Balancing the Equities in Municipal Bankruptcies

When it comes to explaining what has prompted the incidence of financial distress being experienced by an increasing number of our nation's cities, perhaps the most persistent and significant cause is a troubled city's obligations to fund substantial pensions for its employees, both retired as well as its active work force.

It is in this context that the recent rulings regarding pension liabilities in the Detroit and Stockton, CA, bankruptcies have taken center stage. Legal issues surrounding whether pension benefits can be modified under our bankruptcy laws, even in the face of state constitutional protections that would otherwise preclude the abrogation of promised retiree benefits to public employees, are now front-page news. But more recently, the focus has shifted from whether pensions can be impaired to a more complex set of questions about when and to what extent such modifications should be required for a fiscally challenged city to successfully garner a court's confirmation of a Chapter 9 plan of adjustment. More than any other set of legal issues arising in the municipal distress context, it is fair to say that the treatment of pension liabilities has quickly become the most significant focus of creditor constituencies and their professionals.

What's at Stake

In 2014,'the bankruptcy courts in both the Detroit and Stockton cases issued rulings holding that despite state constitutional protections of public employee vested pension benefits, the Bankruptcy Code affords a Chapter 9 municipality the right, if needed, to modify those pension benefits, not unlike its right to alter and impair other of its contractual obligations. Those rulings, if adopted by our federal appellate courts (which most bankruptcy professionals perceive as much more likely than not), are very significant from a federal supremacy perspective. Importantly, if the decisions like those in Detroit and Stockton are broadly adopted by our federal courts, they will provide a city with the opportunity to shape a plan that requires all constituencies to participate in shouldering concessions needed to solve a city's fiscal imbalance.

Additionally, one must consider the goal of preserving the relatively low cost of municipal and state government financing through tax-exempt bonds that depend on a fair and shared allocation of required concessions among all the key municipal creditor constituencies ' bondholders, union membership and retirees, rather than the impairment burden being disproportionately shouldered by bond holder and other financial claimants.

The question, then, is: In a municipal distress context, assuming a city has the power to override state constitutional prohibitions against modifying public pension obligations, should a distressed city that seeks to “cram down” a plan that impairs the treatment of its financial creditors to achieve a feasible long-term balanced budget be obligated to reduce pension benefits as a condition to receiving confirmation of its proposed plan of adjustment? And, if so, to what aggregate extent should those impositions on retirees be made, and on which retirees should the reduced benefits be imposed? In this article, we examine what can be gleaned about these issues from the Detroit and Stockton cases.

The Detroit Case

In the Detroit bankruptcy case, after ruling that public employees' pensions could be reduced, the court approved a plan that only imposed a modest reduction in pension benefits, while, in contrast, sharply reducing the claims of the city's financial creditors. While some bond holders fared better and received relatively substantial recoveries, others received a very small percentage of their claims, in a setting where retiree benefits were only modestly altered. That observed, the Detroit case was ultimately settled without a ruling on the once pending objections of those capital market creditors who had attacked the disproportionality of their treatment when compared with the retirees. Before the settlement was achieved, those same creditors had also objected to the city's refusal to monetize its substantial art collection and other of its non-essential government assets.

Complaining creditors contended that given the haircuts being imposed on them, the city should have been required to monetize those assets and use the proceeds to pay bondholders and others in order to satisfy both: 1) the “fair and equitable” requirement to cram-down a plan under Section 1129 (b) (incorporated by reference as a plan cram-down component of Chapter 9 as well); and 2) the “best interests of creditors” test under Section 943(b)(7). Here again, because the Detroit case was settled without an adjudication of these additional challenges, it is difficult to draw any meaningful conclusion about how our bankruptcy courts will address arguments about disproportionate impairment of bond holders and other financial creditors in cases where most of those creditors choose to actively challenge plans that either fail to monetize available city assets or strongly favor protecting the contractual (and in some circumstances constitutionally protected) pension rights of retirees.

The Stockton Case

In a sense, the Stockton plan's confirmation is more illuminating because the plan in Stockton was confirmed and crammed-down over the objection of one dissenting financial creditor. To confirm that plan, Judge Christopher Klein, who presided over the Stockton case, found it necessary to rule on the objections of Franklin Templeton Investments, a holder of a $35 million claim arising from the funding of the city's golf course. Before reaching the confirmation stage, the court bifurcated Franklin's claim, finding that the golf course was worth about $4 million. Having so ruled, there was no question that the secured portion of the $35 million claim would have to be paid in full over time at a market interest rate. It was the remaining $31 million undersecured claim of Franklin that gave rise to its complaint that the Stockton plan could not be confirmed because under that plan Franklin was only to receive about 1% on its $31 million claim; and the centerpiece of Franklin's objection focused on the pension obligations of the city, which, under the proposed plan, the city chose not to impair in any respect.

Central to its objections, Franklin maintained that to satisfy the city's obligation to treat a dissenting class of creditors in a municipal context “fairly and equitably,” it should have been required to modify and reduce pension benefits of the city's retirees; and had the city sufficiently done so, Franklin could have received considerably more than 1% on its undersecured claim. Franklin alternatively argued that the “best interests of creditors” requirement in Section 943, similarly required the city to take a more balanced approach that required the city to seek concessions from its pension beneficiaries in order to improve Franklin's recoveries.

The Court's Dilemma

In urging the Plan's confirmation, the city first sought to defeat Franklin's objections by raising technical arguments. The city had included Franklin's claim in a class together with the rejection claims of the union memberships that had agreed to significant reductions in their health care benefits. Those rejection claims were actuarially determined to be worth many times over the size of Franklin's claim, allowing the accepting votes of the union memberships to bind the class and override Franklin's dissenting vote under Section 1126 (c). Franklin contended that the class in which it was placed was artificially gerrymandered to override its dissenting vote; but the court disallowed that objection and treated the class in which Franklin was placed to have accepted the Plan, thereby removing the “fair and equitable” objection to the non-impairment of retiree benefit ' an argument that could only have been asserted had the class voted in requisite majorities to reject the Plan.

The city also contended that Franklin could not assert a “best interest of creditors” challenge because all of the other Stockton creditors, including all other of the city's financial creditors, had voted to accept the Plan. The court agreed, and essentially interpreted the best interest test to be a popularity contest among all the constituencies voting on the plan. Here again, Franklin had maintained that Stockton's plan did not comport with the best interest of creditors statutory requirement because the city had not done all it could to maximize creditor recoveries in a setting where slight pension impairments could have resulted in Franklin receiving meaningful treatment on its under secured claim. But interpreting Section 943 as he did, Klein held that Franklin could not raise an objection grounded on the best interest of creditors requirement. Franklin is appealing these legal determinations; and it is very likely that other bankruptcy courts will disagree with Judge Klein's classification decision and the meaning to be afforded to the “best interests of creditors” requirement that led to Franklin being stripped of the means to protest its treatment.

But Judge Klein went one step further and addressed whether, even if Franklin could have effectively had standing to assert both “fair and equitable” and “best interests of creditors” challenges to the Plan, the rationale behind the city's decision to propose a plan that did not alter the rights of pension beneficiaries could nonetheless be sustained over Franklin's objections. Judge Klein found that he could overrule Franklin's objections, relying on the city's assertion and submitted evidence that any modification of the pension benefits of city employees would seriously imperil the ability of the city to retain its critically important work force of police and fire fighters. In sum, having given the city the permission to modify pension benefits if it chose to, and as some court observers viewed the situation, after inviting the city to go down that path, Judge Klein in the end refused to deny confirmation of a plan that avoided making any pension modifications whatsoever.

Recognizing that because of Tenth Amendment considerations, a court overseeing a Chapter 9 case cannot mandate that a city pursue a specific course of action, Judge Klein was left with a choice; either confirm the Plan the city had proposed, accepting its justification for not impairing pension beneficiaries; or, deny confirmation, rendering fruitless all the efforts to achieve a plan and leaving no clear picture about what would then happen to the city. He chose the former. While the Plan is being appealed by Franklin, what should be made of Judge Klein's rulings on the record before him?

The Implications

Perhaps most troubling for bond holders is the recognition that other cities facing fiscal challenges may seek to justify plans of adjustment that stop short of requiring any pension modifications based on the same notion offered in Stockton ; namely, that such modifications would impair the municipality's ability to retain experienced police and fire fighters integral to maintaining a safe and secure populace. What city if it could do so, would want to risk dismantling some of its critical work force because it chose to modify pension benefits, if instead it could fashion a confirmable plan by making more impositions on bond holder claims and still achieve a feasible plan and balanced budget?

But the question that is open to active debate is whether the same balance that was struck in Stockton will be adopted by courts overseeing Chapter 9 filings in other cities and under different circumstances. It seems fair to ask, then, whether other cities may present conditions and circumstances that would lead a court to reject a plan that does not require concessions from pension holders in order to produce a sustainable and balanced budget. Looking at the result in Stockton , one might at first blush conclude that it is unlikely that a bankruptcy court would come out differently than Judge Klein. But change the facts of the Stockton case only slightly and reconsider that assumption in light of the following:

1. Long before the Stockton plan proposed to give Franklin only 1% of its undersecured claim, it had been offered approximately a 50% recovery. Franklin turned that down, and the amounts that it had been offered were given to other creditors who then accepted the plan. Would the Stockton court have come out the same way had Franklin always been only offered from the outset a 1% recovery on $31 million of its $35 million claim?

2. The Stockton court had to weigh the potential upheaval to the work force that might be caused by altering pension benefits to solve an objection raised by one creditor holding a claim of only $31 million. Would the outcome have been different if all the bond holders were vigorously objecting to the plan that they contended unfairly imposed too much on them, asserting that the plan's failure to seek pension cuts was neither “fair and equitable” or in their “best interests”? What if those creditors chose to put on an a comprehensive evidentiary case that seriously challenged, using forensic proof, the city's contention that its work force would quit if some pension modifications were required? What if the Stockton bondholders had also made out a strong case that aside from unfairness in treatment, without meaningful pension cuts, the city's ability to produce a balanced budget in the future was infeasible and an illusion?

3. What if a Chapter 9 city cannot achieve a balanced budget without impairing retirees? In the Stockton case, the city had sufficiently persuaded Judge Klein that given other agreed-upon creditor impairments and cost-containment measures, it could meet its ongoing pension obligations without putting future balanced budgets at risk. In Stockton , the unions had made significant concessions in regard to their health care plans, reducing materially the anticipated annual cost of funding medical care costs of its workers out of the city's operating revenues.

Those concessions, together with consensual impairments to bond claims, allowed the city to produce a balanced budget as long as it did not have to pay Franklin's undersecured claim. But if in other cities the combined proposed cuts in medical coverage together with reasonable impairment of bondholder claims are not sufficient to produce a balanced budget, how could a city not find it necessary to modify pension obligations no matter the consequence. Even if a court were prepared to approve a plan containing extreme impairment of bond claims over strenuous “fair and equitable” and “best interests of creditors” objections from most of the municipality's financial creditor constituencies (that assumption seems dubious), such extreme cuts in financial creditor claims might well not be a sufficient answer to achieving a balanced budget. That is so because it is usually the case that repayment of borrowings only constitutes 10%-15% of a city's operating costs, whereas the cost of labor, current and retired, usually exceeds 70% of a city's expenses.

Conclusion

Stepping back from viewing the Stockton decision as an application of emerging Chapter 9 law and looking instead at the pension concession issue from a broader policy perspective, it seems unrealistic to assume that cities beset with reduced operating revenues and faced with the incapacity to realistically tax their residents at even higher rates to solve their budgetary shortfalls, can somehow fix their imbalances without meaningfully addressing and curtailing their health care and pension funding costs. In Stockton , reduced health care costs were sufficient. In the next case they may not be.

Then, with some acknowledgment that pension cuts will be required, the question will become whose pensions should get modified and to what extent pensioners should be expected to contribute to achieving a balanced budget. None of those questions have as yet been addressed by any court in a cram-down context. Given the delicate nature of these challenging issues, perhaps it will be best to have them resolved at the bargaining table, rather than asking a court in a Chapter 9 case to rule on whether the city's formulation of how the “pain is to be shared” is truly a fair and equitable solution to a very delicate and highly personal set of issues.

Mark S. Kaufman ([email protected]) is a partner in the San Francisco office of McKenna Long & Aldridge LLP, where he serves as co-chair of the firm's Municipal Reform & Innovation Practice. Kaufman advises financially distressed municipalities, special purpose districts, related governmental entities, and bondholders, bond insurers and other investors. Most recently, he served as lead counsel to the Governor-appointed Receiver to the City of Harrisburg, PA.

When it comes to explaining what has prompted the incidence of financial distress being experienced by an increasing number of our nation's cities, perhaps the most persistent and significant cause is a troubled city's obligations to fund substantial pensions for its employees, both retired as well as its active work force.

It is in this context that the recent rulings regarding pension liabilities in the Detroit and Stockton, CA, bankruptcies have taken center stage. Legal issues surrounding whether pension benefits can be modified under our bankruptcy laws, even in the face of state constitutional protections that would otherwise preclude the abrogation of promised retiree benefits to public employees, are now front-page news. But more recently, the focus has shifted from whether pensions can be impaired to a more complex set of questions about when and to what extent such modifications should be required for a fiscally challenged city to successfully garner a court's confirmation of a Chapter 9 plan of adjustment. More than any other set of legal issues arising in the municipal distress context, it is fair to say that the treatment of pension liabilities has quickly become the most significant focus of creditor constituencies and their professionals.

What's at Stake

In 2014,'the bankruptcy courts in both the Detroit and Stockton cases issued rulings holding that despite state constitutional protections of public employee vested pension benefits, the Bankruptcy Code affords a Chapter 9 municipality the right, if needed, to modify those pension benefits, not unlike its right to alter and impair other of its contractual obligations. Those rulings, if adopted by our federal appellate courts (which most bankruptcy professionals perceive as much more likely than not), are very significant from a federal supremacy perspective. Importantly, if the decisions like those in Detroit and Stockton are broadly adopted by our federal courts, they will provide a city with the opportunity to shape a plan that requires all constituencies to participate in shouldering concessions needed to solve a city's fiscal imbalance.

Additionally, one must consider the goal of preserving the relatively low cost of municipal and state government financing through tax-exempt bonds that depend on a fair and shared allocation of required concessions among all the key municipal creditor constituencies ' bondholders, union membership and retirees, rather than the impairment burden being disproportionately shouldered by bond holder and other financial claimants.

The question, then, is: In a municipal distress context, assuming a city has the power to override state constitutional prohibitions against modifying public pension obligations, should a distressed city that seeks to “cram down” a plan that impairs the treatment of its financial creditors to achieve a feasible long-term balanced budget be obligated to reduce pension benefits as a condition to receiving confirmation of its proposed plan of adjustment? And, if so, to what aggregate extent should those impositions on retirees be made, and on which retirees should the reduced benefits be imposed? In this article, we examine what can be gleaned about these issues from the Detroit and Stockton cases.

The Detroit Case

In the Detroit bankruptcy case, after ruling that public employees' pensions could be reduced, the court approved a plan that only imposed a modest reduction in pension benefits, while, in contrast, sharply reducing the claims of the city's financial creditors. While some bond holders fared better and received relatively substantial recoveries, others received a very small percentage of their claims, in a setting where retiree benefits were only modestly altered. That observed, the Detroit case was ultimately settled without a ruling on the once pending objections of those capital market creditors who had attacked the disproportionality of their treatment when compared with the retirees. Before the settlement was achieved, those same creditors had also objected to the city's refusal to monetize its substantial art collection and other of its non-essential government assets.

Complaining creditors contended that given the haircuts being imposed on them, the city should have been required to monetize those assets and use the proceeds to pay bondholders and others in order to satisfy both: 1) the “fair and equitable” requirement to cram-down a plan under Section 1129 (b) (incorporated by reference as a plan cram-down component of Chapter 9 as well); and 2) the “best interests of creditors” test under Section 943(b)(7). Here again, because the Detroit case was settled without an adjudication of these additional challenges, it is difficult to draw any meaningful conclusion about how our bankruptcy courts will address arguments about disproportionate impairment of bond holders and other financial creditors in cases where most of those creditors choose to actively challenge plans that either fail to monetize available city assets or strongly favor protecting the contractual (and in some circumstances constitutionally protected) pension rights of retirees.

The Stockton Case

In a sense, the Stockton plan's confirmation is more illuminating because the plan in Stockton was confirmed and crammed-down over the objection of one dissenting financial creditor. To confirm that plan, Judge Christopher Klein, who presided over the Stockton case, found it necessary to rule on the objections of Franklin Templeton Investments, a holder of a $35 million claim arising from the funding of the city's golf course. Before reaching the confirmation stage, the court bifurcated Franklin's claim, finding that the golf course was worth about $4 million. Having so ruled, there was no question that the secured portion of the $35 million claim would have to be paid in full over time at a market interest rate. It was the remaining $31 million undersecured claim of Franklin that gave rise to its complaint that the Stockton plan could not be confirmed because under that plan Franklin was only to receive about 1% on its $31 million claim; and the centerpiece of Franklin's objection focused on the pension obligations of the city, which, under the proposed plan, the city chose not to impair in any respect.

Central to its objections, Franklin maintained that to satisfy the city's obligation to treat a dissenting class of creditors in a municipal context “fairly and equitably,” it should have been required to modify and reduce pension benefits of the city's retirees; and had the city sufficiently done so, Franklin could have received considerably more than 1% on its undersecured claim. Franklin alternatively argued that the “best interests of creditors” requirement in Section 943, similarly required the city to take a more balanced approach that required the city to seek concessions from its pension beneficiaries in order to improve Franklin's recoveries.

The Court's Dilemma

In urging the Plan's confirmation, the city first sought to defeat Franklin's objections by raising technical arguments. The city had included Franklin's claim in a class together with the rejection claims of the union memberships that had agreed to significant reductions in their health care benefits. Those rejection claims were actuarially determined to be worth many times over the size of Franklin's claim, allowing the accepting votes of the union memberships to bind the class and override Franklin's dissenting vote under Section 1126 (c). Franklin contended that the class in which it was placed was artificially gerrymandered to override its dissenting vote; but the court disallowed that objection and treated the class in which Franklin was placed to have accepted the Plan, thereby removing the “fair and equitable” objection to the non-impairment of retiree benefit ' an argument that could only have been asserted had the class voted in requisite majorities to reject the Plan.

The city also contended that Franklin could not assert a “best interest of creditors” challenge because all of the other Stockton creditors, including all other of the city's financial creditors, had voted to accept the Plan. The court agreed, and essentially interpreted the best interest test to be a popularity contest among all the constituencies voting on the plan. Here again, Franklin had maintained that Stockton's plan did not comport with the best interest of creditors statutory requirement because the city had not done all it could to maximize creditor recoveries in a setting where slight pension impairments could have resulted in Franklin receiving meaningful treatment on its under secured claim. But interpreting Section 943 as he did, Klein held that Franklin could not raise an objection grounded on the best interest of creditors requirement. Franklin is appealing these legal determinations; and it is very likely that other bankruptcy courts will disagree with Judge Klein's classification decision and the meaning to be afforded to the “best interests of creditors” requirement that led to Franklin being stripped of the means to protest its treatment.

But Judge Klein went one step further and addressed whether, even if Franklin could have effectively had standing to assert both “fair and equitable” and “best interests of creditors” challenges to the Plan, the rationale behind the city's decision to propose a plan that did not alter the rights of pension beneficiaries could nonetheless be sustained over Franklin's objections. Judge Klein found that he could overrule Franklin's objections, relying on the city's assertion and submitted evidence that any modification of the pension benefits of city employees would seriously imperil the ability of the city to retain its critically important work force of police and fire fighters. In sum, having given the city the permission to modify pension benefits if it chose to, and as some court observers viewed the situation, after inviting the city to go down that path, Judge Klein in the end refused to deny confirmation of a plan that avoided making any pension modifications whatsoever.

Recognizing that because of Tenth Amendment considerations, a court overseeing a Chapter 9 case cannot mandate that a city pursue a specific course of action, Judge Klein was left with a choice; either confirm the Plan the city had proposed, accepting its justification for not impairing pension beneficiaries; or, deny confirmation, rendering fruitless all the efforts to achieve a plan and leaving no clear picture about what would then happen to the city. He chose the former. While the Plan is being appealed by Franklin, what should be made of Judge Klein's rulings on the record before him?

The Implications

Perhaps most troubling for bond holders is the recognition that other cities facing fiscal challenges may seek to justify plans of adjustment that stop short of requiring any pension modifications based on the same notion offered in Stockton ; namely, that such modifications would impair the municipality's ability to retain experienced police and fire fighters integral to maintaining a safe and secure populace. What city if it could do so, would want to risk dismantling some of its critical work force because it chose to modify pension benefits, if instead it could fashion a confirmable plan by making more impositions on bond holder claims and still achieve a feasible plan and balanced budget?

But the question that is open to active debate is whether the same balance that was struck in Stockton will be adopted by courts overseeing Chapter 9 filings in other cities and under different circumstances. It seems fair to ask, then, whether other cities may present conditions and circumstances that would lead a court to reject a plan that does not require concessions from pension holders in order to produce a sustainable and balanced budget. Looking at the result in Stockton , one might at first blush conclude that it is unlikely that a bankruptcy court would come out differently than Judge Klein. But change the facts of the Stockton case only slightly and reconsider that assumption in light of the following:

1. Long before the Stockton plan proposed to give Franklin only 1% of its undersecured claim, it had been offered approximately a 50% recovery. Franklin turned that down, and the amounts that it had been offered were given to other creditors who then accepted the plan. Would the Stockton court have come out the same way had Franklin always been only offered from the outset a 1% recovery on $31 million of its $35 million claim?

2. The Stockton court had to weigh the potential upheaval to the work force that might be caused by altering pension benefits to solve an objection raised by one creditor holding a claim of only $31 million. Would the outcome have been different if all the bond holders were vigorously objecting to the plan that they contended unfairly imposed too much on them, asserting that the plan's failure to seek pension cuts was neither “fair and equitable” or in their “best interests”? What if those creditors chose to put on an a comprehensive evidentiary case that seriously challenged, using forensic proof, the city's contention that its work force would quit if some pension modifications were required? What if the Stockton bondholders had also made out a strong case that aside from unfairness in treatment, without meaningful pension cuts, the city's ability to produce a balanced budget in the future was infeasible and an illusion?

3. What if a Chapter 9 city cannot achieve a balanced budget without impairing retirees? In the Stockton case, the city had sufficiently persuaded Judge Klein that given other agreed-upon creditor impairments and cost-containment measures, it could meet its ongoing pension obligations without putting future balanced budgets at risk. In Stockton , the unions had made significant concessions in regard to their health care plans, reducing materially the anticipated annual cost of funding medical care costs of its workers out of the city's operating revenues.

Those concessions, together with consensual impairments to bond claims, allowed the city to produce a balanced budget as long as it did not have to pay Franklin's undersecured claim. But if in other cities the combined proposed cuts in medical coverage together with reasonable impairment of bondholder claims are not sufficient to produce a balanced budget, how could a city not find it necessary to modify pension obligations no matter the consequence. Even if a court were prepared to approve a plan containing extreme impairment of bond claims over strenuous “fair and equitable” and “best interests of creditors” objections from most of the municipality's financial creditor constituencies (that assumption seems dubious), such extreme cuts in financial creditor claims might well not be a sufficient answer to achieving a balanced budget. That is so because it is usually the case that repayment of borrowings only constitutes 10%-15% of a city's operating costs, whereas the cost of labor, current and retired, usually exceeds 70% of a city's expenses.

Conclusion

Stepping back from viewing the Stockton decision as an application of emerging Chapter 9 law and looking instead at the pension concession issue from a broader policy perspective, it seems unrealistic to assume that cities beset with reduced operating revenues and faced with the incapacity to realistically tax their residents at even higher rates to solve their budgetary shortfalls, can somehow fix their imbalances without meaningfully addressing and curtailing their health care and pension funding costs. In Stockton , reduced health care costs were sufficient. In the next case they may not be.

Then, with some acknowledgment that pension cuts will be required, the question will become whose pensions should get modified and to what extent pensioners should be expected to contribute to achieving a balanced budget. None of those questions have as yet been addressed by any court in a cram-down context. Given the delicate nature of these challenging issues, perhaps it will be best to have them resolved at the bargaining table, rather than asking a court in a Chapter 9 case to rule on whether the city's formulation of how the “pain is to be shared” is truly a fair and equitable solution to a very delicate and highly personal set of issues.

Mark S. Kaufman ([email protected]) is a partner in the San Francisco office of McKenna Long & Aldridge LLP, where he serves as co-chair of the firm's Municipal Reform & Innovation Practice. Kaufman advises financially distressed municipalities, special purpose districts, related governmental entities, and bondholders, bond insurers and other investors. Most recently, he served as lead counsel to the Governor-appointed Receiver to the City of Harrisburg, PA.