton’s plan fails to treat Franklin fairly and equitably.
“Franklin urged the Bankruptcy Court to make that ruling because Stockton has proposed an unfair and discriminatory plan of adjustment. Stockton’s plan provides for pensions to be paid in full and other unsecured creditors to be paid between 50% and 100%, while Franklin’s unsecured claim is to be paid less than 1%.

“This proposal violates the Bankruptcy Code’s prohibition against unfair discrimination and fails the Bankruptcy Code’s requirement that Stockton provide Franklin with a reasonable recovery paid over time from Stockton’s future revenues. In light of the Bankruptcy Court’s ruling, it is clear that Stockton cannot wipe out Franklin’s claim through a negligible 1% payment while choosing to pay in full its much larger pension debts.
“In fact, the evidence establishes that Stockton can pay substantial amounts to Franklin even if it leaves pensions untouched. Had Stockton chosen to do so, it could have avoided the delay and expense of litigation. Instead, Stockton ignored that evidence and proposed just a small, one-time payment to us. As a result, we had no choice but to resist confirmation in order to stand up for the individuals who have entrusted us with their savings.

“We continue to desire a cooperative partnership with Stockton in which our claim will be repaid over time as Stockton recovers, just as the claims of other creditors and pension holders are to be paid over time from future Stockton revenues. We are hopeful that the Bankruptcy Court’s decision will prompt Stockton to offer a more realistic plan that provides a fair and equitable recovery for our fund investors, as required by the Bankruptcy Code.”

Trading Lots in the Motor City. Detroit Mayor Mike Duggan and Detroit Public Schools Emergency Manager Jack Martin have announced an agreement to eliminate some $11.6 million in debt the school system owes the city in return for the transfer of 77 vacant school buildings and lots. Almost in parallel universes, Michigan had taken control of both Detroit and its public school system—in significant part because of the systemic fiscal scourge created by the city’s significant population decline (its school population dropped by more than 66%). Under the terms of the agreement, Detroit will forgive the debt—consisting mostly of electric bills owed to the city, in exchange for the school system turning over 57 vacant schools (31 secured and 26 unsecured) and 20 vacant lots (where schools once stood). Mayor Duggan said: “This agreement is great for our neighborhoods and DPS school children…It allows DPS to put all of its energies into its core mission, which is to educate our children. It also recognizes that the city is better suited to addressing the important issue of neighborhood blight and redeveloping these properties in a way that is in harmony with the surrounding community,” adding that, under the terms of the agreement, the city “will take [ownership of] between 10 and 12 buildings and move in a timely manner to demolish them,” with plans to tap $4.3 million in Neighborhood Stabilization Program funds that could be used to raze those structures by next summer. Mayor Duggan said: “Each property that has a good playground will be assessed by Parks and Recreation…If they are well maintained, the rec department will make them available to the neighborhood.” As for the vacant schools, the Mayor added the city will not rush to raze all of them: “There may come a day when more people move back into the city,” adding that between 14 and 16 will be secured for future use. As for the school system, Mr. Martin notes that the grand swap will remove $12 million in its liabilities, albeit he still must address 20 other vacant schools which are not part of this agreement, and that it could mark a key step in his efforts to get the system out of debt and state control: the district’s deficit was $127 million as of the end of its most recent fiscal year in June, according to the state. Since the State of Michigan asserted control over DPS in March of 2009, the district has closed 100 school buildings. The district has been leasing and selling property since 2005 and had more than 100 properties on the market. Now facing a $127-million deficit, DPS has shut dozens of buildings over the years as its enrollment declined. In 2002-03, the district had more than 156,000 students; current projections are at about 47,100 students.

Actuarially Challenging. Last month a class action suit was filed by a Detroit retiree, apparently a frequent filer, against the city’s actuary, Gabriel Roeder Smith and Co., for its work advising the city’s (and Wayne County’s) general pension fund. The suit alleges that consultants used faulty assumptions that contributed to underfunding that some say helped drive the city into bankruptcy. (Gabriel, Roeder, Smith & Company is a national actuarial and benefits consulting services firm that focuses on services in the public sector, with clients in every state except Maine, Massachusetts, New Jersey, and Montana.) In the suit, Detroit retiree Colleta Estes, filed in Wayne County Circuit Court, Ms. Estes accused GRS of using a misleading methodology to calculate contributions, and of allowing trustees to spend money they did not have. Now that Detroit is bankrupt, the pension fund is short, benefits are being cut and one of the system’s roughly 35,000 members, Ms. Estes contends the firm used faulty methods and assumptions that “doomed the plan to financial ruin.” GRS has served as the Motor City’s actuary for 75 years. The suits (three) seek recompense outside of the bankruptcy with regard to services rendered by GRS to three public employee retirement systems. GRS’s actual clients – the retirement systems – did not initiate the lawsuits; instead, the named plaintiffs are participants in the retirement systems. The plaintiffs previously brought lawsuits against trustees of the retirement systems and other service providers to the retirement systems. The suits claim GRS helped cause the fiscal mess “by negligently, willfully, recklessly, wantonly and repeatedly committing gross errors and failing to exercise due care and skill in providing actuarial services to the plan, and in failing to promptly discover and disclose those errors to the trustees, (thereby) defendant Gabriel Roeder breached its duties to the plan.” The litigants also claim the General Retirement System “knowingly acted in concert with the plan trustees to further their self-interest, and by agreeing to allow an underfunding scheme, which has greatly impaired the system’s financial soundness, the plan is one of the nation’s worst performing public pension systems.” GRS still works with Detroit’s two pension funds. Members of the Detroit police and fire retirement system have filed a similar lawsuit, as have members of the Wayne County employees’ fund, according to the New York Times. Ms. Este’s lawsuit asks to have the pension plan made whole.

12.5.13

Pit Stops in the Motor City. Long before U.S. Bankruptcy Judge Rhodes issued his written opinion finding the Motor City eligible for federal bankruptcy protection, Detroit’s biggest municipal union, the American Federation of State,

12.4.13

Staring their Engines in the Motor City. Almost before Judge Rhodes had completed his oral summary finding Detroit eligible for federal bankruptcy protection yesterday, the Michigan Council 25 of AFSCME filed a notice of appeal.

11.21.13

Motor City: With U.S. Bankruptcy Judge Steven Rhodes expected to render his decision on Detroit’s eligibility for chapter 9 municipal bankruptcy as early as today or tomorrow, the related costs to the city, its taxpayers, its employees,