Last week Judge Klein approved Stockton, California’s plan of adjustment allowing the city to exit bankruptcy without addressing its largest liability – pensions. Stockton’s plan called for budget cuts, haircuts for bondholders, and a sales tax increase approved by voters last fall in reliance, in part, on the City’s promises to hire more police. While confirmation may be good news on some level, it is not the end of a difficult process. Stockton can be expected to struggle to maintain a balance between providing services to residents and payment of its obligations under the plan. If you question this premise, just take a look at recent crime statistics and the City’s hiring record for police post tax increase.
In confirming Stockton’s plan, Judge Klein said:
I’ve looked long and hard at this case and the responses that have been made including the alternative of putting the whole situation back to Square 1…”
As he proceeded to make specific findings of fact and draw conclusions of law necessary to confirm the plan, Judge Klein stated:
“This plan is about the best that could be done, or is the best that could be done.”
Maybe, maybe not. The conclusion depends entirely on your point of reference. What’s wrong with Stockton’s plan is the parties did not have the benefit of the Court’s view regarding whether and how pensions administered by CalPERS might actually be restructured in bankruptcy during the plan negotiation process. And, the City repeatedly told taxpayers at a number of City Council meetings that it was financially impossible to terminate its agreement with CalPERS because of the lien CalPERS would have in the event of a termination.
To be clear, no one wanted to poke the bear without some idea of how to do it. The parties did not learn of the Court’s views until late summer when the Court had to consider the possibility of impairing pensions in response to Franklin Templeton’s well briefed objections to the plan. At that point, the Court read into the record its view that Stockton legally was permitted to restructure its pension obligations as part of its plan of adjustment. In placing its thoughts on the record, the Court concluded that the Federal Bankruptcy Code trumped California state law which prohibits restructuring of pensions administered by CalPERS in a bankruptcy proceeding. The Court further concluded that the feared CalPERS springing lien was void since it arose on the filing of bankruptcy and the Federal Bankruptcy Code specifically permits the Debtor to avoid such liens.
So, what does Stockton’s confirmation boil down to? First, Judge Klein provided a road map regarding pensions for future cities that may need to restructure in a Chapter 9 case. Second, CalPERS’ springing termination lien can be avoided in bankruptcy. Third, while there is no legal precedent on this issue, Judge Klein’s road map levels the plan negotiation playing field for capital market creditors and taxpayers. Pensions are no longer legally untouchable. And, just having a road map will open up a dialogue about pensions between a city and its creditors, employees, retirees and taxpayers much sooner than at the tail end of a Chapter 9 case. While we still will be operating without binding legal precedent in California, smart money says that exploring whether it makes sense to restructure pensions along with other post-employment benefits and retiree medical can now be expected to happen in conjunction with restructuring a city’s obligations to capital market creditors and managing the necessary balance of providing reasonable services owed to taxpayers. In other words, CalPERS’ tail will no longer wag the proverbial dog and employees and retirees can no longer assume that their pensions are bullet proof. If Judge Klein’s comments are not sufficient to drive this point home, pension restructuring in Detroit and Central Falls can and will.
That doesn’t mean that a bankruptcy court cannot accept a city’s decision not to impair pensions as part of a city’s plan of adjustment. In accepting Stockton’s decision not to impair pensions, the Court noted that the retirees and employees had made “significant concessions” which included cancellation of retiree medical, pay and staff reductions. Finding the plan “feasible”, the Court moved on to find that all of the City’s creditors must be considered in making a determination as to whether a plan is “fair and equitable.” In determining that the City’s plan was fair and equitable the Court overruled Franklin Templeton’s hard fought objection which initially gave rise, as noted above, to the Court’s review of the legal relationship between the City, CalPERS and the City’s employees and retirees.
So what does Stockton’s rather expensive experience mean for other cities seeking to restructure?
Chapter 9 is expensive; Stockton’s legal fees will well exceed $15M. Chapter 9 is not a solution; it is a deeply flawed and legally uncertain process that requires good faith communication and, on some level, cooperation between participants. Chapter 9 is also a process that Judge Klein repeatedly stated was all about “negotiation and impairing contracts”. It is also a process that, unlike Chapter 11, requires carving up an existing pie. It is difficult, if not impossible, to “grow the top line”.
Experience shows that for a meaningful restructuring to take place, negotiation has to involve the city, capital market creditors, employees, retirees and taxpayers. And, that is what Stockton did get right with the Court’s help. With the exception of Franklin Templeton, Stockton presented the Court with a consensual plan. Stockton’s plan was reached as the direct result of mediation, both before the bankruptcy and after the case filed. The positive impact of the mediators, the City’s efforts, and the creditors’ ultimate commitment to the process should not be underestimated or undervalued. If Chapter 9 is all about “negotiation and impairing contracts” then another lesson learned is it is more efficient for the parties to find a way to talk to each other, in good faith, and get on with and mitigate (or on a really good day, eliminate) the sunk costs of a bankruptcy process. A further lesson is the eligibility process should be streamlined unless there are real legal issues about whether a city is an eligible debtor or whether a city is truly insolvent. Detroit got this right in terms of efficiently disposing of this first step. Another lesson is for all participants to actively explore whether restructuring pensions, other post-employment benefits and retiree medical obligations along with restructuring a city’s other obligations makes sense given the size and importance of these obligations. With so much as stake in a municipal restructuring, everyone should expect to engage in a serious discussion with a financially distressed and possibly bankrupt city regarding compromise of their claims and that includes pensions, other post-employment benefits and retiree medical.
Municipal bankruptcies are hard, political, personally devastating and legally uncertain. When a city is service insolvent without sufficient funds to pay creditors, employees and retirees there is more than enough pain to go around. No one wants to reduce pensions or eliminate retiree medical. No one wants not to pay capital market creditors. That being said, absent the wholly unexpected and unpredictable, like landing a Tesla plant, municipal restructuring will always be a challenging and painful process that is full of reduced recoveries and compromise. That is until the parties find new, creative and better options for increasing a city’s revenues. The good news is there is an end, and when done well, a city has the opportunity for a “do over” with a new, hopefully better financial future. How successful the “do over” is remains to be seen. Indeed, the movie “Argo” just about covers it.
“There are only bad options. It’s about finding the best one.”
“You don’t have a better bad idea that this?”
“This is the best bad idea we have, sir, by far.”