Detroit Resurrected, page 7
Still, Gordon advised the new pension board members to keep their mouths shut, despite Orr’s media blitz.
“You’re never going to win in the court of public opinion right now,” Gordon said he told the board members. “No one thinks you guys are a wonderful and empathetic character here. So forget it. Let’s not go there.”
SIMPLY TRYING TO ESTIMATE the size of Detroit’s pension shortfall illustrated the depth of the city’s financial two-step. In the corporate world, generally accepted accounting principles govern pension bookkeeping, making it difficult to skew the impact of legacy benefits. But government accounting standards historically allowed cities to disguise the full effect of these costs on their budgets.
“The problem is government pensions aren’t regulated, so they can do whatever they want,” said Lennox.
What’s more, actuarial assessments for pension funds are part mathematical science, part fortune-telling. Actuaries try to predict the future by applying formulas to project investment returns and mortality rates among pension holders. This allows employers to estimate their pension costs. But actuarial methods involve a surprising amount of guesswork, sprinkled with a heavy dose of worldview.
What is a reasonable rate of return to expect on your investments? Anyone with an online investment account knows that past performance isn’t an indicator of future results. Responsible families, businesses, and governmental entities project conservative rates of return to avoid unexpected shortfalls when the stock market doesn’t perform well. In 2014, the top 100 publicly traded U.S. companies with pension plans projected annual rates of return of 7.3 percent, according to actuarial firm Milliman.
In Detroit, Orr’s team concluded that by projecting average annual investment-return rates of 7.9 percent and 8 percent, the two pension funds had made their collective shortfall look a lot smaller than it really was. Why? The higher the assumed rate of return, the less money governments have to contribute to keep their pension funds healthy. With an expectation of high rates, there’s an assumption that investment increases will be sufficient to meet future pension obligations. This offers governments little incentive to accurately report the health of their pension funds. By simply maintaining an artificially high projected rate of return, they can lower their annual costs and spend money on other priorities.
Although Detroit’s investment expectations are typical of government pension funds, many of these funds, such as Chicago’s, are mired in funding crises. Government pension plans projected average return rates of 7.68 percent in 2014, according to the National Association of State Retirement Administrators. That contributed to what Moody’s Investors Service concluded was a $1.4 trillion unfunded pension liability for government pension plans in 2013.
Like many other pension funds, Detroit’s pension boards also used a polarizing actuarial technique called “smoothing” to spread out investment losses over a long period of time, instead of recognizing the losses immediately. The smoothing process—an actuarial form of lessening the impact of underperforming investments—further masked the seriousness of the pension shortfall in Detroit and allowed the pension boards to obscure the consequences of irresponsible investments.
The shortfall was far greater than the city could afford. A city that was taking in only about $1 billion in total annual revenue through its general fund owed more than three times its entire budget to pensioners. With Orr offering to pay pennies on the dollar to unsecured creditors, retirees feared the cuts could translate into pension reductions of more than 50 percent.
Furious pension officials suggested the city had skewed the numbers to justify pension cuts, pointing out that most government pension plans had similar investment-return assumptions. But Buckfire, the city’s investment banker, said the shortfall was a reality the city could no longer deny. As the city neared bankruptcy, the end result of decades of questionable pension practices and economic decline was becoming clear.
“They had grossly underestimated their liabilities and overestimated their assets,” Buckfire said. “It’s the way they ran these things. No one had bothered to tell them before. We told them the truth.”
CHAPTER 5
If bankruptcy is a stormy sea, bankruptcy attorneys are pirates who roam the waters. They implacably navigate waves, occasionally plundering their unsuspecting targets and defending their own turf against threats. They pop up suddenly when an opportunity presents itself, identifying hidden weaknesses in their opponents.
They adhere to their own shared honor code—federal bankruptcy law—and speak with a peculiar lingo. They are strangers to all lands, parachuting from spot to spot and spending long stretches away from home. Their alliances are constantly shifting, and they don’t typically take things personally because, after all, it’s just business and engagements rarely last long. Yet in some quarters, legendary rivalries flourish. Occasionally, bankruptcy attorneys try to demolish their opponent’s client in relentless pursuit of a victory. And they’re well acquainted with life-and-death scenarios. Sometimes heroes morph into villains, and villains become saviors.
It’s a small sea too. Many professionals in the restructuring world interact with each other constantly, sometimes collaborating on cases and sometimes warring. From an outsider’s perspective, it’s often hard to tell which ones are friends and which ones are enemies. They say things they don’t mean and mean things they don’t say.
The city’s lead law firm in Detroit’s bankruptcy was Orr’s former employer, Jones Day. At rates of approximately $1,000 per hour for the highest-level lawyers, Jones Day attorneys get paid handsomely to handle the most challenging legal situations. (Attorneys representing the city’s biggest financial creditors earn similar rates, though bankruptcy lawyers for the city’s labor creditors generally earn hundreds of dollars per hour less.)
The top attorneys assigned to lead Detroit’s restructuring included David Heiman, Bruce Bennett, Heather Lennox, and Corinne Ball, but they drew on a support system of dozens of other Jones Day litigators, negotiators, associates, and strategists.
As one of the founding members of Jones Day’s restructuring practice, Cleveland-based Heiman had a breadth of bankruptcy experience that made him the leader. He devised strategy and delegated authority to address the countless spokes of the complex case. His calm demeanor fits comfortably within tailored dark blue suits that balance against stately gray hair.
Bennett, a denizen of southern California, had recently represented the Los Angeles Dodgers in the club’s bankruptcy sale after the baseball team filed for court protection in 2011. But it was Bennett’s role in the 1994 Chapter 9 bankruptcy of Orange County, California, that established him as arguably the nation’s leading municipal bankruptcy litigant. He had joined Jones Day in 2012, exiting Dewey & LeBoeuf amid the law firm’s financial implosion.
Cleveland-based Lennox was fresh off a sizzling battle in the bankruptcy of Hostess, which she represented. After the junk-food manufacturer failed to reach a deal with its employees, its unions were obliterated, though the company’s Twinkies were eventually revived under new ownership. New York–based Ball had spent considerable time in Michigan as the lead Jones Day lawyer on automaker Chrysler’s 2009 bankruptcy case, working on a team that included Heiman and Kevyn Orr.
When Orr instructed the City of Detroit to stop paying its unsecured debts and liabilities, it was like waving a red flag to the pirates of the bankruptcy world to descend upon Detroit for battle.
To a Chicago attorney named Stephen Hackney, Orr’s move was a clear sign that it was time to act. Hackney, a partner for the esteemed global law firm Kirkland & Ellis, is a trial lawyer specializing in litigation in restructuring and private equity cases. After graduating from high school in East Lansing, Michigan, Hackney earned a bachelor’s degree from Rice University in 1994 and a law degree from the University of Chicago in 1997. His short-cut black hair, oft-furrowed brow, and athletically slender build give him the look of Agent Smith, the super-villain of The Matrix trilogy whose commitment to his cause would be deserving of scorn if it weren’t admirable for its pure relentlessness.
Hackney’s voluminous vocabulary stretches from Latin legalese to street-sensible dialect, making it easy for him to converse with the world’s top corporate attorneys or connect with ordinary people. But it’s his unwavering gaze in court hearings and in everyday conversation that reveals his ability to, simply, listen to whoever is speaking.
After Orr’s proposal to creditors, Hackney jumped to defend his obscure client, a bond insurer called Syncora. Orr’s pronouncement meant the city would not make a $40 million payment owed to investors holding its pension obligation certificates of participation, or COPs. That was crushing, albeit not unexpected, news for Hackney’s client, which had years earlier insured then-mayor Kwame Kilpatrick’s COPs and swaps deal. The Bermuda-based Syncora insured or owned about $400 million in Detroit’s COPs debt and insured the underlying swaps on the COPs debt. Fellow bond insurer Financial Guaranty Insurance Company, or FGIC, had insured most of the rest of the COPs and swaps.
When Detroit stopped sending payments on the COPs, thus defaulting on the debt, Syncora and FGIC were on the hook to make up the difference by compensating investors. That awoke the street fighters at Kirkland & Ellis, whose rivalry with Jones Day is nearing legendary status in the legal profession. Kirkland’s lead restructuring attorney, James H. M. Sprayregen, who was known in the insolvency industry as the “godfather of restructuring” for his outsized role in many major bankruptcies, dispatched Hackney to battle the city.
“He’s a very smart, capable, aggressive guy who doesn’t wilt under pressure,” Sprayregen said. “And that’s what we needed because we knew he was going to be the bad boy in the courtroom—the Darth Vader or whatever you want to call it. It wasn’t just Hackney. It was the war machine. But Hackney was the general.”
He was the general for a cause with little public support in Detroit. But Syncora had its own problems. A smaller insurer than FGIC, Syncora was believed to be facing potential insolvency if Detroit crushed the COPs. Its stock plunged to forty-eight cents per share as Orr made it clear to the markets that the city had no plan to treat Syncora with a soft touch.
Meanwhile, the city continued to make payments on the interest-rate swaps connected to the COPs. The swaps required the payment of more than $4 million per month to Bank of America Merrill Lynch and UBS. The city was quietly negotiating a settlement with those banks—legally called swap counterparties—to rid itself of the swaps.
Syncora’s reaction was swift. Hackney concluded that the city’s failure to make a payment on the COPs also triggered a default on the swaps. He immediately identified the city’s weak spot: it had pledged its steadiest source of revenue—gambling taxes—as collateral on the interest-rate swaps insured by Syncora and FGIC. Three days after Orr’s June 14 proposal to creditors, Hackney sent a letter ordering U.S. Bank—keepers of the city’s casino-tax collateral—to trap the taxes indefinitely and not release them to Detroit.
“No one is talking to us,” Hackney said. “We just don’t know what the heck is going on, so we trap the cash. That’s the next step to get someone to talk to you.”
Like pirates loading projectiles into a cannon, Syncora immediately drew the gaze of the enemy ship across the water.
“We offered an olive branch on June 14 and asked for peace,” Orr said. “They fired the first shot. And we said, ‘We ain’t gonna be your bitch. We aren’t gonna be punked by anybody. So let’s lawyer up. You want a fight? Let’s have at it. Let’s have a fight.’ ”
After a round of negotiations in New York over the COPs debt failed to deliver a settlement, Hackney left for an Independence Day vacation in Whitehall, a sleepy tourist town on the eastern edge of Lake Michigan.
But on the day after the Fourth of July, the city popped a surprise lawsuit on Syncora in a Michigan court, accusing the insurer of improperly attempting to seize the gambling taxes and requesting a temporary restraining order, or TRO, that would force U.S. Bank to release the gambling taxes to the city. The move was explicitly designed to catch Syncora off guard and regain immediate access to the casino cash. It worked.
“I’m hanging out all day with my little girls and my iPhone just completely blows up,” Hackney said. “I don’t have any Wi-Fi, so I go to this McDonald’s, which has unbelievably slow downloads. And I’m just downloading stuff and I’m like, ‘These cheaters just ran into court and got a TRO!’ ”
The city convinced the state court judge to restrict Syncora from taking further action.
“They basically are telling the court it is a matter of life and death that they get the trap lifted, even though they’re now at a point where, by the way, they don’t have to pay any of the creditors. They’ve already not paid us,” Hackney said. “When you can do that, you no longer have a cash-flow problem. If you need cash, don’t pay your pensioners, don’t pay health care. You can do whatever you want. You have tons of cash.”
But Syncora’s attorneys weren’t present to argue that point.
“No one says, ‘Where is Syncora? Why aren’t they here? Did you even try and give them notice?’ ” Hackney said.
They hadn’t. Jones Day filed the lawsuit without notifying the insurer’s attorneys and convinced the state judge to release the casino money on the day after the Fourth of July.
“That’s the worst form of cheating,” Hackney said. “I got back to my house and I’m reading the Wall Street Journal, and it’s Orr saying that he won’t let Syncora take the city hostage. I was like, ‘This is bullshit.’ I was so angry.”
Orr, who later called Hackney’s boss, Sprayregen, “a good friend of mine,” expressed little sympathy for Kirkland’s plight.
“Fuck ’em if they can’t take it,” Orr recalled, leaning back in his chair and smiling. “They wanted a fight.”
The stage had been set for a bitter conflict between Syncora and the City of Detroit.
“This really set the tone for the bankruptcy because you’ve got to understand how this impacts lawyers. I know everybody thinks lawyers are sharky, and nobody likes lawyers,” Hackney said. “But the fact of the matter is it’s an honorable profession that has a code of ethics, and we really conduct ourselves in a way that we think we’re supposed to. This was really, really bad cheating that went on.”
He prepared a scathing response to Jones Day’s actions. “It basically said, ‘You guys are cheaters, and your lawsuit is invalid,’ ” Hackney said.
Orr, flashing a wide smile, dubbed Syncora’s retaliation a “nastygram.”
“Fuck you very much, have a nice day” was the essence of Syncora’s message, Orr said, chuckling. “Yeah, yeah, yeah. Bite me.”
AMONG RESTRUCTURING PROFESSIONALS, labeling one side as a scallywag is part of the piratey way. That doesn’t mean it’s personal. Bankruptcy lawyers, investment bankers, and restructuring consultants can get passionate, yes, but on the job they’re generally logical beings. In a corporate context, their actions are best viewed through the mechanical lens of a restructuring formula. Slash the debt. Monetize the assets. Fix the balance sheet. Acquire new financing. Reach settlements. Identify a business plan. Move on to another deal.
When examining a distressed company they remove their personal feelings from the equation. They’re like surgeons. If they get emotionally involved in the lives of their patients, they won’t be able to do their jobs.
“We don’t care how you got cancer. Our job is to cut it out and give you a good chance of survival after that,” explained Bill Nowling, senior advisor and spokesman for Orr, describing restructuring professionals. “You’ve got to stop smoking, you’ve got to eat better, you’ve got to get exercise. Otherwise you’ll be back on the table, and we’ll cut more out. I can’t get caught up on how you got here. It doesn’t matter. My job is to fix this problem. I may not like that you made bad lifestyle choices to get here. I may disagree with them philosophically.”
Still, the political context of a municipal restructuring introduces an emotional element that’s often absent in corporate cases. Citizens who rely on police for protection from criminals, pensioners who rely on good fiscal management to protect their livelihoods, and regional leaders who have varying political agendas—all have a significant emotional stake in a Chapter 9 bankruptcy.
That makes Chapter 9 a mystifying realm for even the most seasoned restructuring pirates. Before Detroit, the most significant Chapter 9 bankruptcy was Orange County, California, which had filed in 1994 after a run of bad investments. The largest municipal bankruptcy of the twenty-first century by total debt, until Detroit, was Jefferson County, Alabama, which had filed after a water and sewer debt deal soured.
Several mid-size cities in California filed for Chapter 9 bankruptcy after the Great Recession, but in general, municipal bankruptcy was unexplored territory. In fact, it was so rare that case law in Chapter 9 bankruptcy was quite limited, leaving many fundamental questions unanswered, such as the treatment of constitutionally protected pensions.
Essentially all of the professionals involved in Chapter 9 bankruptcies are veterans of Chapter 11 bankruptcies, in which corporations seek to reorganize their debts. But for good reason Congress established significant differences between municipal and corporate cases. Cities cannot be liquidated, nor can they be split up and sold for parts. So Congress wrote Chapter 9 bankruptcy law to protect cities from being forced to sell assets to satisfy creditors. After bankruptcy, cities must continue to service their residents indefinitely. Police departments must continue protecting the people. Fire departments must continue responding to fires.
In corporate bankruptcies, federal judges can oust executives, effectively seizing control of a company’s operations. But the U.S. Constitution’s Tenth Amendment says, “The powers not delegated to the United States by the Constitution, nor prohibited by it to the states, are reserved to the states respectively, or to the people.”
