18 June 2014

More On "Municipal Bankruptcy"

A week ago I let folks know that my article Municipal Bankruptcy: When Doing Less Is Doing Best was available for download. You can check out that post here in case you missed it. I also briefly explained its conclusion: A bankruptcy court cannot cram down a municipal plan of adjustment over the objection of a dissenting class of creditors when "bankruptcy fairness" (the twin requirements that a plan must be fair & equitable and must not discriminate unfairly) collides with "state law fairness" (the third requirement, i.e., a plan must be in the best interests of creditors).

In practical terms, this means that the current plans in Stockton and Detroit, which give retirees a greater recovery than bondholders, cannot be confirmed unless the bondholders consent. Why? Because bankruptcy law (in Chapter 9) does not give retirees priority over bondholders and any plan that does so "unfairly discriminates" and is not confirmable.

Conversely, although no city has yet tried, in most states a court could not confirm a plan that proposed to give retirees and bondholders the same recovery unless the retirees consented. Why? Because the laws of many sates provides that once vested, public worker retirement benefits cannot be modified.

A paradox that should drives the parties to make a deal, and, although there's one holdout in Stockton, seems to be doing so in Detroit.

But how have American cities found themselves in such a fix? In particular, why is Stockton in Chapter 9? Here's where my article (download here) begins. Quoting myself,
Long before Stockton sought bankruptcy relief, it had agreed to provide pensions and health-care benefits to its retirees, and had contracted with CalPERS to administer those benefits. The  financial burden of those benefits on the city increased over the decades through what the bankruptcy court characterized as an “encrustation of a creeping multi-decade, opaque pattern of above-market compensation of employees.” From the outset, each labor agreement contained some retirement benefits but over time those benefits increased and thus Stockton’s future obligations to its retirees also increased. By the time it filed, the city provided generous lifetime healthcare benefits regardless of the length of an employee’s service. Its pension plans permitted “add-pays” and “pension-spiking” that allowed employees to manipulate their income for their final year of employment and thus increase the pensions they would receive.

In addition, Stockton had borrowed many million to finance what, even without the benefit of hindsight, were boondoggles. With the collapse of the real estate market in 2008, there simply wasn't enough money go around even with drastic cuts in current expenditures.

So what’s a city to do? File a Chapter 9 bankruptcy, of course. Some city property (like the new city hall!) were surrendered to special revenue bondholders. The police and fire departments were cut. Unionized employees entered into new collective bargaining agreements easing work rules and cutting salaries and benefits for new hires. But none of this was enough to give the city a positive cash flow. Only bankruptcy with a plan to reduce payments on existing debt could right the city’s sinking ship.

But here’s the rub: Would the cuts in payments be shared equally by retirees and bondholders? And, if not, would the set of creditors holding the short end of the stick go along anyway? The answers in Stockton’s plan were no and yes with one exception you can read about here. Stay tuned for in a little more than  two weeks Judge Klein is set to issue his judgment on the plan as it is … unless it changes (as I suspect it will).

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