Detroit in Context: Understanding Municipal Defaults and Bankruptcy

Prepared for BDA Members by Nixon Peabody, LLP

The filing of the City of Detroits Chapter 9 case on July 18, 2013 may be a game changer. Not only is it the largest municipal bankruptcy case ever filed in the United States, but it presents key issues for resolution that have not been the subject of prior judicial decisions and on which there is substantial disagreement. For example: i) No bankruptcy case has yet answered the question of whether a municipality can use Chapter 9 to trim accrued pension rights where those rights are also protected by a state constitutional provision like the one present in the constitution of the State of Michigan, which provides that they shall not be diminished or impaired. How will the bankruptcy laws treat a general obligation bond in contrast to other debts, whether secured or unsecured? In this context, just what does a pledge of the issuers full faith and credit pledge mean when the issuer goes bankrupt? This issue is at the heart of the City of Detroit Chapter 9 case as the City does not appear to have sufficient revenues to pay in full all of its accrued pension and general obligation bond debts.

ii)

With each Chapter 9 filing, courts are forced to issue rulings that provide guidance about a bondholders relative rights and priorities. The Jefferson County, Alabama Chapter 9 case has so far produced three decisions that flesh out the rights of holders of special revenue debt. However, we simply do not yet have a significant body of case law discussing what it means to hold a general obligation bond backed by a pledge of the full faith and credit of the municipality. This article reviews the basics of municipal bankruptcy law in order to provide context for the upcoming battle in the City of Detroit Chapter 9 case wherein unions and pensioners will clash with general obligation bondholders -- and the needs of all must be balanced with the ongoing needs of taxpayers for essential government services. 1. General discussion about municipal insolvency When a business cannot pay its debts as they become due, it may decide to take advantage of Chapter 11 (reorganization) of the United States Bankruptcy Code (the Bankruptcy Code). Chapter 11 allows the business to keep its creditors at bay while formulating a plan of reorganization by which to restructure its indebtedness. Alternatively, the business may ask the 1

bankruptcy court for permission to sell off its assets as a going concern with the proceeds distributed to creditors. A different restructuring model applies to municipalities. They are prohibited by federal law from either reorganizing under Chapter 11 or liquidating under Chapter 7 of the Bankruptcy Code. Instead, to resolve the tension between states rights as embodied in the 10th Amendment to the U.S. Constitution and the right of the federal government to adopt uniform bankruptcy laws as found in Article 1, Section 8, municipalities are only allowed to file a petition under Chapter 9 of the Bankruptcy Code. Even more restrictively, access to Chapter 9 is permitted only if the state specifically authorizes the municipality to do so. While Chapter 9 shares many of the features of reorganization under Chapter 11, e.g., the automatic stay, the ability to reject certain contracts and leases and the ability to bind recalcitrant creditors to the will of the majority, Chapter 9 has significant differences. Most of these differences reflect the limited role of the bankruptcy court in a Chapter 9 case in deference to the right of each state to govern its municipalities, a deference required by the 10th Amendment to the U.S. Constitution. No involuntary filings are permitted and a municipalitys eligibility to be a Chapter 9 debtor is determined early in the case. The bankruptcy court cannot get involved in the political or governmental functions of the municipality and no trustee can be appointed. For many creditors the Chapter 9 case will be invisible as the municipality has the right to decide which creditors it will pay while the case proceeds and which it will not pay until a plan of adjustment can be negotiated. That plan can only be filed by the municipality with the bankruptcy court limited to setting a deadline for its filing.1 Most importantly for bondholders, a payment made by the municipality to bondholders prior to the Chapter 9 filing cannot be challenged and recovered during the Chapter 9 case. Chapter 9 also suffers from limited judicial guidance resulting from a paucity of prior Chapter 9 cases thereby making hazardous any predictions as to how a bankruptcy court will rule on an issue arising in a Chapter 9 case. 2. The difference between municipal defaults, remedies and municipal bankruptcies A bondholder investing in a municipal security should consider before making the purchase what happens if the municipality does not pay its obligations to the bondholder when due. This requires an examination of i) the bond documents, ii) state law, and iii) bankruptcy law. The remedies available to a bondholder, and the obligations of the municipality, can change significantly once a municipality enters bankruptcy. a. Defaults and remedies under the bond documents. When a municipal issuer defaults by failing to make a payment of principal or interest due on a bond, or by breaching a covenant contained in the bond documents, and once any cure period has passed without the default being cured, bondholders or their agents will be entitled to pursue remedies against the issuer. Some of these remedies will be set forth in the bond
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Bankruptcy Judge Rhoades, who is presiding over the City of Detroit Chapter 9 case, has set March 1, 2014, as the deadline for the City of Detroit to file its plan of adjustment.

documents. For example, if the bond is secured, i.e. it benefits from a statutory lien or a voluntary pledge of collateral, bondholders may be able to enforce their lien against the collateral. Depending upon the nature of the collateral and state law, they may be required to first have a receiver appointed who will take the enforcement action under the supervision of the state court. They may also be able to set off against what they are owed any moneys or securities being held in reserve accounts. b. Remedies under state law In addition to remedies provided in the bond documents, bondholders or their agents may also be able to pursue legal remedies otherwise available under state law. The remedies available will depend upon the nature of the municipal security and the state in which the municipal issuer is located. If the municipal security is an unsecured obligation of the municipality, i.e. there is no collateral pledged to secure the obligation of the issuer to make payment, a lawsuit is likely to be the only available remedy. While the nature of the lawsuit and the person against whom the remedy will be sought will differ from state to state, the lawsuit will seek a court order requiring the municipality to pay the debt. Assets of the municipality generally cannot be attached in satisfaction of what is owed. In either instance, if bond insurance has been obtained the bond insurer (assuming it has the means to do so) should step in and make the regularly scheduled payments of principal and interest due to bondholders, thereby taking over the pursuit of remedies against the issuer. c. Municipal bankruptcy (Chapter 9) Federal bankruptcy law gives certain municipal debtors the ability to alter the rights and remedies available to creditors, including holders of the municipalitys bonds. Generally, municipal bankruptcy is a process undertaken in the federal courts that stays creditors from exercising enforcement remedies while the municipality seeks to restructure its operations and proposes a plan of adjustment for restructuring its debts. However, bankruptcy is not available to all municipalities in financial distress. Rather, state law controls that states municipalities access to Chapter 9. In the words of the Bankruptcy Code, the state must specifically authorize the municipality to file a Chapter 9 case. Why might a municipality want to file a Chapter 9 petition? Simply put, the Bankruptcy Code provides municipalities with specific restructuring tools that are not available to them under state law. The automatic stay, the ability to reject executory contracts and unexpired leases, the ability to obtain the turnover of municipal property seized by a creditor prior to the Chapter 9 filing and the ability to bind a recalcitrant minority of creditors to a plan of adjustment approved by a majority of creditors are tools all unique to the federal bankruptcy laws. A municipality may require the use of any one or all of the tools in order to adjust its relationship with its creditors.

i. The automatic stay The filing of a bankruptcy case stops all litigation against the debtor/municipality. Pending lawsuits are frozen in place and cannot proceed without permission from the bankruptcy court. In Chapter 9, the stay extends to officials of the municipality so that suits against them are frozen. Efforts to obtain property from the municipality are also stayed. This may give the municipality a chance to sit down with the creditor, as was done in the Chapter 9 case of Mammoth Lakes, CA, to work out a settlement. It also allows the municipality time to gather its resources and devise a plan to address all of its debts. ii. Turnover of municipal property A bankruptcy filing also requires that creditors or their agents in possession of municipal property turn that property back to the municipality. Thus, a receiver appointed by a state court at the request of the indenture trustee for the holders of sewer system warrants issued by Jefferson County was required to return possession of the sewer system back to the county once its Chapter 9 case was filed. iii. Rejection of executory contracts and unexpired leases Under state law, a municipality is bound by the contracts and leases it enters into voluntarily. The Contract Clause, appearing in Article I, section 10 of the U.S. Constitution prohibits a state, and therefore municipalities which are creatures of the state, from impairing rights under an otherwise valid contract. This means that if a municipality entered into a contract that no longer makes sense and that the municipality cannot afford, the Contracts Clause prohibits the municipality from voiding that contract under state law unless the contract itself permits or unless the other party to the contract consents. In contrast, if it has access to Chapter 9, the municipality can reject the onerous contact or lease thereby relieving the municipality from continuing to perform its obligations under the contract or lease. It might do so to avoid moving into a new building it can no longer afford, or to get out of employment contracts in retrospect too rich to continue. The Town of Central Falls, Rhode Island used its ability to reject contracts in its Chapter 9 case to get out of expensive employment contracts and the City of Vallejo, California used this bankruptcy power to reject its collective bargaining agreements with several unions. In each instance, the municipality was able to renegotiate the contracts at a substantially reduced cost thereby allowing it to move closer to matching revenues with expenses so that it could emerge from Chapter 9. iv. Binding a recalcitrant minority Another reason a municipality might want to use Chapter 9 is to deal with holdouts when it tries to restructure its bond debt. Most bond documents require 100% of bondholders to consent to a significant restructuring of the bond debt, e.g. one that extends the term of the bonds, reduces principal or significantly reduces the rate of interest. Again, the Contracts Clause is the problem for the municipality. It does not allow the municipality to avoid paying each bondholder what it agreed in the bond documents to pay, even though a majority of bondholders are willing to accept the restructured payments. 4

In contrast, Chapter 9 permits the municipality to propose a plan of adjustment that embodies the restructuring of the bonds and will bind the holdouts to the deal if the municipality can obtain the consent of a majority of the bondholders. Bankruptcy majority is obtained by obtaining the consent of more than half the number of bondholders who hold more than twothirds of the dollar amount owed. If the municipality obtains such a bankruptcy majority in voting on its plan of adjustment, it can bind the holdouts to the deal. While making a deal with creditors outside of bankruptcy may be possible when the number of creditors is limited and they are both reachable and cooperative, getting unanimous consent is often unrealistic when those creditors are numerous, are located in far flung locales or understand that by holding out they might get a better deal for themselves. Some or all of these tools may be required to address the myriad problems faced by the insolvent municipality. 3. There are limitations on a municipalitys ability to access Chapter 9 Not all municipalities in the United States can file a petition under the US bankruptcy laws seeking the protections and tools available to it under Chapter 9. Section 109 (c) of the Bankruptcy Code lists 5 separate conditions that must first be met before the municipality may qualify for Chapter 9 relief.2 As a result, the beginning of Chapter 9 cases is often punctuated with lengthy and costly hearings over whether the municipality has met these conditions. It can be months before an answer is known. For example, the City of Stockton, California filed its
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11 U.S.C. 109. Who may be a debtor (c) An entity may be a debtor under Chapter 9 of this title if and only if such entity --(1) is a municipality; (2) is specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by state law, or by a governmental officer or organization empowered by state law to authorize such entity to be a debtor under such chapter; (3) is insolvent; (4) desires to effect a plan to adjust such debts; and (5)(A) has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter; (B) has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter; (C) is unable to negotiate with creditors because such negotiation is impracticable; or (D) reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under section 547 of this title.

Chapter 9 petition on June 28, 2012, but the bankruptcy court did not rule that it was eligible to be a Chapter 9 debtor until April 1, 2013, a period of over 9 months! The requirement for specific state authorization to file Chapter 9 reflects the delicate balancing of state and federal power that allows Chapter 9 to pass constitutional muster. It requires that the municipality be: specifically authorized, in its capacity as a municipality or by name, to be a debtor under [Chapter 9] by state law, or by a governmental officer or organization empowered by state law to authorize such entity to be a debtor under such chapter. Several Chapter 9 cases have been dismissed for lack of specific state authorization including cases filed by Harrisburg, Pennsylvania and Suffolk Regional Off-Track Betting Corp. The states have taken four different approaches to this requirement for specific authorization. Specific Prohibition: One state, Georgia, has a law on the books specifically prohibiting its municipalities from filing a Chapter 9 petition.3 No Specific Authorization: Some states, including Alaska, Delaware, Hawaii, Indiana, Kansas, Maine, Maryland, Massachusetts, Mississippi, Nevada, New Hampshire, New Mexico, North Dakota, South Dakota, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin and Wyoming, along with the District of Columbia, have no laws on their books specifically authorizing their municipalities to file a Chapter 9 petition. Specific Authorization: Many states have an existing state statute specifically authorizing their municipalities, or some subset of them, and without getting any further consent, to file Chapter 9 cases. However, care must be taken to examine the statute as several authorize a Chapter 9 filing by some types of municipal entities while excluding others. For example, the Arizona, Colorado, Idaho, Kentucky and Washington statutes authorize taxing districts, Montana excludes counties, New York only has authorization for its counties, cities, towns and villages, and Oregon authorizes only its irrigation or drainage districts. Conditional Authorization: States that impose conditions on the right of their municipalities to file a Chapter 9 petition. The conditions vary. For example: o Some states, like Connecticut and Illinois, New Jersey, North Carolina, and Ohio require the consent of a state official before a Chapter 9 filing is authorized.4

See Ga. Code Ann. 36-80-5 which prevent any county, municipality, school district, authority, division, instrumentality, political subdivision, or public body corporate from filing a bankruptcy petition.

o Other states, like Michigan, Pennsylvania and Rhode Island, impose a rigorous process of increasing state supervision of the troubled municipality with the ultimate step in the process, a state receiver for the municipality, having authority to file a Chapter 9 petition either on the receivers own initiative or with approval of a specified state executive officer.5 In Michigan, Public Act 436 allowed the governor to appoint Kevyn D. Orr as Detroits Emergency Manager to take over control of the City in order to see if he could negotiate a deal with Detroits creditors that would obviate the need for a Chapter 9 filing. When that effort appeared doomed with unions looking to the state courts to prohibit a Chapter 9 filing that would involve any effort to reduce pension or retiree benefits, the governor, following Public Act 436s provisions, authorized the Chapter 9 filing. Similarly, Rhode Islands authorizing statute required the town of Central Falls to suffer the appointment of a receiver to assume responsibility for the towns financial dealings as a predicate to filing its Chapter 9 petition. o Still other states, like California, require that the municipality engage in a 60 day meditation process (or certify that an emergency exists that does not allow time for mediation) before a Chapter 9 filing is authorized.6 The imposition of state law requirements that must be met in order for a municipality to file a Chapter 9 petition makes the beginning of the Chapter 9 process litigious. A Chapter 9 case usually involves months of argument and hearings over whether the municipality has met the eligibility standards imposed by state as well as federal law. The recent filing by the City of Stockton is again emblematic. As mentioned above, California imposes on its municipalities an obligation to mediate with its creditors prior to filing a Chapter 9 petition in an effort to reach settlements that might alleviate the need to file for bankruptcy at all. While the City of Stockton engaged in the mediation process, it was not successful and a Chapter 9 filing occurred. Creditors objected to the Chapter 9 filing asserting that the City had not negotiated in good faith because it had refused to negotiate with CalPERS, one of its largest creditors. The City responded by saying that it had negotiated in good faith. At the heart of this dispute is a set of California state laws that the City and CalPERS assert protect CalPERS from municipal bankruptcies. Bondholders have contested that assertion. Without resolving the dispute, the bankruptcy court found that the City was eligible for Chapter 9 relief stating that [n]egotiation is by definition a two-way street. You cannot negotiate with a stone wall. The question of

See Conn. Gen. Stat. Ann. 7-566 (Connecticut-governor); 50 ILCA 320/9(b)(4)(Illinois-Financial Planning and Supervision Commission); La. Rev. Stat. Ann. 13:4741 (Louisiana-State Bond and Tax Board); N.J. Stat. Ann. 52:27-40(New Jersey-Municipal Finance Commission; N.C. Gen. Stat. Ann. 23-48 (North CarolinaLocal Government Commission of North Carolina); Ohio Rev. Code Ann. 133.36 (Ohio-tax commissioner); See R. I. Gen.l Laws 45-9-3, 45-9-5 and 45-9-7, P. L. 246, No. 47 Municipal Financial Recovery Act known as Act 47). On December 26, 2012, Michigan passed Act No. 436 of the Public Acts of 2012. It allows Michigan municipalities to file Chapter 9 petitions with the prior written approval of the governor. It also allows for the appointment of an emergency manager to run a distressed municipality with the emergency manager having the right to file a Chapter 9 petition on behalf of the municipality, but only with the governors prior approval. See Chapter 675, Statutes of 2011 (AB 506, Weickowski).

whether CalPERS is protected in a municipal bankruptcy will likely have to be resolved, either by a negotiated compromise or by a court ruling, before the case can conclude. The City of Detroits recent Chapter 9 filing is likely to raise at least two eligibility concerns that will be considered by the bankruptcy court at the eligibility trial scheduled to begin on October 23, 2013. First, to be eligible to file a Chapter 9 case the municipality is required to prove that it negotiated in good faith with its creditors prior to filing its Chapter 9 petition, or explain why doing so was impracticable. Some creditor constituencies with whom the City did not negotiate prior to filing will likely challenge whether the City satisfied the good faith standard. Second, the unions may challenge the ability of the City to file a Chapter 9 case in an attempt to adjust pension and other retiree benefits in the face of the Michigan Constitution that specifically prohibits the diminishment or impairment of accrued financial benefits of pension plans and retirement systems. Prior to the Chapter 9 filing, the unions sought to enjoin the Chapter 9 filing on this very basis but the Emergency Manager was able to file the Chapter 9 petition before the state court ruled. While an injunction prohibiting the Chapter 9 filing was issued just after the Chapter 9 filing was made, the ruling is a nullity due to the automatic stay that went into effect upon Detroits Chapter 9 filing. Where the municipality cannot take advantage of Chapter 9 because the state in which it is located has not authorized a Chapter 9 filing, or while the municipality is considering whether or not to file in states where that authorization is present, bondholders can use state law to pursue collection of what they are owed. The process will differ from state to state. Moreover, state laws are subject to change. Even in a state that does not currently provide its municipalities with specific authorization to file a Chapter 9 petition, or limits that authorization in some specific way, the state can always repeal or amend the statute or provide a specific municipality with specific authorization to file a petition under Chapter 9. Instructive is what happened to the City of Harrisburg where the legislature passed a specific statute prohibiting a Class C city, a category into which Harrisburg fell, from filing a Chapter 9 petition for a specific period of time. When a Chapter 9 petition was filed, the bankruptcy court granted a motion to dismiss that case for lack of proper authorization. In virtually every Chapter 9 filing, issues are presented to bankruptcy courts on which there is limited or no precedent to look for guidance. A good example is the January, 2012 decision by the bankruptcy court overseeing the Chapter 9 case of Jefferson County in which the bankruptcy court divested a state court appointed receiver for the countys sewer system from possession of the sewer system and granted bondholders the right to reach net sewer system revenues collected by the county after the filing of the Chapter 9 petition. The Jefferson County Chapter 9 case has produced three decisions addressing the rights of holders of special revenue bonds finally filling the vacuum and providing guidance on what holders of those types of bonds might expect when their issuer files a Chapter 9 case. The lack of guidance or confusion over bondholder rights in a Chapter 9 context has caused bondholders, and the professionals who manage the process by which bonds are issued, to

consider more extensive disclosures of risks associated with Chapter 9 filings. Disclosure of the following might be an aid to bondholders: Is the issuer authorized by its state to file a Chapter 9 case? If a Chapter 9 case is filed, will the bonds be treated as secured or unsecured? If the bond is secured, what is the collateral? Is the bond a special revenue bond as that term is defined in Chapter 9 of the Bankruptcy Code? However, due to the limited number of court opinions issued in municipal bankruptcy cases and the resultant uncertainty over how a bankruptcy court might rule on the issues that have not yet been conclusively resolved, the disclosure of bankruptcy risks will most likely continue to be either general in nature or will point out the various arguments followed by an admonition that the issuer cannot guarantee how a court might rule. 4. Conclusion With each filing of a Chapter 9 petition, our understanding of how Chapter 9 works is expanded. The City of Detroit Chapter 9 filing will likely inform municipalities and bondholders alike whether the bankruptcy laws can be used to reduce the level of accrued pension obligations that are significant threats to the future financial health of cities across the country. It is also likely to bring greater clarity to the relative rights of general obligation bonds when compared to other types of debt, including claims of workers, retirees and other types of bond indebtedness.