by James Spiotto

In July of 2013, Detroit was the first city that was the largest city in the state to seek protection under Chapter 9 of the Bankruptcy Code for municipal debt adjustment. Previously, Chapter 9 had been a remedy used rarely by any city, town, village or county. In the past, the largest cities such as New York City in 1975, Cleveland in 1978 and Philadelphia in 1991 had received assistance from their states in the form of loans, grants or transfer of services to other governmental entities. Such state assistance made Chapter 9 unnecessary by increasing cash liquidity, reducing expenses and providing financial oversight, support and guidance to help those cities refinance debt, address systemic problems and solve financial difficulties.

On November 7, 2014, the Court confirmed the Plan of Debt Adjustment for Detroit.

Since 1937 and the enactment of Chapter 9, there have been 660 cases filed. Chapter 9 is simply a process of debt restructuring to give a municipality breathing room so that it may implement a recovery plan that will allow it to reinvest in the municipality, stimulate its economy, create new jobs, attract new businesses and residents, add to its taxpayers and increase its revenues to create an economic recovery.

The fact that Detroit has confirmed a Plan of Debt Adjustment is one important step in a longer process of recovery. At this stage, we are not able to say with absolute certainty that Detroit, having confirmed a Plan of Debt Adjustment, will make full recovery. Hopefully, that will be the case through the hard work of its mayor and city council, its citizens and taxpayers to attract new business and new residents and to resurrect the City to where it was in its past economic greatness. We are able at this time to note that the Detroit experience has been constructive in offering a number of important lessons that all of us should consider.

Lesson One: Do not defer funding of essential services and infrastructure.    

Detroit is a wake-up call for others that there is never a good reason to defer funding of essential services and infrastructure at an acceptable level. If you do, Detroit’s fate will be yours.

Detroit’s history reflects the unfortunate situation that as essential services and infrastructure erode, business and residents leave, and the tax base is reduced so that, no matter how high you raise taxes, they are insufficient to cover the needed investment in essential services and infrastructure.

Probably one of the most beneficial outcomes from the Detroit filing has been that other municipalities who are suffering financial distress have seen the time, expense, uncertainty and political or social unrest that the Chapter 9 process has caused in Detroit and have recognized the Detroit experience as a wake-up call. Namely, others have realized every city must make sure that essential services are at a level that attracts business and new residents, that infrastructure supports an economic base so that goods, services and employees can move in that system with appropriate efficiency, that the work force is educated to the needs of the business community, and that all have a well-deserved feeling of safety and protection given the services provided.

Detroit’s history reflects the unfortunate situation that as essential services and infrastructure erode, business and residents leave, and the tax base is reduced so that, no matter how high you raise taxes, they are insufficient to cover the needed investment in essential services and infrastructure. Accordingly, it is interesting to note that since Detroit filed in July 2013, no city, town, village or county has filed for Chapter 9. As can be noted, numerous cities have attempted to address their problems in the meantime and to find solutions that do not result in a filing for a Chapter 9 municipal debt adjustment. The prophecy that, after Detroit, others would quickly follow in filing Chapter 9s, has apparently proven false. In fact, Detroit taught other municipalities that they must promptly and efficiently deal with and effectively support essential services and infrastructure and reinvestment in the municipality to prevent any economic downturn.

Lesson Two: Labor and pension contracts under state constitutional and statutory provisions should not be interpreted as a suicide pact.

It appears one of the reasons why resolution of pension and labor costs was not achieved in Detroit prior to filing Chapter 9 was the belief of the workers and retirees that, under the Michigan constitution, those contractual rights could not be impaired or diminished to any degree. This position failed to take into consideration that the municipality can only pay that which it has revenues to pay and, in an eroding declining financial situation there will never be sufficient funds to pay all obligations, especially those that may be unaffordable and unsustainable. So far, recent bankruptcy court decisions have been unanimous, be it in Detroit, Stockton or San Bernardino, that in a Chapter 9 in order for the municipality to survive, unaffordable and unsustainable labor costs and pension benefits can be impaired and must be adjusted to what is sustainable and affordable.

The Stockton court recently ruled that it wasn’t going to substitute its judgment for the City as to whether or not the City will be capable of making those payments, but reaffirmed that such contractual obligations may be adjusted so that the municipality can survive. The real issue is whether or not the myth that unaffordable and unsustainable costs cannot be impaired will continue to prevent the rational consensual adjustment outside a Chapter 9. It is clear that an interpretation of state law and constitutional provisions that the municipality has no choice but to pay that which is unsustainable and unaffordable is illogical and fatal. Needed adjustments must be made. This should never be an excuse not to pay as much as can be paid for worker and retiree benefits. But at the same time, worker and retiree benefits cannot be the reason for the municipality’s financial erosion and continued loss of taxpayers and revenues that will only frustrate the underfunding of benefits and provide even less to workers and retirees.

Lesson Three: Don’t question that which should be beyond questioning and is needed for the long-term financial survival of the municipality.

Detroit sought to significantly reduce the payments to the Unlimited Tax General Obligation Bondholders (UTGOs) and to obtain concessions from its water and sewer bondholders, both of which claimed a sufficient tax revenue base and legal support in the statutory and constitutional law in Michigan that their payments were assured by a dedicated source of funds. There was no real issue that the water and sewer bonds had sufficient revenue flow to pay those bonds during the bankruptcy. The 1988 Amendments to Chapter 9 of the Bankruptcy Code and its legislative history mandated that such revenue bond financing be unimpaired. If there are sufficient revenues to pay operation, maintenance, debt service and all other expenses, there is no basis for not living up to the contractual obligations.  Sections 922(d) and 928(a) of the Bankruptcy Code so mandate it. By language of the state statute, by the intent  of the voters’ referendum in authorizing the UTGOs to have taxes levied above the tax cap to pay these bonds, and by practice, it appeared clear that there should be a levy of tax sufficient to pay the UTGOs and if not, the continuing levy to meet that obligation.

… if there is a dedicated source of payment sufficient to pay the obligations, those promises should not be broken or rewritten in a municipal bankruptcy.

The problem with the effort of the City to contest and question those types of financing is the contagion that this has on other municipalities in Michigan and their ability to use such financing to meet their municipal needs. The questioning and the cloud placed on the financing causes the cost of financing to increase, which means taxpayers will pay more. To the degree that the bonds are issued and the cost is 1% or 2% more because of the cloud means, over a life of a thirty year bond, 30% to 60% more of the principal amount will be paid as an additional borrowing cost by taxpayers’ dollars. This could have gone for all other needed municipal expenses.

In the end, it appears that in Detroit it was recognized by settlement that there was no underlying legal basis for those attacks. Now, for all municipalities in Michigan and for that matter elsewhere, it is important to reaffirm the basic principles that, if there is a dedicated source of payment sufficient to pay the obligations, those promises should not be broken or rewritten in a municipal bankruptcy. A dedicated source of payment, statutory lien or special revenues established under state law must be honored and should not be contested. Capital markets work effectively when credibility and predictability of outcome are clear and unquestioned.

Lesson Four: Debt adjustment is a process, but a recovery plan is a solution. 

As noted above, while Detroit has proceeded with debt adjustment which provides some additional runway so it can take takeoff in a recovery, such plan is not the cure for the systemic problem. Rather, the plan provides additional breathing room so that the municipality, through its Mayor and its elected officials, may proceed with a recovery plan, reinvest in Detroit, stimulate the economy, create new jobs, clear and develop blighted areas and raise the level of services and infrastructure to that which is acceptable and attract new business and new citizens. That is not just an effort of 18 months. It is normally an effort of five to ten years or more. While Chapter 9 is a process that may be necessary to provide the breathing room, it is the recovery plan that will provide the resolution. If the recovery plan is not accomplished and the systemic problem is not addressed, the confirmation of a Plan of Debt Adjustment does not prevent the reoccurrence of the systemic problem left uncured.

Lesson Five: Successful plans of debt adjustment have one common feature: virtually all significant issues have been settled and resolved with major creditors.

While the Detroit Plan started with sound and fury between the emergency manager and creditors and what they would receive, in the end, similar to what occurred in Vallejo, Jefferson County and even in Stockton (with one exception), major creditors ultimately reached agreement and supported the Plan of Debt Adjustment that allowed the municipality to move forward, confirm the Plan and begin its journey to recovery. Buy-in, both on a local level with citizens and taxpayers, with public workers and retires, with creditors who are suppliers and with the capital markets is important so that there are not continuing controversies as opposed to continuing cooperation to move forward to a successful recovery of the municipality’s financial difficulties.

Lesson Six: One size does not fit all.

There are many ways to draft a plan of debt adjustment and sometimes the more creative, the better. As noted above, traditionally major cities of size with significant debt did not file Chapter 9. They refinanced their debt with the backing of the state which reduced their future borrowing costs and allowed them to recover by having the liquidity and the reduced costs necessary to deal with their financial difficulties.

Detroit chose a different path, and one of the questions in Chapter 9 is how should a plan of debt adjustment be structured. As indicated by the Grand Bargain, third-party foundations and contributors along with the state provided $816 million to save the municipal art museum and to address the pension issues. This was a creative and constructive mechanism to provide funds that otherwise were not available to the municipality. While some noted, with some basis, that it appeared the unsecured creditors were treated dissimilarly from retirees, ultimately the municipality created a plan which virtually all of the creditors approved. Therefore, with major creditor support, any argument of dissimilar treatment was ameliorated. More likely than not, this issue would have been a greater problem if the major creditors had not come together with virtually unanimously support for the plan of debt adjustment. In addition, the resolutions with some major creditors including Syncora and FGIC were creative. There should be no doubt that Syncora and FGIC could have been significant obstacles in confirmation and in appeals raising issues that were not necessarily guaranteed to be decided in the favor of Detroit. Their acceptance of interests in real estate and leases meant in essence they would reinvest in Detroit and therefore improve their recovery to provide a purported win win. The insurers resolved their issues, recognizing that there is no assurance that you are going to win and the cost and expense of winning can be significant. Settlement offered an opportunity to improve their recovery by their own skill and ability in investing and management of these real estate opportunities. Such creativity should be encouraged, to the extent it is consistent with the applicable bankruptcy and state law.

Lesson Seven: A recovery plan must provide for essential services and infrastructure. 

“Best interest of creditors” and “feasibility” can only mean an appropriate reinvestment in the municipality through a recovery plan where there is funding of essential services and infrastructure at an acceptable level to stimulate the municipality’s economy to attract new employers and taxpayers thereby increasing tax revenues and addressing the systemic problem.

It is important to recognize that Chapter 9 is a process, not a solution.

While no plan of debt adjustment is perfect or assured, there should be, as the Bankruptcy Court in Detroit throughout the case pointed out, a plan to show the survivability and future success of the City.  This is in essence the recovery plan where the reinvestment in Detroit is a cure to the systemic problem that led to the Chapter 9, namely investing in infrastructure and essential services that had been lacking in the past to stimulate and enhance the economy, the opportunities for jobs and to increase the tax revenues necessary for the recovery. The failure to address these issues even after confirming a plan of debt adjustment will lead to the same systemic problems and economic downturns that were the cause for the filing of Chapter 9. The best interest of creditors and feasibility cannot be interpreted as requiring paying creditors more and sacrificing necessary funding of infrastructure and essential services. This would not be in the best interest of creditors and would eventually lead to the downturn of the economy and less ability for payment to all.

Lesson Eight: Confirmation of a plan of debt adjustment is only the beginning of the journey to financial recovery – not the end.

It is important to recognize, as noted above, that Chapter 9 is a process, not a solution. The recovery plan, which will take dedication and effort by the elected officials of the City along with residents, public workers and other creditors is the only way to achieve success. It is measured not by months, but by years, and by the constant vigilance to ensure that the systemic problem is addressed effectively in a permanent fix.

Obviously, as Detroit proceeds to implement its recovery plan, additional lessons may be learned. However, the eight identified above are basic lessons that should help every municipality that faces financial difficulties deal more effectively with the problems and motivate them to identify and address economic financial distress earlier, encourage help from the state and others and avoid that which should be the last and least desired result, namely the filing of a Chapter 9.

While these lessons unfortunately did not prevent Detroit from having to use Chapter 9, hopefully Detroit, through the good efforts of its elected officials, taxpayers and business community, will find in its recovery plan and reinvestment in Detroit, ultimate success. At the same time, hopefully Detroit’s experience in Chapter 9 will be that lesson that will lead other municipalities to identify their problems effectively and permanently earlier, and thereby not have to repeat the Detroit saga. As children, we learned that the stove was hot either by our own misfortune or by watching an older sibling and realizing it wasn’t necessary to repeat the experience again.

James Spiotto is Managing Director of Chapman Strategic Advisors, LLC and Co-Publisher of MuniNet Guide.