Balancing a City's Past Versus Its Future

Frank Shafroth is director of the Center for State and Local Leadership at George Mason University.

One of the most profound issues that has arisen in the historic cases of municipal bankruptcy over the last five years relates to a city or county's future fiscal sustainability versus its past obligations. In cases involving thousands upon thousands of creditors — in Detroit, alone, there were 100,000 creditors — how does one divvy up what already insufficient resources are available? What does one hold back to ensure a viable future? Especially, how does one weigh a city's accrued debts versus its sustainable fiscal future and the human and capital investment critical to such a future? Perhaps, more simply, how does one balance a municipality's bondholders versus its retirees?

Unlike the federal government, states and local governments have operating and capital budgets — so that state and local leaders have to balance shorter and longer term obligations. In prepping for our annual session with the credit rating agencies many years ago, I impertinently asked if the county leaders — if asked the next morning — would be able to describe the means of honoring a pension commitment made for an employee hired that morning: was there a designated stream of revenue to be certain that when that new employee retired in 30 years, the promised pension obligation would be met? I was met with silence — followed by urgent meetings and a 24th hour commitment by the county's elected leaders to raise the property tax rate and set aside a portion so that such promises would be met.

The challenge of pension promises and bond indebtedness is inextricably entwined. In municipal bankruptcy, it falls upon federal bankruptcy judges to weigh proposed plans of debt adjustment to determine not just the rough justice of their proposed allocations of insufficient fiscal resources amongst thousands upon thousands of creditors, but also between a city's retirees and its fiscal future — that is, between obligations to its own citizens and retirees versus obligations to it municipal bondholders — obligations which, if not honored, could lead to significantly higher costs for the capital investment vital to such a municipality's future. Or, as San Bernardino's City Attorney puts it: "We need to have the pension system not be impaired and not have the perception of it being weakened. Chapter 9 (municipal bankruptcy) is designed to have a city to have life and services post-bankruptcy, and in order to do that, we need to have an adequate workforce."

In his decision granting approval of Stockton's plan of debt adjustment to exit municipal bankruptcy, U.S. Bankruptcy Judge Christopher Judge Klein wrote that a municipal bankruptcy "myth" was that because the Stockton's proposed plan to cut debt and exit bankruptcy left pensions intact, employees and retirees were "not sharing the pain" with the city's municipal bondholders. In addition to pay cuts, however, Stockton replaced its retiree health benefits valued at $545 million with a $5 million lump sum payment. That is, the plan wreaked devastating consequences to its own citizens/employees, notwithstanding that is was a plan the city negotiated approval of with all of its unions and its largest bondholders.

In his Detroit decision, U.S. Bankruptcy Judge Steven Rhodes remarked it was an easy legal decision to authorize pension reductions in Detroit's bankruptcy, despite his compassion for the city's retirees. Nevertheless, the electric rhythm guitar-playing judge affirmed that his groundbreaking ruling to authorize then Detroit emergency manager Kevyn Orr the authority to reduce the city's pension obligations was prudent — notwithstanding Michigan's Constitution, which describes public pensions as a contractual obligation that cannot be cut.

These cases, which have pitted bondholders against public pensioners, in effect pit a city or county's accrued liabilities against its costs for investing in its future. The greater the accrued liabilities, the higher the interest rate potential municipal bondholders will demand — in effect risking putting a city or county in a vicious cycle where its costs of long-term investment in its future economy and infrastructure are greater than other cities and counties. It risks becoming less competitive and confronting a stagnant or declining population at risk of credit downgrades.

The exceptional challenge of balancing a city's creditors in bankruptcy - a challenge between public pensioners and its bondholders — is endlessly complex. In the pending case, EEPK (Erste Europaische Pfandbrief-und Kommunalkreditbank AG), which holds about $50 million of San Bernardino's pension obligation bonds, filed suit against the city in an effort to secure equal payment or balance in any final plan of debt adjustment in the wake of the city's interim agreement with its largest creditor, CalPERS, under which the city agreed it would fully repay CalPERS and require the city to file its plan to exit bankruptcy by September. EEPK argued that treating one pension debt differently from another is legally indefensible, charging San Bernardino cannot legally keep up payments to the state's public retirement system without giving equal treatment to pension-bond holders, presenting a novel legal challenge for CalPERS, which last year lost an argument in federal court over whether it deserved more protection than municipal bondholders.

San Bernardino City Attorney Gary Saenz responds that just because the two debts are similar does not mean they should be treated similarly: "The reason they should not be treated similarly, is because the consequences of treating them similarly are extremely different…We need to have the pension system not be impaired and not have the perception of it being weakened. Chapter 9 is designed to have a city to have life and services post-bankruptcy, and in order to do that we need to have an adequate workforce."

Frank Shafroth is Director of the Center for State and Local Leadership at George Mason University.

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