Legal rulings in the Detroit and Stockton bankruptcies raise questions about treatment of bondholders relative to other creditors in future municipal bankruptcies, according to a Fitch Ratings report.
"The most emphatic message of the Detroit and Stockton plans of adjustment (POAs) is their intent to protect work force sustainability at the expense of bondholder repayment. Both cities argued the importance of providing adequate compensation, including pensions, to retired, current and future employees," said Amy Laskey, managing director.
"In each case, the bankruptcy judge agreed that this goal was more important that repaying investors. The issue then becomes one of public policy rather than legal constraint, and it appears likely that many governments would similarly favor retaining pensions over the good faith of bondholders."
The court's premise is not likely to be tested, although a bondholder is appealing the Stockton POA confirmation. Without a definitive legal framework upon which to rely, Fitch believes it will be difficult for municipal investors to predict the outcome of any future potential municipal bankruptcies.
While Stockton left pension plans unimpaired, Detroit made small reductions to retiree payments and, more notably, initiated new hybrid plans for current and new employees beginning July 1, 2014. The new plans both offer lower benefits and share the risk of lower-than-expected market returns with participants.
Both cities argued that the near elimination of other post-employment benefits (OPEB) should be viewed as an impairment similar to the potential impairment of debt or pensions. Fitch believes the legal obligation to pay OPEB is weaker than debt or pensions, further supporting the notion that the basis for the decisions is public policy rather than legal considerations.
A consequence of Stockton and Detroit having largely insured debt is a significant reduction in the number of creditors with which to negotiate. The end investor is likely to get fully or largely repaid, which appears to make the impairment more palatable to the issuer. Fitch concludes that distressed governments with large pension obligations and mostly insured debt may look upon bankruptcy more favorably.
