U.S. Bankruptcy Court Approves Stockton’s Plan to Exit Municipal Bankruptcy & What is the Role of States in Municipal Bankruptcy?

October 31, 2014

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Taking the Final Stock in Stockton. (From our special correspondent in the courtroom yesterday afternoon in Stockton, Chris McKenzie, the extraordinary Executive Director of the California League of Cities) In a proceeding lasting just over two hours, U.S. Bankruptcy Court Judge Christopher Klein rejected the claims of the remaining holdout creditor, Franklin Templeton Investments, and approved the city of Stockton’s proposed Chapter 9 Bankruptcy Plan of Adjustment. The judge detailed the various classes of creditors and the extent to which they would be paid. He specifically refused to categorize the $32 million Franklin unsecured claim as a separate class, leaving it in a class of even larger unsecured claims, effectively rejecting Franklin’s claim of discrimination. The court previously ruled that roughly $4 million of Franklin’s $36 million claim was secured. Earlier this month on Oct. 1, Judge Klein ruled that federal bankruptcy law preempted California law and made the city’s contract with CalPERS subject to impairment by the city in the Chapter 9 proceeding. Today the judge said that contract was inextricably tied to Stockton’s collective bargaining agreements with various employee groups. Further, he stressed how in reality this amounts to a triangle of contracts because the employees are third party beneficiaries of Stockton’s contract with CalPERS. Contrary to Franklin’s assertion that CalPERS is the city’s largest creditor, the Judge said that the employees are Stockton’s largest creditor, citing ample evidence that their benefits and salaries have been substantially reduced. In response to Franklin’s assertion that the employee’s pensions were given favorable treatment in the Plan of Adjustment, the judge detailed all the reductions since 2008 (not just since the filing of the case in 2012) that have collectively ended the prior tradition of paying above market salaries and benefits to Stockton employees. This includes loss of retiree health care,  reductions in positions, salaries and employer pension contributions, and approval of a new pension plan for new hires, The judge said any further reductions, as called for by Franklin, would make city employees “the real victims” of the proceeding. Judge Klein also referred to the U.S. Supreme Court’s decision in N.L.R.B. v. Bildisco and Bildisco, 465 U.S. 513 (1984) in which the court held that collective bargaining agreements should receive greater deference from impairment in bankruptcy proceedings than other executory contracts. The judge explained how Stockton and its employees previously approved collective bargaining agreements with substantial reductions in costs, and the city was not proposing to further reduce those agreements in light of the substantial reductions that had already been approved. Citing an earlier disclosure by the city of over $13 million in professional services and other costs only through the end of May, Judge Klein also commented that the high cost of Chapter 9 proceedings should be an object lesson for everyone about why Chapter 9 bankruptcy should not be entered into lightly.

Reading Stockton’s Tea Leaves. S&P’s Chris Morgan, after the decision, wrote “The leaders of distressed U.S. municipalities will continue to pursue other options before setting in motion the long and costly process that bankruptcy implies,” even as Mr. Morgan reported that S&P believes that the “implications of Stockton’s exit from bankruptcy will be modest.” Nevertheless, he called attention to Judge Klein’s warning to other cities about the costs of bankruptcy and that it is an area of the fiscal, municipal twilight zone which should not “be entered into lightly.” As of last May, Stockton had paid lawyers and other advisers nearly $14 million, according to its court filings. Now the city, which will begin its exit from bankruptcy once Judge Klein sets a date―mayhap before the end of the year, will be able to focus on its future. As approved by the federal court, the city’s plan of adjustment provided for a $5.1 million contribution for canceling retiree health benefits. One key—both to putting together its plan of debt adjustment, but also to its future—was the voter approval last year to increase the city’s sales and use tax to 9 percent, a level expected to generate about $28 million annually, with the proceeds to be devoted to restoring city services and paying for law enforcement. Moody’s, in its reading of the potential implications of yesterday’s decision, wrote that Judge Klein’s ruling could set up future challenges from California cities burdened by their retiree obligations to CalPERS, with Gregory Lipitz, a vice president and senior credit officer at Moody’s, noting: “Local governments will now have more negotiating leverage with labor unions, who cannot count on pensions as ironclad obligations, even in bankruptcy.” A larger question, however, for city and county leaders across the nation will be the potential implications of Judge Klein’s affirmation of Stockton’s plan to pay its municipal bond investors pennies on the dollar while shielding public pensions.

The Role of the States in Municipal Bankruptcy. In our federalism system—and under the current version of chapter 9 municipal bankruptcy signed into law by the former Governor of California, former President Ronald Reagan, states play a unique role. No municipality, after all, may even file for federal bankruptcy protection—unlike any other corporation—unless authorized by state law. But states also play a role in either helping municipalities not to need access to federal bankruptcy protection—or, sometimes the opposite―as U.S. Bankruptcy Judge Thomas Bennett wrote in the case of the nation’s second largest municipal bankruptcy: “The loss of this unencumbered revenue source was rooted in the inability of the state of Alabama and its Legislature to properly enact a statute…All those who attribute Jefferson County’s bankruptcy case and Cooper Green’s plight only to conduct and actions by the county are ill-informed…The state of Alabama and its legislators are a significant, precipitating cause. Both before and after filing its Chapter 9 case, the county’s revenue-seeking activities with Alabama have been to no avail.”(In Re Jefferson County, United States Bankruptcy Court, N.D. Alabama, Southern Division, December 19, 2012.)

21 States do not provide access to Chapter 9 Bankruptcy, and 16 States set conditions for eligibility; and 12 States provide blanket authorization: Georgia explicitly denies access to municipal bankruptcy (GA Code 36—80-5); the following states do not authorize municipal bankruptcy: Alaska, Delaware, Hawaii, Indiana, Kansas, Maine, Maryland, Massachusetts, Mississippi, New Hampshire, New Mexico, North Dakota, South Dakota, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin, and Wyoming. But beyond the issue of eligibility, as Judge Bennett noted in the case of Alabama—and now a new study from the Chicago Federal Reserve finds, states can have precipitating roles as well as preventative roles (think New Jersey and North Carolina). In the study, the Windy City Fed determined that Michigan’s decade-long policy of repeatedly cutting local aid to help deal with its own fiscal problems has helped drive some of its local governments into fiscal crisis, the Chicago Fed says in a new report:

While economic downturns clearly put pressure on state and local governments alike, in Michigan’s case they have also added volatility and uncertainty into the revenue relationships between state and local governments. Because of changes to Michigan’s statutory revenue sharing program and tax code, local government officials have become increasingly uncertain that statutory revenue sharing will reach pre-2003 levels. Local governments in Michigan may be forced to adjust what their services programs can deliver because of expected lower amounts of state aid over the medium term and possibly the long term. Meanwhile, Michigan localities’ latitude to maintain their own programs with their own revenue sources is seemingly limited by law.

In its report, the author, Martin Lavelle, a senior associate at the Detroit branch, examined the trend of state revenue sharing to local governments in Michigan over the past decade as part of a larger look at how local governments nationally have struggled with state aid cuts, noting that in Michigan, local governments have faced cuts since at least 2003, when the state’s recession began, finding that the cuts helped drive several local governments and school districts into fiscal crisis, so that today the state not only hosts the largest municipal bankruptcy in history (followed, in order by Jefferson County, Orange County (Ca.), San Bernardino, and Stockton), but also where many of the state’s local governments (and school districts) are under state-controlled emergency management. Mr. Lavelle writes that problems tied to state aid cuts are aggravated by constraints on municipal authority to raise their own revenue―the key issue U.S. Bankruptcy Judge Bennett noted in the Jefferson County case. Mr. Lavelle writes: “While economic downturns clearly put pressure on state aid and local governments alike, in Michigan’s case they have also added volatility and uncertainty into the revenue relationships between state and local governments…Local governments in Michigan may be forced to adjust what their services programs can deliver because of expected lower amounts of state aid over the medium term and possibility the long term.” The study notes, interestingly, that the state’s local governments are among the most dependent on state aid in the country, with 43.3% of their budgets funded by the state, according to the Federal Reserve—indeed, fifth highest in the nation, trailing Vermont, which crowns the list, with 66.2% of local governments’ budgets funded by the state. But it is also timing: Mr. Lavelle notes that Michigan’s local governments have received less revenue from the state every year since 2003, with state revenue sharing as a percentage of state spending from state resources dropping to 56.3% last year, down from its peak of 64.3% in 2002 (Michigan distributes state aid according to two formulas, one based on the state constitution and one based on state statute). Mr. Lavelle found that while the constitutional aid has remained fairly flat since the early 2000s, the statutory aid has “fallen sharply.” (Due to the 1978 Headlee constitutional Amendment, local governments in Michigan are among the only municipalities in the nation which confront limitations on revenue, levies, tax rates, and assessment limits, even when property taxes are declining.) Even though a new formula (the City, Village, and Township Revenue Sharing program) is scheduled to take effect in 2015, Mr. Lavelle noted it, too, is “likely to fall short of fully restoring statutory revenue sharing funds to levels before Michigan’s one-state recession.” On the scholastic side, Mr. Lavelle found that Michigan’s reliance on state sales and use tax revenues added to municipal fiscal problems, because Michigan’s school operating budgets’ reliance on state sales tax revenue created cyclical misery by reducing local school aid in economic downturns: “While this program shifts the responsibility for funding education…to the state, it also exposes local education funding to any budget difficulties the state may experience…After Michigan’s recession began in 2003, state revenue sharing to local school districts decreased. And despite Michigan’s economic rebound since mid-2009, local school districts remain fiscally challenged, in part because of recent spikes in teacher retirement costs.”

Mr. Lavelle’s report does not examine the remarkable, bipartisan role of Michigan’s legislative leaders and its governor in fashioning and adopting—in an election year—the so-called Grand Bargain that involved a pioneering state role and substantial state injection of revenues that came to act as a fulcrum towards the Motor City’s hopes to follow Stockton out of bankruptcy next week. No report has tracked the virtually absentee role – or mayhap contributory role – of the State of California, now the unproud home to the country’s third, fourth, and fifth largest bankruptcies in U.S. history.


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