Guest Opinion: About Chapter 9 bankruptcy

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When cities sustain losses to revenue due to COVID-19, is bankruptcy the way?

Gordon Hamlin Jr., is a nationally recognized expert in Chapter 9 (government) bankruptcies.

Many California local governments have experienced major declines in sales and hotel occupancy tax revenue as a result of the worst pandemic this country has seen in a century.

Despite intense lobbying efforts by the National Governors’ Association and the National League of Cities, among others, Congress has been unwilling or unable to appropriate relief aid to the States and constituent local governments, leaving gaping holes in public budgets everywhere.

It remains an open question as to whether Congress would appropriate sufficient funds to cover all these shortfalls in the lame duck session after the election or in 2021, when a new Congress convenes.

If future appropriations are insufficient to fill the budget holes, each local government faces hard choices—cut expenses (usually in the form of personnel reductions), borrow money, or declare bankruptcy.

Many observers have noted that Chapter 9 of the Bankruptcy Act, which is applicable to local governments, might be used to reduce pension or health care obligations.

If a municipality wanted to use Chapter 9 to adjust its debts, what would that look like and how might it apply to pension and health care obligations?

The threshold question is whether a particular municipality is “insolvent,” meaning that it is generally not paying its debts as they become due (unless such debts are the subject of a bona fide dispute) or unable to pay its debts as they become due. 11 U.S.C. § 101(32)(C).

If that criterion is met, for example, due to large declines in sales or hotel occupancy tax revenue, then the municipality must include some certifications in any petition it might elect to file. The municipality must certify that it:

(A) has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter;

(B) has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter; [or]

(C) is unable to negotiate with creditors because such negotiation is impracticable. . ..

11 U.S.C. § 109(C)(5).

Creditor classes might include bondholders (if any), trade creditors, current employees, inactive employees and retirees, for example. The municipality is not required to impair every creditor equally, so long as it can justify the differential treatment. For example, a municipality might prize its access to the bond markets and might not want to jeopardize that relationship.

In any event, in order to force the confirmation of a plan, at least one class of creditors must agree to the proposed impairment of their debts by a vote of creditors holding at least two-thirds in amount and at least one half in number of the claims allowed in that class. 11 U.S.C. § 1126(c).

Now, suppose that a municipality wanted to adjust only its pension or health care liabilities. What would it have to do?

If it had no other class of creditors to impair, it would have to prepare a plan that was more appealing to its employees and/or retirees than what they presently enjoy. How it that even possible to contemplate?

• Take Seal Beach, which has to pay 38.93% of payroll in its Miscellaneous plan and 65.19% of payroll in its Safety plan in FY 2021-22, or Avalon, which has to pay 25.38% and 39.62% for the same plans.

Those are hefty contribution rates, particularly for Seal Beach.

Such high costs might mean that those municipalities cannot hire enough employees to manage all the work. These high costs may mean that raises become impossible to contemplate.

Other municipal services may have to be sacrificed to make the pension payments, and CalPERS is somewhat insistent on receiving all the annual required contributions.

Retirees, on the other hand, may be tempted to simply argue that they are entitled to receive everything they were promised, even if prior generations of local government didn’t contribute enough to fund those retirements.

There are more fair, secure and sustainable pension plans out there than what California presently offers.

Such examples might include the best-funded, best managed American public pension plan—the Wisconsin Retirement System—or the shared risk public pension plans pioneered by the Province of New Brunswick.

If a municipality were to structure a plan like Wisconsin or New Brunswick and offer that to current employees, coupled with a commitment to fund it, then employees might become convinced that such a plan was in fact better than the current arrangement, especially if it freed the municipality from onerous obligations. Agreements to extend the age of retirement, make COLAs contingent on market performance, and convert to a career-average formula could be negotiated and modeled.

The municipality might be able to retrieve its money from CalPERS and assume all liabilities, subject to adjustment in the Bankruptcy Court, and then set up its own plan. By consolidating assets with other municipalities pursuing the same course of action, entire new plans might be established.

Some might ask at this point why a 401(k) option would not be appropriate. The answer is almost self-evident. Why would employees holding two-thirds in value of claims for a pension ever vote to accept a 401(k) instead?

They wouldn’t, particularly not in the aftermath of the 2008 Global Financial Crisis or the 2020 spring Pandemic market crash.

This path of adjusting pension or health care liabilities through Chapter 9 bankruptcy would not be easy, to be sure.

But if Congress fails to provide appropriations sufficient to address the catastrophic declines in local tax revenues, some municipalities may need to consider this path.