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Municipal Bankruptcy: Is It An Option?

April 2, 2009

Today many governmental entities are in dire financial straits. The weak economy has resulted in decreasing revenues, due to declining property values, closed businesses, lost jobs, decreased revenue sharing, declining income taxes, declining populations (citizens and students) and defaults on payment of taxes. Combine this with the need to provide necessary services, the many fixed expenses such as wages, pensions and health care, and the legal obligation to maintain a balanced budget, and it becomes clear that something needs to give. Approval of additional taxes is unlikely, even if there are mills left to capture. Lay offs and reduced services can only go so far without further worsening the situation, as constituents move to other communities or states that can provide better job opportunities and better services.

A recent California case has highlighted the potential to use bankruptcy to deal with labor costs during the term of a bargaining agreement. Chapter 9 of the Bankruptcy Code provides a mechanism for municipalities (covers most governmental entities) to deal with insolvency issues, similar to Chapter 11 protection for private entities. To access this protection, however, the individual state must authorize the municipality to file under the federal statute.

In re City of Vallejo was filed in Bankruptcy Court in the Eastern District of California seeking to reject the City's labor agreements with four of its unions. After the filing, the City was able to reach modified agreements with two of the unions, leaving only the International Association of Fire Fighters' and the International Brotherhood of Electrical Workers' contracts in dispute. The judge did not rule on the motion to reject these contracts directly, but did issue a Memorandum clearly stating that the contracts could be rejected and clarified the standards that would apply if the parties chose to proceed. He encouraged the parties to continue negotiations, pending further evidentiary hearings on the motion to reject the contract.

Vallejo clarifies that once the state authorizes local public entities to file for bankruptcy, federal law will preempt any state law requirements regarding bargaining or labor agreements. For Michigan municipalities, that would mean that Act 312 arbitration and fact-finding procedures would not apply. Further, the procedural requirements for private sector employers to reject labor agreements under Chapter 11 do not apply to municipal filings under Chapter 9.

To reject a labor agreement, the public sector employer need only show that: 1) the labor agreement burdens its ability to reorganize (this will require proposing and implementing to extent possible a viable plan of adjustment); 2) the equities balance in favor of rejection; 3) reasonable efforts to negotiate modifications have been made and are not likely to produce a prompt and satisfactory solution. These are not very onerous standards for a public entity to meet if it truly is in a financial crisis.

Of note is that the California Public Employees' Retirement System and the Official Unsecured Creditors Committee of Retirees filed in opposition to the City's motion to reject these contracts. Both were "creditors," CalPERS for the unfunded portion of the pension benefits, and the Retirees' Committee for unfunded retiree health benefits. These are often significant financial obligations for Michigan public employers also.

So what does this mean for Michigan municipalities? That depends. This ruling from the federal bankruptcy court for Eastern District of California is not necessarily binding on the bankruptcy courts in Michigan. It is, however, well reasoned and quite persuasive. Like California, Michigan has authorized governmental units to utilize bankruptcy as a method of dealing with severe financial circumstances, but the decision to file may be out of the local governmental unit's control.

In 1990, Michigan enacted legislation to deal with local government fiscal crises, the Local Government Fiscal Responsibility Act. This has been used several times over the last couple of decades to deal with governmental units that have gotten themselves into serious economic difficulties. The City of Pontiac and the Detroit Public Schools are the two most notable entities currently under the control of an emergency financial manager appointed by the Governor.

This Act has several steps before a financial take over by the state. Several key steps include notice to the governmental unit that it needs to provide a plan to correct the situation. If the plan is deemed unsatisfactory, a hearing is provided before a take over by a financial manager. Once the financial manager is appointed, s/he has complete control over all contracts and other fiscal matters of the unit of government. This includes exercising any rights of the local government to renegotiate the existing labor agreements. Although this is a powerful tool, it does not free the manager from the existing state labor laws in seeking to obtain modifications or new agreements, and potentially require Act 312 compliance, with its deferral to a third party neutral, for covered bargaining units such as police and fire.

The statute, however, authorizes the financial manager to pursue bankruptcy protection, with the acquiescence of the local emergency financial assistance board (the manager's oversight committee). The rejection of the bargaining agreement includes the opportunity to have new terms and conditions imposed, and to modify or terminate retiree benefits or payments, including health insurance. This is essentially a binding arbitration with the sole focus on the employer's ability to pay. In Michigan, this big stick seems to have sufficed to avoid the need for emergency financial managers to seek protections of bankruptcy court. If Michigan's economic downturn continues, however, we may see more municipal bankruptcies as emergency financial managers seek to void financial obligations and involuntarily reduce and restructure debt to regain financial stability.

If you are interested in learning more about the information presented in this article, please do not hesitate to contact John Patrick White at 616/336-6615, or another attorney in Varnum's Labor and Employment Relations group.

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