Local Government Bankruptcy in California: Questions and Answers

POLICY BRIEF Local Government Bankruptcy in California: Questions and Answers MAC TAylor • le g i s lA Ti v e A nAl y s T • Augus T 7, 2012 Introduction Unanticipated events or prolonged imbalances between resources and spending can result in people, businesses, or governments becoming unable to pay their debts or contractual obligations. The United States Constitution authorizes Congress to make laws safeguarding these parties as they develop financial recovery plans that dismiss or restructure debts and other obligations. The process by which people and businesses file for this relief frequently is referred to by the section of federal bankruptcy code authorizing the process, primarily Chapter 7 (individuals) and Chapter 11 (businesses). The process by which local governments seek relief is known by the section of code where its rules are detailed: Chapter 9. States have no means of filing for bankruptcy. All bankruptcy cases are heard in the United States Bankruptcy Court (the court). Chapter 9 was established in 1937. Since that time, only about 600 cases have been filed nationwide and these cases typically have involved single-purpose entities (such as water or sanitation districts). Recently, three California municipalities filed for Chapter 9 relief: Stockton, San Bernardino, and Mammoth Lakes. These filings—occurring just months after the City of Vallejo completed its three-year Chapter 9 process— have raised questions about the use of Chapter 9 in California. This document addresses some of these questions. What Is Chapter 9? Chapter 9 is a section of federal bankruptcy code created exclusively for local governments to adjust or reduce their obligations when their resources are inadequate to cover their obligations. Similar to other forms of bankruptcy, such as Chapter 7 and 11, Chapter 9 provides filers protection from their creditors while they develop plans to move toward financial stability. Under Chapter 9, a local government’s recovery plan may include reducing payments on bonds or other debts and/or rejection of burdensome contracts and other agreements. Chapter 9 differs from other forms of bankruptcy in certain respects. First, the decision to file a Chapter 9 case is fully at the discretion of the locality. Creditors are not permitted to force a local government to file Chapter 9. Second, the court cannot compel a locality to sell its assets or increase tax rates in order to raise revenues to meet its obligations. Finally, the local government may not be forced to dissolve or reorganize its governance structure. An LAO RepOR t Which Local Governments May File Chapter 9? When May Local Governments File Chapter 9? Federal bankruptcy laws permit all local Beyond being specifically authorized by their governments—counties, cities, special districts, state, Chapter 9 requires localities to meet several school districts, and community college districts— criteria to be eligible to file for relief. Specifically, a to file for relief under Chapter 9 provided that local government must: their state government authorizes this action. • Be Insolvent. A local government is Nationwide, states have taken different approaches considered insolvent if it is unable to (1) pay with regards to granting local governments its current obligations or (2) pay obligations authority to file for Chapter 9 relief, ranging from that will become due during the next fiscal granting broad, unrestricted access to prohibiting year. use of Chapter 9 by local jurisdictions. The majority of states require local governments to • Have No Feasible Alternatives to seek permission to file for Chapter 9 relief from Bankruptcy. The Chapter 9 process their respective state legislatures on a case-by-case is intended to be a local government’s basis. California provides its local governments last resort in addressing unsustainable with broad authority to file Chapter 9, but generally obligations. For this reason, the local requires cities, counties, and special districts to government is expected (with limited engage in a “neutral evaluation” process (described exceptions) to exhaust all possible in a nearby box) prior to filing for Chapter 9 relief. alternatives prior to pursuing the use of the California’s Neutral Evaluation Process and “Fiscal Emergencies” Prior to filing for Chapter 9 relief, Chapter 675, Statutes of 2011 (AB 506, Wieckowski), requires cities, counties, and special districts to work collaboratively with creditors, employee groups, and other interested parties to attempt to resolve the local government’s fiscal problems. As part of this process, the local government and affected parties select a “neutral evaluator” to review the local government’s fiscal condition. The neutral evaluator has limited powers and may not impose an agreement on any party. If at the conclusion of the neutral evaluation process no resolution has been reached, the local government may file for Chapter 9 relief. Chapter 675 also allows local governments experiencing fiscal emergencies to bypass the neutral evaluation process. Specifically, the governing body of any local government that would be unable to pay its obligations within 60 days may adopt a resolution by a majority vote declaring a fiscal emergency. This declaration allows the local government to file for Chapter 9 relief immediately. Does a Declaration of Fiscal Emergency Mean Insolvency? It is important to note that municipalities may declare a fiscal emergency for reasons other than to signal insolvency. This is because the State Constitution gives greater scheduling flexibility with regards to placing proposed tax increases on the ballot to local governments that have declared a fiscal emergency. 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO R EPORT restructure its obligations. with its creditors and employee groups, implementing expenditure reductions, and, if possible, increasing revenues. A locality from creditors or employee groups that legal judgment against the town which obligated it to would provide short-term relief but create greater costs in the long term. Similarly, is more than twice the town’s annual General Fund it is not expected to reduce expenditures beyond the level required to maintain its attempted to negotiate a reduced settlement with basic functions or increase revenues when the developer but no agreement could be reached. limited by constitutional voter approval In February 2012, the developer sought and received requirements or other constraints. a writ of mandate from a state court requiring the town to pay the judgment in full. Still desiring to • Demonstrate Intent to Develop a Plan to Adjust Debts. In general, the local government must display a willingness automatic stay that protects it from the developer’s to develop a plan to adjust its obligations that proposes to reduce the size of the judgment. process simply to evade creditors or delay Court Determines Local Government payments on its obligations. Eligibility. Before a local government may submit a proposal to adjust or reduce its debts or other What Happens After a Local obligations, the court must determine that the Government Files for Relief? eligibility determination is made based on the criteria described in the previous question “When government does not make timely progress through these steps, the court may dismiss the case and bankruptcy, and (3) demonstrate intent to develop a remove the locality’s bankruptcy protections. plan to adjust debts. Local Government Files Case and Obtains Local Government Develops a Plan of Automatic Stay. Adjustment. local government receives an “automatic stay,” process is the development and implementation of which stops collection activities by its creditors a plan to adjust a local government’s obligations in provides a locality time to evaluate how best to is commonly referred to as a plan of adjustment or www.lao.ca.gov Legisl ative An alyst’s 3 An LAO RepOR t provided to a local government by Chapter 9 to specific individuals or groups? adjust its obligations are the ability to modify the • Would the local government and affected terms of its outstanding bonds and other debt and parties be better off under the plan than the authority to reject various contracts, including would be the case if the issue were addressed those with current and retired employees. The outside of the Chapter 9 process? locality is given exclusive discretion over how it uses these tools and the development of its plan of • Will the locality be able to meet its adjusted adjustment. In its plan, the local government must obligations and avoid the need for further detail its proposed changes to its obligations to its adjustment in the foreseeable future? creditors. Generally, creditors are categorized into Once the court approves a plan of adjustment, classes based on the degree of assurance they had it creates a new contractual agreement between been given that their claim will be paid. For instance, the locality and its creditors. This new agreement a claim in which the creditor is entitled to city assets replaces any agreements that existed prior to the in the event of default (referred to as a “secured” Chapter 9 filing. claim) typically is given priority over a claim without similar assurance (an “unsecured” claim). While a What Role Does the Court Play? plan may propose that different classes of creditors Unlike other types of bankruptcy cases, under be treated differently, the plan of adjustment Chapter 9 the court has two primary responsibilities: typically provides for equal treatment of creditors determine a locality’s eligibility and approve its plan within the same class. of adjustment. In carrying out these responsibilities, Creditors Approve Plan of Adjustment. however, federal law does not give the court specific Once a locality has created a plan of adjustment, guidance regarding many significant matters—such it must submit it to its creditors for their review as determining whether a local government has and approval. The local government does not need filed a case in good faith, intends to develop a plan the approval of all of its creditors, but must, at a to adjust debts, and has created a plan of adjustment minimum, have the consent of one class of creditors that provides equitable treatment of its creditors. For that would be negatively affected by the plan. this reason, the degree to which the court’s actions Court Approves Plan of Adjustment. After a affect the outcomes of a Chapter 9 filing can vary local government has created a plan of adjustment from case to case. and secured the consent of at least one class of Despite the lack of specific guidance in impaired creditors, it must submit the plan to the some areas, federal law clearly limits the court’s court for approval. In deciding whether to approve a power to dictate how a locality addresses its fiscal plan, the primary questions the court considers are: situation and prohibits it from interfering with • Would the plan require the local the local government’s operations, organization, government to violate state or local laws? or laws during or after the Chapter 9 case. As • Has the locality obtained approval from a result, the locality retains its authority to govern its own affairs—including managing its regulatory bodies or its electorate, if day-to-day operations, collecting revenues, making necessary? • Does the plan disproportionately benefit 4 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t expenditures, buying or selling property, and in June 2012, citing unsustainable employee borrowing. compensation and retiree expenses, excessive debt load, and the economic downturn as primary Can the Plan of Adjustment factors. In developing its proposed plan to adjust Bypass State or Local Laws? its obligations (which has not yet been reviewed by The court may not approve a plan of the court), the city prioritized among its existing adjustment that requires actions that would bonds and other debts based on whether the debts violate state or local laws, with the exception of were secured or unsecured. Among its secured laws relating to contractual agreements. This is debts, highest priority was given to those backed true even if a law would hinder a locality’s ability by assets that the city considered to be essential to recover from bankruptcy. For instance, the to its operations. For example, for a high-priority court may not authorize a local government to debt—such as certificates of participation backed by increase property tax revenues beyond the limits the city’s library and police and fire stations—the stipulated in the State Constitution or bypass voter city proposed to continue funding payments from approval requirements for increasing other forms its General Fund but extended the time frame of taxation. Similarly, a plan of adjustment must for repayment. For a low-priority debt—such as observe local laws, including those that require unsecured pension obligation bonds—the city certain expenditure levels or restrict revenue proposed to cancel all future payments from its increases. For example, the charter of the city of General Fund. San Bernardino includes a provision stipulating a Can the Plan of Adjustment Void process for determining the salary of public safety Collective Bargaining Agreements? employees. Chapter 9 does not authorize the court to set aside local charter provisions. Thus, the city One of the tools provided to local governments will be limited by this provision if it attempts to in the Chapter 9 process is the ability to reject reduce employee compensation costs during its contracts, such as agreements with its vendors Chapter 9 process. or professional consultants. Under certain circumstances, local governments also may use Can the Plan of Adjustment Reduce the Chapter 9 process to “reject”(that is, nullify) Obligations on Bonds and Other Debt? contracts with employee groups known as Chapter 9 affords a local government the collective bargaining agreements. Specifically, a ability to significantly modify its bond and other locality may reject collective bargaining agreements long-term debts in order to lower its payments to if it can show that (1) the agreement hinders its creditors. In general, a locality’s debt payments ability to achieve fiscal stability, (2) the employee may be reduced by decreasing the total amounts group otherwise would bear a disproportionately owed, lowering the interest rates, and/or extending small burden of the locality’s bankruptcy, and the length of time during which the debts are to be (3) the locality negotiated in good faith with the repaid. employee group but no resolution was reached. The recent bankruptcy filing by the city In some cases, this authority to reject collective of Stockton provides an example of how a bargaining agreements can provide a local municipality may seek to modify various types government significant leverage in negotiations of debt. The city of Stockton filed for Chapter 9 with employee groups, allowing the local www.lao.ca.gov Legislative Analyst’s Office 5 An LAO RepOR t government to achieve concessions without actually significantly reduce health benefits for its retirees rejecting the bargaining agreement. The Chapter 9 by decreasing its payments to a flat rate of $300 per case of the city of Vallejo, filed in 2008, provides month. To date, no California local governments such an example. About a month after filing its have used Chapter 9 to change pension benefits Chapter 9 case, Vallejo requested approval from for current retirees; however, pension benefits the court to reject collective bargaining agreements were changed in at least one case in another state with four of its employee groups. Following the (Central Falls, Rhode Island). Due to the lack motion, the employee groups challenged the city’s of case law regarding the treatment of retiree eligibility for Chapter 9. After an initial decision benefits in Chapter 9, it is not clear if and under and an appeal by the employee groups, the court what circumstances local governments would found that the city was eligible for Chapter 9 be permitted to reduce retiree benefits in future relief. Following its decision, the court delayed its Chapter 9 filings. It is possible that differing benefit hearing on the rejection of the collective bargaining and contractual requirements in different states agreements to allow time for additional negotiation. could result in Chapter 9 applying differently from During this period, three of the four employee one state to another. groups reached agreement with the city. The court What Is the Status of the Recent then approved the rejection of the fourth collective Bankruptcy Filings? bargaining agreement based on the criteria described above. This decision was appealed to the As mentioned previously, three California United States District Court, which affirmed the local governments—Stockton, San Bernardino, bankruptcy court’s position. and Mammoth Lakes—have active Chapter 9 cases and a fourth—Vallejo—recently completed Can the Plan of Adjustment the Chapter 9 process. Figure 1 summarizes the Change Benefits for Retirees? Chapter 9 status of these municipalities. A local government’s agreements with retirees What Factors May Have Contributed to provide pension or health benefits are generally to the Recent Bankruptcy Filings? considered contracts which may be subject to rejection under Chapter 9. However, Chapter 9 The factors contributing to a local government’s cases addressing retiree benefits have been rare. In decision to file for relief under Chapter 9 typically its Chapter 9 case, Vallejo became the first and only are varied and complex. From the information that California locality to use a plan of adjustment to has been made available to date, it appears that Figure 1 Status of Recent California Chapter 9 Bankruptcy Filings Neutral Evaluation Eligibility Recovery Plan City Process Started Chapter 9 Filed Confirmed Approved Vallejo Not applicablea May 2008 September 2008 August 2011 Stockton March 2012 June 2012 Mammoth Lakes April 2012 July 2012 San Bernardino Not applicableb August 2012 a The city of Vallejo filed for Chapter 9 prior to the establishment of the state required neutral evaluation process. b As permitted by state law, the city of San Bernardino bypassed the neutral evaluation process by declaring a fiscal emergency. 6 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t Stockton and San Bernardino’s bankruptcy filings state has assigned county offices of education were driven by some similar factors including: the responsibility to review each school district’s long-term imbalances in revenues and spending, fiscal condition shortly after districts adopt their reduced tax revenues associated with the downturn budgets and then at a few subsequent points in in the economy, some constraints to reducing the fiscal year. School districts that show signs of expenditures in the short term, and increasing fiscal distress receive assistance, with the type and costs to provide retiree benefits. Additionally, amount of assistance depending on the gravity of a substantial borrowing appears to be a factor in district’s fiscal condition. In the most serious case— Stockton’s filing, and prior budgeting practices, when a district no longer appears able to meet its such as borrowing from internal funds, appears to financial obligations—the state provides it with be a contributing factor in San Bernardino’s case. an emergency loan and assumes administrative By contrast, the bankruptcy filing by Mammoth control until the district has demonstrated clearly Lakes appears to be driven by a single significant that it is solidly on the road to fiscal recovery. event—a recent legal judgment that required it to Conclusion pay an amount more than twice its annual General Fund budget. Fiscally distressed local governments can use Chapter 9 proceedings to gain protection Does the State Monitor the Fiscal from their creditors while they develop financial Condition of Local Governments? recovery plans that dismiss or restructure Historically, California has vested its local debts and other obligations. Various parties— governments with significant fiscal independence, bondholders, lenders, vendors, employees, and including the authority to adopt their own budgets, retirees—can be affected by a local government’s negotiate collective bargaining agreements with use of Chapter 9 to adjust its obligations. Generally, their employees, propose tax increases to their local governments in California are provided voters, issue debt, and (in many cases) establish broad discretion over when to initiate a Chapter 9 themselves as a governmental entity, dissolve case, as well as how to use the tools of Chapter 9 their governance structure, or modify their to adjust their obligations. Chapter 9 also does service boundaries. With the exception of K-12 not interfere with a local government’s authority education—where the State Constitution assigns over its own affairs or alter its primary functions the state a major responsibiliy—the state does or governance structure. Chapter 9 can provide not play a significant role in monitoring the fiscal insolvent local governments a means of aligning health of its subordinate governments. Instead, the their resources and obligations that maintains their responsibility for reviewing local government fiscal autonomy and allows them to continue meeting conditions rests with local communities. their primary function of providing public services In the case of K-12 districts, the state has to their residents. On the other hand, the use of created a comprehensive system for monitoring the Chapter 9 by local governments could require fiscal condition of school districts. As we discussed significant sacrifices from creditors and parties more extensively in our April 2012 report, School with whom they contract, including vendors and District Fiscal Oversight and Intervention, the employees. Additionally, Chapter 9 is typically an expensive and time-consuming process for local governments. www.lao.ca.gov Legislative Analyst’s Office 7 An LAO RepOR t LAO Publications This report was prepared by Brian Uhler, and reviewed by Marianne O’Malley. 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