Harvey L. Leiderman

1. MUNICIPAL BANKRUPTCIES A Pension Deficit Disorder?Presentation to NCPERSPublic Safety Employees Pensions & Benefits Conference Palm Springs, CAOctober 13, 2009 Harvey L. Leiderman

2. Why Are We Talking About Municipal Bankruptcies? • State budgetary crises • Municipal budgetary crises • revenues declining – taxes and grants • demands rising – including pension costs • Municipal credit crunch

3. This Program • When may a municipality file bankruptcy? • What happens during the bankruptcy case • What is the effect on the retirement system and members’ benefits • De-mystify the process • De-mythify the process

4. Federal bankruptcy law generally temporary freeze (“stay”) restructure of assets, debts relief from obligations “fresh start” Chapter 9 specifically just for “municipalities” adjustment of obligations balances federalism with states’ rights Overview – Federal Bankruptcy Law and Chapter 9 Plans of Adjustment

5. Who May File Chapter 9 Petition?

6. What Happens During Bankruptcy? • Bright line between pre-petition and post-petition • Snapshot of pre-petition assets and liabilities • Stay (freeze) of all legal actions • Muni is free to continue its operations, expenditures, borrowings and management • Muni must continue to perform all contracts and leases necessary for its post-petition operations • Creditors must file claims, unless clearly uncontested

7. May continue to operate as usual All officials remain in power; no trustees, no court supervision May hire professionals (attorneys, accountants, financial advisors, etc.) and pay them ahead of unsecured creditors Broad powers to borrow money and grant super-secured status to new lenders May reject burdensome “executory” contracts and unexpired leases May “abandon” burdensome property that is of little value or benefit What Are the Muni’s Powers Under Ch. 9?

8. What Are the Muni’s Powers Under Ch. 9? (cont’d.) • May recover pre-petition preferential payments, or transfers made for less than full value • May file suit against others, to assert claims in its favor • May object to claims against it, and bring them to trial in the Bankruptcy Court • May not escape from State political and governmental laws – Tenth Amendment • Must file a timely Plan of Adjustment or be dismissed

9. What is a Plan of Adjustment? • The Plan classifies claims according to their legal priority under state and federal law • class of priority secured claims • class of subordinated secured claims • class of general administrative claims • class of unsecured trade claims • As to each class of similar claims, the Plan provides a “treatment” for how that class of claims is to be satisfied • paid in full in cash • paid over time with interest • exchanged for new value • rejected • Must be confirmed by vote of creditors and Court order

10. Plan of Adjustment - The Disclosure Statement • Issued with the proposed Plan of Adjustment • Like a Prospectus • history, description of the process, overview of the plan, treatment of claims, financial projections • Ballots • Each class must vote in favor • requires 1/2 in number and 2/3 in $ value of each class • Even without affirmative votes, the Court can confirm the Plan if it believes the Plan treats objecting creditors fairly and equitably (the dreaded “cramdown”)

11. What Is Required to Confirm the Plan? • Must be in the best interest of creditors and be feasible • “Best interest of creditors” – best of all reasonably possible alternatives. Ch. 9 test differs greatly from “better than in liquidation” test for Ch. 11 corporate debtors • “Feasible” – the economics of the Plan make sense; it is not likely that the muni will have to return to bankruptcy soon; the muni will have the ability to continue to provide services.

12. What Happens After Confirmation? • Discharge – the muni is discharged (forgiven) from all claims not provided for under the Plan, or which the Plan provides shall be discharged. • Emergence – the muni emerges from Chapter 9 with all of the rights and powers established under state law and under the terms of the Plan.

13. Questions and Answers Q: Is your municipal employer “insolvent”? A: Case-by-case. The employer would have to prove that it is insolvent on a “cash flow” basis (unable to pay its debts when due) rather than on a “balance sheet” basis (liabilities exceed assets). This issue would be hotly contested. Can’t it still tax and borrow? See City of Vallejo case.

14. Questions and Answers Q: Could the municipal debtor reject the current CBAs that grant retirement benefits to its active employees? A: Yes, very likely. See City of Vallejo. The test is: 1. Does the CBA burden its ability to reorganize through a plan of adjustment? 2. Do the equities balance in favor of rejection? 3. Has it made reasonable efforts to negotiate a voluntary modification of the CBAs?

15. Questions and Answers Q: Would the municipal debtor have to reject the entire CBA, or could it “cherry-pick” the terms it doesn’t like? A. Bankruptcy law allows rejection of the entire agreement only, not selected terms.

16. Questions and Answers Q: Could the debtor unilaterally reduce some portions of a CBA before deciding whether to assume or reject it? A: Unsettled. Judge Ryan in Orange County said “not necessarily,” and ordered “meet and confer” before the county could unilaterally change its labor contracts during bankruptcy. Judge McManus in City of Vallejo said “yes.”

17. Questions and Answers Q: If the municipal debtor rejects its CBAs, what happens to its active employees? A: The unions and bargaining units would have to negotiate new contracts.

18. Questions and Answers Q: If the municipal debtor rejects its CBAs, what happens to your members’ retirement benefits? A: Untested. Benefits granted to current retirees are unlikely to be affected. The contract is not “executory” as to them, since no further performance is due from them by way of service or contributions into the system. For active employees, the contract is still “executory,” BUT – For both, the “vested rights protected by the ‘contract clause’ of the Constitution” argument may prevail. BUT –

19. Questions and Answers A, continued: Don’t forget that there is an exception under many state laws to the “vested rights” guarantee: “An employee’s vested contractual rights may be modified prior to retirement for the purpose of keeping a pension system flexible to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system.” Betts v. Bd. of Admin. (CA) • Are the proposed changes reasonable? • Do they bear a material relation to the theory of a pension system? • Will any disadvantage come with a comparable new advantage?

20. Questions and Answers Q: May the municipal debtor suspend transferring employee contributions to the retirement system while in Ch. 9? A: No. Payroll deductions for retirement contributions are not property of the employer but are collected in trust for the retirement system.

21. Questions and Answers Q: What about employer contributions? A: Very complex. There are strong legal reasons why the debtor may not suspend its payments, as required by state statute. At the very least, the “normal cost” portion of the employer contribution should be treated as a current, post-petition obligation and would have to be paid timely. The “UAAL” portion of the employer contribution, however, being the amortization of a debt from past service, might be treated differently.

22. Questions and Answers Q: May the municipal debtor suspend its “pick up” of employee contributions while in Ch. 9? A: No, not unless it rejects the labor contract that provides for “pick-up.”

23. Questions and Answers Q: May the municipal debtor reject its obligations to fund vested benefits? A: No. Ch. 9 does not authorize rejection of state statutory obligations. Would violate the Tenth Amendment to the U.S. Constitution – reservation of rights to the states. Fact that state and local governmental systems are exempt from ERISA indicates limitations of federalism in this arena.

24. Questions and Answers Q: Could the municipal debtor freeze or seize retirement system assets in Ch. 9? A: No. The retirement system is a distinct governmental entity under state law. Its assets are not property of the municipal debtor but rather held in trust for members and their beneficiaries.

25. Questions and Answers Q: Would a debtor’s Ch. 9 bankruptcy filing affect the retirement system’s assets or investments? A: No, the retirement system is a distinct governmental entity – a trust. Its assets and investments are not commingled with those of the plan sponsor (unless the Treasurer is holding plan assets, as in In re Orange County.) However, if the debtor suspends contributions, it could affect your cash flow, asset allocation policies and earnings assumptions.

26. Questions and Answers Q: Could the retirement system make a loan or other financial accommodation to the debtor during Chapter 9 or under a Plan of Adjustment? A: No legal prohibition. BUT – likely unlikely: Would have to meet all prudent fiduciary, administrative and investment requirements and the system’s Investment Policy Statement. If appropriate, could take the form of an interim or long-term loan, sale-leaseback of property, credit enhancement, extended amortization of UAAL or other creative financing –with many caveats. If you explore this route, watch out forconflicts of interest!

27. Questions and Answers Q: How much would a bankruptcy cost taxpayers? A: Big bucks. Plan sponsor professionals and professionals for committees of interested parties – bondholders, retirees, unsecured creditors, etc. Plus professionals for labor unions, creditors, investment pool participants and bondholders who make a “substantial contribution” to the case. In the 1994-96 Orange County bankruptcy, professional fees cost over $100 million – excluding investment manager fees. In addition – higher borrowing costs due to poor credit ratings.

29. About the Speaker Harvey L. Leiderman is a partner with the international law firm of Reed Smith, LLP. He serves as fiduciary, litigation, investment and tax counsel to the California Public Employees’ Retirement System, the California Teachers' Retirement System, the South Carolina Retirement System Investment Commission and multiple California county and city retirement systems. Mr. Leiderman actively practiced bankruptcy law for over twenty years, on behalf of national banks, commercial lenders, public bondholders and private investors. He was fiduciary counsel to the Orange County Employees’ Retirement System during that county’s Ch. 9 case and more recently guided a California municipal water district through a successful Chapter 9 proceeding. His office also represents the largest bondholder trustee in the City of Vallejo case. Harvey Leiderman earned his J.D. from Columbia Law School, New York. He received his B.A. from Case Western Reserve University in Cleveland, Ohio, with honors in Government Studies from The American University, Washington, D.C. Reed Smith LLP · 101 Second Street, Suite 1800, San Francisco, CA 94105 +1 415.659.5914 · HLeiderman@reedsmith.com