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.