Detroit Ruling Adds To A Growing Playbook For Muni Bankruptcy

Injured Piggy Bank WIth Crutches

No one argues that of Detroit, Michigan’s storied 312 year history, the last 50 or so years have marked a kind of downward slide in the city’s status and solvency. Its major industries disappeared, and so have much of its population, leaving burnt out buildings as hollow reminders of what was. Yesterday, an US judge tasked with deciding the future of Detroit, said the city was eligible for bankruptcy and that pensions, guaranteed in the state constitution could be on the chopping block. Earlier this year, CivSource reported on the then nascent idea being pushed by primarily far right pundits that Chapter 9 filings should be a playbook for troubled cities. Now that the option seems closer to reality, what can we learn from what happens now in Detroit?

Detroit has the dubious distinction of unseating Alabama’s Jefferson County for the biggest Chapter 9 filing, but it also has one more – that the filing was made by fiat, through an un-elected emergency manager that can’t be recalled. Against that backdrop not only does this bankruptcy have potential implications as a template for future Chapter 9 filings, it may also be a template for how to disband local democracy ahead of one.

Observers of the Detroit case will be familiar with emergency manager Kevyn Orr. Orr was appointed after Governor Rick Snyder declared the city insolvent and tasked him with setting the books right. Orr surveyed the landscape and subsequently filed for bankruptcy. However, none of this went through easily, Detroit and Michigan voters repealed the law initially, through a public referendum process only to have the Governor re-institute the law allowing for emergency managers and this time with the clause that it couldn’t be repealed. A declaration of insolvency then, effectively ends indefinitely municipal democracy in these cities. Mayors, etc. are retained, but can’t really do much beyond noting their discontent or providing alternative ideas to the emergency manager.

While the fight over emergency managers was happening, Detroit took another hit to its books, this time on state revenue sharing. Typically with a plan like this, when cities pay into the state through their tax base a portion of that is returned to the city budget. Detroit lost out on that and also through another measure in 2012 that cut out another $40+ million from the city budget. The move took Detroit from a city on the ropes, to a city at the end of its rope.

“Most of Chapter 9 filings before this, have been smaller, and more project oriented, so this is an outlier for municipal bond holders, and really everyone involved,” says Craig Barbarosh, Partner, Katten Muchin Rosenman LLP, in an interview. Therein lies another rub in the Detroit case; individual retail investors are usually the most common municipal bondholders. Municipal bonds have a long history of being safe, and even if a project goes bust, those bondholders aren’t necessarily scared off. But, what the city has to pay back on some of these bond deals isn’t quite so straightforward, or affordable.

Beyond retail investors, pensioners are also in the mix. Public workers were guaranteed pension payments under both their employment agreements and the state constitution. Those payments averaged out to around $19,000 per year before the filing. Haircuts proposed in Orr’s bankruptcy plan involve both bondholders and these pensioners. You might wonder what an aging person can do on $19,000 per year, consider less than that. Consider as well, some of these people may also hold bonds. Retail investors have gotten out where they can since the filing, but not entirely and other bondholders – hedge funds and banks are still in.

In a separate interview, I asked a municipal bond fund about what this all means. “There are potentially several legal and constitutional issues coming out of the Detroit bankruptcy that must be settled, including the scope of a Michigan emergency manager’s authorized powers and a city’s ability to haircut its obligations from municipal bonds, which were issued with the full faith, credit and taxing power of the city pledged to repay principal and interest, to pensions to healthcare benefits,” said Garey Fuqua, Group Head and Managing Director, High Yield and Distressed Municipal Strategies at Spring Mountain Capital. Spring Mountain has been involved in distressed municipal strategies for a number of years.

Bondholders and pensioners can both protest, and refuse to agree to haircuts offered, although what that will result in is unclear. The inclusion of both groups in the eligibility ruling could be a canary in the coalmine for other municipal bankruptcies, including those currently underway in California, which makes this case so critical. The current legal precedent for municipal bankruptcies isn’t very rich. Do cities have to try to tax their way out? No judge has yet ruled definitively on that issue. What about user fees? Proposed future rate hikes on public services? What about the loss of institutional legitimacy when city residents, investors, or public servants can trust that guarantees are guarantees? Woe to the risk free asset.

Judge Rhodes has already been involved in cases on rules defining corporate bankruptcies, and now he’ll be involved here which also makes him a unique figure in how this plays out. Unlike a corporation, you can’t liquidate a city – at least in theory. Close watchers of Detroit could argue though, if you were going to try we’re getting pretty close. It may have taken decades to hollow out the city, but what of other smaller municipalities?

To much less fanfare, Jefferson County, Alabama also announced yesterday that it closed the sale of its $1.8 billion in debt and will emerge from bankruptcy. In that case, the county cited $4.2 billion in its original filing centered on high cost sewer services. Emerging from bankruptcy was conditional on closing the smaller $1.8 billion figure after achieved through the bankruptcy process, and will result in higher rates for sewer services inside the county. The county will also be under the view of the bankruptcy court for the next 40 years as part of a plan to win back municipal bond investors. The New York Times says that the rate hike and supervision could be a template for municipal bankruptcies. Residents there are planning to appeal those rates, casting doubt on the idea municipalities could tax and user fee their way out, if they are successful in their appeal. Bondholders too are taking a haircut writing off $1.5 billion.

Pensioners are also caught up in the California bankruptcies in Stockton and San Bernardino, prompting the nation’s largest public pension fund CalPERS to issue this statement on the Detroit ruling, “the Detroit court failed to recognize the difference between a two-party contract and the unique nature of a state public employee retirement system, which creates a three-way relationship among a public agency, its employees and the retirement system. In California, our members’ vested rights to their pensions are protected by the California constitution, statutes and case-law. {…} The ruling is shortsighted and does not take into account the promises made in exchange for the financial and physical investments that public employees and retirees make in our communities. CalPERS will continue to protect and champion the public employees and retirees who serve California every day.” Detroit can become a factor in both of those cases, unsettling pension guarantees, which so far have been left untouched.

Harrisburg, PA a glimmer of hope?

If you, like me, grew up in a time when playing cops and robbers, or fireman and rescue, or even teacher and the class was a thing, and being the cop, fireman or teacher was cool, watching all of this go down kind of makes it seem like that one kid who always wanted to play the robber was probably the smart one. Still though, some municipalities on the brink can avoid going over. Consider Harrisburg, Pennsylvania – the city was able to avoid filing and still establish a receivership plan – the Harrisburg Strong Plan.

“A number of cities have to realistically decide if they are better waiting until they are near Armageddon or are we better hoping against hope that we find a way to avoid bankruptcy and take a pro-active step,” says Mark Kaufman, currently lead counsel to the Receiver in Harrisburg PA and co-chair of the McKenna Long & Aldridge Municipal Reform & Innovation practice. “Once a city gets over its skis and you’re in bankruptcy court, it’s an inherently adversarial situation. At that point it is that much harder to come to a reasonable conclusion.”

Kaufman explains that for the Harrisburg plan to happen, bankruptcy was a leverage point, but not the obvious and only option. He also notes that the city had to be completely transparent from day one, “if you don’t start with an open kimono then the predictability of getting people to share pain is rendered highly problematic. People have to feel like they have all the machinery in their own hands.”

A judge recently ruled that the plan will go forward, and that if the comptroller delayed further the Receiver could sign contracts on the plan to settle over $600 million in debt. The plan, like the one in Alabama involves some rate hikes, and leasing of public assets like parking garages. Not all parties involved like all aspects of the plan, but a recent local report shows that city council members are ready to see the plan go into action under a new mayor.

“Vegas rules don’t apply here,” says Kaufman. “What happens in Stockton doesn’t stay in Stockton, these rulings set precedents for other cities. I think this plan could be its own recipe for other cities. Bankruptcy is very expensive, and very contentious just to come to a settlement. Cities can settle before filing, we’ve been able to do that here.”