Fundamental Federalism Challenges

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In this morning’s eBlog, we applaud what could be a signal breakthrough in San Bernardino that might pave the way towards the city’s exit from the longest municipal bankruptcy in U.S. history. The actions are something those at the Treasury and the U.S. House Committee on Natural Resources might be well advised to consider as they struggle to try and come up with a plan to prevent the rapidly onrushing insolvency in Puerto Rico. As much as the Committee, in its initial draft, has chosen to decry chapter 9 municipal bankruptcy, the process has, time and again, with great patience and an extraordinary federal role, proven prescient. We also try to get schooled on the possible municipal bankruptcy by the Chicago Public School system—something which would require state legislation, and something which would re-raise fundamental federalism challenges between state constitutions and federal law. Oh my.

A Significant Step by San Bernardino. The GE slogan made famous by former California Governor and later President Ronald Reagan in the 1950s was “progress is our most important product.” Yesterday, not so far from the former President’s old stomping ground, the City of San Bernardino, the city in municipal bankruptcy longer than any other in U.S. history, achieved its own significant progress when it reached agreement as part of its negotiation with creditors on a plan of debt adjustment to pay bond holders of its pension obligation bonds 40 percent of what they are owed, thereby achieving a reduction in the total payments to one of its largest creditors by about $45 million. While the deep discount is far short of the 1 percent the city had first proposed, whilst the bondholders sued in an effort to gain the entire amount the city agreed to for the California Public Employees’ Retirement System. In a written statement, City Attorney Gary Saenz noted: “The settlement will end the costly legal battles between the City and the settling creditors over confirmation of the City’s Chapter 9 Plan of Adjustment, as well as how much the creditors are to be paid.” Under the nine-page settlement agreement, those creditors — the Luxembourg-based bank EEPK, and Ambac Assurance Corporation — agreed to drop their litigation against San Bernardino and release the municipality from any future liability related to the pension obligation bonds. The two also agree to support the city’s disclosure statement — an amended version of which is due to U.S. Bankruptcy Judge Meredith Jury today. Under that agreement, San Bernardino agrees to pay its debt over a 30-year period beginning one year after Judge Jury approves its plan of debt adjustment and exit from chapter 9 municipal bankruptcy. The crucial step means the city funds will be freed up for additional investment in public safety of about $2 million per year, according to the city. As we experienced from the invaluable role of U.S. District Judge Gerald Rosen as an intermediary for now-retired U.S. Bankruptcy Judge Steven Rhodes in Detroit, in San Bernardino, U.S. Judge Gregg Zive—serving in a similar capacity—served as the key to the resolution—a resolution the San Bernardino City Council last week approved in closed session.

Getting Schooled on Municipal Bankruptcy. After receipt last month of a signed, sealed, and certified letter to the Chicago Public Schools (CPS) and the city’s board of education, Illinois’ State Board of Education last month commenced a formal investigation “of the financial integrity of Chicago Public Schools,” raising increasing apprehension the city’s massive public school system could become insolvent and bankrupt. Because Illinois does not currently authorize municipalities, including school systems, to file for chapter 9 municipal bankruptcy, the epistle raises the stakes in the Illinois legislature, where Illinois Governor Bruce Rauner has asked the legislature to authorize municipal bankruptcy. Should the state so act on an issue eerily comparable to Congress’s deliberations over the fast-approaching default in Puerto Rico, the impact on the nearly $6 billion in outstanding CPS debt would be at stake. CPS, in its most recent municipal bond sale, warned that one of its pledged repayment streams under the state’s alternate revenue bond structure would meet the bankruptcy code’s designation of “special revenues,” that is revenues that would be affected by a municipal bankruptcy. CPS currently has a failing fiscal grade with some $10 billion in unfunded pension obligations, a looming $1 billion deficit, and a rising annual teacher pension payment of about $700 million. With the issuance just last month of some $725 million in municipal debt—bonds which triggered an 8.5 percent tax-exempt rate in order to sell—and with an accompanying disclosure statement which incorporated language from a special opinion which provides the legal reasoning behind CPS’ position that the municipal bonds’ structure provides a security which preserves the statutory lien on pledged revenues and offers relief from the automatic stay provisions of chapter 9 municipal bankruptcy. The accompanying tax levy for debt service on the bonds is not subject to the property tax caps that non-home-rule units such as the school system operate under. Repayment would rely on a combination of pledged state aid, block grants, and tax-increment financing and personal property replacement tax revenues. Some credit rating agencies have assigned the new debt as junk because of CPS’ severely distressed overall credit profile. The uneasiness about the possibility of a municipal bankruptcy has triggered, unsurprisingly, questions with regard to the so-called “automatic stay” provisions arising from a chapter 9 filing: how would such a filing apply to the application of so-called “special revenues,” e.g. to the payment on the bonds secured by those special revenues? This is, at the moment, further roiled by the absence of any chapter 9 authority under Illinois law and further complicated by the exemption of CPS from some state oversight rules—where CPS is authorized to direct the county to deposit pledged property taxes with the bond trustee, albeit where said direction can may be revoked. All of this would, of course, be confounding to any math student in any Chicago public school, contributing even more to the cost to the system in higher interest rates.

All of this is contributing to the schooling of state legislators on the intricacies of chapter 9 municipal bankruptcy, state authorization of which the Governor had proposed as a key part of what he termed his “turnaround agenda” as a means to provide Illinois’ municipalities leverage in addressing pension negotiations, having, earlier this year, endorsed state legislation which would subject CPS to state statutes allowing for oversight and grading the way for municipal bankruptcy. Were the state legislature to agree, it would raise the kinds of federal-state legal confrontations raised in Detroit’s and Stockton’s chapter 9 municipal bankruptcies with irreconcilable issues because the respective pension programs, defined as contract, are protected by the respective state constitutions; however, those pensions, as reduced under Detroit’s federally approved plan of debt adjustment, reduced the city’s pension obligations—and the initial proposals to pursue appeals to the 6th and 9th U.S. Circuit Courts of Appeals never materialized. Thus, in the wake of the 2014 Illinois Supreme Court ruling two years ago that benefit cuts under Chicago’s 2014 pension reforms violated state law giving contractual status to membership in governmental pension funds, the same federal-state municipal bankruptcy challenge could well re-emerge. The scholarly professor of municipal bankruptcy, Jim Spiotto, yesterday noted to the Bond Buyer that only four school districts have filed for municipal bankruptcy in the last sixty years—in large part because most states hold oversight powers that can be critical to averting insolvency: he said that “Two of the four never got to a plan of adjustment. They realized once they got in there was a better way.” One, the San Jose Unified School District, filed for municipal bankruptcy in 1983 in the face of steep demands under a proposed salary increase plan; however, the parties reached an agreement on a new wage plan and the bankruptcy petition was dismissed. Subsequently, just up the highway, the Richmond Unified School District filed for municipal bankruptcy in 1991 due to fiscal and operational woes. In that instance, school parents sued the state—effectively scoring A’s when the state responded by loaning the district $29 million.

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