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How City Finances Can Be Restructured in the Shadow of a Chapter 9 Case

Thursday, October 10, 2013

By Zack A. Clement

Zack A. Clement is a Partner at the Houston, Texas office of Fulbright & Jaworski LLP, part of Norton Rose Fulbright. This summarizes some of the ideas contained in a law journal article titled How City Finances Can Be Restructured.  

The Detroit Chapter 9 case can show other U.S. cities how to restore balance between their suppliers of labor and capital, and their taxpayers. Other cities will not necessarily have to follow Detroit into a Chapter 9 case. Instead, Detroit's Chapter 9 plan of debt adjustment can demonstrate a financial restructuring to which labor, capital, and taxpayers all contribute that other cities can replicate through negotiations.

Since World War II, U.S. cities have built up substantial bond debt and unfunded pension liability. Detroit's Chapter 9 case will deal with $3.5 billion of pension underfunding and $9 billion of bond debt. There are many other American cities with even more unfunded pension and bond debt. Indeed, since 1945, U.S. cities have accumulated over $3.7 trillion of bond debt and, together with states, over $1.3 trillion of unfunded pension liability.

A Chapter 9 case provides a forum to deal with substantial pension and bond debt when they become unsustainable. If a city is authorized to file bankruptcy, it can reject uneconomic contracts, including labor contracts, and the resulting unsecured damage claims and unsecured bond claims can be paid only what the insolvent city can afford to pay, after it has (i) cut spending reasonably and (ii) made reasonable use of taxation.

Pension obligations are more difficult to deal with, however, because they are typically contained in state statutes (i) that create separate pension funds which owe specified benefits to retirees and (ii) that set the payments the city must make to the pension funds. Moreover, in many states retirement benefits are considered a “contract right” entitled to protection under U.S. and state constitutions, and reductions in benefits could be challenged as an unconstitutional “impairment” of contracts.

A Chapter 9 municipal debtor could argue that its statutory pension funding obligations should be treated no better than private contract rights that can be discharged under the Bankruptcy Code. Under the U.S. Constitution's Bankruptcy Clause, the federal government has the power to enact bankruptcy laws whose purpose is to impair contract rights. Thus, an insolvent city could act by itself in the bankruptcy court to reduce its pension funding obligations. However, its pension funds might be left insolvent unless the benefit obligations they owe are also modified.

Alternatively, a Chapter 9 debtor could ask the state legislature to amend the pension statute, modifying both pension benefits and the city's funding obligations as part of a larger plan to reorganize city finances that includes discharge of other debt and measures to raise revenue. The city's plan and related disclosure statement would give the state legislature the full context of the city's proposed financial restructuring in which to assess legislation restructuring the pension fund, and also provide evidence of the necessity and reasonableness of the amended pension statue to any court reviewing whether it is an unconstitutional impairment of pension contract rights.

This approach would address the solvency problems of both the city and its related pension funds, modifying benefits to conform to the city's modified funding obligations. If a city cannot garner enough political support for such a complete solution, it could still resort to the use of federal bankruptcy power to fix just its own pension funding issues in its Chapter 9 case.

Ultimately a city's real challenge is to restructure its debts so that it becomes sustainably solvent; preferably by agreement among the major constituencies, using the force of federal bankruptcy power only if necessary after a substantial good faith effort to make a deal. Cases considering approval of a municipality's plan to discharge debt in bankruptcy, and cases considering whether amendments to state law are constitutionally permissible even though they impair contracts, have converged on similar principles of simple reasonableness. Both kinds of cases suggest that a broad-based approach has the greatest chance to gain approval as an acceptable solution to a city's insolvency arising from large bond and pension liability.

Consequently, a city should be prepared to show in negotiations, to legislatures and to courts, as appropriate, that:

• It has made efforts to obtain additional funds to pay its obligations by making reasonable reductions in spending on the provision of city services, and that deeper spending cuts would be counterproductive.

• It is proposing adequate use of taxation to obtain funds to pay its obligations and that raising taxes any further would be counterproductive.

• Its rejection of labor contracts and obligations to fund pensions has been done reasonably, with reasonable replacement contracts for current employees and minimal retroactive impact on already-retired employees.

• Its plan will pay residual available cash to unsecured labor contract rejection claims and bond claims and that this is all the city can reasonably afford to pay to unsecured creditors given the limits on its ability to cut expenditures and raise taxes.

This approach would cause the burden of fixing a city's insolvency to be shared among its major constituencies. This is good public policy and will reestablish the social compact in many major American cities among labor, capital, and taxpayers. The possibility of a Chapter 9 case can encourage these interest groups to agree on a shared solution.

If providers of labor and capital don't believe Chapter 9 should be used to force them to make balanced contributions to improve the solvency of a city where they work or to which they have loaned money, the same restructuring will eventually occur without Chapter 9. It will just take longer, be less efficient and cause more pain. Greece, under pressure from capital providers, laid off many government employees, cut pensions, raised taxes and bondholders were still forced to accept payment of less than 50%. This took three agonizing years and is not over yet. The backdrop of a possible Chapter 9 bankruptcy case gives U.S. cities greater power to lead labor, capital and taxpayers to agreement on a fair and feasible plan with much less delay and pain.

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