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MUNICIPAL BANKRUPTCIES
A Pension Deficit Disorder?
Presentation to NCPERS
Public Safety Employees Pensions & Benefits Conference
Palm Springs, CA
October 13, 2009
Harvey L. Leiderman
Why Are We Talking About
Municipal Bankruptcies?
 State budgetary crises
 Municipal budgetary crises
 revenues declining – taxes and
grants
 demands rising – including
pension costs
 Municipal credit crunch
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This Program
 When may a municipality file
bankruptcy?
 What happens during the bankruptcy
case
 What is the effect on the retirement
system and members’ benefits
 De-mystify the process
 De-mythify the process
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Overview – Federal Bankruptcy Law
and Chapter 9 Plans of Adjustment
 Federal bankruptcy law generally
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temporary freeze (“stay”)
restructure of assets, debts
relief from obligations
“fresh start”
 Chapter 9 specifically
 just for “municipalities”
 adjustment of obligations
 balances federalism with states’ rights
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Who May File Chapter 9 Petition?
To be eligible, must be all of the following:
1. A “municipality.” Includes a political subdivision, public
agency or instrumentality of a state. Counties and
cities are; the State is not.
2. Authorized under state law to be a debtor under federal
bankruptcy law. Watch out! States differ!
3. Insolvent. Unable to, or not paying debts when due.
(Cash flow test.)
4. Desires to effect a plan to adjust its debts.
5. Has (a) obtained the consent of its creditors, or
(b) has negotiated in good faith with its creditors, or
(c) negotiation with creditors is futile, or (d) believes
that a creditor is attempting to get an unfair recovery on
a claim.
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What Happens During Bankruptcy?
 Bright line between pre-petition and post-petition
 Snapshot of pre-petition assets and liabilities
 Stay (freeze) of all legal actions
 Muni is free to continue its operations,
expenditures, borrowings and management
 Muni must continue to perform all contracts and
leases necessary for its post-petition operations
 Creditors must file claims, unless clearly
uncontested
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What Are the Muni’s Powers
Under Ch. 9?
 May continue to operate as usual
 All officials remain in power; no trustees, no
court supervision
 May hire professionals (attorneys,
accountants, financial advisors, etc.) and
pay them ahead of unsecured creditors
 Broad powers to borrow money and grant
super-secured status to new lenders
 May reject burdensome “executory”
contracts and unexpired leases
 May “abandon” burdensome property that is
of little value or benefit
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What Are the Muni’s Powers
Under Ch. 9? (cont’d.)
 May recover pre-petition preferential
payments, or transfers made for less than
full value
 May file suit against others, to assert claims
in its favor
 May object to claims against it, and bring
them to trial in the Bankruptcy Court
 May not escape from State political and
governmental laws – Tenth Amendment
 Must file a timely Plan of Adjustment or be
dismissed
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What is a Plan of Adjustment?
 The Plan classifies claims according to their legal
priority under state and federal law
 class of priority secured claims
 class of subordinated secured claims
 class of general administrative claims
 class of unsecured trade claims
 As to each class of similar claims, the Plan provides a
“treatment” for how that class of claims is to be satisfied
 paid in full in cash
 paid over time with interest
 exchanged for new value
 rejected
 Must be confirmed by vote of creditors and Court order
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Plan of Adjustment The Disclosure Statement
 Issued with the proposed Plan of Adjustment
 Like a Prospectus
 history, description of the process, overview of the plan,
treatment of claims, financial projections
 Ballots
 Each class must vote in favor
 requires 1/2 in number and 2/3 in $ value of each class
 Even without affirmative votes, the Court can
confirm the Plan if it believes the Plan treats
objecting creditors fairly and equitably (the
dreaded “cramdown”)
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What Is Required to
Confirm the Plan?
 Must be in the best interest of creditors
and be feasible
 “Best interest of creditors” – best of all
reasonably possible alternatives. Ch. 9 test
differs greatly from “better than in liquidation”
test for Ch. 11 corporate debtors
 “Feasible” – the economics of the Plan make
sense; it is not likely that the muni will have to
return to bankruptcy soon; the muni will have
the ability to continue to provide services.
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What Happens After Confirmation?
 Discharge – the muni is discharged
(forgiven) from all claims not provided for
under the Plan, or which the Plan provides
shall be discharged.
 Emergence – the muni emerges from
Chapter 9 with all of the rights and powers
established under state law and under the
terms of the Plan.
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Questions and Answers
Q: Is your municipal employer “insolvent”?
A: Case-by-case. The employer would have to
prove that it is insolvent on a “cash flow”
basis (unable to pay its debts when due)
rather than on a “balance sheet” basis
(liabilities exceed assets).
This issue would be hotly contested. Can’t
it still tax and borrow? See City of Vallejo
case.
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Questions and Answers
Q: Could the municipal debtor reject the
current CBAs that grant retirement
benefits to its active employees?
A: Yes, very likely. See City of Vallejo.
The test is:
1. Does the CBA burden its ability to reorganize
through a plan of adjustment?
2. Do the equities balance in favor of rejection?
3. Has it made reasonable efforts to negotiate a
voluntary modification of the CBAs?
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Questions and Answers
Q: Would the municipal debtor have to reject
the entire CBA, or could it “cherry-pick”
the terms it doesn’t like?
A. Bankruptcy law allows rejection of the
entire agreement only, not selected terms.
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Questions and Answers
Q: Could the debtor unilaterally reduce some
portions of a CBA before deciding whether
to assume or reject it?
A: Unsettled.
Judge Ryan in Orange County said “not
necessarily,” and ordered “meet and confer”
before the county could unilaterally change
its labor contracts during bankruptcy.
Judge McManus in City of Vallejo said “yes.”
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Questions and Answers
Q: If the municipal debtor rejects its CBAs,
what happens to its active employees?
A: The unions and bargaining units would
have to negotiate new contracts.
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Questions and Answers
Q: If the municipal debtor rejects its CBAs, what
happens to your members’ retirement
benefits?
A:
Untested. Benefits granted to current retirees
are unlikely to be affected. The contract is not
“executory” as to them, since no further
performance is due from them by way of
service or contributions into the system.
For active employees, the contract is still
“executory,” BUT –
For both, the “vested rights protected by the
‘contract clause’ of the Constitution” argument
may prevail. BUT –
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Questions and Answers
A, continued:
Don’t forget that there is an exception under
many state laws to the “vested rights” guarantee:
“An employee’s vested contractual rights may be modified
prior to retirement for the purpose of keeping a pension
system flexible to permit adjustments in accord with
changing conditions and at the same time maintain the
integrity of the system.” Betts v. Bd. of Admin. (CA)
 Are the proposed changes reasonable?
 Do they bear a material relation to the theory
of a pension system?
 Will any disadvantage come with a
comparable new advantage?
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Questions and Answers
Q: May the municipal debtor suspend
transferring employee contributions to the
retirement system while in Ch. 9?
A: No. Payroll deductions for retirement
contributions are not property of the
employer but are collected in trust for the
retirement system.
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Questions and Answers
Q: What about employer contributions?
A:
Very complex. There are strong legal reasons
why the debtor may not suspend its payments,
as required by state statute.
At the very least, the “normal cost” portion of
the employer contribution should be treated as
a current, post-petition obligation and would
have to be paid timely. The “UAAL” portion of
the employer contribution, however, being the
amortization of a debt from past service, might
be treated differently.
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Questions and Answers
Q: May the municipal debtor suspend its “pick
up” of employee contributions while in Ch.
9?
A: No, not unless it rejects the labor contract
that provides for “pick-up.”
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Questions and Answers
Q: May the municipal debtor reject its
obligations to fund vested benefits?
A: No. Ch. 9 does not authorize rejection of
state statutory obligations. Would violate
the Tenth Amendment to the U.S.
Constitution – reservation of rights to the
states.
Fact that state and local governmental
systems are exempt from ERISA indicates
limitations of federalism in this arena.
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Questions and Answers
Q: Could the municipal debtor freeze or
seize retirement system assets in Ch. 9?
A: No. The retirement system is a distinct
governmental entity under state law. Its
assets are not property of the municipal
debtor but rather held in trust for
members and their beneficiaries.
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Questions and Answers
Q: Would a debtor’s Ch. 9 bankruptcy filing
affect the retirement system’s assets or
investments?
A: No, the retirement system is a distinct
governmental entity – a trust. Its assets
and investments are not commingled with
those of the plan sponsor (unless the
Treasurer is holding plan assets, as in
In re Orange County.)
However, if the debtor suspends
contributions, it could affect your cash
flow, asset allocation policies and earnings
assumptions.
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Questions and Answers
Q:
A:
Could the retirement system make a loan or other
financial accommodation to the debtor during
Chapter 9 or under a Plan of Adjustment?
No legal prohibition. BUT – likely unlikely:
Would have to meet all prudent fiduciary,
administrative and investment requirements and
the system’s Investment Policy Statement.
If appropriate, could take the form of an interim or
long-term loan, sale-leaseback of property, credit
enhancement, extended amortization of UAAL or
other creative financing – with many caveats.
If you explore this route, watch out for conflicts of
interest!
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Questions and Answers
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Q:
How much would a bankruptcy cost taxpayers?
A:
Big bucks. Plan sponsor professionals and
professionals for committees of interested parties
– bondholders, retirees, unsecured creditors, etc.
Plus professionals for labor unions, creditors,
investment pool participants and bondholders who
make a “substantial contribution” to the case.
In the 1994-96 Orange County bankruptcy,
professional fees cost over $100 million –
excluding investment manager fees.
In addition – higher borrowing costs due to poor
credit ratings.
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About the Speaker
Harvey L. Leiderman is a partner with the international law firm of Reed
Smith, LLP. He serves as fiduciary, litigation, investment and tax counsel
to the California Public Employees’ Retirement System, the California
Teachers' Retirement System, the South Carolina Retirement System
Investment Commission and multiple California county and city retirement
systems.
Mr. Leiderman actively practiced bankruptcy law for over twenty years, on
behalf of national banks, commercial lenders, public bondholders and
private investors. He was fiduciary counsel to the Orange County
Employees’ Retirement System during that county’s Ch. 9 case and more
recently guided a California municipal water district through a successful
Chapter 9 proceeding. His office also represents the largest bondholder
trustee in the City of Vallejo case.
Harvey Leiderman earned his J.D. from Columbia Law School, New York.
He received his B.A. from Case Western Reserve University in Cleveland,
Ohio, with honors in Government Studies from The American University,
Washington, D.C.
Reed Smith LLP · 101 Second Street, Suite 1800, San Francisco, CA 94105
+1 415.659.5914 · [email protected]
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