STOCKTON’S APRIL FOOLS’ RULING
“….and it is apparent to me that the City will not be able to perform its obligations to its citizens relating to such fundamental matters as public safety, as well as other basic governmental services, without the ability to have the muscle of the contract impairing power of federal bankruptcy law. Therefore, I am persuaded that the petition was filed in good faith.”
(excerpted from transcript of Judge Christopher M. Klein’s ruling in favor of City of Stockton, California)
This past Monday, April 1, the Honorable Christopher M. Klein, presented a thorough, fifty-four pages “FINDINGS OF FACT AND CONCLUSIONS OF LAW” affirming Stockton, California meets all the requirements to file Chapter 9 status.
The ruling was significant but just the beginning of the battle for the decision leaves many undecided issues. Immediate questions that come to mind, post ruling, include:
“How does the decision impact the municipal bond market?” and “Should investors be worried?”
Our short answer to the first question: “To be determined” and to the second, “some, more than others”. These responses are partly based on a read of the Judge’s transcript as well as the City of Stockton’s “Debt Proposal”, a document it submitted to the court.
Clearly, the decision directly impacts Stockton and some of its creditors immediately. Additionally, the ruling potentially affects municipalities across the State of California: certain investors will look warily at general fund and other unsecured debt issued by California municipalities.
More importantly, the final reorganization plan approved by Judge Klein will determine how “capital market creditors” are treated and will greatly influence investor and market maker views of debt issued by California municipalities and, potentially, communities across the country. The manner in which the plan treats “capital market creditors” will be a defining moment, in our view.
SOME RULING DETAILS
Judge Klein ruled Stockton has the right to file for Chapter 9 because its situation satisfies all of the requirements. The ruling also states the “capital market creditors” (Assured Guaranty, National Public Finance Guarantee, Wells -Fargo and Franklin Funds) must negotiate “in good faith” with Stockton.
The Judge’s ruling is quite clear on these two points.
The ruling is a short term victory for Stockton and a setback for debt holders. It allows Stockton to use general fund monies to cover operating expenses rather than principal and interest payments and it forces capital market creditors back to the negotiating table to try and work out a “plan of adjustment” with Stockton.
The named creditors, other than Franklin Funds, removed themselves from negotiations when the City informed them it was not asking CalPERS to make any concessions. California Public Employees Retirement System, or CalPERS, is the provider of Stockton’s employees’ defined benefit pension system. The creditor’s action did not sit well with Judge Klein who stated the City’s refusal to ask CalPERS for concessions did not justify the creditors ending their negotiations.
On other important issues the Judge’s ruling is unclear and questions remain.
Here is our interpretation of the ruling and how it relates to some of the unresolved issues:
1. The ruling does not mean capital market creditors will lose all of their money, although it certainly increases the possibility a haircut is forthcoming.
2. The ruling does not mean the Judge accepts the City’s proposed debt reorganization plan. The plan calls for, on average, a 46% discount on net present value basis for debt holders and treats various debt holders differently. For example, the plan calls for 2007 pension bond debt holders to take an 83% haircut (17% is secured by non-general fund monies, i.e. water fund), while 2003 Certificate of Participation debt holders and the City agreed debt holders will take no more than a 19% haircut with a possibility the haircut may be erased entirely over time.
The Judge realizes a give and take negotiation must occur between the City and debt holders and states so in his ruling:
“The City intended the “Ask” to be the opening of negotiation. And this is a very typical thing in reorganization practice or in workout practice before the filing of reorganization….And that’s exactly what the “Ask” was, was just an opening position that formed the basis for conversation with the parties, with a view toward give and take, to the extent of the goal of getting the City in a spot where it would be able to pay its bills as they come due year in/year out could be achieved.”
3. Importantly, the ruling does not state CalPERS is free and clear of having to make concessions. The City did not ask CalPERS to make any concessions and therefore, CalPERS offered none. The Judge did not rule on this issue and the issue remains unresolved. He did state there may be an issue with CalPERS and that any confirmation plan must be fair and equitable with respect to each class of claims that has been impaired or has not accepted a plan. He accklowledged he may have to “GET DOWN INTO THE NITTY-GRITTY OF THE CalPERS SITUATION.”
Here is an excerpted quote taken directly from Judge Klein’s transcript:
“This does not mean that there’s not potentially a serious issue involving CalPERS. But at this point, I do not know what it is. I do not know whether spiked pensions can be reeled back in. There are very complex and difficult questions of law that I could see out there on the horizon….but no plan of adjustment can be confirmed ……unless that plan does not discriminate unfairly and is fair and equitable with respect to each class of claims that is impaired under or has not accepted a plan”
TIME FOR STOCKTON TO “INVITE” CalPERS TO THE TABLE?
CalPERS is the city’s largest creditor. We are not attorneys, but common sense leads us to conclude any reasonable solution to Stockton’s financial problems requires CalPERS involvement. Stockton has not reduced or suspended payments to its employees’ defined benefits pension unlike San Bernardino, CA during its Chapter 9 odyssey. It is difficult to imagine a solvent Stockton in the near future absent adjusting its annual payment to CalPERS which last year collected nearly $30 million (and rising) from the City.
CalPERS claims it cannot authorize a reduction in the City’s retirement contribution and that it has no place at the table. Judge Klein may view the issue differently. The “capital market creditors” argued it is unfair discrimination for them to take a haircut while CalPERS takes none. Judge Klein offered them some hope when he said:
“So if the City makes inappropriate compromises, the day of reckoning will be the day of plan confirmation. And that’s precisely my analysis with respect to the CalPERS situation and the omission of dealing with CalPERS in the City’s “Ask”…….”
So how is a disinterested CalPERS “invited” to the table if Stockton remains unwilling to engage it?
Debt holders should begin negotiating with Stockton “in good faith” as required by law, making concessions and proposing a deal similar to what the City and Ambac Assurance have agreed to with the previously mentioned 2003 Certificate of Participation issue. The City has already agreed to this restructuring so it is reasonable to assume it could serve as a template for other impaired issues.
Perhaps as a tactic, certain concessions offered by debt holders could be made contingent upon CalPERS taking a haircut of some sort. If debt holders offer something substantive and the offer is made in good faith, it may provide the City with a reason to approach CalPERS.
This, of course, is conjecture, but it seems Judge Klein recognizes the City needs to involve CalPERS in its discussions. He understands the final plan of adjustment must be comprehensive, non-discriminatory and equitable to all creditors. He stated clauses in the state constitution must give way to the Federal Bankruptcy Code under the Supremacy Clause of the Constitution because the ability to impair contracts while in Chapter 9 is sometimes the only way to arrive at the desired point of solvency. IN OTHER WORDS, U. S. BANKRUPTCY LAW OVERRIDES CALIFORNIA PENSION LAWS.
In his opening remarks, while enumerating the many circumstances contributing to Stockton’s insolvency, Judge Klein said this:
“And some of the problems were also the incrustation of a multi-decade, largely invisible or nontransparent pattern of above-market compensation for public employees. Among other things, the City offered generous health care benefits, to which employees did not contribute. Retirees had their entire health care benefits paid for by the City. The City permitted, to an unusual degree, so-called “Add Pays” for various jobs that allowed nominal salaries to be increased to totals greater than those prevailing for other municipalities. Some so-called “Add- Pays” are perfectly legitimate and standard features……..and some were regarded as really not what one would find elsewhere, and, therefore, overly generous.”
The key phrases providing a possible clue as to what Judge Klein is thinking are: “multi-decade”, “nontransparent pattern of above market compensation”, “overly generous”. It is notable to us Judge Klein does not use similar phraseology when characterizing (and criticizing) the genesis of some of the City’s outstanding, impaired debt issues.
Judge Klein continues:
“And some of the problems were also rooted in generous retirement practices. The pensions, of course, are themselves a form of implicit compensation. Pensions were allowed to be based on the final year of compensation, and only the final year of compensation, and that compensation could include essentially an unlimited accrued vacation and sick leave. So it was possible to engage in the phenomenon that’s become known as “pension spiking,” in which a pension can wind up being substantially greater than the annual salary that retirees ever had…..In any event, pension spiking was an issue in Stockton because Stockton’s obligations to CalPERS were based on the amount of pensions that were having to be paid out. So projected pension expenses in particular were soaring.”
The City of Stockton itself recognizes altered retirement benefits are a contributing factor to its financial demise and states this in its reorganization plan:
“In addition, the City issued Pension Obligation Bonds (POBs) in 2007 to reduce the cost of the City’s unfunded liabilities largely created by the enhanced PERS retirement benefits.”
In short, the City issued pension bonds, now in default, to cover a portion of the cost of increased benefits; some of the same benefits the Judge belittles.
Payment terms due to debt holders never increased after issuance; the contract never changed to favor debt holders at the expense of the City. The same point cannot be made about a portion of retirement and health benefits that cost Stockton nearly $30 million last year.
Perhaps a starting point of discussion between Stockton and CalPERS should be “the generous retirement practices” cited by Judge Klein.
SOME TAKEAWAYS FROM JUDGE KLEIN’S APRIL RULING
Here are a few thoughts:
1. If Stockton’s re-organization plan, as currently proposed, is approved by Judge Klein, most municipalities across California will see borrowing costs increase for general fund secured debt issues. Certain issuers will lose general market access altogether for these types of loans and it is highly probable more onerous debt security covenants will be required even for secured debt issued by certain municipalities.
2. The national impact of the ruling, at this point, is minimal. Certain states prohibit Chapter 9 filings and many approach the Chapter 9 process differently. A number of states, when confronted with similar situations, have acted differently than California. From our perspective, there are Chapter 9 situations occurring in other parts of the country that have been handled much better than the State of California’s laissez- faire approach.
A review of the Central Falls, Rhode Island Chapter 9 experience and its speedy resolution (it took only 13 months) and, to date, the State of Michigan’s current approach to solving Detroit’s serious financial problems make the point. In both cases, the governors and state legislatures involved themselves. In the Central Falls bankruptcy, bond obligations were honored. This approach benefits Central Falls and municipalities across the state today. A similar approach, if employed, will help Detroit, and in the end, communities across Michigan.
3. California, to date, has approached Chapter 9 filings differently and this damages nearly all California municipalities. We understand some of this is political reality and some of it is California legal reality. But many investors really do not care much for all of that. The point is not to raise a parade of horribles that will befall Stockton and municipalities across California if debt holders are treated unfairly. This is an unknown at this point. Stockton’s residents and current employees have suffered much in recent years so a degree of compassion is due them, no doubt. But Stockton needs to settle with debt holders quickly and equitably. The State of California and CalPERS can help with this. Once broken, trust is difficult to regain and if Stockton debt holders are treated unfairly a segment of the investing public will invest their capital in other places.
4. A final take way is confirmation of a favorite theme of ours:
ADHERENCE TO THE THREE PILLARS OF MUNICIPAL BOND CREDIT RESEARCH
1. ESSENTIAL DEAL PURPOSE
2. SOUND DEAL STRUCTURE
3. SOLID UNDERLYING CREDIT QUALITY
We believe the three should work in tandem. Ideally, a credit is strong in all three areas. This situation occasionally occurs. More realistically, is the situation where a particular issue is lacking in one or perhaps two areas. In this situation if one is to invest, the third pillar needs to be at its highest level, in our view.
Here is a brief description of Stockton’s outstanding, troubled debt issues:
- 2003 Housing Certificates of Participation issued for library, main police station and fire stations 1,5,14- restructured with continued general fund backstop
- 2004 Arena, Ed Coy, Market Street Parking Garages- impaired, city no longer has possessory interest in garages and intends to pay nothing from the general fund
- 2006 Lease Rental Revenue Bonds for Eberhardt Office Building and SEB garage-restructured, eliminating general fund payments as a backstop
- 2007 Pension Obligation Bonds- 83% percent impaired, 17% secured by various revenue streams
- 2007 Variable Rate Demand Obligations for office building- restructured and continued general fund backstop
- 2009 Lease rental Revenue Bonds for golf courses and parks-restructured with no general fund payments, pledge, backstop, PFF revenue only pledge
- 2006 Department of Boating and Waterway Loan- impaired with no general fund payments, pledge, backstop
Bernardi Securities, Inc. portfolio managed client accounts never owned any of these debt issues and here’s why:
– All issues exhibited average to below average underlying credit quality at time of issuance.
– Only #1 and #4 possess essential deal purpose, as we define the term.
– Only #2, #3, #5 exhibit sound deal structure.
In summary, none of the issues possess all three pillars, two possess none, and five possess only one pillar which we do not view is at a high level.
What was our conclusion from our analysis? Do not invest in any
of these issues.
There are plenty of quality municipal bonds available to investors today. Fewer than in years past, no doubt, but a healthy supply still exists. Analyzing and understanding municipal bond credit is a process and often it is a tedious one. For that reason, we remain municipal bond specialists.
I hope you find this letter helpful. Thank you for your continued confidence.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
April 10, 2013