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.

Friday, November 8, 2013

MBIA and Assured Guaranty File Joint Complaint in Detroit Bankruptcy Case (and Raise Possibility of Personal Liability for Detroit's EM, CFO and Others)

In a prior post, I suggested that the security underlying the Detroit unlimited general obligation (GO) bonds that MBIA and Assured Guaranty (AGO) insured might not be sufficient for these bonds to enjoy secured status in the Detroit bankruptcy case, especially given Detroit's Emergency Manager's treatment of these bonds as unsecured.

I have now read the complaint filed by MBIA and AGO in the Detroit bankruptcy proceeding seeking a declaration that i) Detroit has no equitable or beneficial interest in the proceeds of the ad valorem taxes levied pursuant to voter-approved resolutions which authorized the issuance of the insured GO bonds, and which require that the taxes so levied be deposited into a segregated account and be used only for the payment of the bonds specifically authorized pursuant to such voter-approved resolutions, and ii) Detroit has no authority to grant a super-secured lien on these ad valorem taxes in favor of the lenders in a proposed debtor-in-possession loan.

I think I might want to reconsider my prior thinking on the matter.

The complaint recounts the procedure taken by Detroit in connection with the issuance of these insured GO bonds.  In particular, these bonds are supported by the pledge of ad valorem taxes that Detroit was not authorized to levy, under the Michigan constitution, in the absence of a voter-approved resolution providing for i) the issuance of the insured GO bonds, ii) the levy of additional ad valorem taxes to support repayment of the bonds, and iii) the requirement that these ad valorem taxes be deposited into a segregated account and applied solely to the repayment of the insured GO bonds specified in the voter-approved resolution.

The complaint also walks through the provisions of Michigan statutory law that enforces the obligation of a municipality like to Detroit to honor its pledge and application of ad valorem taxes when such taxes are levied pursuant to a voter-approved resolution.

The complaint also highlights that Michigan statutory law imposes personal liability on any government officer that contravenes this application of the proceeds of the ad valorem taxes supporting the bonds issued pursuant to voter-approved resolutions.

Now, if there is a conflict between federal bankruptcy law and state finance law in a bankruptcy case, the Supremacy Clause of the US Constitution requires that federal bankruptcy law prevails.  But MBIA's and AGO's complaint argues, quite rightly in my view, that there is no conflict presented by federal bankruptcy law and provisions of the Michigan Constitution and Michigan statutory law that require the segregation of taxes and the use of those taxes for the single purpose of paying bonds that have been approved by voters in the resolution that created the bonds and the taxes.

This is not the situation where the Michigan Constitution provides that pensions cannot be impaired, and federal bankruptcy law generally provides for the impairment of obligations.  That is a direct conflict and, in my view, federal bankruptcy law will trump state law.

MBIA's and AGO's complaint shows how these provisions of Michigan state law set forth the terms of, or characterize, the insured GO bonds, and there is no provision of federal bankruptcy law that purports to transform a secured obligation into an unsecured obligation, or which purports to provide a debtor municipality an unfettered beneficial interest in funds which are the proceeds of taxes levied for a specific purpose and which are required to be applied only for that purpose.

I have no doubt that Detroit's EM, now alleged by MBIA and AGO to be on the hook personally for the diversion of funds from payment of the insured GO bonds (this diversion is already more than $9 million in amount), will argue that Chapter 9 goes beyond standard corporate bankruptcy provisions in authorizing the municipal debtor to apply proceeds for legitimate governmental functions in the manner it sees fit.

However, the ambit of whatever powers a municipal debtor might have beyond a corporate debtor has not been elucidated by the federal bankruptcy courts, and the notion that Chapter 9 goes so far as to trump a voter-approved resolution specifying how specially approved tax levies may be applied, where Chapter 9 does not so provide in clear and specific language, seems to me to be a bit of a stretch.  (My personal view is that unlike a Chapter 11 corporate debtor, a Chapter 9 municipal debtor has wide latitude in determining how to apply funds that are legally at its discretionary disposal; that is to decide to use unrestricted moneys to fund the police department a certain amount and the fire department another amount.  It is by no means clear that this enhanced discretion permits the Chapter 9 municipal debtor to apply funds in any manner that it sees fit that are the subject of a voter-approved resolution, which requires under state law that those funds to be segregated and applied for a specific purpose.)

I am wondering if after Detroit's EM read this complaint he started to reread the indemnification language that may apply to the performance of his duties.

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, October 4, 2013

The Supremacy Clause and the Difference between Stockton and Detroit

There has been some muddy thinking about the Chapter 9 bankruptcies of Stockton and Detroit involving the potential application of the Supremacy Clause of the U.S Constitution to conflicts between federal bankruptcy law and provisions of state constitutions.

Let's be clear when the Supremacy Clause applies, and when it does not apply.

In  my view, the Supremacy Clause applies in the case of Stockton because there is a direct conflict between the provisions of Chaper 9 and the California constitution.  The California constitution contains a provision that prohibits the reduction of vested pension benefits of retired Stockton public employees.  However, these vested pension benefits are a simple unsecured liability in the view of federal bankruptcy law, and if in connection with a fair and equitable plan of adjustment Stockton wanted to impair these benefits, or was required to do so in order to get that plan confirmed, it is clear in my mind that federal law would prevail to uphold pension fund impairment. 

Why?  Because the Supremacy Clause says so.

It appears that with recent agreements reached between Stockton and its municipal finance insurers, Stockton may avoid confronting this federal/state law conflict issue.

Detroit's chapter 9 case may also eventually involve a federal/state law conflict over pension impairment.  If so, my view regarding the application of the Supremacy Clause and federal law prevailing would apply as well in the case of Detroit.  But I want to focus on another issue in the Detroit case that, contrary to what I have read in some press reports, does not invoke application of the Supremacy Clause.

In the case of the Detroit bankruptcy, there is a significant question under the Michigan constitution regarding the Emergency Manager's classification of the unlimited general obligation bonds (GOs) as unsecured debt, and the application of tax revenues specifically approved by voters to support those GOs towards the payment of other obligations and expenses.

This is a classification question which creates no conflict between the Michigan constitution and federal bankruptcy law.  The Supremacy Clause is only invoked to say that federal law prevails if there is a conflict between federal and state law.  In the case of Detroit, federal bankruptcy law looks to state law to determine whether an obligation should be treated as secured or unsecured in the bankruptcy proceeding.

Federal law is agnostic on the question.  Therefore, the Detroit Emergency Manager has no power under federal law to treat the GOs as anything other than secured, if indeed the Michigan constitution so provides.

Another instance of federal bankruptcy law agnosticism is whether a municipality is authorized to file to commence a Chapter 9 case.  Chapter 9 looks to state law for this answer.

*   *   *   *   *

As a side note, I have heard much commentary about the Detroit Institute of Art's (DIA) art collection being held "in trust" for the benefit of the people of Detroit (and therefore unreachable by creditors in bankruptcy).  I have one question.

Where is the trust instrument?

If DIA and Detroit wanted its art collection, valued at $2-3 billion apparently, to be owned by a trust and insulated from Detroit creditors, it certainly could have done that (absent the existence of any grantor proscriptions that I have not heard about).

$2-3 billion worth of art looks to me like pretty good collateral that could be applied towards the rebuilding of Detroit.

Tuesday, September 17, 2013

A Mediator's Perspective on Detroit's Bankruptcy

It has been reported that Detroit's creditors and its emergency manager have begun to meet with the mediator assigned to Detroit's bankruptcy proceeding, and so begins the slow and painful process by which a consensual plan for the adjustment of Detroit's debts will be constructed.

As a commercial mediator, I would expect that the process will follow a certain pattern.

Initially, the parties will identify their positions.  Detroit's emergency manager has already put a bid on the table, 80% haircut for bond creditors.  The bond creditors will insist on no haircut, although they are willing to negotiate some terms.  This, of course, will proceed nowhere.

The mediator's task at this point is to move the parties off their respective positions, and have them identify their interests.

Detroit's emergency manager will identify a whole host of Detroit interests that he wants Detroit to be able to pursue, from infrastructure improvements to basic health and safety upgrades, and he will insist that Detroit cannot pursue these without financial flexibility garnered through a radical reduction in Detroit's outstanding debt.

The creditors' interests are that they avoid financial loss, but they are willing to continue to participate in the construction of the financial solution to Detroit's reconstruction.  They will argue that Detroit will not be able to resolve its issues without continued access to financing, and future financing will not be on offer if current creditors are forced to bear losses.  Bond insurers, who in game theoretic terms are repeat players, have a particular interest in not taking a haircut that signals any willingness to accept losses in future restructurings.

At this point, the mediator will need to make a pivot, to avoid having the parties continue to dig themselves into an argumentative hole.  This mediator's pivot often involves the realization that there are not enough parties at the table, and indeed the most important party to the solution of the conflict is missing.

In order to resolve this conflict, the mediator will need for the State of Michigan to get involved in the process of crafting the solution.  Michigan was instrumental in creating the conflict, inasmuch as Detroit was unable to file as a chapter 9 debtor without enabling legislation passed in the Michigan legislature and signed by the Michigan governor.  Michigan Governor Snyder specifically authorized Detroit's chapter 9 filing.  Now, Michigan needs to be instrumental in resolving the conflict.

Michigan has every interest in seeing Detroit exit bankruptcy and have continued access to the financial markets.  The quicker Detroit is able to accomplish this, the sooner Michigan's other municipalities will escape the financing taint of Detroit's bankruptcy by association.  Moreover, Michigan's participation in Detroit's plan will provide political cover for difficult sale and outsourcing decisions Detroit will likely have to embrace, much as Pontiac had to do.

How might Michigan bring Detroit and its creditors together?  It could take any number of practical solutions, such as having Michigan, or some financial subdivision, act as a first loss guarantor on a certain amount of principal and interest of Detroit's refinancings coming out of bankruptcy.  Michigan could also sponsor private/public partnerships that would invest in Detroit infrastructure improvements. 

Detroit's pension leaders have a constructive role to play in crafting a solution that doesn't just involve accepting a haircut.  One might remember the wisdom and courage of Victor Gotbaum some 40 years ago when he pledged that DC37 would buy New York City bonds that no one else wanted. But one might think it reasonable for Detroit's pension leaders to ask what role Michigan is going to play before they commit pension assets.

There are many possible solutions, but I don't see the mediator getting any of these possible solutions on the table unless Michigan is at the table.

Thursday, September 12, 2013

The Difference Between Detroit and Puerto Rico

It seems muniland has gone on a Puerto Rico default watch recently, as it searches the next domino to fall after Detroit.  This is misguided.  Dominoes is a particularly inapt analogy to use in analyzing risk in muniland (as Meredith Whitney might have learned), and this Puerto Rico default watch too shall soon pass.

The principal difference between Detroit and Puerto Rico is that Detroit wanted to default and Puerto Rico doesn't want to default.  Detroit carefully planned out its default, getting special state legislation passed to enable it to become a chapter 9 debtor, and Detroit's game plan is to impose significant haircuts on bond and pension creditors, since Detroit knows it won't be able to access public muniland markets after its chapter 9 filing until well after the cows come home.

Puerto Rico cannot avail itself of chapter 9, and the last thing it wants is to commence a massive creditor restructuring outside of a court-supervised process.  This is not to say that Puerto Rico doesn't face significant economic development issues going forward, but muniland should regard Puerto Rico's successful pension reform that it concluded earlier this year as the best evidence that Puerto Rico not only needs public finance markets but that, unlike Detroit, Puerto Rico places great importance on having continued access to them.

Disclosure:  No holdings of Detroit or Puerto Rico debt.
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.

Wednesday, August 14, 2013

After NoMotown, What Does It Take for GO's to be Secured in Bankruptcy?

Now that Motown has become NoMotown with Detroit's Chapter 9 filing, the question has been framed as to whether the current structure for municipal general obligation bonds (GOs) is sufficient to require their classification as secured for bankruptcy purposes.

The question has huge financial consequences for bondholders and municipal insurers.   If GOs are secured, they will continue to be paid during the pendency of the bankruptcy, and they are more likely to be unimpaired in connection with the rearrangement of debts confirmed in the bankruptcy plan.

It is safe to say that the general expectation among municipal finance practitioners was that GOs should be classified as secured in bankruptcy.  Detroit's bankruptcy filing classifying its GOs as unsecured has caused a cris de coeur within the municipal finance market and, while it is by no means assured that the federal bankruptcy judge in the Detroit case will concur with Detroit's classification of its GOs as unsecured for bankruptcy purposes, I have commented that I thought such treatment was quite plausible.

In essence, there is a difference between security for municipal finance and bankruptcy purposes.  The pledge by a municipality of its full faith and credit to pay principal of and interest on GOs, dedicating tax revenues unlimited in rate and amount to back that pledge, identifies for bondholders what is the municipality's source of funds to make these GO payments, and bondholders can assess, from a financial point of view, the security of such repayment.  This pledge is clearly enforceable outside of bankruptcy.

This pledge, from a bankruptcy point of view, is likely to be characterized as an executory contract that may be rejected as unenforceable by a municipality in bankruptcy.  As I have commented in Detroit and Pandora's Box Part II, there are serious repercussions to a municipality's decision to accord its GOs such unsecured treatment, but bankruptcy has a way of focusing the municipality's mind on the short term as opposed to its ability to sell its bonds in the longer term.

So what is a GO bond investor and municipal finance insurer to do?

I would be shocked if future GOs are not structured in a fashion that provides greater security in bankruptcy, at least in those jurisdictions where municipal bankruptcy filings are not prohibited by state law.  This can be easily done.  One of my suggestions is to require in the GO enabling authorization that tax receipts be deposited in a lockbox, and a security interest be granted GO investors in that lockbox.  The lockbox is controlled by a bank that is required to pay, first, required principal of and interest on the GOs, and, second, disburse to the municipality remaining funds for disbursement as the municipality sees fit.  In this way, as long as the municipality levies taxes, the priority (and hence security in bankruptcy) of GO investors and municipal finance insurers will be clear.

To a surprising degree, finance follows trends, much as hemlines rise and fall in the fashion world.  The taboo of a large municipal bankruptcy has been broken and while it would be wrong to expect many NoMotown copycat bankruptcy filings (because municipalities must prove insolvency on a paying its obligations as they come due basis, as opposed to a balance sheet basis, and this is a point of extremis that few municipalities other than Detroit can claim), it is not wrong to expect that those municipalities that can make a bona fide bankruptcy filing will be more likely to do so in the future.

If I am right in this regard, then municipal finance insurers in particular need to insist on a revised GO structure to deal with the moral hazard bomb that NoMotown has just dropped.

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, July 23, 2013

Detroit and Pandora's Box Part II

In my last blog post, Detroit and Pandora's Box, I posited that various stakeholders in the Detroit Article 9 bankruptcy were in for some unexpected consequences.  I have since received some well-considered feedback, and push-back, on this blog post, so I thought I would elaborate on my thinking just a bit more in this follow up post.

1.  Detroit Pensioners and Impairment.

I argued that notwithstanding the provision contained in the Michigan constitution prohibiting reduction of vested pension fund obligations, Detroit would be authorized to confirm a plan in Chapter 9 in which these pension fund obligations will be impaired.

Generally, when federal and state law conflict, the Supremacy Clause of the US Constitution states that federal law prevails.  The only limitation to this principle is to found where the federal law itself defers to and recognizes that provisions of state law are controlling.  

The most obvious example of the deference of federal bankruptcy law to state municipal law is with respect to the eligibility of municipalities to file under Chapter 9.  Chapter 9 makes clear that it is state law that specifies whether a municipality is eligible to file and under what terms.  In the case of Detroit, special legislation was enacted authorizing Detroit's filing, provided the governor signed off on the filing and Detroit had made a prior good faith effort at negotiating an out of court reorganization.

The state pension fund interests will argue, just as Calpers has argued in Stockton, that Article 9 by its terms defers to the inviolability of state pension fund obligations where state law so provides.  The argument is that Article 9 , Section 903, states that Chapter 9 

"does not limit or impair the power of a State to control, by legislation or otherwise, a municipality of or in such State in the exercise of the political or governmental powers of such municipality, including expenditures for such exercise."

This argument goes on to hold that where the State has prescribed that vested pensions may not be impaired, the State has made this prescription in the exercise of its political/governmental power, and Chapter 9 may not contravene this political/governmental decision by impairing obligations incurred in connection with the political/governmental power.

I am not buying it, and I don't think any federal bankruptcy court judge will either.  This argument proves too much, because it is the exception that swallows the entire federal bankruptcy law as it applies to municipalities.  Indeed, a municipality could argue that all of its outstanding debts were incurred in connection with the exercise of its political/governmental authority.  If true, then all federal bankruptcy judges would be powerless to exercise federal bankruptcy jurisdiction in the case of municipal obligations which, all reasonable minds might agree, was not what Section 903 intended.

The reservation of political/governmental decision making authority to the municipality in a Chapter 9 proceeding relates to those governmental functions in the ordinary course of municipal governance, such as whether to spend $X for police and $Y for fire fighting, and so on.  This reservation keeps the federal bankruptcy judge out of those decisions relating to the provision of municipal services that should be responsive to democratic oversight, inasmuch as municipal residents can vote in municipal elections for municipal officers but not for federal judges.  

In my view, this deference to municipal political/governmental decision was intended to keep a judge out of the micro-budgeting for municipalities on an ongoing basis within the Chapter 9 case itself, and was not intended to render inviolable pension fund obligations that are outstanding, unsecured obligations of the municipality, or any other outstanding municipal obligations for that matter.  These obligations are the typical sort of debt that may be rearranged by the municipality in bankruptcy. 

2.  General Municipal Obligations and Impairment.

Detroit Emergency Manager Kevyn Orr has categorized unlimited general municipal obligations of Detroit as unsecured obligations, parri passu with pension fund obligations.  This has caused consternation within the municipal finance market, as it was thought that these general municipal obligations were secured insofar as they are backed by a pledge of tax revenues unlimited in rate and amount sufficient to pay off the general municipal obligations.  If unsecured, the general municipal obligations will not pay interest while in bankruptcy, and will rank in priority below the rank they would have had they been if classified as secured.  Moreover, the likelihood of impairment for general municipal obligation bondholders and monoline insurers that issued insurance in respect of these obligations will be much greater if they are classified as unsecured than if classified as secured.

In my view, you have to separate in your mind security for purposes of financial analysis and security for purposes of federal bankruptcy law.  Municipal obligations backed by an unlimited pledge of tax revenues are secured outside of bankruptcy by an enforceable obligation of the municipality to collect tax revenues, and increase those revenues if necessary in order to pay off the bonds.  If the municipality doesn't raise sufficient tax revenues, this obligation may be enforced by a bondholder in state court.  

Inside bankruptcy, not every obligation is enforceable.  In my view, the pledge of tax revenues is an example of an obligation that may be rejected in bankruptcy.

The promise to collect taxes sufficient to pay off the general municipal obligations is an executory contract of the municipality which may be rejected in bankruptcy court by Detroit, as debtor.  Moreover, if Detroit decides during its bankruptcy proceeding to increase its allocation of tax revenues towards police and other municipal services, this is a proper exercise of political/governmental authority that the federal bankruptcy judge, and therefore creditors, cannot countermand, as discussed above.  In this respect, bankruptcy law for municipalities is more lenient for the debtor than for corporations.

The best analogy that I can come up with is the example of a pledge of a security interest which is unperfected.  An unperfected security interest results in an obligation that is not secured.  Now, if the general municipal obligation was secured by a security interest in a lockbox into which all tax revenues were required to be deposited, and the terms of the instrument creating the general municipal obligation and governing the lockbox made it clear that the lockbox would be subject to a waterfall payment structure, whereby the payment of general municipal obligations came first and before payment of all other municipal services, then you might have a secured general municipal obligation for purposes of bankruptcy law.  It is not my understand that those are the terms of Detroit's general municipal obligations.  Perhaps going forward, that is how general municipal obligations should be structured.

3.  Detroit Institute of Arts Museum and the Mother of all Auctions.

The Detroit Institute of Arts Museum (DIA) is a magnificent museum that holds well over $1 billion of art that is owned by Detroit.  The DIA has stated its intent that its artwork is held in trust for the cultural benefit of future Detroit residents, and should not be subject to sale in connection with Detroit's bankruptcy.

Now, outside of bankruptcy, this is a fine statement of intent.  It makes clear that the museum is dedicated to cultural education, as opposed to investment gain.  DIA's art is not considered by Detroit to be some portfolio investment (which has probably done quite well, thank you), but rather a cultural legacy.

Inside bankruptcy, this expression of ownership intent matters not one whit.  The art held by DIA is an asset owned by Detroit, and creditors will argue that its value should be marshalled towards the payment of Detroit's obligations in connection with any rearrangement of Detroit's debts.

One wonders whether Detroit will argue that the decision to continue ownership of DIA's art, as opposed to its liquidation and application of the proceeds thereof towards payment of Detroit's obligations, is a valid exercise of Detroit's political/governmental decision making authority, which as discussed above is beyond the jurisdiction of the federal bankruptcy judge.  However, it is one thing to ask creditors, including municipal employee pensioners, to suffer a haircut, and quite another to ask these creditors to stand idly by while over $1 billion of artwork sits on walls that are only less frequently visited by a city population that has dwindled from over two million to about seven hundred thousand.

I expect that if Detroit tries to impose a significant haircut on municipal creditors, a bankruptcy judge will be inclined to order an auction of DIA's art at the request of creditors.  I think a more likely outcome will be some sort of global refinancing of Detroit's debts where a haircut might be nominal, where DIA's artwork might serve as collateral to secure the repayment of this refinancing.  There is no way to know how this will play out. 

4.  Monoline Insurers and the Path Forward

MBIA and Assured Guaranty have written insurance on several billion dollars of Detroit water and sewer bonds that Mr. Orr has proposed to refinance.  Moreover, it is likely that any bonds issued by Detroit coming out of bankruptcy to finance itself going forward will require insurance.  Mr. Orr, Detroit and the monolines may be strange bedfellows, but their interests are frankly more aligned
than opposed at this point.  Mr. Orr has to keep the monoline insurers onside as working partners if Detroit wants to exit bankruptcy with an acceptable financial outlook.

I see Detroit as an opportunity for the monolines to reestablish the utility of municipal financial guaranty insurance both to the marketplace and issuers alike.  As long term interest rates begin to climb, the monoline business opportunity will only expand.

Disclosure:  Long MBI.

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, July 19, 2013

Detroit and Pandora's Box

Detroit's filing for Chapter 9 bankruptcy protection was not only expected, it makes sense from Detroit's point of view.

Essentially, Detroit had nothing to lose--the services it provided Detroit residents were already so bad that there will likely be no discernible degradation in services provided by Detroit under Chapter 9, and something to gain--Detroit was unfinanceable before the filing, subsisting on a financial drip line from Michigan, whereas after filing, lenders can provide Detroit financing which will be treated as an administrative expense under bankruptcy law.  These lenders will get repaid on a priority, last in, first out basis.

But there can be many outcomes from the filing that will definitely be unexpected for various stakeholders, and we can pause to consider what may lie within Pandora's box.

1.  Impairment and Pension Obligations.

Michigan's state constitution contains a provision upholding the inviolability of pension obligations.  While this provision prevents Michigan legislatures from reducing Detroit's vested employee pension obligations, it does nothing to prevent a Chapter 9 bankruptcy proceeding from reducing Detroit's vested employee pension obligations.  Detroit pensioners have the Supremacy Clause of the US Constitution to thank (or should I say blame) for that.

2.  Impairment and the Taxing Pledge Underlying General Obligation Bonds.

General obligation bonds were considered extremely safe by the municipal finance market because they are backed by the municipality's pledge to raise and collect taxes in an unlimited amount sufficient to pay the bonds.  Outside bankruptcy, if the municipality did not stand behind its pledge, the bondholder could walk into state court and obtain a writ of mandamus ordering the municipality's elected officials to honor that pledge.

Inside bankruptcy, that pledge is just another executory promise which can be rendered unenforceable in connection with the municipality's rearrangement of debts. Bondholders could expect a municipality to refrain from filing for bankruptcy, it was thought, since by doing so, that municipality would know that it had just become unfinanceable in the public markets, and no municipality would dare do such a thing.

You can now file this market expectation as another quaint American myth.  MBIA, Assured Guaranty and Ambac can expect to take a haircut on their general obligation wraps.

3.  Has All of Michigan Just Become Unfinanceable?

Under the state legislation authorizing Detroit's Chapter 9 filing, Michigan Govenor Snyder had to sign off on the filing.  Mr. Snyder's and Michigan's fingerprints are all over this filing.  I would expect the municipal finance market to interpret Detroit's filing as a direct attack on the municipal finance market by Michigan itself because, after all, it was Michigan that was backstopping Detroit's ability to finance itself prior to the filing.

To put it bluntly, it has just become a very unwise career move for a municipal finance mutual fund advisor to buy not only Detroit obligations in the future, but frankly obligations of Michigan as well.  What does that advisor say to her superior's potential future admonition, fool me once, shame on you...This is a conversation you don't want to have.  Better to stay clear of Michigan!

4.  Is the Detroit Chapter 9 Filing a Blessing in Disguise for Monoline Insurers such as MBIA and Assured Guaranty?

Suppose you are a municipal finance mutual fund advisor and your boss walks in and asks you to show her the Detroit exposure.  You can either show her Detroit insured general obligation bonds and tell her, no sweat, we are going to get paid, or you can show her uninsured bonds, in which case you can start to sweat.

The insured municipal finance market goes through cycles of complacency and periods of being reawakened to the benefits of municipal finance insurance.  This is one of those periods.

The question is how badly will MBIA, Assured Guaranty and Ambac get burned in the short run in order to revalidate the need for their business?  Inasmuch as MBIA's and Assured Guaranty's exposure to Detroit is mostly in the form of secured sewer and water bonds, which will continue to be paid and which might even get refinanced in connection with the Chapter 9 proceeding, both MBIA and Assured Guaranty may be paying a small price to remind every municipal finance mutual fund advisor why it is good not to sweat.  Ambac will pay a little more.

Moreover, any refinancing of MBIA's and Assured Guaranty's insured water and sewer bonds is a double win for the insurers.  They not only get to wipe off the insurance exposure from their liabilities, but they get to accelerate into income the associated unearned premium.  Detroit's finance czar Orr has already outlined a plan whereby he envisions Detroit refinancing these sewer and water liabilities.

But, one wonders, in what financial world would Mr. Orr expect to sell the bonds that would refinance these outstanding water and sewer bonds.  Certainly not in the real world given this Chapter 9 filing, certainly not without MBIA's and Assured Guaranty's insurance.

So, it seems, MBIA and Assured Guaranty might be holding a trump card in what at first might look like a badly dealt hand.  This article indicates the monoline insurers were trying to act as part of the solution before Detroit's filing; there seems no way in which they won't have to be part of Detroit's solution emerging from bankruptcy.

5. The Mother of all Art Auctions

Detroit's Institute of Arts (DIA) owns over 60,000 works of art, worth by its estimation well over $1 billion.  It has labeled itself one of the preeminent art museums in the country.  It also will sponsor one of the world's most prestigious auctions of art since, you see, Detroit owns all of this art and Detroit is now bankrupt.

In art auctions, provenance is key, and buying from a renown museum is nearly the best of all provenance, next to buying directly from the artist.  Buying from a museum rarely happens because arts museums eschew deaccessioning, since that indicates that blood is in the water for that museum with respect to all future donors.  However, DIA will have none of these concerns since whether it realizes it or not, the jig is up for the DIA.  Detroit has bills to pay.

Postscript:  Add this to the list of unexpected consequences.  This Michigan state court judge is going to find out what federalism and the Supremacy Clause is all about.

Disclosure:  Long MBI.

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, July 2, 2013

New York Supreme Court Commercial Division Line Up Welcomes Justice Friedman to MBS Litigation

On May 23, 2013, the chief administrative judge of the New York Supreme Court, Commercial Division, rendered an order that all mbs cases not otherwise assigned should be assigned to the newbie of the Commercial Division justice line up, Justice Friedman.  This order put into writing what the administrative judge determined was the division's assignment practice at the time.  It was curious, then, to see that Ambac v Nomura was initially assigned to Justice Sherwood in contravention of this assignment order.

Curious, and distressing to Ambac, as the line up of the Commercial Division justices can be assessed for sympathy to plaintiff mbs claimants in much the same manner as the Supreme Court justices can be assessed for "liberal' or "conservative" orientation.

While it is something of a generalization, just between you, me and the lamp post, Justice Bransten is most sympathetic to the claims and arguments presented by mbs plaintiffs, with Justices Kapnick and Kornreich lying somewhere in the middle ground, and Justices Ramos and Sherwood most antagonistic to plaintiff mbs arguments.  We will find out about Justice Friedman in the bye and bye.

So, one wonders why Ambac v Normua was initially assigned to Justice Sherwood, or perhaps rather how Nomura's counsel was able to persuade the assigning clerk to make this initial assignment.  In any event, Ambac was able to petition to vacate this assignment and oblige the Commercial Division to follow its own rules.  See here.

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, July 1, 2013

ResCap Examiner's Report Concludes It is Unlikely that (i) Piercing Corporate Veil and (ii) Substantive Consolidation of Ally and ResCap Claims Would Prevail

The Examiner's Report in the ResCap Bankruptcy Case has been unsealed and may be read in all of its War and Peace-length glory here.

There are a stunning number of creditor claims set forth in the report that the Examiner reviews and handicaps as to legal merit, after having conducted an exhaustive investigation.  These creditor claims, if they prevailed, would have served to increase the size of the bankruptcy estate of ResCap for the benefit of ResCap's creditors and to the detriment of ResCap's parent, Ally.  It was the threat posed by these creditor claims and the looming shadow cast by the Examiner's Report that led to the plan support agreement among Ally, ResCap and ResCap's principal creditors, in which Ally is to contribute $2.1 billion to the bankruptcy estate in exchange for a release of claims.  This plan support agreement was recently approved by the ResCap bankruptcy court.  A reorganization plan based upon this plan support agreement has yet to be filed.

But there are no bigger creditor claims considered in the Examiner's Report than the (i) piercing the corporate veil and (ii) substantive consolidation arguments alleged by ResCap's creditors.  These are doomsday claims, as they would have potentially put Ally on the hook for all of ResCap's liabilities.  It is hard to see how a plan could be confirmed based upon the plan support agreement that provides a $2.1 billion contribution by Ally if the Examiner had concluded that it was likely that these veil piercing or substantive consolidation creditor arguments would prevail.  Such a conclusion could have put Ally on the hook for as much as $25 billion of potential claims, according to published estimates.

No worries for plan support agreement proponents, at least with respect to these doomsday claims, as the Examiner concludes at pps. 45-47 that it is unlikely that these doomsday claims would prevail.  Moreover, a claims valuation scorecard is set forth by the Examiner, beginning at p. 51, which indicates that, on a present value basis, Ally's $2.1 billion consensual contribution is within the ballpark of what ResCap creditors might reasonably be expected to recoup by means of litigating its claims.

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.

Saturday, June 29, 2013

Ambac v Bank of America Schedule

I have posted that Ambac is the principal remaining beneficiary of Justice Bransten's summary judgment opinions in MBIA v Bank of America (BAC) at Ambac Is Using MBIA's Roadmap in Its Over $1 Billion Representation and Warranty Case Against Bank of America.  Like MBIA's case, Ambac's case against BAC is for damages exceeding $1 billion dollars.  

Ambac will be alleging the exact same facts as MBIA did in its argument for BAC successor liability, and much the same facts regarding Countrywide's origination process and representation and warranty (R&W) breach rate regarding mbs loans in its insured pools.  So being able to read and react to Justice Bransten's opinions in what amounts to a free dress rehearsal is mastercard-like priceless.

The court has just posted the agreed schedule for the case which shows that arguments for summary judgment are scheduled for early 2015, with decisions rendered on those motions presumably coming sometime during the summer of 2015.  The trial date would depend on whether there are appeals of the summary judgment decisions, and whether Justice Bransten stays the trial pending any such appeals.

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.

Disclosure: no positions in Ambac or BAC.  Follow me on twitter.

Friday, June 28, 2013

The ResCap Bankruptcy, Bank of America Article 77, and the Death of Competence of Wall Street

The ResCap bankruptcy case and the Bank of America (BAC) Article 77 proceeding involve companies with many similarities, so it is striking to see how different are the two different judicial processes in efficiently and fairly resolving the cases.

ResCap and Countrywide are both insolvent mbs originators subject to a multiplicity of legal claims arising from the financial crisis.  They have solvent parent holding companies each of which conducted transactions with the subsidiaries which give rise to claims that the parent company should have successor liability for the subsidiaries' liabilities.

There is one major difference, however.  ResCap's bankruptcy case is proceeding in an open and fair manner with a full investigation into all of the relevant facts necessary to adjudicate the claims, and reach a settlement in connection therewith.  BAC's Article 77 proceeding, by contrast, is the concluding act to a mockery of a process that, if the BAC/BNYM settlement is upheld, presages the death of competence on Wall Street.

What do I mean by this?  It has been reported that Justice Kapnick, the presiding judge of the Article 77 proceeding, herself has stated in open court that "everything is backwards" in the Article 77 proceeding.  When you compare the bankruptcy proceeding to the Article 77, in particular with respect to the extent the facts of the dispute have been investigated before a settlement was reached, as well as the inclusiveness of the process, you will see why this is so true.

In the ResCap bankruptcy, there was a thorough investigation of the facts underlying the claims and transactions at issue in the case.  This was performed not only by the parties, but also by an examiner appointed by the bankruptcy judge, who shared his materials with the debtor and creditors committees as he was conducting the investigation.  While his final report was not unsealed while the debtor and the creditors committees were negotiating the plan support agreement, it is safe to conclude that the parties profited from the fruits of this investigation and, because of this investigation, the debtor and creditors had all of the facts at their disposal necessary to negotiate their settlement in an intelligent manner.

As well, when it came time to negotiate a deal with the debtor and the contribution its parent would make to the bankruptcy estate, all of the unsecured creditors were included in a committee, and each had the benefit of representation of counsel for the entire committee.  The negotiation also had the benefit of a mediator, a sitting federal bankruptcy judge, who was able to encourage settlement.

So in the ResCap bankruptcy, the facts were obtained before the negotiation, and the negotiation was conducted by all of the creditors sitting at the table represented by impartial counsel who represented all of the creditor committee members.

This is a competent process designed to result in a competent result, because all of the work that needed to be done before a settlement decision was reached had, in fact, been done.

As for the Article 77, as Justice Kapnick puts it, everything is bakwards.

BAC and the settling investors negotiated a settlement without knowing the important facts.  Which facts?  The extent to which the loan files sitting in the custody of BNYM, as trustee, complied with representations and warranties made about them in the transaction documents!  The parties were speculating about breach rates, and the trustee's financial advisor accepted BAC's speculation of breach rate, all in complete ignorance of what the actual breach rate was.  This actual breach rate could have been determined by a re-underwriting of the loan files.  Why did the trustee maintain the loan files? For precisely this sort of eventuality!  Can you imagine a bankruptcy judge endorsing the fairness of a case in which the parties had ready access to the facts but declined to investigate them?

Moreover, the negotiation between BAC and the settling investors did not involve a group of creditors that represented all creditors with an interest in the matter, and no effort was made by the trustee to try to include them.  The settling investors and its counsel expressly disclaim any inference that they were acting on behalf of the creditor group as a whole.

In fact, BAC was able to argue that Countrywide's bankruptcy would result in no recovery for creditors because there would be no successor liability for BAC, the creditors would have to show that the representation and warranty breaches directly caused the creditors' losses, and that sampling of loans and extrapolation to the entire pool would not be permitted, all of which were highly debatable claims by BAC which were given far too much credence by the settling investors precisely because the settling investors had failed to do their homework and had not conducted a thorough investigation before settlement discussions (unlike the case in ResCap).

Moreover, the settling investors were represented by counsel not qualified to practice New York law, which would apply to any litigation of the dispute (Ms. Patrick is a Texas lawyer), and who was not independent (Ms. Patrick's firm will receive a success fee equal to 1% of the settlement paid by BAC, but only if the settlement is upheld in the Article 77; indeed, Ms. Patrick's firm is more a party with an economic interest in the outcome of the proceeding than counsel representing creditors, much less all of the creditors whose interests are being adjudicated).

My point is not that the settling investors are not sophisticated financial institutions, nor that Ms. Patrick is not an able litigator or negotiator.  It is simply the point that the settling investors did not avail themselves of a process by which they could complete a full and fair investigation of the relevant facts before they commenced negotiations, a process also that would fairly include all creditors with an interest in a settlement that purports to bind all creditors...and now, the settling investors seek judicial approval over this failed process.

Instead, the settling investors were bullied by bluffing threats made by BAC that betrayed the settling investors' lack of knowledge of the relevant facts, for failure to have conducted a prior investigation.  To the BAC reported threat that it would put Countrywide in bankruptcy (which apparently moved the settling investors off their initial settlement bid in a hurry), the settling investors should have said, "go ahead make our day"...then, you would have had a bankruptcy process adjudicate the BAC/Countrywide matter in a way that would have resembled the ResCap/Ally matter.  Based on the ResCap/Ally bankruptcy result and Justice Bransten's holding that New York law applies to BAC's successor liability, want to place a bet on whether this would have resulted in a higher settlement award payable by BAC?

Indeed, putting Countrywide into bankruptcy was the last thing BAC would have wanted, as it would have effectively consolidated all of the investor and monoline mbs cases against it and Countrywide into one proceeding where the adversaries' costs of that proceeding would have been borne by the bankrupt estate. This would have eliminated BAC's legal strategy of economic attrition against the monolines. A completely idle threat!

The distressing thing to me about the Article 77 proceeding is what it implies as to the future of competence on Wall Street.  While Justice Kapnick is a very able judge, she has not practiced a day of commercial law in her life, and simply knowing what the law says about a trustee's duties, in general terms, is no substitute for having practiced on Wall Street where, at one time, competence mattered.  Really, competence is on trial in the Article 77, as well as the interests of the intervening investors.

So, now it is reported that Justice Kapnick has requested that the parties submit the Article 77 matter to mediation, a request that BAC refused.  It seems that BAC has found itself a process by which competence is not a prerequisite to approval, and it is intent on sticking with it.

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.