Last week, Central Falls, Rhode Island—the smallest city in the smallest state in the nation—commenced a case under chapter 9 of the Bankruptcy Code. Municipal bankruptcies are rare; thus it would be understandable to assume, at quick glance, that the chapter 9 case of a city of less than 20,000 residents is an isolated event. But the circumstances of Central Falls' insolvency, and the broader implications of its resolution, merit close observation.
A Tale of Two Obligations
According to the official report of the state-appointed receiver directing Central Falls' restructuring, the city has approximately $20 million in outstanding funded debt. Yet this pales in comparison to the approximately $80 million that Central Falls reportedly owes in retirement benefits, most of it unfunded, to only 214 former employees. Though Central Falls' predicament is particularly stark, it is emblematic of the massive unfunded public pension obligations presently faced by cities and states nationwide, which are estimated to range from $1 trillion to more than $3 trillion, depending on rate or return assumptions.
To protect the ability of the state and its municipalities to continue to borrow, Rhode Island last month passed a law that effectively ensures bondholders will be repaid in full in the event that a city files for bankruptcy. (It did so entirely expecting Central Falls to seek chapter 9 protection.) To that end, Central Falls has already indicated it does not intend to impair bondholders. This means Central Falls filed for bankruptcy because it cannot satisfy its obligations to its current and former employees, not because of its municipal bond debt.
Does the distinction matter? Yes. It is generally (and correctly) believed that insolvent cities and towns make every effort to avoid chapter 9 due to fears that a filing would make it impossible (or at least prohibitively expensive) to subsequently access the capital markets, which are an indispensable source of funding for public works projects like roads, bridges, and hospitals. If Central Falls is able to restructure itself successfully, with minimal or no pain to bondholders, conventional wisdom could be upended—and we could be entering a new era in which chapter 9 is more readily accepted, and more widely employed, by distressed municipalities seeking to restructure unprecedentedly high levels of unfunded pension and other retiree obligations.
Chapter 9 Theory and Practice
In the 1930s, in the midst of the Great Depression and the endemic inability of municipalities to satisfy their public debt, Congress adopted the predecessor to chapter 9. Voluntary readjustment negotiations were common, but holdout bondholders had the power to block consensual workouts. Because Article I, Section 10 of the U.S. Constitution prohibits states from passing any "Law impairing the Obligation of Contracts," a federal response was needed to bind dissident creditors.
In debating whether to allow cities and towns to file for bankruptcy, Congress's principal concern was roiled debt markets. Critics predicted downgraded credit ratings and increased borrowing costs for insolvent municipalities, with similar unintended consequences for their solvent brethren.
Notably, however, economic chaos did not follow. The certainty of even partial repayment for creditors, no longer beholden to the opportunistic tactics of minority lenders holding out for a par recovery, actually had a stabilizing effect on the financial system. Also, the practice of chapter 9 debtors has most often been to continue paying bondholders, without impairment, presumably to ensure future access to the capital markets.
But the most obvious reason chapter 9's impact has, to date, been limited, is that municipal bankruptcies have been relatively scarce and small. Since its adoption, there have been only approximately 620 cases brought under chapter 9 (or less than an average of 10 per year), and most were filed by smaller municipalities or special taxing districts. This is because the ability to file for bankruptcy, as a credible option of last resort, has been an effective mechanism to generate negotiation between municipalities and their stakeholders (including holdouts), and ideally reach a consensus that averts the inherent costs and risks of a court proceeding.
Rejecting CBAs to Restructure Pensions
Central Falls' bankruptcy, however, presents a new paradigm. Unfunded public pension obligations are unsustainable. Is the mere prospect of a chapter 9 filing sufficient to overcome the holdout problem, where the holdouts are pensioners, not bondholders?
Although Central Falls was not able to avoid bankruptcy, the outcome of its chapter 9 case may significantly influence the number and nature of subsequent filings. Since July 2010, the state-appointed receiver seemingly has utilized every available measure to attempt to restore Central Falls to solvency. The first-day pleadings filed with the court in Central Falls' chapter 9 case detail extensive cuts in expenditures, services, and jobs; revenues raised through increased taxes, fees, and debt; and the unsuccessful pursuits of a state bailout and potential merger with a neighboring municipality.
These efforts were not enough to correct Central Falls' structural fiscal problems. According to the receiver, doing so requires addressing labor costs, which are governed by collective bargaining agreements (CBAs) with the police, firefighters', and municipal workers' unions—and which cannot be modified unilaterally by Central Falls outside of chapter 9.
The receiver says Central Falls and its unions engaged in months of good-faith negotiations, with the looming possibility of a chapter 9 filing, to reach agreement on substantial changes to the CBAs. The receiver ultimately made a formal request for voluntary concessions, but only two of the relevant retirees ultimately agreed (by the deadline set by the receiver) to reduce the amount of their pension benefits.
Unable to reach an agreement, Central Falls filed for chapter 9 and, on the petition date, immediately moved to reject its CBAs. Central Falls argues its rejection decision must satisfy only section 365 of the Bankruptcy Code and the standard established by the Supreme Court in its 1984 Bildisco decision, which essentially requires the debtor to prove the CBA burdens the estate. The unions will fight this and, if a settlement is not reached, the Bankruptcy Court will have to decide whether to authorize rejection, and the Court's ruling may have ramifications that reach vastly beyond the 1.5 square miles of Central Falls. If Central Falls is successful in utilizing chapter 9 to reduce its obligations to current and retired employees, other municipalities and unions should take note. The result may be more chapter 9 filings—or more out-of-court settlements—as all stakeholders weigh the risks of a court-imposed resolution.
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