Chapter 9 Revisited:
Preparing for the
Next Down Turn
An in-depth article by David Dubrow featured in
Pratt’s Journal of Bankruptcy Law, April/May 2016
Article Overview
Given the recent municipal bankruptcies and likelihood of more to come during the next
recession, the author draws lessons from recent cases to determine what changes to
Chapter 9 would be in the interest of the nation.
Washington, DC / Los Angeles / New York / San Francisco / arentfox.com
PRATT ’S JOURNAL
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Chapter 9 Revisited: Preparing for the Next
Downturn
By David L. Dubrow*
Given the recent municipal bankruptcies and likelihood of more in a few
years, the author draws lessons from recent cases to determine if changes to
Chapter 9 would be in the interests of the nation.
The municipal market was shaken by the Great Recession. Revenues
decreased significantly while fixed expenses increased, resulting in a severe fiscal
crisis among many states and municipalities throughout the country. Revenue
generation diminished not only due to a downturn in tax revenues but also on
account of decreased federal aid to states and state aid to municipalities. In
addition, numerous state laws previously capped tax increases thereby leaving
limited room for many municipalities to be able to raise taxes to address the
economic crisis. Fixed expenses increased largely on account of growing pension
liabilities, retiree health care costs and wages. A number of municipalities were
also over-leveraged with large debt service payments on bonds issued prior to
the Great Recession. From large swap termination payments, to higher interest
rates on account of draws on liquidity facilities, to the elimination of the
auction rate market, municipalities were financially harmed.
Certain parts of the country were hit harder than others. States such as
California, Nevada, New Jersey, and Florida, which had thriving real estate
markets, were particularly hurt by the economic downturn caused by the
bursting of the real estate bubble. The Midwest, which was suffering from a
long term structural decline on account of the demise of manufacturing, was
also severely damaged. States with a history of strong unions were at a
disadvantage because the higher wages and benefits gained by the unions were
motivating more businesses to gravitate to foreign countries or other localities
in the United States where labor costs were lower.
It should therefore be no surprise that the states that experienced the
bankruptcy filings of an unprecedented number of sizable cities were California,
Michigan, and Pennsylvania. It should also be no surprise that cities in the
states of Illinois, Nevada, and New Jersey have also been under increasing strain.
*
David L. Dubrow is a partner at Arent Fox LLP representing financial institutions and
clients in a variety of other industries in lending transactions, work-outs, and bankruptcies. He
also represents bond trustees, credit enhancers, and bondholders in their recoveries of defaulted
tax-exempt bonds and in municipal bankruptcies. He may be contacted at
[email protected].
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Technically, the United States economy is in the seventh year of a recovery.
However, the recovery has been very timid and unlike other post WW II
recoveries. Interest rates have been at deflationary-like levels throughout the
recovery, job growth has been in lower paying jobs and the distribution of
income has become more lopsided than ever. The recovery has been strained
and uneven. It is one that seems to mark a new phase of United States economic
history whereby many children will in all likelihood be worse off economically
than their parents.
This new economic phase will be challenging for municipalities. A typical
recovery lasts for about seven years. This suggests that we are in the later stages
of the present recovery. Yet, while municipal revenue has started to increase,
controlling expenses continues to be difficult in many parts of the country.
Pension and retiree health care costs have increased dramatically. Some states
deliberately underfunded their pension obligations thereby resulting in increased future payments needed to pay growing unfunded liabilities. A number
of states such as Illinois, New Jersey, and Pennsylvania have state laws making
it nearly impossible to reduce pension payments while they simultaneously face
opposition from strong public unions resisting any reduction in wages or
benefits. Over the past number of years, notwithstanding the significant rise of
the stock market, unfunded liabilities of many municipal and state pensions
have increased on account of the pace of required contributions.
Historically, too many municipalities have relied on a fiscal strategy of
kicking the can down the road. The common expectation was that eventually
a recovery would address and resolve all fiscal problems. This strategy is no
longer available. Consequently, the next recession is likely to have a particularly
negative impact on municipalities especially in states like Illinois, New Jersey,
Pennsylvania, Michigan, and California.
Entering the next recession, notwithstanding that municipalities have been
building up reserves, a number of municipalities will already have a budget
based on severe cuts in services and a backlog of infrastructure needs. Many
municipalities will also continue to have growing retiree health care costs and
growing pension liabilities that cannot be easily reduced under state law. The
combination of declining revenue in a recession with already highly cut expense
budgets, increasing pension and retiree health care costs and growing infrastructure repair needs will be unprecedented. There will likely be another series
of municipal bankruptcies of sizeable municipalities.
This likelihood will be reinforced by the reduction of the stigma of
bankruptcy in the market place. The market now better understands and, to a
certain extent, expects there to be some municipal bankruptcies of sizable
municipalities. In addition, municipalities like Jefferson County and Detroit,
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have found ways to access the capital markets post-bankruptcy. This ability
further enhances the possibility of more filings.
The next downturn is likely to occur later in 2016 or in 2017. Therefore,
Chapter 9 filings are likely to decline prior to the downturn but increase
thereafter. Given the recent municipal bankruptcies and likelihood of more in
a few years, this is a good time to draw lessons from these recent cases and
determine if changes to Chapter 9 would be in the interests of our nation.
LESSONS FROM RECENT CHAPTER 9 FILINGS
Before drawing specific lessons, we should be clear on some contextual issues.
First, it needs to be understood that the fiscal crisis of municipalities is a
symptom of a struggling national economy. Increased taxes and declining
public services, dilapidated infrastructure and a poorer quality of public
education are part of the deeper challenge of achieving meaningful economic
growth in our country. The fundamental basis for this challenge must be
addressed or material economic growth will remain elusive.
Second, we need to recognize that Chapter 9 does not address these
underlying causes of tepid growth. Rather it provides a method for:
(i)
determining the amount of sacrifice necessary to achieve long term
fiscal stability and a basic level of service provision by the municipality
to its citizens; and
(ii)
for sharing the sacrifice among citizens, employees, retirees, bondholders and general unsecured creditors.
It is a tool to address the immediate fiscal insolvency by determining the level
of necessary pain and distribution of such pain in order to achieve solvency. The
pain is designed to result in a satisfactory level of solvency for the municipality
but it does not provide an engine and basis for growth or a basis for raising the
standard of living. Put differently, it distributes the decline in the standard of
living and in and of itself does nothing to improve it. Determining the level of
sacrifice necessary to achieve long term financial health is a very difficult task.
Creating a fair solution for all parties in an inherently no-win situation is no less
challenging. The only satisfactory solution will be one that addresses the
underlying causes of our national economic stagnation and its impact on
municipalities.
Finally, while Chapter 9 cannot address the macroeconomic causes of a fiscal
crisis, it can and should address any municipal governance and operational
causes that resulted in the fiscal decline. Failure to address these issues means a
failure of Chapter 9 to accomplish its purpose of providing a path to long term
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fiscal health. These governance problems typically include political corruption,
severe operational deficiencies, inept governance based on unwillingness to
make politically difficult decisions, political infighting and inherently ineffective governance structures. These governance and operational causes have been
present in each of the recent Chapter 9 filings and should not be ignored.
Politics Has a Significant Influence on Outcome
There are a number of important lessons from recent experience that serve as
an important guide for how to improve Chapter 9. The first lesson is that
politicians are not the best parties to play a central role in determining the
amount of and how to allocate pain among the affected stakeholders or to
address governance issues. Distributing pain is antithetical to their political
survival. Yet, since Chapter 9 allows only the municipality to propose a plan,
politicians necessarily play a central role and politics inevitably plays a critical
role in the process. Competition among politicians in the executive and
legislative branches can make for a very dysfunctional process. Concerns for
obtaining votes can result in outcomes that, although politically attractive, are
not in the interests of long term financial health. Moreover, existing officials
likely had some role in contributing to the fiscal problems and are far from
being the best parties to promote governance and operational reforms.
Concomitantly, it must be understood that while a receiver or emergency
manager can create the context for an efficient decision making process they
cannot insulate a bankruptcy process from politics. The reason is simple. A
receiver or emergency manager is appointed by a Governor and accountable to
a Governor. Governors are politicians too. Political considerations inevitably
influence the Chapter 9 process.
State Policy Plays a Critical Role
A second lesson is that state policy matters in determining the outcome of a
Chapter 9 case. States such as Rhode Island, Michigan, and Pennsylvania have
taken active roles in addressing fiscal distress in their states. Although each state
has a receiver or emergency manager statute, state policy has been different. The
state or court-appointed receiver played very different roles in recent cases based
on these divergent state policies.
In Rhode Island a coherent policy was implemented to protect the access of
municipalities throughout the state to the capital markets at reasonable interest
rates while encouraging the use of Chapter 9 to address the severe pension crisis.
The policy was accomplished by the passage of a law providing that all general
obligation bonds issued by municipalities would be secured by a statutory lien
on all tax revenue. This law provided critical security for general obligation
bonds in the event of a Chapter 9 filing.
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The Central Falls’ bankruptcy was a test case. In that case, general obligation
bonds were left unimpaired. The receiver was able to negotiate labor concessions and restructure the pension plans. The case was resolved in about one year.
It then provided leverage for other cities in Rhode Island to negotiate pension
changes outside the context of a Chapter 9 filing.
Michigan’s policy was very different. The governor’s policy, implemented
through the emergency manager, was that preserving access to capital markets
was not an issue of significant concern; rather the priority became minimizing
harm to pensioners. Therefore, the emergency manager, with the governor’s
support, made a frontal attack on all bond types including unlimited general
obligation bonds, limited general obligation bonds, pension obligation bonds
and water and sewer bonds. In relation to pensions, the governor supported
legislation that provided approximately $300 million of state support for
Detroit pensioners. It was the only form of state support provided in the
bankruptcy.
In Pennsylvania, the state policy was to work to avoid a Chapter 9 filing if
at all possible so as not to harm municipalities throughout the state. The
receiver in Harrisburg opposed a bankruptcy filing and worked to develop a
consensual plan outside of bankruptcy. Since the receiver was provided with the
power to make a Chapter 9 filing, the bankruptcy threat was used as leverage
to negotiate settlements. An approach was designed to protect general access to
capital markets by not harming general obligation bonds but to restructure
revenue bonds that were issued to finance a very troubled incinerator project.
In terms of labor issues, pensions were not harmed but labor concessions were
agreed to in order to assist Harrisburg in balancing its budget.
These three distinct approaches demonstrate the fundamental influence that
a state can exercise to affect the approach of municipalities to their fiscal
insolvency. State policy as implemented through laws and through the approach
to treatment of differing creditor groups plays a critical role in determining the
outcome of a Chapter 9 case, including which constituencies are and are not
materially harmed.
Judges Have Significant Powers in Chapter 9
A third lesson is that the widespread ambiguities in Chapter 9 and lack of
legal precedent addressing these ambiguities creates uncertainty for debtors and
creditors and provides decision makers with very wide latitude in shaping the
Chapter 9 outcome. While ostensibly Chapter 9 provides judges with less
power than under Chapter 11, the reality is that judges have significant power
in Chapter 9 cases due to these ambiguities and the difficulties involved in
winning an appeal of the confirmation of a plan. Without clarity in statutes,
judges end up making the law. In addition, since almost all judges have little
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experience with municipal finance they may be prone to apply corporate
finance constructs and Chapter 11 constructs to municipal issues in a manner
that distorts outcomes.
Meaning of Best Interest of Creditors Test Uncertain
A plan proposed by a debtor in bankruptcy must be in the best interests of
creditors. A fourth lesson is that the best interests of creditors test, which is a
critical protection for creditors, may be rendered meaningless by the courts
under Chapter 9. In Chapter 11, this test is applied by comparing recoveries
under a plan to what recoveries would have been if the company had liquidated.
Under a plan, each class of creditors must receive at least as much as they would
in a liquidation. If this is the case, the plan meets the requirements of the best
interests of creditors test.
Municipalities cannot liquidate. The test in Chapter 9 has generally been
applied by comparing plan treatment with recoveries to creditors assuming the
case were dismissed. This typically results in the conclusion that all creditors are
treated better in the plan due to the death spiral and chaos projected if the case
were dismissed. This conclusion strips the test’s protection from creditors who
have stronger rights under state law and would presumably fare better than
other creditors outside of a bankruptcy. Whereby a liquidation analysis
necessarily takes into account differing rights of creditors, the Chapter 9
dismissal analysis has failed to do so by concluding that all creditors would be
worse off because of the race to the courthouse by all creditors to enforce their
rights. This conclusion can be reinforced by the limited remedies often available
to creditors under state law.
Another way the best interests of creditors test has been applied in Chapter
9 is by determining if the plan maximizes recoveries of creditors in a manner
reasonable under the circumstances. That creditor recoveries should be maximized is obviously critical for creditors—but what this principle means in
practice is entirely unclear. A uniform and unambiguous framework for the
application of these standards in Chapter 9 is needed.
Meaning of Unfair Discrimination in Chapter 9 Uncertain
A fifth lesson is that application of the concept of unfair discrimination in a
municipal context is also unclear, resulting in considerable risk to creditors of
a cram down. In determining what constitutes “unfair discrimination,” courts
in the corporate context generally apply either the traditional “four factor test”
or the newer “rebuttable presumption test.” The four factor test considers:
(i)
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(ii)
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tion;
(iii)
whether the discrimination is proposed in good faith; and
(iv)
the treatment of the classes discriminated against.
The rebuttable presumption test permits a material difference in treatment to
be overcome by demonstrating that the treatment is consistent with the results
the classes would obtain outside of bankruptcy or that a greater recovery is
affected by contributions to the reorganization from a particular class.
Notably, Judge Rhodes in Detroit set a new standard for unfair discrimination, declaring that the moral conscience of the court was essentially the
dictating factor. It is difficult to imagine a more subjective standard. Should
other courts follow Judge Rhodes’ lead, both municipalities and creditors will
face even more uncertainty in future cases.
Determining Plan Feasibility Is an Issue
A sixth lesson is that it is very difficult for judges to have an objective basis
to determine the feasibility of a plan. A plan is feasible so long as it is reasonable
to expect that the debtor will be able to implement it. The municipality will
argue the plan is feasible because it is proposing the plan. Rather than arguing
the plan is not financially feasible, creditors are very likely to argue that the
debtor can, in fact, afford to pay them a greater recovery than the recovery
proposed in the plan. Therefore, creditors also have little interest in challenging
feasibility since challenging feasibility suggests the debtor cannot afford to pay
more to creditors.
In the post-Great Recession Chapter 9 cases there has not been one serious
challenge lodged to the feasibility of a Chapter 9 plan. Not in Vallejo (which
may end up filing again during the next economic downturn), Stockton (which
will face growing pension payments that may challenge its solvency in the not
so distant future), Detroit (where the Judge wisely hired his own feasibility
expert who was on the fence regarding feasibility based on her report), Jefferson
County or Central Falls. This is an important issue since the reluctance of
politicians to impair pensions, the most significant and increasing expenses of
municipalities, raises questions about the feasibility of proposed plans. Consequently, in the next downturn we may see some municipalities filing a second
Chapter 9 petition (colloquially known as a “Chapter 18”).
A related lesson is that feasibility should be viewed to include governance
issues. To the extent issues relating to governance played a material role in
causing fiscal insolvency, these issues must be addressed in any feasibility
analysis of a plan. A plan is only feasible to the extent its execution will be
responsibly implemented.
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Critical Need for Clarity and Further Integrating Chapter 9 with
Municipal Realities
Greater specificity and less ambiguity would help minimize the role of
politics in the process. It would also make law through the legislative process
rather than through the judicial process so that it is based on a uniform
coherent public policy. More clarity in the statute would allow all parties to
know the rules and base their behavior on this knowledge.
From a policy perspective, Chapter 9 changes should be consistent with the
purposes of a uniform bankruptcy law, the 10th amendment and municipal
realties. The proposals advanced below are intended to achieve such consistency.
They are also intended to be based on principles of fairness.
It is important to note that the proposed amendments may in fact be
consistent with existing law. But the law as currently drafted is so ambiguous
that it is open to numerous interpretations and unpredictable results. The
advancement of these proposed amendments is not intended to suggest that
they are inconsistent with existing law, but rather that greater legislative clarity
is needed.
PROPOSED AMENDMENTS TO CHAPTER 9
Determination and Treatment of Secured and Related Claims
In a bankruptcy plan claims are divided into classes. Each member in a class
of claims is treated the same.
There are different types of claims in a Chapter 11 bankruptcy. One type is
secured claims which are claims that are secured by a lien or security interest in
some type of property. Examples are claims secured by mortgages or liens on
equipment, securities or bank accounts.
Secured claims are essentially treated in a plan based on the value of the
collateral securing the claim. If the value of the collateral is greater than the
principal amount and accrued interest on the debt, then a secured claim will
generally be unimpaired. If the value of the collateral is less than amounts owing
the creditor, then the claim may be split into a secured claim up to the value
of the collateral and an unsecured claim for the deficiency.
In addition, secured claims also face the risk of cram down. A cram down is
where a class of creditors votes against a plan but is forced nonetheless to be
bound by the plan. For a class to be crammed down, at least one other impaired
class must vote to accept the plan and the plan cannot discriminate unfairly and
must be fair and equitable. To be fair and equitable with respect to a class of
secured claims, a plan must provide: (i) that the lien securing the claims remains
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in effect and the class receives deferred cash payments totaling at least the
amount of the value of the collateral; or (ii) for the realization by the claim of
the indubitable equivalent of such claim.
Therefore, the risk for secured creditors is that their claims could be
“crammed down” based on disputes regarding the value of the collateral and the
meaning of providing an “indubitable equivalent,” especially as it related to the
interest rate on the debt.
In the municipal realm, unlike the corporate realm, liens are generally on
revenue streams and not on hard assets. In addition, there are statutory
mechanisms designed to restrict the use of designated revenue streams for
payment of debt service on specified bonds. These statutory restrictions are not
liens but are intended in the municipal realm to function like liens.
Statutory liens mandated by state law survive a Chapter 9 filing while
contractual liens do not survive as a result of Section 552 of the Code which
cuts off contractual liens as of the date of the filing. In addition, bonds secured
by special revenues have special protections. However, there are important
issues that should be clarified in the Code.
Special Revenue Bonds
In the Detroit bankruptcy the issue arose as to whether special revenue bonds
may be crammed down. A cram down of special revenue bonds could mean that
the principal amount of the bonds is reduced based on the value of the revenue
stream securing the bonds being valued at an amount lower than the principal
amount of the bonds. A cram down could also mean that the interest rate on
the bonds may be lowered to a market rate preserving present value at current
interest rates. A cram down may also entail eliminating a prepayment premium
or a lockout on redemption. In Detroit a cram down was threatened to reduce
the interest rate and eliminate call protection.
The Code is ambiguous on whether a cram down is applicable to special
revenue bonds. On the one hand, Chapter 9 incorporates the cram down
provisions of Chapter 11. On the other hand, the protections provided to
special revenue bonds and the legislative history of Chapter 9 demonstrate an
intent to exclude special revenue bonds from the risk of a cram down. The Code
should be amended to be consistent with the intent expressed in the legislative
history that special revenue bonds should maintain the business terms of their
original bargain. Cram down should explicitly not apply. Special revenue bonds
should ride through bankruptcy unscathed.
Special revenues include “special excise taxes and other revenue derived from
specific functions of the debtor.” The legislative history of the Code suggests
that these special excise taxes and other revenue constitute special revenue if
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they were used to secure bonds that financed a project or system of some kind
that related to the generation of such tax or revenue. One example would be a
hotel excise tax generated by a hotel at a convention center financed with bonds
secured by, among other things, the excise tax. However, some parties have
entered into transactions with municipalities in which obligations are secured
by excise taxes or other such revenue and are not related to revenue bonds.
These parties have claimed special revenue status in Chapter 9. The Code
should be amended to clarify that special revenue obtains special revenue status
only when it secures revenue bonds.
Restricted Funds
Another issue that deserves clarification is the treatment of restricted funds.
A common device in municipal financing, but not corporate finance, is the
dedication of a particular revenue stream to the payment of specified debt. This
dedication is not accomplished with a lien but rather by specifying in a statute
that the revenue stream, e.g., a specified tax, must be deposited in a segregated
fund to be used solely to pay debt service on specified bonds and for no other
purpose unless and until the bonds are paid. An undecided issue in Chapter 9
is whether the owners of bonds payable from restricted funds have a property
interest in those funds that will be protected in bankruptcy. This issue was
raised but not decided by the court in the Detroit bankruptcy.
The Code should address the treatment of bonds payable from restricted
funds by providing that they be treated in the same manner as bonds secured
by special revenue. The concept of special revenue was introduced into Chapter
9 to preserve and protect the revenue bond market. Bonds payable from
restricted funds are fundamentally similar to special revenue bonds and should
be provided the same protections.
Intercepts
A common financing device in the municipal market is the intercept of state
monies to be paid to a municipality. The intercepted state monies are not paid
to the municipality but rather paid directly to a trustee on behalf of
bondholders. Typically, a lien is not granted on these state monies.
An open issue in Chapter 9 is whether these intercepted monies are property
of the municipality and thereby subject to the automatic stay. To preserve the
functioning and intent of the municipal market, Chapter 9 should explicitly
provide that state intercept monies paid directly to a bond trustee are not
property of the debtor for purposes of Chapter 9. Such a provision would
permit these bonds to be paid during the Chapter 9 case as intended.
Treatment of Unsecured Claims
In addition to secured claims, the other basic type of claim is an unsecured
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claim. Unsecured claims are not secured by any collateral but rather are solely
a payment obligation of the debtor. The Code identifies a number of unsecured
claims which are given a priority in a Chapter 11 bankruptcy. Priority claims are
generally paid in full in cash or a note providing for full payment on a present
value basis. Unsecured claims, which are not priority claims, should be treated
in the same manner in a plan unless a debtor can demonstrate it is fair to
discriminate between or among classes of similarly situated creditors.
Priority Claims
Chapter 9 does not incorporate the vast majority of claims treated as priority
claims under Chapter 11. The only priority unsecured claims incorporated into
Chapter 9 are through Section 503(b). These are claims pertaining to necessary
post-petition operating expenses of the municipality. However, Section 904
limits the ability of the court to interfere with the revenue and property of the
debtor. Consequently, the court does not have the power under Chapter 9 to
determine necessary operating expenses of a municipality. This creates an
ambiguous tension in Chapter 9 that should be clarified.
Collier on Bankruptcy presents a framework to address this tension that this
author believes should be incorporated explicitly into Chapter 9. In Collier’s
framework the only operating expense priority would be the expenses and fees
of the debtor’s professionals in relation to the bankruptcy case itself. Section
943 requires that these fees be disclosed and be reasonable. Otherwise, 503(b)
should not be incorporated into Chapter 9 because the court is prohibited from
determining necessary operating expenses of a municipality. This approach
reconciles competing provisions presently in Chapter 9. It is also the approach
taken by the one court that has addressed this issue—the bankruptcy court in
the New York City Off-Track Betting Corporation Chapter 9 filing.
General Unsecured Claims
Unsecured claims constitute a broad array of debt obligations, all payable
from the general fund of the debtor. Based on the very limited nature of priority
claims in Chapter 9, virtually all unsecured claims will not have a priority but
will be of the same general status. Therefore, the critical issues in Chapter 9
relating to unsecured claims are:
(i) the legitimate basis, if any, for differentiating between and among
unsecured claims to create classes with materially different recoveries;
and
(ii) whether recoveries as a whole to unsecured creditors are fair under the
circumstances.
Best Interests of Creditors Test
As explained above, the best interests of creditors test has been essentially
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rendered meaningless in its application in Chapter 9 since, unlike corporations,
municipalities cannot liquidate. In applying this test, courts have analyzed
whether creditors would have recovered more than provided in a plan if the
Chapter 9 case were dismissed. Invariably, courts decide that the race to the
court house and the subsequent “death spiral” would be worse.
The best interests of creditors test in the corporate context is designed to set
a minimum bar for recoveries to each creditor class and creditors as a whole.
This can be meaningfully achieved by analyzing how claims would be treated,
relative to each other and as a whole, in a hypothetical liquidation. Applying
this test to a municipality by analyzing a hypothetical dismissal fails to achieve
the essential purpose of establishing this bar.
The Code should set parameters for analyzing treatment in a hypothetical
dismissal. The Code could specify that in Chapter 9 the best interests of
creditors test should be applied to each class of claims and to creditors as a
whole.
When applying the test to each class of claims, the court should be required
to compare treatment in a plan to treatment in the event of dismissal of the
case:
(i)
taking into account material differences in legal rights between and
among classes of unsecured claims; and
(ii)
assuming that courts will enforce creditors’ legal rights.
All obligations that are expressly provided constitutional or statutory protections with the intent of requiring superior payment rights should be treated
materially better in a Chapter 9 case. Examples of these obligations would
include:
•
Obligations backed by the full faith and credit of the municipality with
no statutory limit on the ability to raise taxes to provide payment.
•
Obligations that must be paid under all circumstances pursuant to a
constitutional provision as interpreted under state law such as pensions
in Illinois.
•
Obligations that must be paid as a first payment priority pursuant to a
constitutional or statutory provision.
This framework would require the court to, at a minimum, preclude a class
of unsecured claims with materially better rights under state law from being
treated worse than a class of unsecured claims with materially worse rights. The
court should apply the test so that an unsecured class with materially superior
legal rights would be treated materially better than other unsecured classes.
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When applying the test to creditors as a whole, the court should determine
whether the debtor has maximized recoveries for creditors in a reasonable
manner under the circumstances. This is a complicated issue but we suggest a
simple framework.
First, a plan should not be confirmed unless a municipality reduces expenses
so that wages and benefits are paid at a market level for the geographic area and
based on the wealth of the community. The number of employees should be
comparable to those in other cities of its size and the workforce should be no
larger than is reasonably required to provide needed services to citizens.
Generous above market benefit packages also cannot be sustained by a city that
cannot pay its bills. Failing to cut labor related expenses, for whatever reasons,
including local laws that may prevent such cuts, is not fair to creditors.
Second, there should be a requirement that if taxes could be higher without
resulting in population loss, counterproductive economic results or a violation
of state law, taxes must be raised or a plan cannot be approved. Finally, if a
municipality owns assets that are not used for public functions but rather for
proprietary functions, the value of such assets should be maximized for the
benefit of creditors. Assuming that the monetization value of any such asset is
meaningfully greater than any debt encumbering such asset, the asset should be
monetized and the excess monies should benefit creditors.
It has been argued that a court in a Chapter 9 proceeding cannot compel
expense cuts, tax increases or asset sales because Section 904 of the Code
prohibits the court from interfering with the property or revenue of the
municipality. This is true. However, a court does not have to confirm a plan
that violates the best interests of creditors test. The power of the court is to deny
confirmation of a plan that does not meet the confirmation requirements. Then
the municipality has the choice of meeting the requirements established by the
Code or risking its case being dismissed.
So, for example, if local law requires above market salaries for safety workers
and the citizens choose not to change this law, then a plan should not be
confirmed if impaired creditors reject it. Or if citizens vote down a tax increase
that would not have negative economic consequences for the municipality, then
a plan should not be confirmed if impaired creditors reject a plan. Or if the
value of a proprietary asset is not maximized for the benefit of creditors, then
a plan should not be confirmed if rejected by impaired creditors.
The above requirements should be made explicit in the Code. Courts would
have to apply these guidelines to the facts and circumstances but the explicit
framework would make clear the intended meaning of these tests in the
municipal arena. A battle of experts would undoubtedly take place and judges
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would have to make their own determinations based on an evaluation of expert
testimony.
Unfair Discrimination
The issue of unfair discrimination has arisen in municipal bankruptcy cases
mainly relating to the treatment of pensions versus other unsecured claims. The
framework set forth by Judge Rhodes in the Detroit case relied almost solely on
the moral conscience of the judge. This approach is too subjective. The
treatment of pensions is a critical policy issue that will be addressed in more
detail later in this article.
Discrimination should not be permitted among or between similarly situated
creditors unless the reason for the discrimination is compelling and based on
objective criteria. The Code should provide that material disparate treatment
would be considered fair only if:
•
New value were contributed to the municipality by a creditor justifying
the better treatment for this creditor; or
•
The disparate treatment is justified on account of materially different
legal rights under state law.
The second prong of this test is consistent with the best interests of creditors
test proposed above. The test provides a clear and objective basis for
determining whether unfair discrimination is occurring.
Feasibility
In determining whether a plan is feasible, the court should evaluate the
financial feasibility of the plan in the context of any political issues that
materially contributed to the fiscal crisis. These political and governmental
issues should be addressed by the debtor in a manner that satisfies the court that
they will not be material obstacles to implementation of the plan. A plan that
will not reasonably be able to be implemented on account of governmental
problems is not a feasible plan. The Code should be amended to require such
an inquiry and determination as it relates to feasibility.
Examiner
To assist the judge and creditors in assessing whether the feasibility and best
interests of creditors tests have been satisfied, Chapter 9 should be amended to
allow any party in interest to request that an examiner be appointed by the
court to evaluate whether the plan adequately addresses:
(i)
Financial feasibility;
(ii)
Implementation feasibility including assessment of any materially
ineffective government structures and issues of corruption and
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government ineptitude;
(iii)
Best interests of creditors test comparing treatment to a hypothetical
dismissal; and
(iv)
Best interest of creditors test determining if the plan maximizes
creditor recoveries.
A court should be required to appoint an examiner if any creditors
committee or material creditor requests it. The appointment of an examiner in
that circumstance would enhance an objective and independent assessment of
the complex matters required to determine feasibility and whether the best
interests of creditors test has been satisfied.
The appointment of an examiner does not violate Section 904 or the 10th
amendment because an examiner merely offers an analysis as opposed to
making decisions regarding a municipality’s property, revenue or assets.
Any examiner appointed should be required to evaluate issues surrounding
both feasibility and the best interests of creditors test. There is an inherent
tension involved in these tests and fairness requires that both tests be analyzed
as opposed to one or the other.
The cost of an examiner should be treated as an operating expense priority
and should be an explicit exception to the Section 904 prohibition of the court
interfering with revenue of the municipality.
Mediation
Mediation has been prevalent in Chapter 9 cases and has generally been very
helpful in promoting settlements. One issue relating to mediation should be
addressed. The Code should be amended to provide that, without the consent
of all parties involved in a mediation, any mediator in a Chapter 9 case will be
prohibited from:
(i)
disclosing to the bankruptcy judge the nature or substance of
mediation discussions;
(ii)
involving the bankruptcy judge in any manner in the mediation
process including the participation in meetings; and
(iii)
communicating with the bankruptcy judge about the case including
any issues involved in the case other than issues related to timing and
scheduling matters.
Addressing the Pension Challenge
Pension obligations are the fastest growing and most significant liability of
many municipalities. Yet, debtors in Chapter 9 have generally been unwilling to
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FOR THE
NEXT DOWNTURN
impair pensions. The reason is that retirees and workers who will be entitled to
pensions are victims who understandably engender tremendous sympathy in a
municipal bankruptcy. These public workers have no government guaranty of
their pensions as exists for private sector workers, and in most cases, they also
cannot rely on social security.
In corporate bankruptcies, the Pension Benefit Guaranty Corporation
(“PBGC”) guarantees the payment of certain basic pension benefits to workers
and retirees. When the corporate sponsor of the plan is in severe financial
distress—typically while in bankruptcy—the PBGC takes over the pension
plan’s assets and liabilities and then has a claim against the Chapter 11 debtor
for the plan’s shortfall. This is not the case in a municipal bankruptcy. If public
pensions are impaired, the retirees and vested workers will potentially suffer
from a material decrease in their pension benefits.
Therefore, the absence of a PBGC for public workers creates a significant
challenge in a municipal bankruptcy. The bankrupt municipality faces significant pressures to assume its pension plan. Yet pensions are often its most
significant liability. It is likely that its fastest growing liability will result in the
municipality having to make more severe cuts to services for citizenry and to
infrastructure spending. The ongoing exposure to the pension liability also
raises considerable doubt about the feasibility of the municipality’s plan.
The amendments proposed above do not resolve this fundamental challenge.
Rather, these amendments would mean the following for the treatment of
pensions.
1.
Pensions could be assumed but there would be closer scrutiny of
feasibility if an examiner were appointed.
2.
If pensions are rejected, pension claims would be unsecured claims and
could be treated materially better or worse than other unsecured claims
depending on how pension obligations are treated under state law
relative to other unsecured obligations. A plan rejection could result in
significant losses for retirees and workers.
To address this fundamental challenge, Congress should act by passing a
federal law which would both enhance security for pensioners and fiscal stability
for states and municipalities.
CONCLUSION
Short term political considerations and pressures need to be minimized in
Chapter 9. The political realities, coupled with the numerous ambiguities in the
Code and lack of substantial precedent, are resulting in Chapter 9 simply not
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being as effective a solution as it could be. Congress could improve this. The
suggested amendments to Chapter 9 clarify a number of material ambiguities
in Chapter 9 and root policy in municipal realities. Adoption of these
amendments would provide all stakeholders with greater clarity on the impact
of Chapter 9 and the risks for all parties as a result of a filing. They would also
provide important safeguards encouraging plans that are both feasible and fair
to all parties.
132
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