Jeffrey B. Ellman & Daniel J. Merrett, Pensions and Chapter 9: Can Municipalities Use Bankruptcy to Solve Their Pension Woes?

• Publication year: 2011

PENSIONS AND CHAPTER 9: CAN MUNICIPALITIES USE BANKRUPTCY TO SOLVE THEIR PENSION WOES?

Jeffrey B. Ellman* Daniel J. Merrett**

INTRODUCTION

As world markets and private industries struggle to recover from the financial collapse of the late 2000s, speculation has grown about the next wave of financial troubles. One area that has come under increasing scrutiny from experts and the media is the crippling debt loads of government entities. From local municipalities to sovereign nations, the risk of governments and governmental units defaulting on their debts is real and reflected in elevated

rates of return for those willing to invest.1 Rumors abound in the media that

numerous United States cities and other municipalities2 are on the brink of

* Jeffrey B. Ellman is a Partner at Jones Day. Mr. Ellman heads the firm’s Business Restructuring and Reorganization practice in Atlanta, Georgia.

** Daniel J. Merrett is an Associate in Jones Day’s Business Restructuring and Reorganization practice

and also resides in Atlanta.

The authors would like to thank Sarah Heck Griffin and Lisa Rothman Jesner for their assistance and contributions to this Article. Ms. Griffin is a Partner in Jones Day’s Employee Benefits and Executive Compensation practice and resides in Los Angeles. Ms. Jesner is an Associate in Jones Day’s Employee Benefits and Executive Compensation practice and resides in New York. In addition, the authors would like to recognize Robbin S. Rahman, a former Associate with Jones Day, who was instrumental in preparing the initial drafts of this Article. Mr. Rahman currently is an Associate in the Atlanta office of Kilpatrick Townsend and Stockton LLP and a member of its Bankruptcy and Financial Restructuring practice. Note that the views expressed herein are those of the authors alone and do not reflect the views, positions, or policies of Jones Day or its clients.

1. See, e.g., Tom Petruno, Municipal Bond Yields Rise as Market Rally Stalls, L.A. TIMES, Feb. 4, 2011,

   at B5 (reporting that the strained finances of many state and local governments has caused municipal bond yields to rise); Satyajit Das, European Death Spiral—Communicable Diseases, AUSTRALIAN BROADCASTING CORPORATION (Jan. 12, 2011), http://www.abc.net.au/unleashed/42864.html (reporting that the cost of funds for Portugal, Italy, Ireland, Greece, and Spain had risen to between 5 and 12% by the end of 2010).

2. Throughout this Article, the terms “municipality” and “municipal” are intended to be interpreted

   consistent with the definition of “municipality” in Title 11 of the United States Code (“the Bankruptcy Code”). See 11 U.S.C. § 101(40) (2006) (defining a “municipality” as a “political subdivision or public agency or instrumentality of a State”). As more fully explained below at note 28, the Bankruptcy Code definition of “municipality” encompasses not just traditional cities, but also counties and certain other public agencies and authorities. This definition may be considerably broader than the commonly accepted meaning of the term “municipality.” See, e.g., Municipality Definition, MERRIAM-WEBSTER, http://www.merriam-webster.com/ dictionary/municipality (last visited Feb. 22, 2011) (defining “municipality” as “a primarily urban political unit having corporate status and usually powers of self-government”).

   
   

   defaulting on their obligations.3 Faced with unsustainable and deepening budgetary shortfalls, municipalities are being forced to consider every option to extricate themselves from their difficult financial positions.4

   
   

   The crisis among the nation’s municipalities has many fathers, and every troubled municipality faces its own unique challenges.5 Yet some common drivers can be identified. Not unlike private entities, municipalities across the nation have found themselves trapped in an extended cycle of declining revenues.6 Plummeting real estate values and high rates of foreclosure have

   
   

3. See, e.g., Jeannette Neumann, Global Finance: Warning From S&P on Munis, WALL ST. J., Jan. 24, 2011, at C3 (reporting “growing fears that some state and local governments will default on their debt”); Sara Behunek, Three American Cities on the Brink of Broke, FORTUNE (May 28, 2010), http://money.cnn.com/ 2010/05/28/news/economy/american_cities_broke.fortune/index.htm (reporting on potential defaults by Detroit, Michigan; Harrisburg, Pennsylvania; and Jefferson County, Alabama); William Selway, U.S. Mayors Say City Bond Defaults Likely Amid Strain, BUS. WK. (Jan. 19, 2011), http://www.businessweek.com/news/ 2011-01-19/u-s-mayors-say-city-bond-defaults-likely-amid-strain.html (predicting the number of defaults among United States cities by the Chicago and Los Angeles mayors, along with banking analyst Meredith Whitney’s forecast of as many as 100 significant municipal defaults).

4. The budgeted general-fund shortfalls among America’s major cities are illustrative of the scale of the

   crisis. For example, for fiscal year 2011, Detroit projected a shortfall in its general fund of $126 million; Los Angeles projected a $492 million shortfall; and New York estimated a budget deficit of almost $5 billion. See THOMAS GINSBERG, PEW CHARITABLE TRUSTS, NOT OUT OF THE WOODS: THE RECESSION’S CONTINUING

   IMPACT ON BIG CITY TAXES, SERVICES AND PENSIONS 2 (Larry Eichel ed., 2010). For the same period,

   Chicago projected a shortfall of over $650 million in its general fund—nearly 20% of its proposed general fund budget. See Amy Merrick, Chicago Projects Record Budget Shortfall, WALL ST. J., Jul. 30, 2010, http://online.wsj.com/article/SB10001424052748703999304575399404117403866.html (reporting that the City of Chicago projected a 2011 deficit of $654.7 million after the city “plugged a $520 million gap” in its 2010 budget by mandating that employees take furlough days and dipping into city reserves).

5. Boise County, Idaho, for example recently filed its chapter 9 petition to allow it to continue operating

   notwithstanding an adverse judgment amounting to approximately 50% of the county’s annual operating budget. See Stan Rosenberg, Small Idaho County Files for Bankruptcy, WALL ST. J., Mar. 3, 2011, http://online.wsj.com/article/SB10001424052748704005404576176841523443046.html. The City of Vallejo, California, which filed its chapter 9 petition in 2008, experienced plummeting property tax revenues with the departure of the United States Government’s Mare Island shipyard in the midst of the housing crisis. See Jonathan R. Laing, The $2 Trillion Hole, BARRON’S (Mar. 15, 2010), http://online.barrons.com/article/ SB126843815871861303.html#articleTabs_panel_article%3D1. In 2009, a declining population exacerbated by the closure of a military base caused the City of Prichard, Alabama to file its second chapter 9 petition in ten years. See Matt Miller, Taboo: Chapter 9, DEAL MAGAZINE (Mar. 19, 2010), http://www.thedeal.com/ newsweekly/features/cover-stories/taboo:-chapter-9.php. Jefferson County, Alabama has been crippled by unfavorable swaps that it entered into to shield against rising interest rates on variable rate debt that financed a new sewer system. See Mary Williams Walsh & Jonathan Glater, Contracts Now Seen as Being Rewritable,

   N.Y. TIMES, Mar. 31, 2009, at B1. Meanwhile, the City of Harrisburg, Pennsylvania has been feeling the pinch since a local authority reneged on a $288 million debt for the purchase of an incinerator that the city guaranteed. See Romy Varghese, Harrisburg Council Refuses to Meet Recovery Consultants, WALL ST. J., Jan. 25, 2011, http://online.wsj.com/article/SB10001424052748704698004576104401574252370.html.

6. See Miller, supra note 5 (stating that “tax revenues from property, businesses[,] and retail sales [have]

   hit the skids”).

   
   

   eroded the property tax base, negatively impacting income.7 Widespread unemployment and, in some cases, decreasing populations have depleted revenue from sales taxes and other forms of taxation.8 In some cases, the shortfall in revenues is compounded by “out of the money” derivative

   transactions and tumbling markets, which have depleted many municipalities’ cash positions.9 Moreover, the cost to municipalities of issuing debt to replace this lost revenue is rising. The low interest rates traditionally enjoyed by large municipalities are becoming harder to find, whether because of the general “tightening” of the credit markets resulting from the financial crisis or because investors are beginning to take notice of the confluence of factors currently threatening municipalities.10 Municipal debt traditionally was considered a

   relatively “risk-free” investment, but that has changed in the current market. Municipalities now find that their debt is the subject of an increasingly robust market in credit default swaps—one of the vehicles many claim was a leading culprit of the global financial crisis and the global sovereign-debt crisis.11

   
   

   But perhaps the single largest problem facing municipalities today is the dramatic and growing shortfall in public pension funds. Considering only state pensions and those of municipalities participating in state funds, for example, the deficit is estimated by some to exceed $3 trillion nationwide12 and may

   
   

7. See Eric Morath, Restructuring Experts Predict U.S. Municipal Default, WALL ST. J., May 17, 2010, http://blogs.wsj.com/bankruptcy/2010/05/17/restructuring-experts-predict-us-municipal-default (reporting that “[m]unicipalities are struggling in part because widespread foreclosures and commercial property vacancies have caused property values to fall, which in turn limits how much property tax local government can . . . collect[]”).

8. See Miller, supra note 5 (reporting that a declining population caused the City of Prichard, Alabama to

   file its chapter 9 petition).

9. See Behunek, supra note 3 (reporting that Jefferson County, Alabama’s financial difficulties stem in part from its purchase of billions of dollars in failed interest rate swaps); Leah Nathans Spiro & Nanette Byrnes, Today, Orange County . . ., BUS. WK., (Dec. 19, 1994)...