On November 7, 2014, the City of Detroit’s historic Chapter 9 municipal bankruptcy case culminated with the confirmation of the City’s proposed plan of adjustment (after eight amendments), and the approval of various related settlements. Although little more than a month has passed, a great deal of ink has already been spilled on what the City’s bankruptcy case means, particularly from the viewpoint of the municipality and its citizens. As counsel for one of the insurers of Detroit’s bonds, one of the largest creditors in the City’s Chapter 9 case, Chadbourne was intimately involved in virtually every aspect of the case. With the benefit of that perspective, we offer the following nine lessons that creditors and other stakeholders of distressed municipalities can take away from the Detroit bankruptcy. 1. Taxes Pledged for Repayment of General Obligation Bonds Cannot Be Diverted Without Bondholder Consent The municipal bond market traditionally regards a “full faith and credit” tax-backed general obligation bond as the safest debt that a municipality can issue, apart from obligations secured by pledged special revenues. This is because such debt is often protected by pledges of dedicated tax levies and a “full faith and credit” pledge to increase such tax levies to an amount sufficient to pay such bonds in full. Detroit’s full faith and credit unlimited tax general obligation (“UTGO”) bonds had the benefit of a pledge of a specific voter approved “millage”—incremental property taxes assessed solely for payment of the UTGO debt and required by Michigan law to be kept separate from the City’s general fund. Unfortunately, when in the dire financial straits that inevitably accompany a Chapter 9 bankruptcy, a municipality may be tempted to ignore state law and divert pledged tax revenues. Detroit initially pursued this path and proposed to divert UTGO bondholders’ millage to the City’s general fund. Needless to say, such a blatant proposed violation of UTGO bondholders’ rights sparked intense litigation that dominated the early stages of the bankruptcy case. This provided UTGO bondholders with significant leverage, which they applied to extract favorable plan treatment from the City in exchange for their acquiescence to allow a portion of the dedicated millage to be applied to stabilize the City’s pension funds. Creditor Lesson 1: State law restrictions on the application of tax revenues remain enforceable in bankruptcy. 2. UTGO Pledges Are More Than Unsecured Claims In addition to seeking to divert their millage, the City initially proposed paying UTGO bondholders pro rata with all unsecured creditors—which the City estimated would have resulted in recoveries of approximately 11%. Even this meager recovery was dependent on the City’s meeting certain revenue milestones. Unsurprisingly, UTGO bondholders (acting through their bond insurers) had no interest in being treated like general unsecured creditors and stripped of the benefit of their voter-authorized unlimited tax pledge and millage, which they argued entitled them to treatment as fully secured creditors of the City. After significant litigation, the City ultimately agreed to pay UTGO creditors 74% of their claims and granted them “most favored nation” protections ensuring that no unsecured financialC L I E N T A L E R T 2 creditor could receive any greater recoveries. In addition, UTGO bondholders received an express lien on specific millage securing the bonds, which the bankruptcy court determined are “special revenues” under the bankruptcy code, as well as a lien on state aid distributable to the City. Creditor Lesson 2: UTGO bondholders should demand the benefit of their voter-authorized pledges and expect recoveries that substantially exceed those of general unsecured creditors. 3. Liens on “Special Revenues” Are Sacrosanct The Detroit bankruptcy proved yet again that municipal obligations secured by and payable from special revenues are sacrosanct. One of the pillars of municipal finance is that special revenuefinanced projects are intended to be wholly separate from a municipality’s general finances, and that bonds secured by a lien on pledged special revenues must remain unaffected by a Chapter 9 case of the affiliated municipality. In fact, when Congress amended the Bankruptcy Code in 1988 and introduced the concept of special revenues, it specified in the legislative history that the amendments were intended to guarantee that, even in bankruptcy, special revenue bondholders receive the “benefit of the bargain”—”unimpaired rights to the project revenues pledged to them.” Consequently, debt secured by a lien on pledged special revenues has never been impaired in Chapter 9 without creditor consent. Despite Congress’s clear intent, the City sought to impair holders of bonds secured by a lien on special revenues generated by the Detroit Water and Sewerage Department by, among other things, subordinating their debt service payments to a newly created payment obligation to the City’s general fund, reducing their coupon rate and stripping call protection. Oddly, the City pursued this path even after it concluded (as the bond insurers asserted) that any money saved through impairment would have been required under state law to remain in the respective water and sewerage systems and could not have benefited the City’s general creditors. This crossed a proverbial red line for virtually all financial institutions with an interest in municipal finance and provoked a firestorm of opposition from parties—including the bond insurers—whose strong support the City would ultimately need to confirm any meaningful plan. This approach even contributed to further downgrades of the City’s credit rating, with at least one rating agency noting that it did not believe the City would be able to confirm any plan that impaired special revenue debt. In the face of objections from bond insurers and special revenue bondholders demanding the protections guaranteed to them by Congress, the City reversed course at the eleventh hour—literally during the confirmation trial—and agreed to reinstate all special revenue debt in full. By doing so, the City was able to obtain plan support from many of its largest creditors—support that it could easily have obtained much earlier in the case. That support, once obtained, rapidly facilitated the array of settlements that made confirmation of the City’s plan possible. Creditor Lesson 3: The outcome in Detroit confirms the unique character of a lien on pledged special revenues in Chapter 9. 4. Pensions Are Not Sacrosanct, but May Be a Special Category Perhaps the most important ruling to come out of the Detroit bankruptcy case was the bankruptcy court’s unequivocal holding that pension debt may be impaired in bankruptcy regardless of protections provided to pensions by a state constitution or statutory laws. Simply put, federal law trumps state law, and federal bankruptcy law allows unsecured debts—even pension debts—to be impaired.C L I E N T A L E R T 3 Nevertheless, pension claims may not necessarily be treated exactly like other unsecured debt obligations. In ruling that Detroit was eligible for Chapter 9 and that pension debt could be impaired during the case, the court emphasized that it would “not lightly or casually exercise the power under federal bankruptcy law to impair pensions.” Indeed, pension claimants, while still impaired, ultimately received significantly better treatment under the City’s plan of adjustment than other unsecured creditors, which caused those creditors to argue that the plan unfairly discriminated in favor of pension claimants. The bankruptcy court rejected that argument, concluding that, in the context of confirming a Chapter 9 plan, a bankruptcy court has exceptionally broad discretion in determining whether unfair discrimination exists. The court found that no unfair discrimination existed in the Detroit plan because the pension claimants made significant concessions (even if less than those of many other unsecured creditors). Creditor Lesson 4: Given the typical human and political dynamics surrounding pensions, it is reasonable to expect the Detroit example to be followed in other Chapter 9 cases. 5. Unencumbered City Assets Can Be Creatively Monetized in Chapter 9 A bankruptcy court cannot force a municipality to sell its assets. But that does not mean that assets cannot be (or should not be) monetized in a Chapter 9 case. In fact, a bankruptcy court can refuse to confirm a Chapter 9 plan if it believes that the debtor has not adequately deployed its assets to satisfy creditors. The final version of the Detroit plan—and all of its attendant settlements—provides an interesting case study in how assets can be beneficially monetized while enhancing, rather than harming, the quality of life in a municipality. Famously, the City became embroiled in litigation over whether—and to what extent—the world-class art collection of the Detroit Institute of Arts (“DIA”) should be monetized. Certain creditors contended that the art should be sold in full, while other stakeholders argued that no monetization of the art was appropriate. After substantial collaboration among the DIA, the bankruptcy court’s mediator, certain prominent foundations and citizens, the State of Michigan, and other interested stakeholders, a middle ground was eventually reached: the City would transfer the art collection to a new independent entity, which would hold the art in a perpetual charitable trust for the benefit of the people of Detroit and the State of Michigan. In exchange, the DIA and various charitable foundations would contribute hundreds of millions of dollars (but well below the market value of the art had it been sold outright) to assist in funding Detroit’s pensions. This is the so-called “grand bargain”.” The bankruptcy court endorsed this approach, finding that the art collection was central to Detroit’s culture and education and that a sale of the art would “only deepen Detroit’s fiscal, economic and social problems.” The DIA settlement, in the bankruptcy court’s view, perfectly captured what Chapter 9 is supposed to be about: generating recoveries for creditors while ensuring that the municipality is able to thrive post-bankruptcy. Less public notice has been given to deals the City made with major creditors to renovate or redevelop deteriorating or underused municipal assets rather than providing creditor recoveries purely in terms of cash payments or restructured debt instruments. In the end, the City was able to settle at the eleventh hour with some of its most entrenched litigation adversaries by employing that type of creative dealmaking. Creditor Lesson 5: Creditors must push municipalities to creatively monetize municipal assets in Chapter 9.C L I E N T A L E R T 4 6. Mediation is Key: Creditors Should Participate Aggressively The early portion of the City’s bankruptcy case suffered significantly from the City’s aggressive approach in dealing with its creditors (a continuation from the City’s failure to meaningfully negotiate with its creditors prior to filing for bankruptcy). As a result, little real progress was made. Even after several iterations of its plan, the City faced virtually unanimous opposition from creditors. Yet, by the time the confirmation hearing concluded, the plan was essentially fully consensual, with every major creditor having withdrawn its objections and agreed to support the plan. The catalyst? Mediation. On August 13, 2013, the bankruptcy court appointed Gerald Rosen, Chief Judge of the U.S. District Court for the Eastern District of Michigan, as the mediator in the bankruptcy case. Judge Rosen and other mediators he appointed worked tirelessly behind the scenes to identify and bridge the gaps between the parties, and it was that mediation process that enabled the numerous settlements making the plan possible. As different constituencies hammered out individual deals that guaranteed their support for the plan, the case began to build momentum towards confirmation. Consequently, those that were the last to settle faced a very significant prospect of losing at a confirmation trial and facing an unappetizing appellate process, and thus possessed less leverage than those that settled earlier. Creditor Lesson 6: Given that Chapter 9 cases are generally dominated by negotiated, rather than litigated, outcomes, municipal creditors (acting individually or collectively through an insurer or trustee) should aggressively engage in mediation when available from the outset. In addition, experts in municipal finance (both financial advisors and investment bankers) should be brought into the process early to explore public finance market-based solutions. 7. Debtors’ Professional Fees Are Not Immune from Scrutiny The Bankruptcy Code explicitly prohibits bankruptcy courts from interfering with the governmental powers of a municipal debtor. Specifically, Chapter 9 does not require court approval for the retention of counsel or payment of professional fees. Nevertheless, a bankruptcy court may not confirm a plan of adjustment unless “all amounts to be paid by the debtor or by any person for services or expenses in the case or incident to the plan have been fully disclosed and are reasonable.” As a result, the Detroit bankruptcy court felt compelled to give close scrutiny to the expenses of the City’s professionals, including the lawyers and consultants responsible for managing the City’s bankruptcy and, with the City’s consent, retained a fee examiner to perform the necessary analysis. More controversially (and without precedent), the court found that it was also obligated to independently evaluate the reasonableness of professional fees incurred by the City and a wide range of entities with claims against the City as part of the Court’s confirmation analysis. Most recently, the court went so far as to rule that it is required to evaluate the reasonableness of the professional fees of the City’s retirement systems’ professionals on the ground that the City funded the retirement systems which paid the fees. Creditor Lesson 7: Fee examiners are likely to become a fixture of Chapter 9 practice. 8. Faster Is Not Necessarily Better for the Debtor All else being equal, debtors are generally better off if they can emerge from bankruptcy quickly. However, “all else” is rarely equal, and undue haste to complete the bankruptcy process can easily backfire by creating animosity between the debtor and its creditors that can be difficult to overcome. In the Detroit case, the City proposed an aggressive plan before obtaining the support of any significant creditor group, and few creditors thought stood any realistic chance of being confirmed. The result wasC L I E N T A L E R T 5 enormous pushback, significant litigation and a plan process that stalled unproductively for many months. This scenario played out in the face of a statutory deadline for the tenure of the City’s Emergency Manager, which all parties knew would create tremendous pressure for the City to conclude the case. Had the City pursued a more collaborative and less hurried approach immediately before its filing and during the early months of the case, it might have been able to emerge from bankruptcy much more quickly and at less expense for all parties involved. Creditor Lesson 8: Creditors must be prepared to use the debtor’s timetable to their advantage. 9. Politics Is Part of the Process Municipal bankruptcies, like most other major events impacting a governmental entity, can be intensely political in nature. Quite rightly, many citizens and other stakeholders of an insolvent municipality will have strong views on how that insolvency should be resolved. So too will the state, given that state authorization is required for a municipality to file for Chapter 9 and because municipal bankruptcies can have significant electoral consequences for state-level officials. While the Bankruptcy Code is facially neutral, these political forces can have a profound effect on how a municipal bankruptcy case develops. Certain unsecured creditors (typically pensioners) and stakeholders (for example, indigent citizens in need of drinking water) are likely to inspire sympathetic media coverage and enjoy broad political support. As Detroit showed, this can have tangible effects, such as the monetization of DIA art for the benefit of pensioners and the creation of a special fund to cover the water bills of those who truly could not afford to pay. Other creditors may be seen as less sympathetic, particularly those who are the beneficiaries of complex “Wall Street” financial transactions that are perceived (rightly or wrongly) to have cost the municipality dearly. This too can have tangible effects, such as the attempted outright disallowance of certain claims. When combined with the Detroit bankruptcy court’s ruling that unfair discrimination is essentially whatever the court perceives it to be, this political imbalance can potentially translate into a litigation and negotiation imbalance. In the Detroit case, state officials played a constructive role in the development of the City’s plan, not only by providing pension funding but also by supporting refunding solutions for the Detroit Water and Sewer Department and making the Michigan Finance Authority available as a refunding issuer. Creditor Lesson 9: Creditors and other stakeholders in an insolvent municipality should approach the process with both the legal and political realities of their position firmly in mind, and not be surprised when these realities are manifested in the form of a plan that proposes to treat similar creditors significantly differently. Also, the importance of state involvement should not be overlooked. * * *Our client alerts are for general informational purposes and should not be regarded as legal advice. If you would like additional information or have any questions, please contact: New York Lawrence A. Larose +1 (212) 408-1140 llarose@chadbourne.com Samuel S. Kohn +1 (212) 408-1060 skohn@chadbourne.com