On Wednesday of last week, Detroit’s creditors were presented with Detroit Emergency Manager Kevyn Orr’s plan of adjustment for how the city would emerge from Chapter 9 bankruptcy. Although the plan itself has not been released to the public, rumors of low recovery rates on its general-obligation debt, pension and OPEB liabilities, and COPs have been circulating. Bloomberg News is stating that pensions will recover 45-50 cents on the dollar; OPEB, 13 cents; GO bondholders, 46 cents; and COP holders, 20 cents. Coincidental with the details of the plan of adjustment now circulating, the emergency manager filed a complaint in US bankruptcy court on Friday night against the two service corporations the city used to make pension payments to the city’s retirement systems by issuing COPs. The emergency manager’s complaint alleges that these transactions were illegal and therefore void and not enforceable by the court since these entities were set up to enter debt-like transactions with the sole purpose of circumventing state statutory limits on debt.
The original restructuring proposal put forth by the emergency manager in June put GO bondholders and pension beneficiaries on equal footing. Back in June, this move itself was seen as an extreme measure: at that time the general-obligation pledge was still considered a secured claim and “sacrosanct” – senior to all other claims against a debtor, requiring the debtor to raise taxes to repay bondholders. The emergency manager’s decision to treat a general-obligation pledge as unsecured and his initial offer of 20 cents on the dollar for Detroit’s general-obligation bondholders, while he left water and sewer bonds mostly intact, has “flipped” the municipal market’s standard perception of an issuer’s capital structure upside down. Since June, the market has penalized treatment of local GO debt, and in particular Michigan local GO debt, with an added risk premium of 30-40 basis points.
The emergency manager’s lawsuit against COP holders is a legal maneuver to force acceptance of the reorganization plan. We question the viability of this strategy on the grounds that not only COPs but also other bond security structures such as sales tax bonds, income tax bonds, and state-sanctioned public authorities (e.g., New Jersey Turnpike Authority) were all created at one point (in the 1940s, we believe) to circumvent state debt limitations. In the 1950s, when state debt issuance expanded rapidly to finance the interstate highway system and major mass transit systems, statutes limiting debt to a percentage of revenues or property values were widely considered to be unreasonable, throttling as they did the means to pay for the large infrastructure needs of a rapidly expanding economy. We cite the New Jersey Turnpike Authority as an example, created in 1949 to operate the 122 miles of roadway in New Jersey that connects Boston and New York to points south along the Northeast corridor. It issued its first bonds in 1951 backed by toll revenues and not state tax money. For those questioning its essentiality we recommend driving from Delaware to New York State on back roads to see how long that takes. Some states rely solely on these alternative financing structures, without use of the G.O. pledge at all. The states of Colorado and Indiana rely on COPs and issue conduits instead of general-obligation bonds to fund many of their general-purpose functions, education, and critical infrastructure.
The Detroit emergency manager’s claim questioning the legality of such financing structures is somewhat naïve, yet it raises questions about how holders of COP “debt” will be treated in distressed situations. Since COPs are in fact contractual obligations, similar to leases, the bankruptcy judge is given the power under a Chapter 9 proceeding to reject them and not cure them at all. The emergency manager may choose this route, which many have called the “nuclear option.” This wouldn’t be typical: Stockton lease-backed bondholders received recovery of 80-100%. Lastly, if the emergency manager did not believe the COP transactions were legitimate from the outset, why were they treated as secured debt when the restructuring plan was first proposed prior to bankruptcy? The emergency manager seems to have taken an extreme 180 on this subject of “who gets what” in the ongoing battle of “creditors versus pension beneficiaries” in the bankruptcy process.
The history of these types of invalidation is both disturbing and detrimental. The Washington Public Power Supply System (WPPSS or “Whoops”) defaulted on two series of bonds in 1982. The supply system (now known as Energy Northwest) had plans to build five nuclear power plants. Lower energy demand combined with cost overruns and delays led to the cancellation of the last two plants. Though the bonds for the cancelled plants were guaranteed by the participating utilities, the Washington State Supreme Court ruled that these “take or pay” contracts had flaws and that the utilities were not obligated to repay the bonds. On one hand, the ruling demonstrates the importance of economics in any bond issue. But the legal invalidation of seemingly strong legal covenants resonated far beyond just the bondholders of WPPSS. For many years following the default of WPPSS #4 and #5 bonds, ALL Washington issuing entities paid a penalty in terms of extra yield – not just utilities (which probably paid an additional 1% for a number of years), but local school districts, sales tax bonds, and bonds issued by the state itself. That is the hidden cost of judicial overrule of bond covenants.
New York City’s failure to roll over its notes in 1976 had a similar effect on the market for New York paper of various ilks, and even Orange County California’s relatively quick default (followed by a resumption of paying on its debt) sent shockwaves through the large California bond market and municipal bonds in general. The potential shock is the reason that the states of Pennsylvania and Rhode Island refused to let the cities of Harrisburg and Central Falls respectively go into federal Chapter 9 proceedings. Not that these were large issuers in the municipal bond market, but the fact is that the ripple effect would have been felt by all central Pennsylvania issuing bodies and certainly by every issuer in Rhode Island, not the least of which would be the state itself.
The repercussions of the abrogation of bondholders’ security and the lack of follow-through for stated remedies mean one thing for certain: All of Michigan’s issuing entities will pay more – most likely much more – in terms of debt service on their bonds. That does not make THOSE entities bad investments – it does mean that their costs will be increased by the trampling of bondholders’ rights in the case of Detroit. The bottom line to this discussion is two-fold. First, the Detroit plan underscores the critical importance of continued emphasis on credit when it comes to the municipal bond market. Second, it demonstrates that not only headline risk (which we have often mentioned in our commentaries) but judicial risk as well can combine with economic risk to hurt bondholders. We are monitoring events as they unfold and will keep our readers apprised of new developments.
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