Modifying or terminating pension plans through Chapter 9 bankruptcies with a focus on California.

• Author: Lau, Joanne
• Position: 40th Anniversary Symposium

Introduction I. An Overview of Chapter 9 and Pensions in Chapter 11 Generally A. Chapter 9 Bankruptcy Generally B. Treatment of Pensions in Chapter 11 Bankruptcy C. Added Complications of Chapter 9 D. California as the Focus II. Federal Law v. State Law and the Nature of Pension Plans A. Federalism Issues in Chapter 9: Where State and Federal Powers Conflict B. Various State Law Perspectives on the Nature of Pension Plans and Their Ability to be Modified in Bankruptcy C. Whether a Pension Plan is an Executory Contract: The Countryman Test D. Rejection as a Prepetition Breach of Contract E. Federalism Issues Regarding Treatment of the Pension Plan as a Prepetition Breach of Contract Claim 1. Treatment Under California State Labor Law 2. Treatment Under Federal Bankruptcy Law III. Pension Plans May Be Rejected as Executory Contracts Conclusion INTRODUCTION

When Stockton, California, a city of just under 300,000 people, filed for Chapter 9 protection on June 28, 2012, (1) it became the largest U.S. city by population to do so. (2) Like other municipalities, Stockton has been greatly affected by the collapse of the sub-prime lending market from 2007 to 2008. (3) Stockton, however, was disproportionately affected because of its location in the Central Valley region of California, an attractive location for those who want to live near the Bay area, with one out of every thirty homes in foreclosure. (4) The high foreclosure rate, coupled with declining home values, has decreased Stockton's tax revenue from property taxes. (5) Because of this decrease in tax revenue, the city has had difficulties repaying obligations to creditors as they become due. (6) In order to meet its obligations, Stockton has been forced to cut the services it provides to citizens to the bare minimum required to maintain the city. (7) Although Stockton has been ranked as the second most dangerous city in California, second only to Oakland, and one of the ten most dangerous cities in America, it has had to slash its police force by twenty-five percent to cut costs. (8) Stockton was also named America's most miserable city by Forbes in 2011. (9) Citizens who are able to leave the city are doing so as a result, sending Stockton into a downward spiral with even more decreases in revenue from property taxes. (10) After rounds of failed negotiations with creditors, required by Section 53760 of the California Government Code, Stockton filed for Chapter 9 protection to solve its fiscal crisis. (11) The California Public Employees' Retirement System (CalPERS), a state executive agency that manages pension and health benefits for California's public employees, retirees, and their families, (12) is Stockton's largest creditor, with a contingent, unliquidated claim of over $147 million. (13) This obligation is an obstacle to a city that is trying to provide for its citizens, meet other debt obligations, and maintain some form of credit in order to borrow in the future.

The story of Stockton is not unlike that of many other U.S. cities. Municipalities have mounting obligations as a result of providing services, building infrastructure, paying payroll, and contributing to benefits for city employees. (14) The economic recession and collapse of real estate values reduced the tax base and tax revenues generated at the local level with lower property values translating to decreased property taxes. (15) The result is a lower municipal income and tighter budget constraints. (16) The high foreclosure rate reduces the value of the property foreclosed upon and that of surrounding properties. There is also less federal funding to states, which means less state funding for municipalities. Some municipalities operate on short-term financing, borrowing money in the form of bonds in order to pay for current obligations. (17) These municipalities need to continuously borrow money in order to meet those obligations. (18) When credit froze, these municipalities defaulted on their obligations, which in turn caused additional cross-defaults on other credit obligations. (19)

Public pension plan obligations are an increasing problem for municipalities with large deficits. (20) Public employees are promised more in their retirement plans than the municipalities can afford to pay. (21) Pension plans have been underfunded in the last couple of years because estimated rates of return on pension plan investments have been significantly higher than actual returns. (22) Municipalities typically promise public employees defined-benefit plans, where employees are promised certain specific benefits upon retirement. (23) The Government Accounting Standards Board (GASB) has provided general standards for accounting and financial reporting that most state and local government plans follow. (24) However, median investment return for public pension funds was negative 24.91% in 2008. (25) The aggregate market value of state and local government pension funds dropped from $3.2 trillion in 2006 to just $2.3 trillion as of October 31, 2008. (26) This chronic underfunding, coupled with demographic pressures like increased life expectancies and pension envy, where public sector employees generally expect larger pensions than their private sector counterparts, has contributed to the mounting pension obligations of many municipalities.

Part I of this Note provides background information on Chapter 9 (27) of the Bankruptcy Code, treatment of private sector pension plans under Chapter 11, and the differences between Chapter 9 and Chapter 11 as they relate to pension obligations. This Note then examines the conflicts presented by various state law perspectives on the nature of pension plans and their ability to be modified, whether a pension plan is an executory contract, and federalism issues regarding treatment of prepetition breach of contract claims. This Note then argues that in jurisdictions such as California, where public employees' rights under pension plans are viewed as contractual rights, pension plans may be rejected as executory contracts, pursuant to [section] 365, (28) as applied at a Chapter 9 municipal reorganization proceeding. The extent to which rejection amounts to a modification of pension plan obligations will depend upon the extent to which these obligations have "vested" under federal law. Thus, municipalities may use the tools available in bankruptcy to reorganize debt and better provide for their constituencies going forward.

1. AN OVERVIEW OF CHAPTER 9 AND PENSIONS IN CHAPTER 11 GENERALLY

   Since Chapter 9 bankruptcies are so rare, there is little case law on treatment of pensions in Chapter 9. Chapter 9, a reorganization chapter, adopts many of the provisions available in a chapter 11 bankruptcy, also a reorganization chapter of the Bankruptcy Code. (29) As such, an analysis of treatment of pensions in chapter 11 is necessary to analogize what may happen in chapter 9 bankruptcies, taking into account the differences between the two chapters. Here, this Note discusses Chapter 9 bankruptcies generally, how pensions are treated in Chapter 11 bankruptcies, what makes treatment of pensions in Chapter 9 more complicated than treatment of pensions in Chapter 11 bankruptcies, and why California is the focus of this Note.

   1. Chapter 9 Bankruptcy Generally

      Chapter 9 of the Bankruptcy Code allows municipalities to reorganize their debts. (30) It provides municipalities in financial-distress protection from creditors while it develops and negotiates a plan for readjusting its debts. This reorganization typically involves extending debt maturities, reducing the principal or interest rates of loans, and refinancing existing debt. (31)

      Chapter 9 is different from other chapters of the Bankruptcy Code, in that some provisions of the Bankruptcy Code do not apply. (32) Only those sections listed in [section] 901 apply to Chapter 9 bankruptcies, while all provisions of Chapters 1, 3, and 5 apply to bankruptcies under Chapters 7, 11, 12, and 13 of the Bankruptcy Code. (33) In the context of pension modification, Chapter 11 reorganizations have specific provisions that govern rejection of collective bargaining agreements and treatment of retiree health benefits. (34) Sections 1113 and 1114, which discuss collective bargaining agreements and retiree health benefits, respectively, might otherwise govern in a Chapter 9 reorganization, but neither is listed as an applicable provision under [section] 901. (35) Section 362, however, does apply to Chapter 9 bankruptcies, giving municipalities the benefit of the automatic stay while it attempts to negotiate with creditors. (36) Section 365 also applies, which allows the debtor to assume or reject executory contracts. (37)

      There are two significant sources of limitations in Chapter 9 that differentiate Chapter 9 from other sections of the Bankruptcy Code: a municipality cannot liquidate and dissolve in bankruptcy, and there are constitutional limits of the bankruptcy court's power. (38) Giving the Bankruptcy Court the power to approve and manage a liquidation and dissolution would be a violation of the Tenth Amendment's protection to states of sovereignty over their internal affairs. (39) States can dictate whether their municipalities seek Chapter 9 bankruptcy protection. (40) An unauthorized municipality is ineligible for relief. (41) It is through the requirement of state authorization that Chapter 9 satisfies the requirements of federalism. Through these means, the federal government's interests in financially sound municipalities are balanced against states' sovereign authority over its municipalities.

      Section 109 governs eligibility for Chapter 9. (42) Under [section] 109, an entity must be (1) a municipality, (2) authorized by statute by the state where the municipality is located, (3) that is insolvent and (4) desires to affect a plan to adjust such debts, and (5) (A) has obtained the agreement of impaired classes of creditors; (B)...