Wednesday, April 9, 2014

The Detroit GO Settlement, and My Halls of Fame and Shame

The monoline insurers MBIA, Assured Guaranty and Ambac ("monolines") scored a major victory when they settled with the City of Detroit with respect to the Chapter 9 treatment of the insured Detroit unlimited tax general obligation bonds (GOs).

The term sheet for the settlement provides, among other things, the following:
  • the entire $388 million claim in respect of the GOs will be allowed in the Chapter 9, and the existing ad valorem taxes securing the GOs will be treated as "special revenues" for purposes of the Chapter 9, thereby rendering the GOs as secured for purposes of the Detroit plan of confirmation.
  • 74% of the GOs will be reinstated for the benefit of the holders (Reinstated GOs), and 24% of the GOs (Stub GOs) will be reinstated and assigned to a fund for the benefit of the poorest Detroit pensioners.
  • ad valorem taxes securing the GOs will continue to be levied in an amount sufficient to pay off all of the GOs, but such tax revenues will be applied first to pay the Reinstated GOs, and any excess will be applied thereafter to pay the Stub GOs.
  • upon plan confirmation, the Reinstated GOs will be exchanged for GOs issued by the Michigan Financing Authority, which will be secured by both the existing Detroit ad valorem taxes as well as a 4th lien on state aid provided by the State of Michigan. There are further bond protections provided.
This is a significant victory for the monolines since the Detroit Emergency Manager (EM) had proposed an allowable claim of just 15%, or $58 million, in the proposed plan of adjustment.  This settlement constitutes an incremental $229 million win for the monolines.

Readers of this blog will not find this settlement win for the monolines to be surprising.  I have previously stated in this blog and in an online debate on the Public Sector Inc. website that I thought the monolines would win this fight with the EM.  It was clear to me that the GOs were secured by ad valorem taxes which were created and levied in connection with the authorization of the GOs, such that these taxes would be treated as "special revenues" and the GOs treated as secured obligations in Chapter 9.

Why the 26% discount if it was so clear that the monolines would prevail?  There are several possible theories.  One is that the monolines perceived some risk that given the weakening of property values in Detroit, the ad valorem taxes would not be sufficient to pay the GOs in full, even if the GO claim was allowed in full. This would explain why the monolines obtained in the settlement further security for the Reinstated GOs in the form of the state aid lien.  

Additionally, remember that the GOs were double barrel bonds, secured by (i) a full faith and credit pledge, as well as (ii) a pledge of specially levied ad valorem taxes in connection with the authorization of the bonds.  The monolines might have been concerned that while Judge Rhodes would find for the monolines on the ad valorem pledge, and therefore provide the monolines an allowable claim in full, Judge Rhodes might have found against the monolines on the full faith and credit pledge, thereby creating an undesirable precedent for monolines to deal with down the road.

Moreover, let's remember, that no matter how certain a litigant may believe it will prevail, one must discount one's chances by at least 10%, given the nasty vagaries of judicial whim.  If one starts with a 90% certainty that the monolines would prevail, settling for a 74% recovery is a meager settlement discount, especially in the face of a 15% offer.

Hall of Fame

My hall of fame award goes to the monolines.  They have proven to all municpal issuers and bondholders the practical value of bond insurance.

Consider this:  suppose you were a bondholder without the benefit of insurance, and the EM just told you that he was going to shaft you by offering $.15 on the dollar, even under circumstances where you rightly believe that on the merits you are entitled to par.  Would you have have been able to contest successfully the EM's proposal in an adversary Chapter 9 proceeding?  Would you have preferred to form a committee of bondholders and commenced litigation against the EM? You would have faced a collective action problem that likely would have prevented you from mounting an effective challenge.

If there was ever a perfect illustration of the value of bond insurance, this is it.  The monolines are keeping the bondholders whole and are obtaining a recovery that is $229 million better than what the EM offered.  Bond insurers provide financing benefits to issuers in the form of reduced interest rates, but they also provide benefits to holders after issuance by assuming the risks and costs of asserting creditors remedies.

Hall of Shame

My hall of shame award goes to the EM.  This is just another example of how the EM has screwed the pooch in the Detroit Chapter 9 proceeding.
  • The EM failed to understand municipal bankruptcy law and recognize the lien underlying the GOs in respect of the pledged ad valorem taxes, and therefore failed to make the monolines a fair offer in the proposed plan of adjustment.  The EM had a good faith obligation to classify Detroit's claims in Chapter 9 properly, and the EM both failed in this regard, and then wasted Detroit resources in trying to defend its failure.  
  • The EM failed to understand municipal bankruptcy law and recognize the absence of any lien securing the swap obligations, which has led the EM to make overly generous offers to the swap banks on two occasions, with the result that each settlement has been rejected by Judge Rhodes.  A third swap settlement between the EM and the swap banks has been teed up for a possible strike three later this week. 
  • The EM stated that it was central to its plan of adjustment that Detroit lease its water and sewer facilities to the surrounding counties, and apply any lease payments in excess of payments on the bonds secured by these facilities towards Detroit's rehabilitation.  The EM has not been able to even begin to implement this proposal, because the EM has not been able to provide the counties sufficient financial information for the counties to even understand the EM proposal, much less negotiate it.
  • The EM failed to find a way to maximize proceeds from the Detroit Institute of Art fine art collection while still maintaining the cultural viability of the DIA.  Here is a meaningful DIA solution offered up by a monoline insurer.  The EM ignored the huge collateral value of the DIA art and has made Detroit pensioners suffer losses because of this EM failure. 
Of course, the EM is good at making public appearances and giving press interviews, and is now busy trying to save face.  Notice this specious explanation from the EM spokesman regarding the GO settlement with the monolines given to a columnist in today's Detroit News:

"Orr spokesman Bill Nowling said bondholders are getting a better deal now because the city previously didn't include revenue from voter-approved property taxes in its iniital offer to investors of Detroit's debt."

This makes it seem like the EM has suddenly become magnanimous in reaching settlement, as opposed to the reality of the situation, which was that the EM was abjectly wrong in excluding such tax revenues as security in the first place in making the GO offer!

One simply hopes that this buffoonery on the part of the EM doesn't dissipate Detroit resources for too much longer.

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Monday, February 24, 2014

Detroit Chapter 9 Redux: Finding the Lien Securing the Insured GOs

In my last blogpost, I discussed the merits with respect to the secured status of Detroit's insured General Obligation bonds (GOs) in terms of whether there had been a pledge as security for purposes of the Bankruptcy Code of the ad valorem taxes that have been levied to provide for the repayment of the GOs.  

In my view, the City of Detroit's emphasis that you won't find the word, "lien", in the granting language of the resolutions was unavailing, given the specific circumstances relating to the issuance of the GOs.

It is apparent, however, that Judge Rhodes won't have to strain himself unduly to find the lien in favor of the GOs that the City of Detroit has argued is absent.

Section 101(37) of the Bankruptcy Code defines "lien" to include "an interest in property to secure repayment of a debt."  I discussed in my last post that the legislative resolutions that authorized the levy and collection of the ad valorem taxes in connection with the issuance of the GOs mandate that Detroit deposit these tax proceeds into a segregated debt repayment account, and use such funds solely to repay the GOs.  Michigan law imposes personal liability upon any city official that doesn't apply such funds in this manner. The legislative resolutions also mandate that the City collect such taxes until the GOs have been retired.

Do the GO bondholders and the monolines insuring the GOs have a property interest in the ad valorem tax collections that are mandated to be deposited into the bond repayment account?  In other words, are such funds secured by a lien in favor of the insured GO bondholders and monolines, for purposes of Section 101(37) of the Bankruptcy Code?

As with all matters construing whether there is a property or security interest in favor of a Detroit Chapter 9 creditor under bankruptcy law, Judge Rhodes must look to Michigan law.  The monolines in their opposition brief refer to a Michigan Supreme Court case, Sawicki v. City of Harper Woods, that makes it clear that, under Michigan law, when taxes are levied and collected for the express purpose of being deposited into a segregated account and used for the sole purpose of paying specified debt, 

"[s]uch money, when collected from the several property owners becomes a trust fund, to be used only for the purpose specified, and when the bonds and interest and other legal expenses chargeable against such fund have been satisfied, the balance belongs to the landowners".

Sawicki makes it abundantly clear that, for purposes of Michigan law, the GO bondholders and the monolines are the beneficiaries of an equitable trust and, therefore, have a beneficial and equitable interest in and to the ad valorem taxes that must be levied, collected and deposited into the bond repayment account.

The GO bondholders' and monolines' ownership of this entire equitable and beneficial interest in and to the tax proceeds makes it clear that the GO bondholders and monolines are secured by a "lien" for purposes of the bankruptcy code.

So, to the City of Detroit's refrain, "where's the lien?", one can simply reply, Sawicki!

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Friday, February 21, 2014

In Detroit Chapter 9, When is a Pledge Just a Promise, Not Security?

The City of Detroit and the monolines have finished their arguments before Judge Rhodes with respect to whether or not the insured Detroit GOs are secured obligations.  What turns on this question?  Seems like about 80% of the insured GOs aggregate principal amount (over $300 million), when you see that the Detroit plan of adjustment seeks to treat secured debt as fully-protected (100% recovery), whereas if the insured Detroit GOs are deemed unsecured, the plan's opening gambit is for only a 20% recovery.

The monolines' argument, boiled down for the sake of brevity (I do write this on a Friday afternoon, after all), seems to be that the resolutions that authorized the issuance of the insured GOs pledged a special levy of ad valorem taxes as a stream of revenue dedicated towards the repayment of the insured GOs.  This dedication took the form of a legislative requirement that the proceeds of the special ad valorem taxes be deposited into a special account, and be used solely for the repayment of the GOs.

Moreover, the legislative resolutions pledge these special taxes, which may only be deposited into this bond repayment account, toward repayment of the bonds.

The City of Detroit argues by asking, "Where's the Lien?"  This form of rhetoric worked for Wendy's, but not candidate Mondale, a few decades ago; will it work for the City of Detroit?  In other words, the City of Detroit is arguing that of the two common language definitions of "pledge," a) a promise, and b) an act of providing something as security for repayment, the proper understanding of the pledge underlying the creation of the insured GOs is only that of a "promise"(and mere promises may be impaired in bankruptcy).

Of course, the monolines argue for "security" as the proper understanding of the pledge, for purposes of constructing the meaning of the legislative resolutions relating to the insured GOs.

Everything turns on this because, if the monolines are right, then the pledge as security of the special taxes will mean these taxes constitute "special revenues" and the insured GOs should be deemed secured, under Sections 902E and 928 of Chapter 9.

Where will Judge Rhodes look for guidance to construe the meaning of "pledge," as it relates to these insured GOs?  He has no choice but to look to Michigan state law.  He has made clear that Michigan state law governs the application of questions like this, as well as whether Detroit's pension obligations were solely unsecured, or secured, obligations.

When Judge Rhodes turns to Michigan law to answer this question, he will be directed by the monolines to a state Michigan court of appeals decision, Kinder Morgan v. City of Jackson (744 N.W 2d 184, 2007), wherein the court states "'obligations pledging the unlimited taxing power of the local governmental unit' are necessarily obligations by which a municipality pledges its unlimited taxing power as security for the repayment of the debt." (emphasis added).

So, my guess is that Judge Rhodes will come to a decision about the secured status of the insured Detroit GOs based upon whether he signifies the word "lien" with shamanistic power, and focuses on the absence of the word in the legislative resolutions, as the City of Detroit would have him do, or is persuaded by the monolines' argument that in Michigan, a pledge is more than a mere promise and signifies security for repayment...especially in the context where, as here, the tax revenues are required by legislative mandate to be deposited only to a restricted account for application solely to repay the insured GOs.

I am still thinking that the monolines have the better of this one.

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Monday, January 13, 2014

Public Sector Inc. Debate on Secured Status of Municipal GOs

debate the "Secured" side of the question, What's the Status of General Obligation Bonds in Municipal Bankruptcy? on Public Sector Inc.'s website.  Public Sector Inc. is a project of the Manhattan Institute's Center for State and Local Leadership

Tuesday, December 17, 2013

Detroit Emergency Manager Does a Laydown on Security for Unlimited Tax General Obligation Bonds

In my last post, I argued that the Detroit unlimited tax general obligation bonds (UTGOs) that MBIA and Assured Guaranty (AGO) insured were secured obligations, based upon the terms and provisions of their issuance under Michigan state law.  This question was recently at issue in connection with the Detroit Emergency Manager's (EM's) request for court approval of a debtor-in-possession (DIP) loan.  

Super-priority claims status for the DIP loan would be granted in all Detroit revenues not pledged to secure repayment of other obligations.  Of course, MBIA and AGO have filed a joint complaint arguing that their insured UTGOs are secured by certain ad valorem tax revenues created at the time the UTGOs were authorized and issued, so this raises the question for the court as to whether these tax revenues would be available to repay the DIP.

The wisdom and efficacy of the DIP has been discussed in an excellent article in the Financial Times by an author who goes by the twitter nome de plume of bondgirl (@munilass).  Focusing instead on the legal question as to whether certain tax revenues secure repayment of the insured UTGOs and are thus not available to repay the DIP, it can only be stated that the EM's argument against such secured status for the UTGOs in connection with approval of the DIP was extraordinarily weak. 

EM's argument was contained in two throw-away paragraphs at the end of his reply to objections to the DIP (EM Reply).

Paragraph 91 of the EM Reply states that MBIA and AGO have presented no evidence that there is a statutory lien upon the tax revenues that they assert secure repayment of their insured UTGOs.  Of course, this is correct.  It is also completely beside the point.

There are essentially two ways that UTGOs can be secured: (i) state law may provide that there is a statutory lien that automatically is granted upon certain revenues upon bond issuance (see Spiotto, Primer on Municipal Debt Adjustment--Statutory Liens Protect Bondholders), or (ii) the terms and provisions of the UTGO provide for the financing of a specified improvement, and are secured by a pledge of taxes that were levied specifically in connection with the issuance of the UTGOs.

MBIA and AGO argue that their insured UTGOs are secured by means of (ii) above.  The EM argued that they were not secured because (i) above was not satisfied.  This response by the EM doesn't meet the red face test.  (One might think that the EM would fire his counsel, Jones Day, after seeing such a weak legal argument made in his case...except that, one recalls, the EM was a partner of Jones Day, and one might assume will again be a partner of Jones Day once the Detroit bankruptcy plan is confirmed.)

The second response of the EM was contained in paragraph 92 of the EM Reply.  Essentially, the EM argues that Judge Rhodes doesn't have to decide now, in connection with his approval of the DIP, whether the insured UTGOs are secured; if the court eventually finds that they are secured, the DIP super-priority claim will not apply to the tax revenues that support the insured UTGOs.

Taken together, these two paragraphs, which constitute the entirety of the EM's response made up to now to the monolines' argument of secured status of the insured UTGOs, are known in the trade as a complete laydown.  You offer one response which is not germane to the question, and you follow with a second response that says if we lose, then we will lose, but you don't have to tell us right now that we have lost.

Accordingly, if the DIP is to be approved on the basis of the EM laydown (hearings are being conducted today and tomorrow), it will carve out (for now) from the DIP loan super-priority claim the tax revenues securing the insured UTGOs.  The proposed order reads:

"There is litigation pending before the Court between certain bond insurers of certain of the limited and unlimited tax obligation bonds, on the one hand, and the City, on the other, in respect of ad valorem property tax revenue (the “Property Tax Revenue”).  To the extent this Court finds and determines (and pending such finding or determination), or approves any settlement or confirms any plan of adjustment that provides that any Property Tax Revenue of the City is subject to a property interest (such as a lien or pledge) of any holders of limited or unlimited tax general obligation bonds issued by the City or that such Property Tax Revenue is not generally available for use by the City other than for payment of such limited or unlimited general obligation bonds and is not available for distribution to general unsecured creditors as part of a plan of adjustment in this case, then the Superpriority Claim granted hereunder shall not, in such circumstance, be paid from the Property Tax Revenue unless and until any allowed claims arising from such limited or unlimited general obligation bonds have been satisfied in full."

So, you have now seen the EM's best shot in support of his initial determination that the insured UTGOs are unsecured, and it is nothing more than a laydown. 

Disclosure:  Long MBI; AGO.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Tuesday, December 10, 2013

Detroit, Chapter 9 Pension Impairment and Special Revenues Pledged to Secure General Obligation Bonds

The Detroit Eligibility Ruling and Impairment of Pension Obligations

In Judge Rhodes's opinion determining that Detroit was eligible to file Chapter 9, Judge Rhodes found that Detroit will be entitled under federal bankruptcy law to impair its pension obligations owed to retired employees in connection with the confirmation of its plan of debt adjustment.

Judge Rhodes determined that these pension obligations were unsecured contractual obligations under Michigan law and, as such, would be entitled to no greater priority of payment under federal bankruptcy law than any other general unsecured Detroit obligation.  While the Michigan state constitution provides that accrued pensions cannot be reduced, the Supremacy Clause of the United State Constitution requires that federal bankruptcy law provisions authorizing impairment of municipal debts and obligations take precedence over this conflicting Michigan constitutional provision.

In other words, the Michigan state constitution can prevent the Michigan legislature from passing a state law that impairs Michigan public pension obligations, but it cannot prevent Congress from passing a federal bankruptcy law that does so.  And in Chapter 9, Congress has unambiguously done so.

Parenthetically, this is not a surprise ruling.  I have been on record that federal bankruptcy law would trump state law (even state constitutional law) where they conflict as to impairment of pensions.  This ruling is likely to be appealed by the public unions to the 7th Circuit Court of Appeals, where I fully expect that it will be affirmed.

Moreover as an aside, because this ruling was so well thought-out and written, it would appear that it will be persuasive in California municipal bankruptcy cases where pension impairment is at issue.  Notwithstanding CALPERS protestations to the contrary, there does not appear to be anything distinctive about Callifornia municipal pension obligations or the California constitutional provisions relating thereto that would argue for a different result.

How Does the Detroit Pension Impairment Ruling Affect Detroit Insured General Obligation Bonds?

Now, it is crucially important to understand the methodology Judge Rhodes used to reach the pension impairment ruling, and understand how this analysis might be applied to determine whether Detroit general obligation bonds (GOs), including in particular the GOs insured by MBIA (MBIA) and Assured Guaranty (AGO), are entitled to be classified as secured obligations for purposes of the Chapter 9 case.

I think there might be some confusion among institutional investors and the municipal finance press/twitterati in this regard.  Some seem to think that Judge Rhodes pension impairment analysis supports the expectation that the GOs will suffer impairment.  Actually, as I will argue below, the methodology adopted by Judge Rhodes in the pension impairment analysis actually supports the monolines' argument that their insured Detroit GOs are secured.

You will remember that (i) the Detroit Emergency Manager (EM) has already proposed to classify MBIA and AGO insured Detroit GOs as unsecured obligations, which would rank them parri passu with pension obligations in terms of repayment priority, and (ii) MBIA and AGO have filed complaints in the Chapter 9 case challenging this proposed determination, and are seeking declaratory judgments that the (a) insured GOs are secured obligations based upon the particular facts relating to their authorization and issuance, and (b) Detroit EM is obligated to segregate ad valorem tax receipts that have been pledged to repay these insured GOs, and apply those receipts solely to the repayment of the insured GOs, as is required by the voter-approved resolutions that authorized issuance of these insured GOs.

To think clearly about how the Detroit chapter 9 case may play out, you have to (i) understand what are the terms of the particular municipal obligation in question, whether it be a plain vanilla GO, a municipal obligation that is secured by a pledge of special revenues, or a pension obligation, (ii) understand the state law provisions that apply to the terms of the particular municipal obligation, and (iii) determine if there is a conflict between those state law provisions and federal bankruptcy law.

The point that needs to be understood is that for the most part, federal bankruptcy law looks to state law to characterize the priority of, and the nature of the security for, repayment of any obligation (indeed, both in corporate chapter 11 and municipal chapter 9 cases).   These state law provisions are simply enforced by federal bankruptcy law.  It is only in the case where state law conflicts with federal bankruptcy law that the state law provisions will not be enforced.  Now, this is not to say that there will be any Detroit obligation that won't suffer impairment in connection with an adjustment of its debts in chapter 9; it is to say, however, that the degree to which an obligation is impaired depends upon its priority ranking and secured status, and this is, largely, a matter of state law under chapter 9.

If you want to understand whether and why pension obligations may be impaired or GOs may be secured, you have to understand the methodology regarding whether the federal bankruptcy law simply enforces state law, or is in conflict with and therefore trumps state law.

The Enforceability Methodology Behind the Pension Impairment Ruling:  Peeling the Onion

The perfect example illustrating this methodology can be found in Judge Rhodes's analysis of the pension impairment issue. 

Judge Rhodes begins with the proposition that it was well within the State of Michigan's power to prevent federal bankruptcy law from being in conflict with state law, and therefore prevent federal bankruptcy law from impairing Detroit pension obligations.  The State of Michigan could have simply declined to enact the specific enabling legislation that authorized Detroit to file a Chapter 9 case.

Federal bankruptcy law looks to state law to determine Chapter 9 eligibility for municipalities within the state, and if the State of Michigan did not enact a statute authorizing Michigan municipalities to file for chapter 9 (remarkably, soon after such proposed authorization was rejected by voter referendum), then Detroit's pension obligation would not be subject to impairment under federal bankruptcy law.  (Laws are laws, and money is money, and one would still be left wonder where Detroit would find the funds to pay its pension obligation, even if unimpaired).

So, by taking the affirmative step that submits Michigan municipalities to federal bankruptcy jurisdiction, Michigan created the opportunity for the conflict between state constitutional law and federal bankruptcy law relating to pension impairment.

But this is just the beginning of the analysis. Before the authority of federal bankruptcy law can be applied to impair obligations and adjust debts, it must be determined what are the terms of the debt involved.  In almost all circumstances, this determination is governed exclusively by state law.  Indeed, before Judge Rhodes applies federal bankruptcy law to the pension obligation, he first analyzes the nature of Detroit's pension obligation, and in doing so, he utilizes entirely a Michigan state law analysis.

Before the Michigan state constitution was amended in 1963 to address public pensions, at common law public pensions in Michigan were viewed as gratuitous allowances that could be revoked at will, because a retiree lacked any vested right in their continuation.  The Michigan Constitution enhanced the public pensioner's security in 1963 by making clear that vested pension rights were contractual obligations of the municipal employer (“The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.” Mich. Const. art. IX, § 24.)

Now, Judge Rhodes pauses to point out that Michigan could have characterized the public pension obligation as something other than a contract right, such as, for example, a property interest.  If Michigan law characterized the public pensioners' interest in pension assets as a property interest, rather than its right to receive pension payments as a contractual right, the federal bankruptcy law treatment of Detroit's pension obligation would have been completely different:  the pension obligation qua property interest would not be subject to impairment, because the pension assets would not be deemed property of the bankruptcy estate of Detroit.

So the State of Michigan served up a double whammy to public pensioners:  it specifically authorized Detroit's chapter 9 and it characterized pension plan assets as Detroit property instead of pensioners' property held in trust for eventual distribution to pensioners when due.

While Judge Rhodes doesn't elaborate upon this property interest point, let's pause to consider the difference between a public defined benefit plan where the pension obligation is a contractual promise to pay made by Detroit, and a defined contribution plan where the pension assets are owned by pensioners and are held in trust and invested on their behalf pending eventual distribution.

The first and most essential difference, of course, is that the pension as contract is subject to impairment in chapter 9, while the pension as property asset of pensioners is not subject to impairment.  The other principal difference is that there is far less opportunity for a municipality to fudge the books on its pension funding.

By using heroic investment income projections, the municipality can underfund the defined benefit plan, and leave pensioners with only an underfunded promise to pay subject to impairment.  With a defined contribution plan, there are no future investment assumptions involved, simply a current annual funding amount that the municipality must meet.  While the pensioners benefits are subject to the vagaries of the pension plan's investment return, this is no different than almost all private pension plans, and the contributed pension assets would be outside the reach of the chapter 9 municipal debtor.

A prominent fixed income analyst has recently suggested that the Detroit pension impairment ruling may have the salutary effect of having municipalities and public unions both find it in their interest to change their pension plans from defined benefit to defined contribution.

Judge Rhodes also went to point out that Detroit's public pension obligation was not secured by any assets.  If security had been given, then the pension assets would be treated as a secured obligation, and entitled to a higher priority of payment than unsecured obligations, and not subject to impairment as unsecured obligations.  The obvious choice of security for the pension obligation was the pension assets themselves.  But the public unions could have been even more creative, and protective of their pensioners.

For example, Detroit's public pension obligation could have been secured by all of the world class (and unencumbered) art owned by Detroit and displayed in the Detroit Institute of Art (DIA).  We are talking about some substantial security value with respect to this art, estimated to be worth well over $1 billion.

Does it sound strange to secure Detroit's pension obligation with its treasure trove of art?  Well, according to this recent article, the mediator in the Detroit bankruptcy case is seeking to require DIA, as a condition of maintaining its art collection and independence, to raise funds from DIA donors and philanthropic organizations, the proceeds of which would be applied towards payment of Detroit's public pensions.  One assumes that the DIA would raise more money in the event that this fundraising effort was being conducted to stave off a secured creditor's auction gavel.

Applying the Enforceability Methodology to the MBIA/AGO Insured GOs

The world of municipal finance is neatly divided between GOs, which are unsecured in bankruptcy but which are entitled to repayment from all of the jurisdiction's sources of revenues, and revenue bonds which are secured in bankruptcy but which are entitled to repayment from only the project or facility financed.  Right?

So this means that the unsecured GOs are subject to a lower priority of repayment in Chapter 9 than secured revenue bonds (assuming the outstanding principal amount of the revenue bonds are fully secured by the value of the pledged collateral), and are parri passu with general unsecured obligations such as pension liability.  Right? 

It is clear that the GO bondholder can go into court and obtain a court order for a municipality which has pledged its full faith and credit to raise taxes sufficient to repay the GOs, but this remedy is unavailable once the municipality has filed chapter 9, which stays all litigation.  So the GO bondholder is left without remedies other than as an unsecured creditor.  Right?

Well, all this must be right, because that is how the municipal finance press and twitterati refer to the universe of municipal finance!  Indeed, prominent investment banking and mutual fund companies subscribe to this view!

Hogwash.  Since when is life in general, and finance in particular, subject to neat division into such tidy and separate parcels?

When you examine the terms and provisions of the bond resolutions authorizing issuance of the MBIA and AGO insured GOs, where each were approved by voter referendum, you will see that these insured GOs share characteristics of GOs as well as revenue bonds.   Some might characterize the Detroit insured GOs as "double barrel bonds."

These insured GOs were issued to finance specific public improvements.  But unlike revenue bonds, which are typically paid from revenues derived from the operation of the financed improvement, the insured GOs are paid from the levy of ad valorem taxes levied by Detroit in connection with the issuance of the insured GOs, but which Detroit did not have the authority to levy without the voter approval of the authorizing bond resolution.  But like revenue bonds, these tax receipts were specifically pledged to repay the insured GOs, were obligated to be segregated from other Detroit revenues and deposited into an account devoted to the repayment of the insured GOs, and no authority was granted to apply these tax receipts other than towards the repayment of the insured GOs.

In other words, the insured GOs are hybrids, revenue bonds secured not by the proceeds derived from the financed facility, but rather from the levy of special taxes created in connection with the issuance of the bonds.  These insured GOs are unlimited to the extent that the millage, or tax rate, is not subject to limitation.

The terms of the insured GOs are further set forth in the MBIA and AGO joint complaint filed seeking declaratory judgment.  I have discussed this complaint in a prior post.

So, in applying the enforceability methodology found in Judge Rhodes impairment ruling to the insured GOs, one can see that Judge Rhodes will analyze the insured GOs in accordance with their terms and applicable state law, and determine whether the insured GOs are secured by the tax receipts that were pledged to repay them, and whether those receipts should be segregated by the Detroit EM and applied solely to the repayment of the insured GOs.  The Detroit EM is currently commingling these tax receipts with general funds and has defaulted on the insured GOs.

While we have not seen the Detroit EM's answer to the MBIA and AGO joint complaint, it is not clear to me how he can successfully argue that under applicable Michigan law, the insured GOs are not secured obligations of Detroit, and entitled to priority of payment as such.

However, there may be two avenues that he might pursue, (i) first, to defend his failure to segregate the tax receipts securing the insured GOs, and (ii) second, to claim that the insured GOs, even if treated as secured obligations under Michigan law, nonetheless lose their secured status by application of Sections 902(2) and 928 under chapter 9.

As to the first possible answer, the Detroit EM may cite to powers reserved to the municipal chapter 9 debtor under Sections 903 and 904 to exercise generally the political and governmental powers of Detroit, including expenditures for such exercise.  See generally Spiotto, Primer on Municipal Debt Adjustment--Unique Features of Chapter 9.

While the chapter 11 debtor is subject to substantial bankruptcy judge and creditor committee oversight regarding the conduct of business in the ordinary course by the debtor, it was thought that it would be too undemocratic to bestow similar powers to the chapter 9 judge and creditors.  Therefore, it is up to the Detroit EM, rather than Judge Rhodes or any creditor committee, to decide, for example, how much to budget for police as opposed to fire safety.  I think it is highly unlikely that this reserved governmental power can be stretched to include the putative power of the Detroit EM to ignore the terms of the insured GOs requiring segregation of tax receipts pledged to repay the insured GOs.

The second possible answer by the Detroit EM is that the tax receipts securing the insured GOs are not "special revenues" under Section 902(2), such that the pre-petition pledge of tax receipts securing the insured GOs does not continue to apply post-petition to the receipt of those taxes under Section 928.  If the Detroit EM is right in this regard, the insured GOs lost whatever secured status they might have enjoyed once Detroit filed for chapter 9.  See generally Spiotto, Primer on Municipal Debt Adjustment--Special Revenues Pledged to Bondholders.

Section 902(2)(E) provides that "special revenues" includes... "taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sale, or income taxes (other than tax increment financing) levied to finance the general purpose of the debtor."  As Spiotto elaborates, "Under clause (E), an incremental sales or property tax specifically levied to pay indebtedness incurred for a capital improvement and not for the operating expenses or general purposes of the debtor would be considered “special revenues.” (at p.29 of Primer). 

When you parse through the bond resolutions that authorized the issuance of the insured GOs and the levy of the taxes pledged to support their repayment, it seems to me that these tax receipts constitute "special revenues" for purposes of Section 902(2)(E).  If so, the pledge of these tax receipts in favor of the insured GOs should survive the filing of the chapter 9 petition and continue to secure payment of the insured GOs under Section 928, and the Detroit EM should be ordered by Judge Rhodes to segregate such tax receipts and apply them solely to the repayment of the insured GOs.

Cautionary Tale

It is improper to extrapolate the treatment under federal bankruptcy law of Detroit pension obligations to Detroit insured GOs without being careful to observe the methodology used by Judge Rhodes in the pension impairment ruling.  One needs to pay attention to the terms and provisions of the relevant municipal obligation, and how state law applies thereto. 

Even more so, it is improper to extrapolate the reasoning that one may eventually glean from the treatment under federal bankruptcy law of Detroit insured GOs to the massive outstanding supply of GOs issued by various municipalities nationwide.  

Consider this article:  Detroit Puts $1.1 Trillion of G.O.’s Under Scrutiny: Muni Credit. Hopefully as we have seen by now, it is not the label of the security but rather its terms and provisions, as well as the applicable provisions of state law, that matter.

Disclosure:  Long MBI; AGO.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.