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Like many companies, a number of large U.S. cities, including San Diego, Pittsburgh and Detroit, are in serious financial distress. While it is not uncommon for financially strapped corporations to file for bankruptcy under Chapter 11 of the Bankruptcy Code to deal with their financial woes, resort by municipalities to the bankruptcy process — under Chapter 9, which is specifically applicable to municipalities — is quite infrequent. In fact, the last major municipal bankruptcy under Chapter 9 was the Orange County, Calif., case filed in 1994. Unlike the Orange County case, which was a restructuring driven principally by speculative investment decisions and resulting degraded asset values, the large municipal bankruptcy cases on the horizon are likely to be driven more by the massive health care and pension liabilities facing large cities than by a need to restructure their debt instruments. For example, San Diego faces a whopping $1.4 billion pension shortfall, with little relief in sight. Patrick Fitzgerald, “Lawyers See Wave of Municipal Filings on Cities’ Shortfalls,” Dow Jones Newswires, Jan. 4, 2006. In addition, under a change in accounting standards scheduled to become applicable to large cities in 2007, large cities will be required to account for the total amount of retiree health care benefits promised to public retirees, potentially revealing billions in additional unfunded liabilities. See Governmental Accounting Standards Board Statement No. 45, “Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions.” Consequently, any large municipal bankruptcy filing in the near future will likely center around very different legal issues than those that were the focus of previous municipal bankruptcy cases. This article first focuses on the treatment of those issues that are likely to figure prominently in any large Chapter 9 cases — namely, health care and pension liabilities owed to current and retired municipal employees — contrasting their treatment under Chapter 9 with their treatment in business reorganizations under Chapter 11. It then addresses the treatment of health care and pension liabilities under Chapter 9 plans of adjustment, comparing and contrasting Chapter 9 plans to their Chapter 11 counterparts where relevant. It concludes by discussing the fundamental question of whether Chapter 9 is an effective tool for large municipalities to resolve health and pension liabilities. An employer’s liabilities to current and retired employees for health care benefits typically arise under a collective bargaining agreement (CBA). In the seminal decision addressing the treatment of CBAs in bankruptcy, the Supreme Court held that an employer in Chapter 11 could reject (i.e., breach) a CBA by satisfying the requirements of �365 of the Bankruptcy Code — the statutory provision governing the assumption and rejection of executory contracts — by showing the CBA to be burdensome, and by demonstrating that the balance of the equities favored rejection of the CBA. NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984). Rejection of a CBA under �365 left employees with general unsecured claims for damages. 11 U.S.C. 365(g)(1), 502(g)(1). In addition, Bildisco held that a debtor in Chapter 11 did not commit an unfair labor practice by unilaterally modifying the terms of a CBA prior to court approval of the rejection of the CBA. The treatment of an employer’s obligations to provide health care benefits to current workers under a CBA is generally governed by �1113 of the Bankruptcy Code, enacted by Congress in response to Bildisco. Section 1113 imposes numerous procedural and substantive requirements for a debtor seeking to reject a CBA, most notably that the debtor must demonstrate that rejection is necessary for the debtor to reorganize. NO UNILATERAL ACTION In addition, Congress enacted �1113(f) of the Bankruptcy Code to legislatively overrule the portion of Bildisco that permitted a Chapter 11 debtor to unilaterally modify the terms and conditions of employment under a CBA prior to receiving formal approval of the rejection without being guilty of an unfair labor practice. Consequently, under �1113(f), a Chapter 11 debtor may not unilaterally terminate or modify a CBA without first complying with the procedural and substantive requirements set forth in �1113. Section 1114 of the Bankruptcy Code governs the payment of “retiree benefits” in Chapter 11. Retiree benefits are defined as payments to retired employees and their families and dependents for medical, death and accident benefits under a plan, fund or program established prior to the debtor’s Chapter 11 filing. 11 U.S.C. 1114(a). Section 1114 contains numerous procedural and substantive requirements similar to those in � 1113 that must be satisfied for a debtor to modify retiree benefits during a Chapter 11 case. See 11 U.S.C. 1114(e)-(h). Furthermore, for a Chapter 11 plan to be confirmed, it must provide for the continuation of all retiree benefits at preconfirmation levels. 11 U.S.C. 1129(a)(13). Given the dearth of cases filed under Chapter 9, the law on the treatment of health care liabilities in a Chapter 9 case is much less well developed than it is under Chapter 11. What appears certain is that �� 1113 and 1114 do not apply in Chapter 9 cases. See 11 U.S.C. 103, 901. The only reported decision instead holds that Bildisco generally applies to CBAs in Chapter 9. Orange County Employees Ass’n v. County of Orange (In re County of Orange), 179 B.R. 177, 183 (Bankr. C.D. Calif. 1995). However, the bankruptcy court ruled in the case that the municipality was required as an equitable matter to comply with state law and demonstrate that the impairment of an existing contract was justified by a sufficient emergency as a predicate to being able to unilaterally modify a CBA prior to rejection of that CBA. Id. at 183-85 (citing Sonoma County Organization of Public Employees v. County of Sonoma, 591 P.2d 1, 5 (Calif. 1979), and applying a four-pronged test under California law for determining whether the emergency justified unilateral impairment of contract rights). The court’s ruling was based in part on �903 of the Bankruptcy Code, which provides that Chapter 9 generally does not impair the power of a state to control its municipalities. 11 U.S.C. 903. In view of the scarcity of reported case law, the extent to which a municipality may rely on Chapter 9 to modify or terminate its contractual health care liabilities to employees and retirees is less than clear. There is a lack of any case law addressing the treatment of pensions in Chapter 9. In Chapter 11, a debtor generally may terminate its pension plan if it satisfies one of the tests for a “distress termination” set forth in �4041 of the Employee Retirement Income Security Act (ERISA). See 29 U.S.C. 1341. The most common test is satisfied if the bankruptcy court determines that the debtor will not be able to reorganize under Chapter 11 unless the plan is terminated. Upon such a termination, the Pension Benefit Guaranty Association (PBGC), a federal government agency, provides covered employees with a certain guaranteed level of benefits, and has a general unsecured claim against the debtor to the extent of the plan’s underfunding. However, ERISA does not apply to municipal pension plans, and the PBGC does not provide benefits to municipal employees when such plans are terminated. Given the lack of reported case law on the treatment of pensions in a Chapter 9 case, the extent to which a municipality in bankruptcy could modify or terminate its pension obligations is uncertain. CONTRACTS CLAUSE To the extent that its pension obligations constitute executory contractual obligations, a municipality presumably could reject them pursuant to �365 of the Bankruptcy Code, by showing that they are burdensome, and, if the obligations arise under CBAs, that the balance of the equities favors rejection, under the Bildisco standard. In applying the balance-of-the-equities test, the bankruptcy court could take guidance from the Orange County decision by requiring the municipality to satisfy applicable state law standards for breaching an existing contract. Upon such rejection, the pension beneficiaries apparently would be left with general unsecured claims. However, the ability of a municipality in Chapter 9 to modify or terminate its pension obligations may be limited by the contracts clause of the U.S. Constitution. Under the contracts clause, a state or municipality generally may not substantially impair a contract of its own making without showing that such impairment is “reasonable and necessary to serve an important governmental purpose.” U.S. Trust Co. of New York v. New Jersey, 431 U.S. 1, 21 (1977). If the contracts clause applies in Chapter 9, it is uncertain what facts a municipality would need to demonstrate to satisfy this standard. For example, it is conceivable that a court would find that this test is not met if the municipality has the ability to raise taxes or reduce spending on other programs to avoid modifying or terminating its pension obligations. It is also possible that a municipality in bankruptcy would seek to restructure its health care and pension liabilities through a Chapter 9 plan, which provides considerable flexibility for restructuring a municipality’s financial obligations. Under Chapter 9, a municipality is required to file a proposed plan to adjust its debts. 11 U.S.C. 109(c), 941. However, unlike in Chapter 11, no other party can file a competing plan. To merit confirmation, a Chapter 9 plan must satisfy certain requirements, many of which are comparable to those required for confirmation of a Chapter 11 plan. See 11 U.S.C. 901, 943(b). Like a Chapter 11 plan, a Chapter 9 plan generally must be accepted by a majority of each class of claims impaired under the plan. 11 U.S.C. 901(a), 1124(1), 1129(a)(8). However, as in Chapter 11, the bankruptcy court may confirm a Chapter 9 plan even if all impaired classes have not accepted the plan through a “cramdown” if at least one impaired class accepts the plan, and if the court determines that the plan is “fair and equitable” and does not “discriminate unfairly” with respect to each class of impaired claims that has not accepted the plan. 11 U.S.C. 901(a), 1129(b). Moreover, as with a Chapter 11 plan, a Chapter 9 plan must be in the best interests of creditors and must be feasible. 11 U.S.C. 943(b)(7). The best-interests-of-creditors test compares treatment under the plan to other realistic alternatives to the plan, but does not require that the municipality increase taxes or sell its assets to the extent necessary to pay all creditor claims. See Hollstein v. Sanitary & Improvement Dist. No. 7 (In re Sanitary & Improvement Dist. No. 7), 98 B.R. 970, 974 (Bankr. D. Neb. 1989). To satisfy the feasibility test, the municipality generally must demonstrate that it can meet its obligations under the plan. Id. at 975. Additionally, a Chapter 9 plan must satisfy any regulatory or electoral approval necessary under applicable nonbankruptcy law in order to carry out any provision of the plan, and the municipality must not be prohibited by law from taking any action necessary to carry out the plan. 11 U.S.C. 943(b)(4) & (b)(6). Because there is virtually no reported case law on the application of these standards to health care and pension liabilities in the Chapter 9 context, it is difficult to predict how successful a municipality would be in seeking to modify or terminate its health care and pension liabilities through a Chapter 9 plan. It therefore is unclear how effective a tool Chapter 9 would be for a municipality seeking to restructure its health care and pension liabilities. Such uncertainty may lead a municipality to look to other options, such as increasing taxes, to deal with these obligations. Further, even if a municipality is able to use Chapter 9 to shed some of its pension and health care liabilities, the resulting savings may be offset by the increased costs of social services and other programs provided to affected workers and retirees. Finally, political considerations likely will influence the decision of a municipality to file Chapter 9 to reduce its pension and health care costs. Gary M. Kaplan is a shareholder at San Francisco-based Howard Rice Nemerovski Canady Falk & Rabkin, concentrating on bankruptcy, creditors’ rights and commercial law. Joel S. Moss is an associate at the firm, specializing in bankruptcy and creditors’ rights.

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