Municipalities In Crisis: Options Short Of Last ResortFebruary 27, 2013 Presented by:

David S. Kupetz, Partner, SulmeyerKupetzdkupetz@sulmeyerlaw.com

Dean G. Rallis Jr., Partner, SulmeyerKupetzdrallis@sulmeyerlaw.com

Robert Tormey CPA, CTP, CIRAbob@roberttormey.com

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California Cities in Crisis:• Presenters

• Current Circumstances

• Guidance for Elected and Appointed Officials

• Constructive Use of Fiscal Emergency

• AB 506 Advantages

• Purpose and Power of Chapter 9

• Filing Chapter 9

• Status of Pension Obligations: San Bernardino and Stockton

• Chapter 9 Precedents

• Conclusions

• Precedents Summary

• Questions and Comments 2

Dean RallisFor over 30 years, Dean Rallis has focused his practice

in the areas of business reorganization, corporate insolvency, commercial and bankruptcy litigation, as well as the acquisition of assets and businesses in bankruptcy court and out-of-court workouts. He has functioned as lead counsel for debtors, creditors (both secured and unsecured), creditors’ committees and purchasers in the bankruptcy, restructure and liquidation of companies, and represented Tri-City Mental Health Center in its successful chapter 9 municipal debt adjustment case.

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David KupetzDavid Kupetz specializes in troubled transactions, crisis avoidance consultation, workouts,

restructurings, reorganizations, bankruptcies, receiverships, assignments for the benefit of creditors, municipal debt adjustment, and other non-bankruptcy insolvency proceedings. He represents debtors (in restructurings and workouts and in chapter 11 reorganization cases), secured creditors, unsecured creditors' committees, assignees for the benefit of creditors, buyers/sellers of businesses/assets in distressed circumstances and other entities in insolvency and bankruptcy situations.

Practicing law at SulmeyerKupetz for over 25 years, David has substantial experience in municipal debt adjustment matters, and speaks and writes extensively on the subject. SulmeyerKupetz represented the Ventura Port District and Tri-City Mental Health Center in their successful Chapter 9 municipal debt adjustment cases, the Orange County Transportation Authority in connection with the Orange County Chapter 9 case, and a group of cities that were creditors in the Chapter 9 case of Desert Hot Springs. In recent years, SulmeyerKupetz has represented a number of local public entities in out of court negotiations with creditors, workouts, and restructurings that have allowed them to avoid Chapter 9. The firm has also represented other governmental entities in connection with Chapter 9 cases.

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Robert Tormey, CPA

• Bob Tormey is a Certified Public Accountant and Crisis Manager who specializes in highly leveraged situations, crisis situations and turn-arounds.

• He has acted as financial advisor to Lenders, lender's counsel, equity stakeholders and as interim management to debtors and has significant expertise in for profit education, municipal finance, aerospace manufacturing, business services, and acquisitions integration.

• Bob holds and MBA from the Johnson School of Cornell University and a BA from Loyola University of Los Angeles. He is also a member of the Turn Around Management Association and the Association of Certified Insolvency and Restructuring Advisors.

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Current Circumstances - Federal

• The Simpson Bowles Commission, i.e. the National Commission on Fiscal Responsibility and Reform was a Presidential Commission created in 2010 by President Obama to identify "…policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.

• The Commission’s report was released on December 1, 2010.• The Commission’s report was supported by over 60% of the members (11 out of 18), and an

equal number of Democrats and Republicans; however, the report did not reach the 14-vote threshold required to formally endorse the blueprint and have it sent to Congress.

• The Government took no action on the Commissions recommendations.• Proponents of the plan praised it for hitting all parts of the federal budget and for putting the

national debt on a stable and then downward path. • Prominent supporters include JP Morgan Chase CEO Jamie Dimon, Democratic Leader Nancy

Pelosi, and Republican Senator Tom Coburn.• On August 5, 2011, Standard and Poor’s lowered the credit rating of the United States

Government to AA+, the first time the credit rating of the United States has ever been lowered.• On March 1, 2013, the United States begins the process of sequestration as a result of an inability

to arrive at a legislative solution to its fiscal crisis.

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Current Circumstances - California

• The Little Hoover Commission, officially, the Commission on California State Government Organization and Economy, is an independent California state oversight agency that investigates state government operations.

• Two years ago, in its February 2011 report, entitled “Public Pensions for Retirement Security,” the Commission made the following determinations:

• Pension costs will crush government: the Math doesn’t work, the system lacks discipline, oversight and accountability.

• State and local governments need the authority to restructure future, unearned retirement benefits for their employees. The Legislature should pass legislation giving this explicit authority to state and local government agencies. This legislation may entail the courts having to revisit prior court decisions.

• Failure to seek this authority will prevent the Legislature from having the tools it needs to address the magnitude of the pension shortfall facing state and local governments. The situation is dire.

• The pension reform measure signed into law in September by Gov. Jerry Brown, AB 340 left current employees alone, focusing instead on new hires. Government officials will have to wait until 2018 to negotiate with public employee unions to reform pensions for current employees. In short, the advice of the Little Hoover Commission was ignored.

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Current Circumstances - California

• The California State Controller’s office estimates the pension underfunding as of 2010 as only $128 Billion.

• However, according to the Little Hoover Commission, as of 2010, the 10 Largest Public Pension funds in California faced a combined shortfall of as much as $240 Billion.

• As of February 2013, the California Public Policy Center has released a study entitled ‘Public Retirement Systems Annual Report for 2010” which calculates California’s total unfunded pension liability using the new criteria proposed by Moody’s Investor Services for adoption in 2014. The CPPC estimates the underfunded amount to be $326 Billion.

• UnionWatch has estimated both the pension underfunding and the related retirement healthcare plan underfunding as approaching $872 Billion.

• The Government Accounting Standards Board, the GASB, plans to require municipalities to disclose the unfunded pension liabilities on their balance sheets beginning in 2014. In that year, auditors are expected to opine as to whether the municipality can be considered a going concern with such liabilities under GASB 67 and 68.

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• Maintain flexibility • Avoid fiscal crisis • Preserve general fund liquidity• Identify unrestricted fund balances held in other funds• Investigate opportunities to reduce service levels and headcount• Negotiate plans with Unions for alternative delivery and service

consolidation approaches to further reduce costs• Insist on multi-year forecasts for all funds• Complete a “prospective insolvency” analysis

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Guidance for Elected Officials

Guidance for Elected Officials

• Analyze costs of services and opportunities for generating fees• Evaluate cost recovery opportunities that might result in additional

revenue to aid in the restoration of needed services• Poll voters to gauge support for augmenting existing revenue sources• Consider debt restructuring – outside of court, if possible• Negotiate benefit reductions with existing employees• Implement two-tier benefit plans for new employees• Outsource and consolidate services with other agencies and JPA’s

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Guidance for Elected and Appointed Officials

Watch Closely for Warning Signs• Resignation of accounting personnel (San Bernardino)• Interfund borrowings - (Compton)• General fund below threshold levels (Montebello)• Prospective insolvency analysis (Vallejo)• Fiscal problems facing local school district(s) at FCMAT website• Pension obligation bonds issued or proposed (Fresno, Oakland)• Unrealistic budget projections – i.e., budgets which "assume"

growth in revenue

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Constructive Use of Fiscal Emergency• Constitutional

– In order to raise taxes outside of a regularly scheduled election.• Contract Impairment – Case Law Precedent

– Blaisdell, 290 U.S. 473 (1937) & Sonoma County, 23 Cal.3d. 296 (1979)• Requires actual emergency• Temporary• Benefits the Public Interest• Appropriately tailored to the emergency

– United States Trust Co. of N.Y., 431 U.S. 1 (1977)• Reasonable and necessary to serve an important public purpose

• Statutory –AB 506

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AB 506 • Adopted after the City of Vallejo filing• Promotes mediation with key creditors before Chapter 9• Requires either a – Completion of a 60 day neutral evaluation (mediation) process, or– A declaration of fiscal emergency

• Stockton first California city to use evaluation process• San Bernardino declared fiscal emergency and filed Chapter

9 without the neutral evaluation process• Costs of process to be shared between debtor and creditors

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AB 506 - Advantages• Signals seriousness of fiscal circumstances to all stakeholders• Allows "confidential" negotiations out of court and without scrutiny of

Brown Act disclosures• May help manage or avoid potential embarrassment and scandal

factors as information can be disclosed to stakeholders in confidential fashion

• Opportunity to shape perceptions of liquidity and feasibility• If agreement can be reached with some or all key creditors, Chapter 9

may be avoided or made more efficient if still necessary

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Purpose & Power of Chapter 9 • Provides a framework for eligible governmental entities to restructure

debt• Was drafted solely for municipalities• Allows insolvent local public entities to remain viable

• Similar to Chapter 11, main benefits of Chapter 9 are:o The automatic stay; ando Adjusts debts through a plan

• The Goal of a Chapter 9 Case is Confirmation of a Plan of Debt Adjustment

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Purpose & Power of Chapter 9 • The bankruptcy court cannot interfere with the municipality's ability to

continue its operations or dictate what type of services or level of services the governmental entity may provide.

• Municipalities are permitted to adjust burdensome contractual relationships under the power to reject executory contracts and unexpired leases, subject to court approval.

• Municipalities may also reject collective bargaining agreements (Vallejo and Orange County) or potentially retiree benefit plans.

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Purpose & Power of Chapter 9 • Creditors cannot expect that all excess funds go to the payment of

their claims under a Chapter 9 plan.• The Municipality must retain sufficient funds from which to operate,

make necessary improvements and maintain its facilities and assets, and continue to fulfill its governmental responsibilities.

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Filing Chapter 9 - Last ResortAB 506 process is completed before filing.Sale of assets or new bonds, raising taxes, assessments, and fees,

and other alternatives have been exhausted.All opportunities to reduce costs and increase revenues have been

examined.Consensual debt restructuring, debt moratoriums, and debt

adjustment potential solutions have been explored, or have proven impossible to arrive at through consensual negotiation (Stockton).

Municipal dissolution or merger has been considered.

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Filing Chapter 9 - Last ResortEligibility for Chapter 9• Chapter 9 has significant eligibility requirements• Requirements– Municipality– Specifically authorized by State Law– Must be determined to be ‘Insolvent’

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Filing Chapter 9 - Last ResortProspective Insolvency • Bridgeport almost required cities to fail.• In Vallejo, the bankruptcy judge (McManus) determined

Vallejo was ‘prospectively insolvent’:o The City's General Fund will begin fiscal year 2008-09

with no reserves, and possibly with a negative balance;o Absent the Chapter 9 case, the General Fund would

operate at a multi-million dollar deficit in fiscal year 2008-09, with projections by the City ranging from a $10 million to $17 million deficit;

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Filing Chapter 9 - Last Resort

Eligibility for Chapter 9 – Cont.• Desires to effect a plan to adjust debt• Obtain agreement, negotiate in good faith, unable

to negotiate, or reasonably believe creditor may attempt to obtain a preference

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Status of Pension Obligations: San Bernardino and Stockton

• San Bernardino – – City suspended postpetition contributions to CalPERS– CalPERS filed opposition to City’s eligibility for Chapter 9• Asserting (i) City cannot demonstrate desire to effect a

plan to adjust its debts because City had not come forward with a plan and (ii) Chapter 9 petition was not filed in good faith because City did not negotiate with creditors before filing

– Matter is still pending

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San Bernardino• CalPERS filed motion for relief from automatic stay to

pursue debt collection action in state court– Asserting City’s failure to make contributions

violated state law (including Public Employees’ Retirement Law, California Labor Code, and California Constitution)

– CalPERS contended automatic stay not apply to it because it is an arm of the state exercising its police power

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San Bernardino– To extent stay applies, CalPERS argued cause for

relief because City had failed to comply with applicable state law and failed to pay postpetition administrative expenses

– Court denied CalPERS motion for relief from stay without issuing written opinion

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San Bernardino

• Capital Market Creditors (Indenture Trustee, Bondholder, and Bond Insurer) opposed relief sought by CalPERS, asserting:– City’s insolvency caused by rising employee salaries

and benefits coupled with declining revenues– CalPERS is seeking to bully the City into providing

CalPERS with special treatment

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Stockton• City has not suspended payments to CalPERS• City defaulted on bond payments• Bond Creditors have filed objection to City’s eligibility for Chapter 9• Primarily arguing, among other things, that (i) City did not negotiate with

CalPERS, its single largest unsecured creditor, and negotiation was not impracticable, and (ii) City’s decision not to negotiate with CalPERS was tainted by conflicts of interest, made without due care, and thus not made in good faith

• Matter still pending• CalPERS is opposing relief sought by Bond Creditors

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Chapter 9 Precedents – Stockton (478 B.R. 8)

– Federal bankruptcy power of the Supremacy Clause of the U.S. Constitution trumps the contracts clause in the California state constitution. – Stockton suspended payment of retired employees’ health

care benefits.– Retirees contended these were vested contractual rights.– Court found the Bankruptcy Clause of the U.S. Constitution

eclipses the Contracts Clause – Authorizes Congress to make laws that impair contracts.

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Chapter 9 Precedents – Stockton

– Federal bankruptcy power trumps California law. – Accordingly, while a state cannot make a law impairing the

obligation of contract, Congress has properly done so in the U.S. Bankruptcy Code.

– Moreover, the goal of the Bankruptcy Code is adjusting the debtor-creditor relationship. The court determined that, even if the retirees held vested property interests, "the shield of the Contracts Clause crumbles in the bankruptcy arena.“

– The court held "although the City's unilateral interim reduction of retiree health benefit payments may lead to tragic hardships . . . before their claims are redressed in a chapter 9 plan of debt adjustment, the motion for injunctive relief must be denied."

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Debtor’s Freedom to Act during PendencyDebtor does not need court approval to settle claims.

Stockton settled a damages lawsuit and requested court rule that it was precluded from approving or disapproving the settlement.

Creditors argued city required to seek Court approval.Court determined its approval was prohibited without debtor

consent.Court indicated the debtor’s actions are subject only to review in

connection with plan of debt adjustment.

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Chapter 9 Precedents

• Collective Bargaining Agreements May be Rejected – Vallejo and Orange County Cases

• Jefferson County Decisions re Section 928 and Automatic Stay o special/pledged revenues and necessary operating

expenseso automatic stay and extension of stay to protect

municipal officials and representatives

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Observations– Vallejo – ‘Prospective Insolvency’ (i.e. looking forward) will likely be

the test for eligibility. This has significant implications as GASB 67 & 68 are enforced in 2013 and 2014. The insolvency of an increasing number of municipalities will be apparent.

– Stockton - Federal bankruptcy power trumps California constitution. Contracts can be impaired in bankruptcy.

– San Bernardino – CalPERS vested contract rights and sovereignty arguments will likely fail when tested.

– Stockton - Debtor municipalities have broad powers to act during pendency without court involvement.

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Observations• Despite California’s resolution of current year deficit staggering

unfunded obligations remain.• Legislative initiatives fall short of what is required.• Negotiations are not accomplishing enough.• Stockton’s test of mediation under AB 506 inconclusive – no

confirmable plan emerged.• Ballot initiatives in San Diego and San Jose quickly challenged in

court.• California municipal obligations will increasingly require restructuring.

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