Our Outlook for the Municipal Markets
Relevant questions (and answers) for investors as they continue their research into bankruptcy and pension issues.
Pension Liabilities and Municipal Bankruptcy
Recent headlines regarding the building stress of pension obligations on states and municipalities as well as several high-profile court cases such as Detroit's Chapter 9 bankruptcy have resulted in heightened concern in the municipal market. Investors are scrutinizing credit quality like never before, with many specifically questioning whether pension obligations will force their cities or states into bankruptcy court.
As we've stated in our in-depth pension analysis, municipal pension liabilities have gained prominence in recent years, often representing a significant financial challenge to governments. Current data indicates that these pressures are not expected to abate anytime soon, and with that, additional concern is indeed warranted. Deciphering whether these liabilities will ultimately lead to a bankruptcy filing or how they could affect bondholder recovery rates if debt service payments are impaired requires even more detailed analysis.
In our ongoing effort to shed more light on municipal bankruptcy and pension issues, we've compiled some relevant questions for investors as they continue their research.
What Does It Mean to File for Chapter 9 Bankruptcy?
Chapter 9 is a portion of the federal bankruptcy law that allows for the reorganization of municipalities. It was created by Congress in 1937 to permit financially stressed governments to continue to deliver basic services while restructuring debt and rebuilding solvency. Other sections of the bankruptcy code include Chapter 11 and Chapter 13, which provide protection for distressed corporations, businesses, and individuals.
It's important to remember that not all governments are eligible for protection under Chapter 9 and those that qualify likely face a long, difficult, and potentially costly process. Once approved, municipalities remain obligated to negotiate with creditors, pay certain debts, and restructure government to avoid insolvency. They could have difficulty accessing the credit markets and will likely experience higher borrowing costs, making Chapter 9 an unattractive option for many.
Who Can File for Relief Under Chapter 9?
According to federal code, only municipalities are allowed to file for Chapter 9. The term "municipality" is defined as a "political subdivision or public agency or instrumentality of a State," and includes cities, counties, townships, school districts, and public improvement districts, as well as revenue-producing organizations such as bridge and highway authorities, and municipal utilities. Importantly, states are not permitted to file for Chapter 9 protection under federal law.
To be eligible for Chapter 9 relief, a municipality must prove that it's insolvent, be willing to produce a plan of adjustment for its debt, and prove that it negotiated in good faith with its creditors or that it was "impracticable" to do so. Municipalities also need permission from their state government to file. Notably, states impose a variety of qualifications and restrictions on local governments seeking Chapter 9 protections. Some grant broad, unrestricted access to Chapter 9 relief while others prohibit the use of Chapter 9 by local jurisdictions. The majority of states require local governments to seek permission to file from their respective state legislatures on a case–by–case basis.
Research conducted by James E. Spiotto, a municipal bankruptcy lawyer at Chapman and Cutler LLP, titled "Primer on Municipal Debt Adjustment," indicates that 12 states specifically authorize municipal bankruptcies, 12 states conditionally authorize municipal bankruptcies, three states allow limited authorization, and two states prohibit filing. Spiotto also notes that the remaining 21 states are either unclear or do not have specific authorization for Chapter 9 filings.
How Common Are Chapter 9 Filings?
Even though headlines throughout the country remain occupied with concerns of municipal bankruptcy, overall the fundamental credit quality of the municipal market remains sound, and bankruptcy filing remains rare. It's estimated that only 13 general-purpose local governments have filed for Chapter 9 protection over the past five years. A larger number of utility authorities and special tax districts with small jurisdictions have also filed since 2008; however, the total number of entities remains low by comparison to the number of total governmental entities throughout the country.
Since 2008, the following general-purpose local municipalities have filed for Chapter 9:
As a whole, we believe that credit quality throughout the municipal market remains generally sound. Although some have made dire predictions of market disruptions and widespread stress resulting in massive bankruptcy filings, several years after the Great Recession we've seen little evidence of either. There is no doubt that municipal budgets are strained, and many will continue to feel pressure because of slow economic growth and mounting cost pressures, especially those stemming from unfunded pension liabilities. Yet, for those municipalities that have the option available, the Chapter 9 bankruptcy process remains arduous and usually an option of last resort.
How Do Pensions Fit Into This Discussion?
Similar to local government bankruptcy provisions, states are responsible for defining pension protections for current public-sector workers and retirees. States approach these legal protections in a variety of ways, often making it complex and difficult to reform these benefits. Budget concerns have highlighted the need for pension reform, and states that have achieved it have usually done so through adjustments to benefits for future employees, which governments have more flexibility to cut. Few governments have been able to effectively address pension benefits of current workers and retirees, which have contributed to large unfunded liabilities. Individual case law adds some guidance for reform efforts, yet in most states, a clear path to sustainable pension reform for current workers is far from clear.
According to research conducted by the Center for Retirement Research, or CRR, at Boston College, as reported in "Legal Constraints on Changes in State and Local Pensions," by Alicia H. Munnell and Laura Quinby (August 2012), most states protect pension benefits under a contracts-based approach. The Federal Constitution's Contract Clause and similar provisions in state constitutions prohibit a state from passing any law that impairs existing public or private contracts. State actions must pass a three-part test that determines whether a contract exists and what it includes, whether the state action actually impairs the contract, and whether the impairment is justified.
Several states, such New York, Illinois, and Michigan, also have state constitutional provisions that specifically prevent the state from reducing pension benefits that participants have either accrued already or that they expect in the future, making adjustments extremely difficult. Interpreting state constitutional language stating that pension benefits cannot be "diminished or impaired" is the focus of stakeholders on both sides of the reform effort in these states.
The CRR research also notes that a handful of other states use a property-based approach for protecting pensions, which cites that these benefits cannot be taken away without due process according to the Fifth and Fourteenth Amendments to the U. S. Constitution. This and other approaches that treat pensions more as a promise of compensation without an explicit contract seem to provide more flexibility for benefit changes, although this not always clear, either.
How these protections are treated when a governmental entity enters into bankruptcy is mostly uncharted territory. For those states that allow their local governments to file, there exists a conflict of whether the ability to adjust debts and contracts granted by federal bankruptcy law trumps state constitutional and legal protections for pension benefits. Legal experts often point out that federal law trumps state law when the two are inconsistent, yet with this specific topic little clarity has surfaced to date.
Below are several cases we will continue to watch, as we feel that they will have an impact on how municipal bankruptcy and pension protections evolve.
City of Detroit
Public Act 436 of 2012 is the state legislation that allows local municipalities in Michigan to file for Chapter 9 after a series of reviews and determinations from state officials. Under the state's old law, only a state-appointed emergency manager could apply for a Chapter 9 bankruptcy, with the governor's consent. Public Act 436 of 2012 moves the Chapter 9 option up earlier in the process, giving more choice to local officials. If a local unit is found to be in a state of financial emergency, that unit has seven days, under the Local Financial Stability and Choice Act, to elect one of four options: a consent agreement with the state similar to what Detroit currently has in place, participation in a neutral evaluation and mediation process, the assignment of an emergency manager, or application for Chapter 9 bankruptcy with the governor's consent. The emergency manager still has the power to request a Chapter 9 filing, which is what happened in the City of Detroit in July 2013.
On Dec. 3, 2013, federal bankruptcy court judge Steven Rhodes announced that the City of Detroit is eligible for Chapter 9 bankruptcy. The ruling came more than four months after Detroit filed for bankruptcy protection and a nine-day eligibility trial in which the city argued that it cannot deliver services while repaying its estimated $18 billion of liabilities. The announcement makes Detroit the largest municipality in U.S. history to qualify for legal protection under the U.S. Bankruptcy Code.
Although it was expected that Detroit would be deemed eligible for Chapter 9, Rhodes surprised many by ruling that he will allow pension benefits to be impaired as a part of Detroit's bankruptcy process. The Michigan Constitution protects pension benefits as a "contractual right" and explicitly states in Article IX, Section 24:
"The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby."
One of the most controversial questions in Detroit's case has remained whether the city's pension benefits could be impaired in bankruptcy or whether the state's constitution fully protects them. Rhodes clearly ruled that the state's protections do not apply to the federal bankruptcy court. Federal bankruptcy law allows debtors to impair contracts, and pensions are not entitled to "any extraordinary attention" compared with other debts. This does not necessarily mean that the judge will confirm a plan that severely impairs pension benefits, and his ruling is expected to be swiftly appealed, yet the ruling remains significant.
This explicit ruling that pension benefits do not warrant additional protection above that of other debts and contracts once eligible for Chapter 9 is the most clear legal opinion handed down on the topic to date. Its effects, if upheld, will likely include more leverage for municipalities during negotiations over pensions before Chapter 9 filings, and a clear precedent for those that enter federal bankruptcy protection.
State of Illinois
Much like the State of Michigan, the State of Illinois has strong language that specifically protects its municipal pension benefits from cuts written into its Constitution. Specifically, Article XIII, Section 5 reads:
"Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired."
This language is the focus of the current debate concerning the state's recent passage of comprehensive pension reform. Illinois lawmakers approved sweeping reform to the state's ailing pension system in a special session on Dec. 3, 2013. After months of contentious negotiations, the Illinois General Assembly passed the plan, which aims to fully fund the state's $100 billion unfunded pension liability by 2044 while saving Illinois an estimated $160 billion in payments over 30 years and immediately reducing its unfunded liability by at least 20%. Chronic underfunding, unanticipated investment losses, and changes in actuarial assumptions benefit increases over decades led to an aggregate funding ratio of 40.4% at the end of fiscal 2012 for the state's five pension systems. To achieve its objectives, the legislation urges a variety of benefit cuts for current retirees and workers and increases in the state's contributions, which have been lacking for decades. Opponents vow to fight the changes through the court system, citing the reforms as illegal and unconstitutional, and argue that the constitution protects both accrued and future benefits as a part of the employee contract.
As we know states cannot legally file for protection under Chapter 9 of the bankruptcy code, the question has been recently asked with regard to the state's local municipalities, mainly the City of Chicago. Chicago currently faces its own looming pension crisis, as its pension system is approximately 36% funded with more than $20 billion in unfunded liabilities. Under the current state legislation that dictates payments, the city's required contribution will balloon to $1.1 billion in 2015 from $480 million in the last fiscal year. Without changes, Chicago's mayor suggested that the city will face a 2015 budget that will either double city property taxes or eliminate vital city services.
We've recently seen that it may be possible to adjust current pension benefits in bankruptcy, with the recent ruling by Judge Rhodes in Detroit's Chapter 9 case, yet this may have little effect on Chicago's situation. Though Chicago may experience more fiscal stress as a result of its pensions, its current economic diversity and stability, management and operating procedures, and financial flexibility safeguard it from the threat of insolvency in the near term. Even if city officials would like to declare bankruptcy to adjust its pension burden, that is currently not an option.
Illinois law is more limited with its permission to file for Chapter 9 for local municipalities compared with Michigan. Specific authorization to file voluntarily for Chapter 9 exists only for the Illinois Power Agency. Other units of local government cannot voluntarily petition for municipal bankruptcy without the specific authority of the state. Smaller local governments are governed by the Local Government Financial Planning and Supervision Act, which details state oversight of fiscally stressed municipalities with populations under 25,000. Under the law, these governments can petition the governor to establish a financial planning and supervision commission to determine whether a fiscal emergency exists, and to oversee efforts to stabilize the entity's finances and operations. The Commission has broad authority to make changes to a municipality's financial operations yet has no power over labor agreements. As a last resort, the Commission may recommend that a municipality seek relief under Chapter 9.
Larger municipalities, which are considered "home rule" governments, have considerable ability to raise taxes, and are subject to Illinois' Financially Distressed City Law, or FDCL, of 1990. After the municipality fulfills certain tax rate and other requirements, the FDCL allows for the establishment of a special financial advisory authority that has broad powers to secure the financial operations of the local government. The law doesn't provide for the authorization of a Chapter 9 filing, so the question of bankruptcy for larger entities such as the City of Chicago is less significant.
State of California
In California the state government provides very little formal oversight for local governments, and its local entities have broad authority to file for Chapter 9 relief. With legal barriers to Chapter 9 low and financial stress high in some areas, it is more likely here that significant unfunded pension liabilities could encourage governments to file for bankruptcy relief.
Cities, counties, and special districts are required to engage in a "neutral evaluation" process prior to filing for Chapter 9, as defined in Chapter 675, Statutes of 2011 (AB 506, Wieckowski). According to the law, this involves working collaboratively with creditors, employee groups, and other interested parties to attempt to resolve the local government's fiscal problems. The local government and affected parties select a "neutral evaluator" to review the government's fiscal condition. The neutral evaluator has limited powers and cannot impose an agreement on any party. If at the conclusion of the neutral evaluation process no resolution has been reached, the local government may then file for Chapter 9.
Pension protections in California are more stringent than state oversight provisions, yet they are not explicitly included in the state's constitution as in Illinois and Michigan. Municipal employees in California generally participate in one of two statewide systems, the California Public Employees' Retirement System or the California State Teachers' Retirement System. Here, the obligation of a local government to make payments to the pension systems and the obligation for the systems to pay retirees from the pension trust fund are covered in state legislation. Measures that include making it a criminal act for cities to pay payroll without making contributions to the pension system and giving the pension systems the ability to terminate the plan and the participation of the public agency in the event of missed payments are included in legislation as enforcement mechanisms.
Because of the unique construct of pension benefits in California legislation, there is some debate as to whether there exists a contract for retirees that can be impaired by a bankruptcy court. Whereas most recognize that there is a contract while an employee is working for the employer, once in retirement, it is the pension trust fund that is obligated to the retiree, not the employer. Based on current law, the employer is obligated to the trust fund to make payments, not the retiree.
Officials from CalPERS argue that because of this arrangement, the recent ruling in Detroit's case does not apply to their California members. In a statement made on Dec. 4, 2013, CalPERS said:
"The Detroit court failed to recognize the difference between a two-party contract and the unique nature of a state public employee retirement system, which creates a three-way relationship among a public agency, its employees and the retirement system. In California, our members' vested rights to their pensions are protected by the California constitution, statutes and case law.
"Unlike Detroit, CalPERS is not a city pension plan. CalPERS is an arm of the state and was formed to carry out the state's policy regarding public employees. The Bankruptcy Code is clear that a federal bankruptcy court may not interfere in the relationship between a state and its municipalities. The ruling in Detroit is not applicable to state public employee pension systems like CalPERS."
This premise is expected to be tested in court in the following months through several bankruptcy cases in California, particularly with the City of San Bernardino. In August 2013, San Bernardino became the third California city in recent years to qualify for Chapter 9 bankruptcy. It followed the cities of Vallejo, which was awarded Chapter 9 protection in 2008, and Stockton, which was granted protection in April 2013. Steep personnel and benefit costs were significant factors in all three filings, yet San Bernardino has been the only city to suspend its payments to CalPERS after declaring bankruptcy Aug. 1, 2012. The city resumed pension payments this year, but the city's unfunded pension liability of about $143 million and the $50.4 million in bonds it issued in 2005 to help fund pension obligations remain financial burdens.
In its objection to the city's eligibility, CalPERS states that San Bernardino did not qualify for bankruptcy status mainly because it ignored its looming financial crisis for many years. Both Stockton and Vallejo continued to pay CalPERS on time while adjusting other debts, most likely to avoid a costly battle with the nation's largest retirement system. Assured Guaranty, which insures a portion of Stockton's bonds, challenged the notion that CalPERS is exempt from being treated like any other creditor through the courts.
The recent stress experienced by municipalities large and small has highlighted questions regarding overall credit quality in the municipal market and the future funding of long-term liabilities. The questions are complex, with the answers coming on a case-by-case basis through detailed analysis of state statutes and through judicial decision. We'll continue to watch these high-profile cases to understand how they may influence each other and to further our understanding of how they could affect bondholder risks and recovery rates.
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