Public Pension Fund Litigation Database

In carrying out research for a client about public pension fund trends, I came across a website called Pension Litigation Tracker. Maintained by the Laura and John Arnold Foundation, this collection of court documents and descriptions of ongoing developments in "pension reform lawsuits" looks to be a helpful resource at a time when there is increased pressure on numerous municipalities to address the challenges associated with underfunded retirement plans, including questions about the constitutionality of benefit arrangements. A drop down menu allows the user to search by state or by topics such as double dipping, increased employee contribution, pension rights and reduced benefits.

As I have discussed extensively in analyses about the impact of pension deficits on the sponsor's ability to raise capital, service debt and/or sustain economic growth, it is no surprise that litigation and regulatory enforcement that alleges either contractual non-performance or fiduciary breach (or both) is growing. Interested readers can download "Muni Bonds, Pension Liabilities and Investment Due Diligence" by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz (American Bankruptcy Institute Journal, July 2014). Also visit the Municipal Bond section of the Good Risk Governance Pays website.

These cases have the potential to be large in terms of dollar damages as well as the cost of defense. An example is the class action filed against the Board of Trustees of the Kentucky Teachers' Retirement System by its "75,000 active members, and over 45,000 annuitants."

While http://pensionlitigation.org/ emphasizes the legal nature of disputes about benefit reforms proposed by cities and states, it does not showcase the large number of investment-related lawsuits wherein a public pension plan(s) files a 10b-5 lawsuit against the issuer of a security that is owned by the plaintiff, alleging securities fraud. These actions are likewise large and plentiful. More will be said about this topic in a later post.

Pensions and Bankruptcy Claimants

The tug of war continues between pension plan participants and outside creditors. As a result, doing business with troubled municipalities may end up costing creditors time, money and headaches. Just a few days ago, Judge Christopher Klein with the United States Bankruptcy Court for the Eastern District of California ruled against Franklin Templeton Investments. By doing so, this asset manager will not be able to recoup the $32 million it sought from the City of Stockton as the municipality seeks to exit bankruptcy. Instead, as Reuters journalist Robin Respaut writes in "Holdout creditor in Stockton bankruptcy denied higher claim" (December 10, 2014) the city's plan would give Franklin "just over $4 million of the $36 million it said it is owed." This follows an October thumbs-up from the Court to reduce the payout to bond investors in order to maintain retirement and health care benefits and thereby (hopefully) prevent an exodus of badly needed city workers. 

A topic not actively discussed but critically important to ignore is that once-burnt lenders are unlikely to come knocking again. If they do, they will charge a higher cost of capital and demand tighter collateral safeguards to reflect the bigger risk associated with exposure to struggling borrowers. After all, lenders are accountable to their customers. As Bond Buyer's Keeley Webster describes, investors in Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund will suffer as the result of a low recovery rate in the neighborhood of twelve percent for loans made to Stockton. 

As Attorney B. Summer Chandler discusses in "Is It 'Fair' to Discriminate in Favor of Pensioners in a chapter 9 Plan?" (American Bankruptcy Institute Journal, December 2014) putting pensioners ahead of other unsecured creditors may not seem right to some but could be supported by "limited case law assessing chapter 9 plans..." taking into account "the unique nature of a municipality, its relationship to its citizens (including pensioners and current employees) and the purposes of chapter 9..."

To reiterate, customer risk is real for organizations such as Franklin Templeton. Unless its higher costs can be passed along to customers, expect some lenders and suppliers to say "never mind" and look elsewhere for business. This would logically reduce the supply of capital and services and could mean higher costs for all municipalities, not just those seeking bankruptcy protection. As my co-authors and I discuss in "Muni Bonds, Pension Liabilities and Investment Due Diligence" by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz (American Bankruptcy Institute Journal, July 2014), the evolution of decision-making can reduce uncertainty. We add that "...legal, economic and political skirmishes associated with municipal bond distress now being played out are helping to set the stage for future clarity." We assert that future bond buyers may still lend to a municipality if they "are comfortable in their belief that large unfunded post-employment obligations can be compromised as part of a distressed-debt workout..." and that "fresh capital can be a lifeline for a municipality that has fallen on hard times, even if it comes with a higher service cost.'

The best outcome is that pension-plagued municipalities seeking to exit from bankruptcy get their financial house in order as quickly as possible. While retirement plan participants have received a reprieve in some situations such as what happened with Stockton, the overall funding crisis is likely to reverberate in ways that could lead to future skirmishes. Witness what is happening right now, courtesy of the U.S. Congress. According to "Pension Bill Seen as Model for Further Cuts" (December 14, 2014), Wall Street Journal reporter John D. McKinnon portends future diminutions in employee benefit payouts if such action is deemed to prevent the "failure of just a few" plans being able to destroy "the federal pension safety net" (i.e. the Pension Benefit Guaranty Corporation). While the focus of lawmakers right now is on corporate union plans, it is not much of a stretch to imagine certain reductions being allowed throughout the United States and in other countries, postured as protection for the "greater good."

Detroit Swaps, Counterparty Risk and Valuation

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain's Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.