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.

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