Detroit and beyond
Conventional wisdom holds that U.S. municipal bonds are a safe investment. Even though U.S. law theoretically allows some municipalities (that is, cities and other political subdivisions of a state, such as water reclamation and sewer districts) to seek bankruptcy relief, such cases have been rare, and in these cases, municipal bondholders have emerged all but unscathed. Given the increasingly acrimonious battles between bondholders and pension funds, the future in this area may well look quite different from the past.
To assess the risks to bondholders in municipal bankruptcies and to understand the onslaught of media reports on high-profile cases like Detroit’s recent largest-ever municipal filing, this quarter’s column examines a few key aspects of U.S. municipal bankruptcy.
Unlike companies attempting to reorganize under Chapter 11 of the U.S. Bankruptcy Code, municipalities seeking relief under Chapter 9 must establish eligibility to file. This is no rubber-stamp process. Creditors have aggressively opposed eligibility in several recent municipal bankruptcy filings, and the Bankruptcy Courts have expended considerable time and effort establishing the satisfaction of these eligibility requirements. Municipalities must clear four key hurdles before being allowed into the reorganization process.
First, only in the context of municipal bankruptcies, U.S. law retains an element from European insolvency law: the debtor-municipality must prove that it is insolvent. There is no similar requirement for company or individual bankruptcy and reorganization cases. Solvent companies may and sometimes do seek to reorganize under Chapter 11.
A municipality, in contrast, must prove that it needs relief; that it is insolvent, which is specially defined to mean that a municipality is unable to pay its debts as they come due. Given the effects of the recent housing crisis on property tax and other city revenues, solvency is likely to be a relatively easy hurdle to clear, even if it is often hotly contested by creditors. The fact that a municipality might theoretically have the ability to create revenue by raising certain taxes is unlikely to defeat a claim of insolvency in light of the practical and often legal hurdles to a city’s taxing its way out of debt. In the case of troubled cities like Detroit, insolvency is all but a foregone conclusion.
Second, the law of the state in which the municipality is located must have specifically authorized bankruptcy filings by municipalities or by a specific municipality. This might be a blanket authorization (“municipalities of this state meeting the following conditions may seek Chapter 9 relief”) or authorization of the state governor or some other entity to review and permit such filings on an ad hoc basis.
Only about half of the U.S. states have a law taking either of these approaches to authorize municipal bankruptcy filings. States hosting prominent municipalities such as Illinois (Chicago), Georgia (Atlanta) and Massachusetts (Boston) currently have no such law. Of course, even in the states that lack such a law now, state lawmakers might respond to the entreaties of a distressed municipality at any time to pass a specific law authorizing a Chapter 9 filing. The public books of cities like Chicago are looking more and more distressed these days, particularly in light of increasingly acrimonious battles with public unions.
Chicago was all but forced to sell the future revenue from its parking meters for the next 75 years to raise a billion dollars to plug a budget gap in 2008, and the sale proceeds are already spent. With rising pension and health care obligations, requests for state legislatures to authorize Chapter 9 reorganizations might not be out of the question for cities like Chicago in the years to come.
On the subject of unions and collective bargaining, a third eligibility requirement is that the municipality must have negotiated in good faith with its creditors. With the agreement of creditors holding a majority in amount of claims of each class from whom the municipality seeks concessions, the municipality can satisfy this “negotiation” factor and proceed with what would likely be a pre-packaged plan.
Creditors vote on a Chapter 9 plan just as they do for a Chapter 11 company reorganization plan, so approval by a majority of creditors satisfies the third eligibility requirement and paves the way to confirmation and implementation, including cram-down on dissenting creditors. More likely, the municipality would have to establish that its failure to secure such majority agreement was the result of an inevitable breakdown in negotiations despite the municipality’s good faith efforts. Public pension funds and unions have been very vocal in their criticism of municipalities’ claims of good faith negotiation.
Once again, though, in light of the sorry state of the finances of many municipalities like Detroit, the old adage about blood and stones will often belie creditors’ claims of lack of good faith negotiation. If there is simply not enough money to pay accrued debts and ongoing obligations for public pensions and city operations – again, setting aside the theoretical but likely impracticable option of a substantial tax levy – this factor will likely established.
The fourth hurdle straddles the line between eligibility for relief and the requirements for ultimately obtaining that relief. That is, the municipality must intend to implement a plan of reorganization for its debts, but Chapter 9 specifically requires for any plan that “the debtor is not prohibited by law from taking any action necessary to carry out the plan.” Creditors in several recent cases, including Detroit’s, have argued that the city must be bent on proposing a plan that violates the law by modifying the rights of certain creditors (most prominently retirees with vested pension rights), and state law (often the constitution) specifically prohibits such modification.
The meaning of “prohibited by law” here is far from clear, and many observers have pointed out that federal bankruptcy law is an extraordinary regime that generally trumps state laws that purport to protect creditor claims. The interplay between federal bankruptcy law and state pension-protection laws raises very sticky and complex issues of federalism and statutory interpretation that will have to be sorted out by the courts of appeals and perhaps even the U.S. Supreme Court.
If the proponents of pension inviolability win the argument, bondholders are likely to be the only creditors left from whom significant concessions can be extracted. If vested pensions can be modified in a municipal bankruptcy, we can expect to see many more municipal bankruptcy filings in the years to come focused on addressing this weightiest of burdens encumbering many large U.S. cities today.
While it is all but impossible to predict how this debate will be resolved, this is the question on which fund managers should be focused in assessing the likelihood of more municipal bankruptcy filings and Conventional wisdom holds that U.S. municipal bonds are a safe investment. Even though U.S. law theoretically allows some municipalities (that is, cities and other political subdivisions of a state, such as water reclamation and sewer districts) to seek bankruptcy relief, such cases have been rare, and in these cases, municipal bondholders have emerged all but unscathed. Given the increasingly acrimonious battles between bondholders and pension funds, the future in this area may well look quite different from the past.their effects on bondholders.