Detroit’s hasty plan of adjustment

February 14, 2014

Having watched six municipal bankruptcies happen before Detroit filed for Chapter 9 protection, it was never clear why Michigan Governor Rick Snyder and Detroit Emergency Manager Keyvn Orr thought that they could conclude court proceedings in only fourteen months. Previous bankruptcies were much smaller and less complex, and each took several years to conclude.

Detroit’s bankruptcy leaders have set an aggressive schedule to resolve difficult elements of the case. Reuters reported:

Detroit will file a plan to adjust its debt with the Bankruptcy Court next week, an attorney representing the city told the judge overseeing the case on Monday.

Bruce Bennett, an attorney with law firm Jones Day, told Judge Steven Rhodes that Detroit’s filing target of Friday was too tight and needed to be extended.

The city, which filed the biggest municipal bankruptcy in U.S. history in July, sent a proposed plan to creditors on January 29, saying it expected to submit a plan to the court in about two weeks. Rhodes had set an ultimate deadline of March 1 for the city to produce its required roadmap out of bankruptcy.

March 1 is only seven and half months since Detroit filed for bankruptcy last year.

The liabilities of Detroit include several classes of creditors whose proposed treatment by Orr is different from previous municipal bankruptcies. Unlike the bankruptcy of Central Falls, Rhode Island, where retiree pensions were drastically cut with minimal negotiation by the city’s state-appointed receiver, Detroit’s relatively well-funded pension funds had allocated $5 million to fight against the emergency manager. Detroit employees and retirees say that the Michigan Constitution explicitly protects their pensions, even in the event of bankruptcy. This has created several streams of litigation challenging the bankruptcy process.

Healthcare benefits for retirees generally have little to no legal protection. Orr moved to eliminate this coverage as of February 28th and replace it with a $125 per month stipend for those retirees who are not enrolled in Medicare. In 2012, retiree health benefits cost the city approximately $150 million per year, according to the June 14 creditor proposal (page 36). Retired fire and police employees were offered health insurance. The premiums are multiples of the stipend.

I was told on background that retiree groups would be willing to settle with Orr for about half of the supposed $3.5 billion of unfunded pension liabilities. It’s unclear how that sum would be paid to Detroit’s pension fund.

Non-profit groups have pledged $370 million to protect the holdings of the Detroit Institute of Art (DIA) from sale. Governor Snyder has proposed that the state divert around $17 million a year from its tobacco settlement trust to additionally fund the pension funds. State legislators and employee unions seem lukewarm to the idea. Legislators may have reservations, since the Michigan state employee pension fund has only 65 percent of the assets it needs to be fully-funded; a lower rate than either of Detroit’s pension funds. Establishing a funding mechanism for Detroit’s pension funds seems a way off.

Orr had also proposed to haircut, or reduce the principal returned, for a class of bondholders who bought unlimited tax obligation (UTGO) bonds. Bond insurers Assured Guaranty and MBIA are currently fighting Orr to protect these secured bonds from a principal reduction. The security of these bonds is an important issue for muniland.

One of the most complex and expensive pieces of the bankruptcy puzzle is Orr’s treatment of the swap counterparties for the pension obligation certificates of participation issued in 2005 and 2006. The New American describes what has happened:

Orr tried to cut a deal with BofA, UBS (the swap counterparties) and Financial Guaranty where the city would pay just $230 million [instead of a supposed $350 million initial termination fee]. Judge Rhodes said no; it was too sweet a deal for the banks. Orr went back to the three miscreants and cut another deal: $165 million. Again Rhodes threw it out.

The reason? Rhodes thinks the city has a strong case against the three on several counts, including outright fraud and using casino income to fund the swaps. All told there are eight different charges Detroit and Orr could bring against them.

The second rejection by Judge Rhodes of the proposed swap settlement led Orr to sue the service corporations that city had set up in 2005 and 2006 to be a conduit for payments from the city to COP bondholders. This debt is linked to the swaps over which Judge Rhodes rejected the settlement. The Detroit Free Press reported:

The City of Detroit filed a lawsuit Friday aimed at wiping out a massive debt from the Kwame Kilpatrick administration, saying that the now disgraced ex-mayor and city banks established ‘a sham’ legal structure that saddled Detroit with $1.4 billion in debt, which helped drive the city into bankruptcy.

The lawsuit, filed in U.S. Bankruptcy Court against two quasi-legal subsidiaries called ‘service corporations’ and two trusts the city created, challenges a complex pension debt deal brokered in 2005 and 2006 that eliminated the city’s unfunded pension liabilities.

The importance of this part of the bankruptcy can’t be overstated. The COP structure is used extensively in muniland, often to evade legislative or constitutional debt limits. Wells Fargo Senior Analyst Natalie Cohen wrote about the prevalence of the COP structure in a recent note on Detroit:

In California, for example, following Proposition 13, COPs became a common way to build needed infrastructure, particularly for schools. (A quick search of the MSRB EMMA system produced more than 3,500 results in California since 2000.)

How Orr resolves this element of the Detroit bankruptcy is very important to the municipal securities market. Setting a precedent for the full elimination of debt issued in contravention of debt limits could be significant.

Another wild card to arranging the revenue pieces for a post-bankruptcy Detroit is the resolution of the ownership and control of the Detroit sewer and water system. Orr faces massive opposition from suburban leaders over whom neither he nor the bankruptcy court have any control or leverage. From The Detroit News:

Suburban leaders say they’re far from agreeing on joining a regional authority that would run Detroit’s Water and Sewage Department, despite pressure to reach a deal to facilitate the city’s bankruptcy restructuring.

Top aides to Oakland County Executive L. Brooks Patterson made their position clear during a meeting Tuesday night with officials from Macomb and Wayne counties to discuss the proposed authority. Their concerns include forcing suburban customers to bear the brunt of future costs associated with the water and sewer system. Oakland County doesn’t feel it has to make a quick deal with Detroit, deputy executive Gerald Poisson said.

‘They certainly have timelines imposed by the court but we have repeatedly informed them their timelines aren’t ours,’ said Poisson. ‘We are on the hunt for a mutually beneficial agreement.’

It’s a pity that the timetable for Detroit’s bankruptcy is so compressed. With so many important legal issues at stake for muniland, time should be available for litigation to be completed on the issues that have sprung up within the case. The presentation of Detroit’s hasty plan of adjustment should be postponed again.

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