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.

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