Many American cities are facing financial distress; some have
yet to recover from the recession of 2008-2009, as foreclosures and
depressed property values continue to erode property tax receipts
and other revenues. Many of those cities also have substantial
obligations for pensions and medical costs.1 As a result
of the difficulty in restructuring benefit obligations out of
court, many of which are protected by state law,2 some
commentators suggested that municipal bankruptcies under Chapter 9
of the Bankruptcy Code might provide a means to achieve that
goal.3 But in the recent bankruptcy of Detroit, Mich.,
it was financial creditors—and not employees and
retirees—who were asked to bear the heaviest costs of
restructuring. Detroit's pensions and benefits were largely
protected. The result raises the issue of whether Detroit's
restructuring is a long-term solution that will become a future
model or a short-term fix with an uncertain shelf life.
No large American city has suffered as badly as Detroit: Its job
losses and population decline decimated its tax base, leading to
years of budget deficits, which it plugged through borrowings and
one-off financing transactions. Detroit's strained finances led
to a cycle of deep service reductions, which contributed to
extensive blight.4 Responding to these problems in 2012,
the Michigan legislature enacted a law authorizing Michigan
governor Rick Snyder to appoint an emergency manager, Kevyn Orr,
who determined that a municipal bankruptcy was the only workable
solution.5
But Detroit's financial problems are not unique. Such
diverse cities as Boston, Chicago, Los Angeles, Philadelphia and
San Francisco also have substantially underfunded municipal pension
plans. Many cities have pension plans that are 20-30 percent
underfunded, and a recent study estimated that cities have funded
only 6 percent of their estimated retiree health care
obligations.6 Detroit may have exhausted its financial
resources sooner than other cities, but its problems cannot be
dismissed as isolated. The lesson of Detroit is that it is
difficult to achieve reductions of pensions and health benefits,
even in Chapter 9.
Detroit's Chapter 9
When it filed its case in July 2013, Detroit's liabilities
included $11.9 billion in unsecured obligations owed to bondholders
and retirees and over $6.4 billion in revenue bonds, making it by
far the largest municipal bankruptcy. In its filing, Detroit took
the position that approximately $650 million of its general
obligation bonds were unsecured.7 Detroit also said that
pension and retiree health benefits represented $9.2-$9.9 billion
of the unsecured claims, and that it intended to use the bankruptcy
process to reduce and restructure those obligations.8
After approximately 16 months of intense litigation and
mediation, on Nov. 7, 2014 Detroit's bankruptcy plan of
adjustment (the Plan) was confirmed by Judge Steven W.
Rhodes.9 The approval was expected because Detroit had
settled with all of its principal adversaries, largely as a result
of mediations between the city and its various
creditors.10 An important driver to the various
settlements was the high level of litigation risk faced by all
parties. Because Chapter 9 cases remain rare, and many of the
historic cases have involved small municipalities, the case law
offers sparse guidance to litigants.11
While Detroit's focus on exiting Chapter 9 promptly is
certainly commendable, at 16 months, the case was far shorter than
many far smaller commercial Chapter 11 cases. But the nagging issue
that was raised in the confirmation hearing was whether the Plan is
a real solution. To assist in evaluating Detroit's Plan, Rhodes
appointed his own expert, Martha Kopacz, a partner in a turnaround
consulting firm, who concluded that Detroit's plan was
feasible, meaning that Detroit was more likely than not to be able
to satisfy its future obligations. But she acknowledged that the
plan "was on the skinny edge" of
feasibility.12 Even under Detroit's Plan, its annual
pension contributions will not cover the amount of annual benefit
payments. Thus, unless the pension plans, which are currently about
78 percent funded, meet their investment goals, they risk further
deterioration in their funded status, a risk Kopacz
acknowledged.13
Pension and Health Benefits
When Detroit filed its case, its unions and retirees challenged
Detroit's eligibility as a debtor,14contending that
Detroit's goal of reducing pensions was improper because they
were protected by the Michigan Constitution.15 They
argued that the bankruptcy court lacked authority to modify
Detroit's pension obligations, and a filing aimed at that end
was improper. In December 2013, the bankruptcy court ruled that
Detroit was eligible for bankruptcy relief,16 and held
that pensions in Michigan were contractual and subject to
adjustment.17 At that time Detroit had not yet filed its
Plan, so the court could have avoided ruling on that issue. But the
ruling was a clear signal that pensions could be
restructured.
Despite that favorable ruling, Detroit's pension and health
benefits for retirees were only modestly restructured through a
complex package that became known as the "Grand Bargain."
Non-uniformed retirees, whose pensions averaged $19,000 per year,
will see a 4.5 percent reduction in their pensions and lose future
cost-of-living adjustments. Police and fire retirees will retain
their pensions, which average $30,000 per year, but their
cost-of-living increases will be reduced by 55 percent. Detroit was
also able to eliminate its exposure to retiree health costs by
creating trusts, known as VEBAs, to manage those expenses. Although
the reductions in pension and health benefits clearly benefit
Detroit, they fall far short of Detroit's original proposal,
which called for freezing its unfunded pension liability, which
estimated at $3.5 billion, and satisfying it at an estimated 30-40
cents on the dollar and substantially reducing
benefits.18
Detroit obtained the funding for the "Grand
Bargain" through a mix of sources. The most significant
funding came through a spin-off of Detroit's Institute of Arts
(the Institute).19 The Institute's renowned
collection had been a source of tension in the case, with financial
creditors pressing Detroit to monetize the collection; even Rhodes
had pressed Detroit to consider monetization of its
assets.20 But Detroit resisted a sale, contending that
under the Bankruptcy Code, it could not be required to sell assets
to fund the Plan.21 Attempting to force a sale of art
carried litigation risk; although estimates of the Institute's
holdings were as high as $1.5 billion,22 there were
question about the ownership of the art, and the Institute said it
would fight any attempt to sell any part of its
collection.23 Instead, the Institute bought its freedom:
Private donors and the Institute itself pledged $466 million to be
paid to Detroit and the Institute will become an independent
charitable trust.24 The other final piece of the
"Ground Bargain" was a special appropriation of $195
million from the Michigan Legislature.25
Treatment of Bondholders
Although Detroit's restructured its secured obligations,
such as its water and sewer system bonds, those restructurings
generally provide for payment in full.26 However,
holders of Detroit's general obligation bonds and
pension-linked "certificates of participation" took sharp
losses. The holders of unlimited tax general obligations bonds are
recovering 74 percent of the $388 million owed to
them,27 while holders of limited tax general obligation
bonds are recovering 34 percent of the $164 million owed to
them.28 But all of these bond issues were supported by
bond insurance, so they were the real losers.
Detroit's unlimited tax general obligation bonds were backed by
a pledge of the city's ad valorem tax receipts and the
city's full faith and credit. Based on that pledge, the
bondholders argued that they were secured. Detroit countered that
the bondholders had no lien on those revenues and were unsecured.
In its initial plan, Detroit proposed to pay those bondholders just
20 cents on the dollar. Rhodes directed Detroit to mediate with its
bondholders.29 Although the mediation did not succeed
initially, by April 2014, Detroit had settled with the holders of
unlimited tax general obligation bonds; by September it reached
agreement with the holders of limited-tax general obligation
bonds.
Certificates of Participation Litigation
In 2005, Detroit was in arrears on contributions to its pension
plan and beneficiaries had brought suit to compel the payments. At
that time, Detroit could not directly issue municipal bonds because
it had exhausted its statutory debt capacity. To evade that
limitation, Detroit created two special-purpose entities, which
issued approximately $1.5 billion of the debt instruments, called
certificates of participation (the Certificates). The proceeds of
the issuances were paid to Detroit, which used the cash to fund its
pensions and make debt service payments on the Certificates.
Because some of the Certificates had floating interest rates, the
issuers also entered into interest rate swaps. Due to Detroit's
finances, however, investors were unwilling to buy the
Certificates, and the banks were unwilling to issue the swaps,
without insurance. Of the $1.5 billion in Certificates, Syncora
Guaranty insured approximately $400 million and Detroit's swap
obligations, and Financial Guaranty Insurance Corp. (FGIC) insured
approximately $1.1 billion of the Certificates.
Detroit defaulted under the swaps in 2009, so the swap
counterparties gained additional collateral in the form of a pledge
of casino tax revenues, which were swept into a lockbox. The
lockbox revenues were first applied to the swaps and the
Certificates, and the remaining funds were paid to Detroit. In June
2013 Syncora asserted that an event of default had occurred, and
directed the lockbox bank not to release those revenues to Detroit.
Detroit then obtained a temporary restraining order requiring the
bank to release the funds. That litigation was pending when Detroit
filed for bankruptcy. In Chapter 9, Detroit sought to void the
Certificates, arguing that they were sham transactions structured
to evade Detroit's exhausted capacity to issue municipal debt.
The litigation over the Certificates was also referred to mediation
and Detroit eventually settled with both Syncora and FGIC for 13.9
percent of their claims, although each creditor also obtained the
right to develop various parcels of real property in Detroit.
Conclusion
Detroit estimated that its Plan reduced its overall debts by approximately $7 billion, much of which came directly at the expense of financial creditors. The lesson was perhaps most painful for holders of Detroit's general obligation bonds, because the experience of market participants had been that the non-payment risk was very small.30 After Detroit's Plan had been confirmed, Richard Ciccarone, a municipal debt analyst, said: "Hopefully this will educate not only investors, but also political leaders. You can't treat municipal debt as a risk-free investment."31 The ruling in Detroit's bankruptcy that pensions in Michigan were contractual gave the city the legal tools to seek substantial reductions in its pensions and health benefits. The results were more modest, and suggest that in municipal bankruptcies, when the interests of financial creditors clash with workers and retirees, protection of pensions will continue to receive priority. And given the risk of future financial distress in Detroit, it remains to be seen whether the city has solved its problems or merely postponed a more painful reckoning.
Endnotes:
1. Pew Charitable Trusts, "A Widening Gap in the
Cities" (hereinafter "A Widening Gap"), Jan. 16,
2013, available at http://www.pewtrusts.org/en/research-and-analysis/reports/0001/01/01/a-widening-gap-in-cities
(accessed Oct. 24, 2014).
2. Alice H. Munnell and Laura Quinby, "Legal Constraints on
Changes in State and Local Pensions," Center for Retirement
Research at Boston College, available at http://crr.bc.edu/wp-content/uploads/2012/08/slp_25.pdf
(accessed Oct. 25, 2014).
3. See, e.g., David A. Skeel Jr., "Is Bankruptcy the Answer
for Troubled Cities and States?," 50 Houston L. Rev. 101
(2013); Richard M. Hynes and Steven D. Walt, "Pensions and
Property Rights in Municipal Bankruptcy," 33 Rev. Bank. &
Fin. Law 611 (2013-2014).
4. Declaration of Kevyn D. Orr (hereinafter "Orr
Declaration") in Support of City of Detroit, Michigan's
Statement of Qualifications Pursuant to Section 109(c) of the
Bankruptcy Code, case 13-53846, Bankr. E.D. Mich., Docket 11,
(subsequent references to pleadings will be cited as Docket
__).
5. Michigan Public Act 436 of 2012, the Local Financial Stability
and Choice Act, MCL §141.1541 et seq. ("PA
436").
6. "A Widening Gap," supra note 1.
7. Attached as Exhibit A to the Orr Declaration was a proposal (the
"Creditor Proposal") that Detroit circulated to creditors
in June 2013. The details of Detroit's funded debt are at page
109 of the Creditor Proposal.
8. Although Detroit's financial statements showed a far smaller
liability for pension and health benefits, Detroit said the actual
liabilities were far higher. Creditor Proposal at 23.
9. Notice of Filing of Revised Proposed Order Confirming Eighth
Amended Plan for the Adjustment of the Debts of the City of Detroit
(Docket 8249).
10. Order to Certain Parties to Appear for Continued Mediation on
Sept. 11, 2014, Docket 7395.
11. Skeel, "Is Bankruptcy the Answer for Troubled Cities and
States?," supra note 3, at 102.
12. Expert Report of Martha E.M. Kopacz Regarding the Feasibility
of the City of Detroit Plan of Adjustment, Docket 6993; Robert
Snell, "Expert: Detroit Officials Must Embrace Debt
Plan," Det. News, Oct. 22, 2014, available at http://www.detroitnews.com/story/news/local/wayne-county/2014/10/22/detroit-bankruptcy-trial/17706507/
(accessed Nov. 11, 2014).
13. Mary Williams Walsh, "Detroit Emerges From Bankruptcy, Yet
Pension Risks Linger," N.Y. Times, Nov. 11, 2014, available at
http://dealbook.nytimes.com/2014/11/11/detroit-emerges-from-bankruptcy-pension-risk-still-intact/?_r=0
(accessed Nov. 13, 2014).
14. In a municipal bankruptcy the debtor must establish its
eligibility under §109(c) of the Bankruptcy Code.
15. Michigan Constitution, Article IX, §24.
16. In re City of Detroit, Mich., 504 B.R. 97
(Bankr. E.D. Mich. 2013).
17. Id. at 154.
18. Creditor Proposal at 109.
19. Fourth Amended Disclosure Statement With Respect to Fourth
Amended Plan for the Adjustment of Debts of the City of Detroit
(hereinafter the "Disclosure Statement"), Docket 4391, at
158.
20. Nathan Bomey, "Judge Rhodes Questions Orr: 'Why Not
Monetize the Art?'" Detroit Free Press, Oct. 3, 2014,
available athttp://www.freep.com/story/news/local/michigan/detroit/2014/10/03/detroit-bankruptcy-dia/16638995/
(accessed Oct. 23, 2014).
21. To protect the sovereignty of municipal debtors §904 of
the Bankruptcy Code provides that the bankruptcy court has no
authority to "interfere with ... any property of the
debtor."
22. Disclosure Statement, supra note 19, at 157.
23. In 1919, the Institute transferred ownership of the art and its
building to Detroit in exchange for annual funding. However, many
of the works donated to the Institute were given under gift deeds
specifying that the artworks had to remain owned by Detroit for the
benefit of its citizens. See Brent Snavely and Matt Helms,
"Orr Says Settlement With DIA Averted Costly Legal
Fight," Detroit Free Press, Oct. 2, 2014, available at http://www.freep.com/story/news/local/detroit-bankruptcy/2014/10/02/bankruptcy-preview-day/16562469/
(accessed Oct. 28, 2014).
24. Disclosure Statement, supra note 19, at 65-67.
25. Kathleen Gray, "Michigan Senate Oks Historic $195M Detroit
Aid Package; Snyder's Signature Next," Detroit Free Press,
June 4, 2014, available athttp://archive.freep.com/article/20140603/NEWS06/306030043/Detroit-bankruptcy-pensions-artwork
(accessed Nov. 4, 2014).
26. Disclosure Statement, supra note 19, at 62-64.
27. Eighth Amended Plan for the Adjustment of Debts of the City of
Detroit, Docket 8045, at 55.
28. Id. at 59.
29. The Bond Buyer, "Detroit Meditator Orders City to Meet
With Bondholders," Dec. 31, 2013, available at http://www.bondbuyer.com/issues/123_1/detroit-meditator-orders-city-to-meet-with-bondholders-1058615-1.html
(accessed Oct. 23, 2014).
30. Securities and Exchange Commission, Report on Municipal
Securities Market, July 31, 2012, avalailable at http://www.sec.gov/news/studies/2012/munireport073112.pdf
(accessed Oct. 28, 2014), at 24-26.
31. "Detroit Bankruptcy Teaches Muni Bond Investors Painful
Lessons," Bloomberg News, Nov. 7, 2014, available at http://www.crainsdetroit.com/article/20141107/NEWS01/141109896/detroit-bankruptcy-teaches-muni-bond-investors-painful-lessons
(accessed Nov. 12, 2014).
Stephen B. Selbst is a partner at Herrick, Feinstein, where he
is chair of the bankruptcy and restructuring group.
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