Politics a Principle Driver of Filing for Chapter 9

Daily Business Review
August 22, 2012

While businesses post record-breaking profits and consumer confidence grows, for public sectors, the late 2000s financial death spiral is still a violently spinning vortex. From sovereigns to local municipalities, governments labor under increasing financial pressure.

For local governments, that pressure derives in part from the "spend now, pay later" mentality that inevitably seeps into fiscal policies. The best example of that is unfunded pension liability, which is often the product of unfortunate collective bargaining agreements.

Overall, the fiscal problems of municipal governments are the by-product of the huge devaluation of taxable assets, higher than usual unemployment and low returns on capital, resulting in dwindling tax bases, general revenues and state financial aid.

Making matters worse, the public's view of municipal debt as "risk free" has changed dramatically, with a profound effect on the cost of borrowed money for local governments.

Their financial fix is not easily prescribed, given the socio-political considerations that are also in play. Re-election priorities all too often define the strategies, and revisions generally end up neutralized for the sake of votes.

One restructuring tool that has long been available to local governments is Chapter 9 of the Bankruptcy Code. In theory, the decision to file any bankruptcy is grounded in the sound business judgment of the decision makers.

In reality, bankruptcy for a governmental unit is generally regarded as political suicide, and thus, Chapter 9 has not been popular with politicians, even when it makes good business sense. However, as the situation worsens for some communities, Chapter 9 is steadily becoming the "Hail Mary" game plan.

While Chapter 9 has never been used by a Florida municipality, Florida is among the states that expressly permit local governments to commence bankruptcy proceedings without obtaining permission from the legislative or executive branches.

Thus, we should expect that the viability of Chapter 9 will be the subject of closer scrutiny by Florida municipalities that see no other way out of the storm.

Pension Benefits

While Chapter 9 does not provide for all the rights and protections afforded a corporation under Chapter 11, it does give some important, though limited, relief that is useful in dealing with public debt, collective bargaining agreements and debilitating litigation.

What is particularly interesting about Chapter 9 is that as a law, it must bridge the differences between principles of federalism and the powers granted to the states under the Tenth Amendment. As a consequence, Chapter 9 has a much more limited view of bankruptcy court jurisdiction than Chapters 7, 11 or 13.

For example, there is no provision for involuntary municipal bankruptcies, and only the municipality can file a "plan of adjustment" the Chapter 9 analog to a reorganization plan, for which there is no deadline, leaving expediency to good political sense.

Moreover, in Chapter 9, the courts are enjoined from interfering with managing the municipality or using its income-producing assets. The Chapter 9 debtor is not even required to file schedules or statements of financial affairs.

Unquestionably, pension liabilities are the 800-pound gorilla in all this. The Florida Constitution prohibits any law impairing the obligation of contracts. This provision has been interpreted by the courts to protect vested pension benefits. Thus, once a municipal employee's retirement benefits vest, the benefit attains constitutional protection and cannot be altered.

However, in Chapter 9, there is a stay or injunction against the enforcement of retirement benefits during the pendency of the bankruptcy. This provides enormous bargaining leverage to the employer/municipality, and Chapter 9 debtors have effectively used it to renegotiate their pension liabilities.

This leverage is further augmented by the formidable right to reject contracts, including collective bargaining agreements. While the right to reject contracts also exists in Chapter 11 cases, the rules of engagement are much different in Chapter 9, where the test for rejection may boil down to the fact that the contract is burdensome.

Cram Downs

The end game in every reorganization proceeding is a plan; however, in Chapter 9, only the municipality can propose the plan, giving it the leverage of fully controlling the plan process.

The notion of cram down persists in Chapter 9 and thus, with only one consenting class, the debtor can impair the claims of other classes, including affecting pre-filing pension liabilities.

The touchstone for Chapter 9 cram downs is that the impaired creditor is reasonably treated under the circumstances. That is a relatively low bar in cases of budget shortfalls and pension under-fundings.

Notwithstanding the leverage a municipality may find in Chapter 9, it is unreasonable to expect that politics will not remain a principal driver in the filing decision. As it turns out, however, that's not so bad if you think bankruptcy should be reserved for the worst-case scenario.

Scott L. Baena is a senior partner with Bilzin Sumberg Baena Price & Axelrod in Miami and chair of the firm's restructuring and bankruptcy group. His practice focuses on creditors' rights, workouts, bankruptcy and commercial loan transactions.

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