By Joshua Levin-Epstein, Esq.
During the Great Recession, when 60 Minutes aired an interview with banking analyst Meredith Whitney her dire prediction of an impending municipal bond imbroglio of “hundreds of billions” of municipal defaults ignited a firestorm of controversy. While Whitney’s forecast never quite materialized, the recent filings of high-profile municipal bankruptcies such as Detroit, Michigan and Stockton, California, can indeed be a cautionary tale for bondholders’ investment in the $3.7 trillion U.S. municipal market. Conservative, well-respected international publications, such as the Economist, have recently warned that the poor state of the United States’ public municipal finances threaten the safety of municipal bonds investments. While municipal bankruptcies are rare, a discussion of the Detroit bankruptcy case, in particular, offers an instructive lesson about financial instruments widely considered to be the safest fixed income investments in the United States.
Reasons for the Detroit Bankruptcy
The tepid economic recovery forced Detroit officials to seek bankruptcy protection as dwindling tax revenues and the inability to obtain additional financing made obligations to bondholders, retirees, and employees unaffordable. Detroit’s commencement of bankruptcy proceedings wrested the ignominious distinction as largest U.S. city ever to file for bankruptcy from Stockton, California. Detroit’s bond defaults marked some of the last milestones on a road to bankruptcy that included the imprisonment of Detroit’s former mayor for official corruption and the decline of the City’s population from a peak of nearly 2 million in 1950 to approximately 685,000 in 2014.
Decades of financial mismanagement and imprudence culminated in the City’s accumulation of $18 billion debt. Prior to the bankruptcy filing, the City’s financial projection was bleak. For example, in Detroit, more than $0.38 of every tax dollar the City collects is dedicated to the service of legacy debts, with the amount expect to increase to $0.65 in five years. Kevin Orr, the City’s emergency financial manager, characterized the City’s decline as a “death spiral,”
In a jarring example of Detroit’s implosion, in 2011, approximately 136,000 crimes were reported in the City; 15,245 of these were violent crimes such as homicide and robbery. Detroit ranks as the leader in virtually every category of undesirability for major cities, including unemployment, crime rates, abandoned buildings, and reductions in emergency services and personnel. In yet another example of Detroit’s destitution, approximately 40% of the City’s street lights are not working. No major U.S. city has a lower credit rating than Detroit. The City is broke, financially and otherwise.
Detroit’s problems are not isolated to issues affecting its residents. The City’s bankruptcy spills over to investors in municipal debt, bond insurers that insured portions of the municipal debt, and possibly the state and federal government which may need to intervene to cover shortfalls in retirement benefits for public sector employees.
Credit rating agencies and bond insurers have publicly cautioned that the Detroit bankruptcy has the potential to set unfavorable legal precedents for bondholders and insurers. A bond insurer with a stake in the City’s restructuring issued a public statement declaring that the City’s proposal for restructuring its bond debt was “harmful to Detroit and the interests of the taxpayers in Michigan” and “necessarily imperiled” the City’s access to cost-effective financing.
The Bankruptcy Code’s Scheme for Distributing Payments to Creditors
The Bankruptcy Code includes a statutory scheme for the priority and distribution of payment that generally provides payment for secured creditors ahead of unsecured creditors— known in bankruptcy jargon as the “absolute priority rule.” As a corollary to the “absolute priority rule,” the Bankruptcy Code provides for the equal treatment of similarly situated creditors. For example, general unsecured creditors usually receive a pro rata distribution of funds set aside for the general unsecured creditor claim pool. Detroit’s classification of certain general obligation debt as unsecured and the potential that the City may provide retirees’ unsecured obligations preferential treatment is a source of controversy.
Bankruptcy Issues for Municipal Bond Investors in the Detroit Bankruptcy
The main concern for general obligation bondholders in municipal bankruptcies is the potential misclassification of general obligation debt as unsecured and the potential prioritization and preferential treatment of unsecured retiree obligations. The majority of Detroit’s 20 largest unsecured creditors are comprised of general obligation bond debt, which certain insurers of bondholder debt are contesting the City’s designation as unsecured. Bond insurers have initiated lawsuits in the Detroit bankruptcy proceeding for a declaration that the City’s pledge of tax revenue to pay down voter-approved bond issuances constitutes a lien under Michigan law that confers secured status in the bankruptcy proceeding. The outcome of the lawsuits for retirees and general obligations bondholders could have far-reaching impact on the stakeholders’ recoveries.
The first issue of concern for municipal bond investors in the Detroit bankruptcy proceeding centers on the dispute over the classification of certain general obligation bonds as unsecured. General obligation bonds are a type of bond backed by a city’s “taxing power.” Under the Bankruptcy Code, the classification of secured claims is limited to claims secured by a lien on property. The City classified certain of its general obligation bond debt as unsecured on the basis that the pledge of the City’s tax power to repay the bond issuances did not qualify as a lien to secure property. Contrary to the City’s position, the bond insurers claim that the City backed its bond issuances with a pledge of taxes, as security, to repay the bonds exclusively. For holders of Detroit’s general obligation debt, the dispute over the classification of the general unsecured bonds severely impacts the prospects of full recovery.
The second issue of concern for municipal bond investors is the prospect that retirees and other public sector employees may receive favorable treatment. The bankruptcy court is a court of equity that has the power to treat similarly situated creditors differently. For example, trade creditors may receive preferential treatment in the priority of payment because the bankruptcy court deems that the trade creditors provide a critical service. Holders of Detroit’s unsecured general obligations bonds are concerned that the unsecured pension debt, which constitutes the City’s largest unsecured claim aggregating $2,037,000,000.00, may not be treated be treated pari passu with unsecured bond debt.
The Bankruptcy Plan and its Treatment of Unsecured Bondholders
Concomitant with the emergency manager’s objective of exiting bankruptcy no later than September 2014, the City recently submitted its restructuring plan. Not surprisingly, the City’s bankruptcy exit plan offended unsecured bondholders, bond insurers, and credit rating agencies. For unsecured bondholders, the City’s classification of certain unsecured bonds as unsecured and the plan’s disparate treatment of unsecured bondholders relative to retirees has the potential to set a problematic legal precedent.
The City’s bankruptcy plan classified as “unsecured” certain unlimited tax general obligation bonds that are backed by unlimited tax general obligations and a voter approved property tax for the purpose of paying debt service on the bonds. The bonds’ insurer filed a lawsuit within the bankruptcy proceeding challenging the unsecured classification on the grounds that the pledge of a voter approved property tax confers the bonds secured status. The outcome of the legal challenge has severe consequences for bondholders because the Court’s designation of the bonds as unsecured reduces bondholders’ recovery to 20% rather than a full recovery.
To further aggravate matters for unsecured bondholders, the City’s bankruptcy plan is generally more favorable in its treatment of retirees that hold unsecured claims compared with the unsecured bondholders. While the recovery for the retirees varies widely from 66%-96% under the City’s plan, the recoveries for general unsecured bondholders are far less, at 20%.
Upon release of the City’s plan, credit rating agencies publicly cautioned that the disparate treatment of bondholders may have the unintended effect of higher borrowing costs for local issuers and higher property taxes in Michigan.
Despite the recent filing of several high-profile municipal bankruptcies, municipal bond analysts still consider municipal bonds a safe investment and a nationwide wave of municipal bankruptcy unlikely. Detroit’s and Stockton’s bankruptcies have not spooked the marketplace for municipal bonds as interest rates on the highest-quality 30-year bonds do not reflect a substantial risk premium. For these reasons, the Detroit and Stockton bankruptcies are best viewed as a cautionary tale rather than a portent of things to come.
While the Bankruptcy Court has not approved the City’s restructuring plan and the lawsuits concerning the City’s classification of certain general obligations bondholder debt as unsecured have not been decided, the issues in front of the Michigan Bankruptcy Court should serve to heighten the bond community’s awareness about which states protect municipal investment by laws that support the treatment of general obligations bonds as secured debt in municipal bankruptcy.