Municipal Bankruptcy in the United States

Municipal Bankruptcy in California

By Pamela A. MacLean. She was a contributing writer at California Lawyer

California is one of just ten states that permit cities to file for municipal bankruptcy under Chapter 9 of the federal bankruptcy code. (Cal. Gov’t Code § 53760.)

Following the bankruptcy of Vallejo in 2008, the Legislature added a requirement that cities engage in a 60-day good-faith mediation with creditors before filing. (Cal. Gov’t Code §§ 53760, 53760.3.)

Should negotiations fail, a bankruptcy judge then must find the city eligible for protection from creditors to permit its debt restructuring. The municipality must be insolvent; it must desire to effect a plan of adjustment; and it must have negotiated with creditors in good faith.

Once the city files a plan of adjustment, it is subject only to the court’s approval or rejection. (To avoid violating constitutional separation of powers protections, during the proceedings the judge may not meddle in a city’s interim pendency plan.) Nor do creditors have a right to file an alternative plan of adjustment, as they would in Chapter 11. But to win the court’s approval, it’s generally in the city’s interest to woo creditors, since their support may be crucial if a “cram down” is to be forced on dissenters. The cram down, just as it sounds, requires objecting creditors to accept the terms, like them or not.

The debtor municipality also gets to decide whether it will perform or reject executory contracts – those agreements, such as real estate leases, that require ongoing operation to avoid a breach. While the city decides whether to ask for concessions, the creditor must continue to perform.

Should the court find the plan of adjustment to be unfair or unreasonable, it has the option to dismiss the entire case – leaving the city to face the full wrath of creditors in state court. “If the judge thinks the unions are too disadvantaged [by a plan] versus the bondholders, or if there is a bias favoring unions, the judge can send them back to the drawing board,” says Van C. Durrer II, a corporate restructuring partner in the Los Angeles office of Skadden, Arps, Slate, Meagher & Flom.

Of course, unlike in corporate bankruptcy, a city can’t issue stock to raise money to reorganize. It can only seek to extend the time it has to repay its debts, or force creditors to accept less money. But all creditors don’t share the pain equally: Secured creditors are at the front of the line. Their lien against a specific project is leverage against the city’s attempts to cut repayment. Employees are next in line, with the right to claim unpaid wages (including vacation, overtime, and other pay) earned up to 90 days before the bankruptcy.

Unsecured creditors are invariably the largest pool, and the most exposed in reorganization. Employee pension plans terminated prior to bankruptcy fall into this group, Durrer says, but pensions terminated after bankruptcy may as well, depending on how they were terminated. Stockton did not terminate its contract with CalPERS before filing under Chapter 9.

In June 2012, facing a $26 million budget deficit and $800 million in unfunded liabilities, Stockton became the largest U.S. city ever to file for protection under Chapter 9 of the federal bankruptcy code. (In re City of Stockton, No. 12-32118 (Bankr. E.D. Cal. filed June 29, 2012).)

Under a so-called pendency plan, the Stockton city council adopted a balanced budget for fiscal year 2012-13 – but only by using measures that, outside of bankruptcy, would otherwise violate state law or its contractual obligations.

Stockton’s attempt to emerge from bankruptcy under a plan of adjustment become a defining legal battle. The contest pits the city against a laundry list of disgruntled creditors, including current employees, retirees, banks, bond insurers, and the California Public Employees’ Retirement System (CalPERS) – the biggest public employee pension fund in the United States with assets of more than $230 billion. (…)

When the City of Vallejo, 70 miles west of Stockton on San Pablo Bay, filed for bankruptcy in 2008, its four public sector unions challenged the city’s eligibility. Chapter 9 requires that the debtor municipality must be insolvent, must have tried in good faith and failed to negotiate an agreement with creditors, and must seek a plan of adjustment. (11 U.S.C. § 109(c).) U.S. Bankruptcy Judge Michael S. McManus found that the city had satisfied those requirements, and a year later the Ninth Circuit’s bankruptcy appellate panel affirmed. (In re City of Vallejo, 408 B.R. 280 (B.A.P. 9th Cir. 2009).)

The unions also challenged Vallejo’s authority to cancel retirees’ health care coverage, unilaterally abrogating collective bargaining agreements in violation of state labor laws. Judge McManus found that under bankruptcy law the city could do so, and U.S. District Judge John A. Mendez affirmed his ruling. “This court declines to legislate from the bench and create a new exception to federal preemption,” Mendez wrote. “If California had desired to restrict the ability of its municipalities to reject public employee contracts in light of state labor law, it could have done so as a pre-condition to seeking relief under Chapter 9.” (Int’l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo (In re City of Vallejo), 432 B.R. 262, 270 (Bankr. E.D. Cal. 2010).)

In January 2011, Vallejo announced a plan of adjustment that only paid unsecured creditors between 5 and 20 cents on the dollar. Under the amended plan approved by the court later that year, retirees would have to stand in line with all of Vallejo’s other unsecured creditors.

Barely a month after Stockton filed its bankruptcy petition in June, things again went sour for city retirees. An association of retired employees had sought a temporary restraining order, or in the alternative, permission from the bankruptcy judge to challenge the constitutionality of impairments to their health benefits. The retirees alleged violations of the contracts clauses of both the U.S. and California constitutions, as well as provisions of state law.

But in early August, U.S. Bankruptcy Judge Christopher M. Klein in Sacramento dismissed the complaint, stating that section 904 of the Bankruptcy Code “forbids the court from using any of its powers to ‘interfere with’ property or revenues of a chapter 9 debtor.”

Judge Klein continued, “Accordingly, although the city’s unilateral interim reduction of retiree health benefit payments may lead to tragic hardships for individuals in the interval before their claims are redressed in a chapter 9 plan of adjustment, the motion for injunctive relief must be denied.”

Klein’s ruling devastated the retirees’ constitutional arguments. “While the Contracts Clause is a key navigational star in the firmament of our Constitution and economic universe,” he wrote, “it is subject to being eclipsed by the Bankruptcy Clause. … Significantly, the Contracts Clause bans a state from making a law impairing the obligation of contract; it does not ban Congress from making a law impairing the obligation of contract. This asymmetry is no accident.”
Klein found that the Constitution’s bankruptcy clause necessarily authorized Congress to make laws that impair contracts. “In sum,” he wrote, “even if the plaintiffs’ benefits are vested property interests, the shield of the Contracts Clause crumbles in the bankruptcy arena.” (Ass’n of Retired Employees of the City of Stockton v. City of Stockton, 2012 WL 3193588 at *1-3 (Bankr. E.D. Cal.).)

California law treats public retirement benefits as deferred compensation and part of an employment contract, earned as the employee works. As contractual obligations they are protected by the state constitution’s contracts clause, meaning the vested rights may not be impaired except in rare circumstances.

But what constitutes those rare circumstances? “There is a whole school of legal thought that retirement benefits are guaranteed by the state constitution,” says Schiff Hardin’s Denniston.

Peter Mixon, CalPERS general counsel, certainly thinks they are. In an address to his administrative board in September, Mixon summarized the pension fund’s legal position. He emphasized that CalPERS is an arm of the State of California, which has sovereign powers reserved by the Tenth Amendment. And because Congress reserved for states the power to control municipalities, he asserted, it “determined that Chapter 9 … would not preempt state laws that control the political and governmental powers of municipalities and arms of the state.” (See 11 U.S.C. § 903.)
Bolstering his case, Mixon argued that contracting municipalities are “bound by the constitutional and statutory provisions governing the system and the decisions of the CalPERS Board of Administration.” Because the Legislature created CalPERS as a trust fund, he added, it has a fiduciary duty to beneficiaries and therefore “does not have the right to ‘forgive’ or reduce employer contributions.” Moreover, it is precluded by state law “from lowering the benefit formula for existing employees who are members of the system.”

In a statement posted on its website this fall, CalPERS asserted, “Under federal law, the Bankruptcy Court may not interfere with the relationship between the State and a City. Accordingly, remedies available to CalPERS include not only seeking relief from Bankruptcy Court, but also exercising CalPERS’s governmental powers.”

But CalPERS’s legal strategy was challenged in October in yet another municipal bankruptcy when the City of San Bernardino took the unprecedented step of suspending its regular contributions to CalPERS. Compton – not yet in bankruptcy but citing a short-term cash-flow problem – also suspended payments the same month, and CalPERS filed suit.
The giant pension fund, however, may have an ace up its sleeve – a virtual poison pill against impairment in bankruptcy court. State law allows the CalPERS board to put a lien on the assets of any agency terminated for nonpayment, and those claims rank second only to wages. (Cal. Gov’t Code § 20574.) As Mixon told his board in September, “Because termination of the relationship essentially closes the pension plan, any unfunded liabilities as of termination must be fully paid by the employer. … Termination by a municipal debtor would create a much larger obligation to CalPERS, which would impair the ability of the debtor to make payments to its unsecured creditors and severely dilute the return to such creditors.”

Lyons of Assured Guaranty disagrees. “Once the state consents to federal bankruptcy jurisdiction” by permitting a municipal filing, he says, “that trumps state law priority.”

Ultimately, Stockton’s exit from bankruptcy may come down to which prevails: Chapter 9, or the constitutional guarantee that states have the right to manage their own affairs. In August, Judge Klein warned that although a state may set the terms for its municipalities to file a Chapter 9 case, “it cannot revise Chapter 9. For example, it cannot immunize bond debt held by the state from impairment.” But he also noted, “The overall goal is a balance that does not offend the Tenth Amendment.” (Stockton, 2012 WL 3193588 at *4.) (…)

In San Jose, 70 percent of voters approved a plan to give current employees the option of switching to lower defined benefits or paying more into the city’s independent pension system. The measure also cuts retirement benefits for future hires.

As soon as the votes were tallied, San Jose sought a preemptive ruling in federal court that the measure did not violate the U.S. and state constitutions. The unions shot back with five state court lawsuits raising a variety of claims. By October, the parties had stipulated to dismiss the federal case and proceed in a consolidated case before the Santa Clara superior court. (See San Jose Police Officers Ass’n v. City of San Jose, No. 112CV225926 (lead case).)

In San Diego – which also operates an independent public pension system – voters approved a measure to freeze the pay formula used to calculate pensions for current employees, and switch future hires to a 401(k)-style defined contribution plan. Both measures drew lawsuits.

The unions asked the state Public Employment Relations Board to invalidate the initiatives as an unfair labor practice, on the ground that the city had refused to bargain before placing them on the ballot. The city won an injunction blocking the board’s proceedings, but it lost the jurisdictional issue on appeal. (See San Diego Mun. Employees Ass’n v. Superior Court, 206 Cal. App. 4th 1447 (2012).) At the core of the dispute is whether city council members, acting as citizens, have the right to avoid collective bargaining by going directly to the voters on key issues.