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Municipal Pension Holders at Risk As Chapter 9 Bankruptcy Filings Increase

Jefferson County, Alabama filed the biggest Chapter 9 bankruptcy in United States history on November 9, 2011. The $4 billion filing covering the city of Birmingham and 658,000 county residents far surpassed Orange County, California, the previous record holder, which filed for Chapter 9 bankruptcy in 1994 with $1.7 in debt.

The filing raises issues about a local government’s inherent obligation and guarantee to pay its creditors on time. As a result of filing Chapter 9, Jefferson County was relieved at least temporarily from paying most debt obligations and in fact stopped paying general debt holders. This situation raises a new and grave concern for public employees, mainly whether their pensions are safe from Chapter 9 bankruptcy.

The purpose of Chapter 9 is to provide a financially distressed municipality with protection from its creditors while it develops and negotiates a plan for adjusting its debts.

Underfunded pension plans for firefighters, teachers, police, and other municipal employees are increasingly a major consideration in a municipality’s ability to repay its debt. Pensions are considered to be underfunded when the accrued liabilities of the plan exceed the actuarial value of the plan’s assets.

Nationwide, the Pew Center on the States estimates a $1.26 trillion funding gap, as of 2009, between the promises states have made for public employees’ retirement benefits and the money set aside to pay for them. The situation is much worse for retiree health care benefits, since states have saved only about $31 billion, or 5 percent, toward these obligations. As is true for the private sector, public employee retiree health benefits are “pay as you go” obligations of the employer.

Municipal plan sponsors may take various steps to reduce this unfunded liability going forward without requiring immediate additional employer contributions to the plan. Ultimately, however, if the plan does not have sufficient funds to fund pension benefits for current retirees, then the municipal plan sponsor will have to raise revenues, cut spending, or face a default on its obligations to retired employees. Because Chapter 9 has been used so rarely, there are many unanswered questions about what can and cannot be achieved in a Chapter 9 bankruptcy.

(Realizing the financial risk inherent in unfunded pension liabilities, many municipalities are moving as quickly as possible to adopt 401(k)-type defined contribution plans in place of traditional defined benefit plans that obligate the municipality to these high future payments.)

Chapter 9 offers a potentially powerful mechanism to assist municipalities in obtaining relief from creditors and adjusting their debts. The commencement of a Chapter 9 bankruptcy case operates as a stay, applicable to all creditors, of most efforts to collect prepetition claims, including attempts to gain possession of property or enforce contractual rights.

Some jurisdictions view public employee retirement benefits as a property interest and some view them as contractual rights, both of which may be constitutionally protected. Accordingly, while the automatic stay is in effect, a municipal debtor may assert that it cannot be compelled to honor its obligations to retirees. Finally, the stay may require that pensioners assert their rights in the bankruptcy forum, which often is perceived as more “debtor friendly.”

In the Chapter 9 bankruptcy case commenced by the City of Prichard, Alabama, in October 2009, the stay initially prohibited the pensioners from prosecuting their preexisting lawsuit that sought, among other things, to hold certain of the City’s officials liable for breach of fiduciary duty for the poor financial performance of the City’s pension fund.

In the Chapter 9 case involving the City of Vallejo, California, the automatic stay allowed the City to reduce retiree health benefits. One of the City’s arguments was that retirees had no vested rights in the health benefits since they were negotiated as part of a collective bargaining agreement.

While Chapter 9 is somewhat similar to Chapters 7 and 11, it is significantly different in that there is no provision for the liquidation of the assets of the municipality and distribution of the proceeds to creditors.

Of course, not all municipalities have the opportunity to avoid their pension obligations. Many states require special authorization for a Chapter 9 filing. As a result, Chapter 9 will not be available to all municipalities in all states. Even where it is available, Chapter 9 does not provide municipalities with all of the bankruptcy tools that practitioners are familiar with in corporate bankruptcies. When bankruptcy is an alternative, Chapter 9 does not necessarily provide a struggling municipality full immunity from its pension obligations. However, very little experience exists in this area. As a result, how effective these bankruptcy tools will be in addressing a municipality’s pension debt is far from clear.

January 2012