This week Bruce Norris is joined by James Spioto. James is a partner with Chapman & Cutler Law Firm in Chicago. He is an expert on the municipal bankruptcies, and he produced a document called A Primer on Municipal Debt Adjustments that Bruce recently read. Mr. Spioto is head of the Litigation, Bankruptcy and Workout Group. He has represented banks and bank groups, insurance companies, institutional investors, funds, indenture trustees and bondholders in litigation or workouts for more than 400 troubled debt financings in over 35 different states and ten foreign countries. He has testified in front of Congress a number of times.
Bruce first asked what James’s feeling was when he heard the word “entitlement” because up until the previous night Bruce had a different definition. He wondered if the word had a positive or negative connotation, both to himself and to people in general. James said the question that all of us really ask is what we are entitled to. Bruce said it bothers him that it usually seems like a negative term. James agreed and said in one sense we should not ask for more than what we justly deserve; and in another sense we look to the municipalities and the states to provided essential governmental services. This not only includes public safety, but health, welfare, and education. Whatever the right level of this is the government working with its citizens.
At some point it may come to the agreements being arranged where we will be taking away some of these things in a Chapter 9. However, if you are working for one of those municipalities and that is what you decided to do as a career choice, you probably made that decision based on the concept that you knew you were giving up something but were gaining quite a healthy retirement on the back end. Bruce never thought of this, but the way it was described in the CalPERS document was as earned income that you were just going to receive later. In some ways it changed Bruce’s opinion of how lightly we should view not giving people what they have already earned. In a question of fairness from the workers’ perspective, they believe this to be part of the benefit of their bargain.
If you go back in history and in time, 40 years ago pensions were viewed as a gratuity in the municipal context and treated as such. States then started to put into either their constitution or their statutes provisions that made them a contract enforceable. Some even went so far as to put in Constitutional amendments that said you could not impede or diminish contractual obligations for pensions. That is a far change from a gratuity, which is an interesting development regarding municipals.
There are different vehicles for retirement, and the one that seems to be the dominant problem would be something called “defined benefit” as opposed to “defined contribution.” If we recall what happened with corporations years ago, we used to have defined benefit programs too. They found out, and we saw a series of bankruptcies and Chapter 11s. Those plans were either rejected before a 401k plan or a defined contribution plan came in and replaced them. What our corporations saw was in a defined contribution plan, you promised a fixed return to the employee overtime regardless of how you did investments and how the corporation may have done them. What we found out was they were not able to make the return or afford the promised benefits. What they determined was in a defined contribution plan, they could basically make the contribution since it would be fixed. They could put it into their forecasts, and it was far more economically feasible for them to meet those promises. In the defined benefit, it was impossible to predict what the real cost would be. In a defined contribution, you were going to receive that benefit.
If you looked at the scope of a CalPERS program where you have 500,000 people already retired and another 1.1 million involved that have not yet retired, Bruce wondered if most of those people were on defined benefit programs. James said unlike corporations today, which virtually all of them are defined contributions if they have a pension program at all, in government they have generally been a defined benefit. There is a trend going on right now to try to change this. A lot of it is based on a percentage of salary based upon years of service times a certain percentage of your highest pay. It would be interesting if you had an investment like in 2008 where CalPERS probably lost principal. With this, ultimately the designated back holder is still the employer. No matter how things work out, it always is supposed to work out where the defined benefit is a guaranteed future stream of payments, no matter what happens. It is basically a question of risk-shifting or risk-sharing.
In a defined benefit program, the employer, in this case the municipality takes the risk of the market and the risk of what benefits will be able to be paid because you are guaranteeing that the employee will get that benefit during their retirement years. This seems like such a wildcard that it has to probably have a negative end. If a city runs out of money, this is where Chapter 9 bankruptcy begins to be a tool. Yet, it seems the thing that is causing the biggest problem is the least defected area. For example, if you look at Chapter 9 bankruptcy, then you need to ask why a city would go that route and what the benefits are that might be accrued if they do that. James said it is hopeful to start with discussing how Chapter 9 first came about in the first place.
Chapter 9 came about during the depression when we had over 4,000 cities that were suffering lawsuits and a real demand on Congress to find a solution. They could not afford the lawsuits, let alone the ability to pay the debt that was being sued on. Congress came up with Chapter 9 after a couple starts to get it constitutionally correct. By 1936, we had Chapter 9 that was determined to be constitutional because you had a relationship between the state and the Federal Government where they were both co-sovereigns. Given the tenth amendment, the Federal Government cannot interfere with the Government affairs or revenues of the state and of its subdivisions. That becomes a very important item in developing it. It has been used practically very seldom if you look at its counterpart for corporations.
Since 1936 and 1937, there have only been 635 Chapter 9s. You have 80,000+ municipalities, but only 635 since 1937. Last year, you had over 11,000 Chapter 11s, so you can see how sparingly they are used. They are used generally for small, special tax districts or smaller municipalities. The reason for this is municipalities need to borrow money. They don’t have shareholders of equity to provide funding for them. No one can put their money in as a shareholder. To provide money other than collecting revenues on a regular annual basis for taxpayers, if they want to build a capital improvement, a road, school, sewer system, water treatment system, city hall, or court they need to borrow money. The reason is because they cannot collect where it is not feasible to collect all in one year the tax revenues necessary to run the municipalities and build those capital improvements. Therefore, they spread it over 30 years by borrowing the money and paying it off over time.
Bruce wondered what types of debt a city has that causes problems usually. When you mention things like a sewer, this is probably revenue generating. They are probably programs that are municipal enterprises that create their own revenues, whether it is waste water, trash, electricity, or even toll facilities. If managed correctly and properly assessed, they generally charge rates more than sufficient to cover cost of the indebtedness and operation of the municipality. There are some services such as public service and education that come through general taxes, real estate, income, sales, or other revenue sources that are part of the governmental services that are provided.
You have different types of services provided, and some of them may or may not have revenue sources. The important thing is some issues such as pensions from employees, a lawsuit, or something where someone did something to where someone was hurt or harmed could lead to the other party receiving a judgment larger than they thought and not affordable. The municipality would have to then deal with this. They can issue bonds to finance those unexpected liabilities. Adjustment bonds are provided most dates where they can issue ways of financing it, or they can consider ways of some form of debt resolution, which includes a Chapter 9. The problem is Chapter 9 is normally the last resource, because in order to borrow the money to build the infrastructures, you need credibility in the market. You only get credibility in the market if you pay your debts.
The cost for a municipality to avoid a problem, even if it is in millions of dollars, could be far greater to the municipality if it does not have access to make those capital improvements they need to make. However, they do not have access at a reasonable cost because even if you raise them1-3%, when you spread the 3% over the next 30 years you’re talking in simple terms 90% more paid by the taxpayers.
Bruce wondered if James sees the Chapter 9 tool being used more often in 2012 and beyond. He said there has been an interest in whether Chapter 9 will provide something more for municipalities than are under financial distress. Rhode Island has addressed this issue by giving their bondholders’ public debt a first lien on ad valorem taxes and on the general funds of the municipality in order to make sure they have access to the market. Then they have had towns such as Central Falls file for bankruptcy and fairly quickly resolve their issues since the bondholders and ability to borrow money in the municipal market was not in play. They were down to the debt obligations that needed to be adjusted that were the problem.
More often than not the real problem with Chapter 9 and some of the mechanisms is if it really allows one to effectively deal with it. Many times, with Chapter 9 for example, it does not provide any more revenue. It may tip over, i.e., effect relationships that are good deals for the municipalities, which you don’t want to happen. What you really want to do is selectively hit the targets that are your real problems, whether it may be pensions, a type of unprofitable business needing to be restructured, a judgment that needs to be negotiated, whether refinanced or solved in some way.
Bruce wondered if there is a natural priority debt structure for a city where if they declare Chapter 9 bankruptcy, there is still some debt that is more susceptible to discount or negotiation than others. James said there is and that there is debt that could be backed by a statutory lien. This is a state law that gives a lien to the holder of the debt and generally provides that the proceeds or value of it has to first go to the creditor and cannot be used for any other source. There is also what is called special revenues, which are generally revenues from different types of municipal enterprises that are pledged to the bondholders who provided the financing for that enterprise. They either have a gross or a net revenue pledge. The net means the net after paying operation and maintenance costs. Those special revenues will even pay us through bankruptcy and will be unaffected by bankruptcy. Likewise, a statutory lien cannot be taken away in bankruptcy; it has to be honored because it is a state law, and the Federal Bankruptcy Court cannot undo that state law granting that lien.
Bankruptcy occurred in Orange County back in the early 90s mostly because of a very specific investment strategy that went upside down. The people who were the bondholders were eventually paid back in full because they had a statutory lien, so there was really no choice. It was not only the right moral decision, but it was the right legal decision. Bruce got the impression that Orange County would prefer not to pay it back, but they really had no choice.
With Vallejo, it was a different story. Their bankruptcy, as with most bankruptcies, provided a precedent for a road map of what probably can be used by other cities in the future. There they had appropriation bonds, which are bonds that are paid by an annual appropriation because there is a building or facility that has been financed by that with a promise of appropriation to the degree that the municipality needs that facility or building. They appropriate money to pay the debt service, which is rent or some obligation to pay. That obligation would be appropriated because they don’t want to give up that valuable asset. If they fail to pay, there are generally provisions that prevent them from being able to at least use them if not lose that facility. It can then be re-lent to other parties for other purposes. Generally, those appropriation bonds, if there is a value there, should be received.
In Vallejo, they renegotiated the payments, and it was a settlement in compromise. There were water bonds that had special revenues that were paid throughout the bankruptcy and not impaired. There were general and secured creditors including the wages of the employees and their contract clients along with vendors and trade creditors, which were general and secured claims. They were paid the remaining percentage of their claim over time as part of the bankruptcy, which was only between 5-20% and was not a very big percentage.
Bruce wondered if they solved the structural issues that caused the bankruptcy, or if the problem is still there and only kicked down the road a piece. James said you have to look at the various types of municipal problems and solutions. New York City had municipal problems in 1975. They considered going into a Chapter 9 proceeding but chose not to. They obtained some assistance from the state where the state through the municipal assistance corporation provided a backup for their financing, helped refinance their debt, provided some additional revenues for them, and worked through their situation. The same was true in Cleveland in 1978 and Philadelphia in 1991. We have more examples of states coming in, helping provide some grants and loans, moving some services to other governmental agencies, and salvaging or restructuring a municipal situation without the use of Chapter 9 in the larger municipal context. The issue with Chapter 9, whether it has been Vallejo or Orange County, has always been what pain will be suffered by the municipality on their taxpayers. In Vallejo, one question that lingers is a question about the services they had before they went in versus the services they had after they came out. Some have contended that some of the services are far less than half of what they used to be. The goal and mission of a municipality, as we all know, is to provide the right level of services to the citizens so that everybody not only wants to stay there, pay their taxes, but also attract business to other citizens to come live there and help it to grow and prosper.
If a city like Vallejo ultimately cannot generate the revenue to pay the people who are retired or going to be retired, Bruce wondered if there is a designated bag holder after the city that is called the state. James said for one, the city may or may not choose to get involved. Since it is the state and the sovereign itself, it can choose what it will do and what it will not do. Second, we always have to be careful of not putting on Band-Aids when we need a permanent fix. One of the issues that will be the challenge in the Vallejos of the future will be if this is really a permanent fix where we solve the problem, or did we just kick the can down the road to come up again in the future. Bruce said he would agree with this, and it seems like we do have a habit of no matter what the debt is we are experts at kicking it down the road and not solving it. Bruce does not know if Vallejo has solved their issue. You have half your police force and firefighters for a city of the same size, and at some point you have to say that makes it a little bit more of a dangerous place to live. This would not be the goal of any city.This is the concern of a lot of people who are working for the cities, and it seems the trend is for everyone to think that this responsibility can go away by simply declaring bankruptcy, and it was interesting for Bruce to read that this is not the case and should not be the case. These are debts owed on money they have already earned.
Tune in next week as Bruce continues his discussion with James Spioto.
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