Cities and counties face fiscal challenges in the pandemic era

Even prior to widespread recognition that the Coronavirus pandemic is likely to wreck economic devastation on the national and global economies, there were many cities and counties throughout the country facing significant financial challenges.  Some of these pre-existing problems included: insufficient liquidity; excessive debt burdens; inadequate reserves; declining revenues; and unsustainable employee retirement and health care obligations.  These problems existed during a sustained period of economic expansion.  In the event of a future recession, local public entities in may be hammered by reduced collections of sales and property taxes coupled with escalating pension and healthcare expenses.

Some will need to realign their resources and obligations in order to remain solvent.  Local governments facing significant financial challenges should proactively explore means of avoiding severe fiscal problems.   As a last resort, they may find it necessary to file for municipal debt adjustment under Chapter 9 of the Bankruptcy Code to achieve long-term financial sustainability.

Based on the COVID-19 crisis, it seems likely that relying on economic growth to address fiscal issues will not be a viable solution.  Cities and counties facing present or potential fiscal stress need to engage in careful evaluations of their ability to reduce costs and increase revenues.  They should thoughtfully consider reductions in force, services, infrastructure spending, employee benefits, pension obligations, outsourcing, and other means of cost cutting.   At the same time, it is important to analyze the other side of the equation and evaluate the potential for monetizing assets, taxes, assessments, bonds, fees, and other alternatives to enhance revenues.  For cities facing severe financial straits, debt restructuring, moratoriums, and adjustment are potential solutions that may need to be explored.  Such exploration takes place in the shadow of Chapter 9 of the Bankruptcy Code.

Chapter 9 provides a framework for eligible governmental entities to restructure debt.  While Chapter 9 is federal law, the gateway to Chapter 9 is governed by state law.  For example, California law requires municipal debtors to engage in “neutral evaluation” (mediation) before being eligible to file for Chapter 9, except in the case of a declared fiscal emergency

Chapter 9 is designed to enable a municipality that is unable to pay its debts as they come due to continue to provide essential services to residents while working out a plan to adjust its debts.  In order to avoid disruption of necessary services, Chapter 9 is intended to facilitate the continuance of insolvent municipalities rather than their dissolution.  Not unlike Chapter 11 bankruptcy reorganization for non-governmental entities, two primary benefits of a Chapter 9 filing are (1) the breathing spell imposed by the automatic stay, and (2) the ability to adjust creditors’ claims through the plan process.

Under a Chapter 9 plan, creditors are to be provided as much as the realistic alternatives and the municipal debtor must show the court it can meet its obligations under the plan and to continue to provide public services.  Further, since Chapter 9 debtors do not have equity holders, payment of non-consenting creditor classes in full is not required in order for the local public entity to retain its assets.  Instead, in order to cramdown a plan over the objection of a class of creditors, a Chapter 9 plan must provide creditors with only as much as can be reasonably expected under the circumstances.

Creditors should not expect that, under a plan of debt adjustment, all excess cash go to payment of their claims.  A municipal debtor is to emerge from Chapter 9 having made the adjustments necessary to achieve long-term financial sustainability.

The payment of pre-Chapter 9 obligations can be suspended during the Chapter 9 case.  For example, payment of the following pre-Chapter 9 debt can be suspended:  pension and healthcare payments to retirees, payments on bonds (except with respect to pledged special revenues), lease payments, trade debt, bank and other loans, labor claims, court judgments, and obligations owing to the State.  Under a Chapter 9 plan of debt adjustment, local public entities can restructure debt to permanently reduce or modify outstanding obligations.

In Chapter 9, collective bargaining agreements and other contracts can be rejected and/or modified and retiree payments and benefits can be suspended and/or modified.  The risks facing unions and retirees in Chapter 9 can lead their representatives to recognize the need to make significant concessions.  The likelihood that payment and other obligations will be suspended during the chapter 9 case and reduced and/or modified under a Chapter 9 plan can create significant leverage that can lead to negotiated changes that may be adequate to allow the local public entity to avoid Chapter 9.

In order to avoid ever getting to the point of a fiscal emergency and to address fiscal challenges, local public entities should proactively:  preserve general fund liquidity; identify unrestricted fund balances held in other funds; develop plans for lower service level scenarios; and develop plans for alternative delivery approaches to further reduce costs.  Municipalities should also consider developing multi-year forecasts for all funds, engage in an analysis of projected costs of services and opportunities for generating fees, and evaluate cost recovery opportunities that might result in additional revenue to aid in the restoration of needed services.

When necessary, local governments may even consider voter polling to gauge support for augmenting existing revenue sources.  Finally, if a proactive approach was not taken in time or is not sufficient, it may become necessary for a local public entity to engage in debt restructuring.  This should be conducted outside of court if possible, with Chapter 9 lurking in the shadows and only entered as a last resort.

David Kupetz is a partner at SulmeyerKupetz.  He is an expert in business reorganization, restructuring, bankruptcy, municipal debt adjustment, and other insolvency solutions and related litigation.  He can be reached at [email protected]