LOS ANGELES — The factors that pushed Stockton, Calif. and San Bernardino, Calif. into Chapter 9 bankruptcy are not as unique as some bond professionals would like to believe, according to Mark Kaufman, a partner with McKenna Long & Aldridge.
Kaufman and other panelists discussing municipal bankruptcy and fiscal distress at The Bond Buyer’s California Public Finance conference here last week said the potential exists for more bankruptcies to occur, creating a much broader problem for bondholders.
For example, panelists said, both Stockton and San Bernardino struggled with pension liability issues and lack of flexibility in adjusting employee compensation during the downturn. Pension funds and bondholders are both cities’ most significant creditors. And many other cities have been struggling to catch up from the Great Recession during the glacially slow recovery of the past five years.
Panelists questioned whether municipal leaders who have been carving away services to make bond payments and balance budgets will just give up at some point and decide that bankruptcy is an easier choice.
“We suspect there will be more bankruptcy filings,” Kaufman said. “We do not think it will be widespread.”
“The final big question is whether we will see the emergence of an idea called “service level insolvency,” said Eric Hoffmann, a senior vice president with Moody’s Investors Service.
The concept is that cities reach the point where they have so severely cut services that bankruptcy sounds like a better solution.
What Moody’s analysts are watching for is whether the current spate of bankruptcies creates a situation where bonds no longer retain the level of coverage investors are used to seeing, Hoffmann said.
Manny Grillo, a partner in the New York office of Goodwin Procter and the panel’s moderator, asked the speakers whether the bankruptcies would result in a new definition of the “full faith and credit” guarantee given by governments to back general obligation bonds.
Kaufman responded that the issue raised the question of which creditors in a government bankruptcy hold “subordinate” debt.
“When you talk about subordinate, you are really talking about who gets paid first,” when an entity has financial problems, Grillo said.
In California, general obligation bonds are well-secured, but not because of any full faith and credit pledge, Hoffmann said. It’s arguably a special revenue bond, he said.
“In our arguments about security, we think GOs are still well-secured relative to POBs (pension obligation bonds),” Hoffmann said.
That was reflected in Moody’s change in approach last year to California credits, drawing a stronger distinction between GOs and lease revenue bonds, Hoffmann said.
The fact that municipal bankruptcies have been a rarity means that attorneys are commonly trying to predict what will happen in Chapter 9 municipal bankruptcy cases based on precedents from Chapter 11, which governs reorganization in corporate bankruptcies, said William Greendyke, a partner with Norton Rose Fulbright.
“Our staff is excited because we are going to learn a lot in the next few years,” said Greendyke, a former bankruptcy judge.
Cities have been in a constant stress mode of trying to balance budgets, Hoffmann said.
“When Stockton and San Bernardino get decided, there will be a template, if cities just get tired of being in stress mode,” he said.
One aspect of bankruptcy that Kaufman believes could fall away is the stipulation that municipalities must prove “eligibility” to be in bankruptcy.
“I think eligibility wastes a lot of time and produces a lot of hot air,” Kaufman said.
Unless the eligibility question is related to whether the state will provide relief, Kaufman believes the courts will question the efficacy of having cities prove eligibility.
Everyone will just have to wait to see what plays out in the bankruptcies cases in California and Michigan to know what the true potential is, Greendyke said: “The first rule is: Never doubt the 100% discretionary power of a bankruptcy judge.’ ”
Look to how the cases are going in San Bernardino, Stockton and Detroit based on the different judge’s personalities.
While it took San Bernardino a long time to achieve eligibility, the judge in Detroit is being much more aggressive, Greendyke said.
“We are in uncharted territory,” Kaufman said. “What is the judge going to say to cities? Tax your way out?”
At what point would a judge order a city to raise taxes to repay creditors, he asked.
Existing case law restricts a judge in a Chapter 9 from directing city functions in the same way a corporation could be required to take action by a judge, according to panelists.
The question in San Bernardino will be whether pensions are more protected in Chapter 9 than Chapter 11, Grillo said.
San Bernardino has taken the unprecedented step in a California municipal bankruptcy of trying to impair a pension fund. In Stockton and Vallejo, both cities continued payments to pension funds while in bankruptcy and gave bondholders a more significant haircut to avoid impairing pensioners.
“I think the real question is whether sacred cows exist,” Kaufman said.
He argued that if cities want access to Chapter 9 that should not be deciding who gets paid and who doesn’t before the judge rules.
For instance, in Vallejo, Calif. the city should not have been able to decide which creditors to pay.
“There is case law that says you can’t cherry pick, which creditor to impact,” Kaufman said.