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Originally presented as testimony to the Cities and Villages Committee of the Illinois House of Representatives on May 8th, 2018.

By: Mark Glennon

Introduction

Chapter 9 bankruptcy for municipalities is a last resort and a bad option. The question, however, is whether it is the only option offering any hope to Illinois’ most distressed communities. Additionally, we must consider whether mere availability of the option would help borderline communities achieve the negotiated settlements they need to avoid collapse, without the need for actually going into bankruptcy.

I am convinced that offering the option isn’t just the right thing to do, but that delay will doom some communities to circumstances not even bankruptcy can help. Time is working against us. About half of the nation’s states authorize municipal bankruptcy in one form or another, and we should join them.(1)

That is the case that I want to make today, and I will not try to address exactly what form a bankruptcy authorization bill should take.

Let’s look at the basic things bankruptcy does, and think about them in light of the frightening direction Mr. Dabrowski described that so many communities are heading in. Most importantly, think about what will become of some communities without bankruptcy.

Debt reduction, for some communities, is essential

Only bankruptcy can cut debt when creditors won’t voluntarily agree to reductions, and only bankruptcy can do it fairly and ratably. The debt that can be cut includes all unsecured debt, including unsecured bonds and the unfunded portion of pension liabilities. Some of our municipalities simply cannot hope to achieve a minimum level of services and reasonable taxation unless their debt is cut. It’s that simple.

Let me address a few things about pension debt in particular. The news is dominated by stories about fat pensions, but at some point they will be matched by stories of severe hardship in poorer communities. With municipal funding ratios averaging only 50%, most municipal pensions don’t have enough to cover even current retirees. There’s nothing there for current workers, and many communities have no real prospect of correcting that. Some form of benefit adjustment is essential, but that’s what our courts have ruled out. The options to overcome those rulings may be limited to bankruptcy or a constitutional amendment, though an amendment might not work because of federal constitutional issues and would take years to pass.

Far more importantly, however, pensioners usually have come out better than unsecured bondholders in Chapter 9 cases. I urge you not to be influenced by those who are looking to protect returns on bonds already issued, who may oppose bankruptcy out of self-interest. So far, only they have been playing the insolvency game of hardball as it is usually played in the private sector. I have written often, and spoken to some of you in the past, about several pieces of legislation that have come up that would prioritize already-issued bonds over other obligations.(2)

I have also criticized securitization by municipalities of their money from the state, the sole purpose of which is to ensure bondholders win in bankruptcy.(3) It has now been used by Chicago and Bridgeview. It’s now mandatory for any municipality wanting to use its state money as collateral for bonds.(4)

Those efforts are dangerous because they, along with the habit of most municipalities to borrow and borrow, are increasing the risk of “assetless bankruptcies.” That’s where there’s nothing to work with because everything is mortgaged to the bank, and bankruptcy won’t work because nothing is left to pay for government services or pensions. Debt backed by a mortgage or security interest of some kind — secured debt — must be paid in full even in bankruptcy. This is part of why time is our enemy.

While municipalities sink further into insolvency, more and more of their assets already are being grabbed for bonds and will be unavailable for government services, pensions or anything else.

The alternative is chaos

Let me turn to another key feature of bankruptcy, which is that it freezes all individual attempts to collect and enforce judgments, stays most other litigation, centralizes priority disputes and ensures that similar creditors get equal treatment. The basic idea is to sort things out in an orderly, consistent way, instead of through a race for judgements in different court proceedings and endless fights for priorities.

Think about how important that will become in many Illinois communities sinking further into insolvency.

Illinois courts have clearly ruled that, when a pension fails to pay, the pensioner may directly sue the sponsoring municipality. Those suits are only a matter of time in some municipalities. Will each pensioner be racing to court to execute judgements, or will cases be consolidated, or certified as a class?

That will be just the start.

We’ve already seen, through the Harvey firefighter pension decision last year, that courts will order specific tax levies to fund pensions. How long until some community faces a similar judgment for both its police and fire pensions? What will become of property tax rates across the state if a rash of those orders come?(5)

We also know those court-ordered tax assessments for pensions may be imposed even where property taxes already are impossibly high – they were 5.7% in Harvey. That result is patently irrational and must be corrected somehow. In the most challenged communities, taxes effectively are becoming infinite because owners are just walking away and homes become worthless.

And now we have pension intercepts beginning. Wirepoints research concluded that over 200 municipalities may face an intercept of state money by the Comptroller.(6) Some of that money is mortgaged to bondholders. Who wins that priority battle with the Comptroller? What about any number of other creditors who try to execute judgements on municipal assets? Those questions will have to settled by courts.

Consider the difficult position trustees are in at those pensions that could force an intercept if they choose. As fiduciaries for pensioners, they should be considering it seriously, but if they do they may cripple their communities and force layoffs, as occurred in Harvey.
Finally, bonds will default and bondholders will enforce remedies that may include executing on assets, garnishing money from the state and foreclosing on security interests in sales tax revenue and other state sources. Where alternate revenue bonds have been issued, bondholders can force further property tax increases, too.

Will we wait until all that combines in some communities before authorizing bankruptcy? If we do, it will be too late for many. For their creditors, the results will be haphazard and heavily consumed by attorneys’ fees.

This is a choice between an orderly insolvency proceeding intentionally structured to provide a fresh start, and a disorderly one driven only by collection efforts.

Municipalities won’t rush into bankruptcy, not just because they shouldn’t, but because they can’t.

Bankruptcy won’t work for many Illinois municipalities. Whether it will is a case-by-case matter. It will depend, primarily, on how insolvent they are and how much of their debt is secured. Bankruptcy is expensive and outcomes are unpredictable. A municipality will have to weigh all those considerations and more to determine what is best for all stakeholders.
Legally, they will be required to do just that. The hurdle for “eligibility” under Chapter 9 is strict, and basically requires the municipality to exhaust all other options.(7)

It is designed to force out of court settlements or prior agreement to the reorganization plan to be presented in bankruptcy.

The particular bill now pending reinforces that requirement and requires a thorough process before an actual bankruptcy filing could be made.

As Chapter 9 cases become more common, “prepackaged” cases will become the norm. That was the history of Chapter 11, which is reorganizations for private sector businesses. Stakeholders and their lawyers come to know what to expect in bankruptcy, so they sign off before bankruptcy on the reorganization plan they would expect to end up with anyway. That makes the process far quicker, completely predictable and less expensive. Many concerns about Chapter 9 therefore can be expected to dissipate.

Indeed, in many instances it makes an actual bankruptcy filing unnecessary at all. Rockford’s former mayor, Larry Morissey, has long said that about Rockford. The changes he said he believed were needed to stabilize Rockford could be accomplished if merely the threat of bankruptcy was available.

Conclusion

Bankruptcy and insolvency professionals know that a primary rule, once insolvency is apparent, is to be fast, decisive and comprehensive – to implement a reorganization or go into bankruptcy quickly, with a plan that thoroughly fixes what is wrong. They know all stakeholders come out better if that rule is honored rather than letting insolvency deepen.

But all the forces of politics and government have pushed us to do the opposite – deny, delay, extend and pretend. With each day that passes, the inevitable, ultimate losses and hardship are growing at dozens of municipalities across Illinois. Many are heading toward insolvency so deep that even bankruptcy will not afford them a chance for a fresh start.

In the right circumstances, however, the results can be dramatic. Just five years after it entered bankruptcy, Stockton, California was rated last year as one of the most fiscally healthy cities in the nation by researchers at The Fiscal Times.(8) Bankruptcy unquestionably brought new life to Detroit, a city many had written off as hopeless.

Directors of insolvent companies in the private sector have a fiduciary duty to consider whether bankruptcy is the best option for their shareholders. Illinois has no reason to deny its insolvent municipalities even the option of doing the same.

Endnotes

[1] How Rare Are Municipal Bankruptcies? Governing Magazine, January 24, 2013

[2] Illinois Bill To Prioritize Bondholders Over Public Must Be Stopped, Wirepoints, February 25, 2017.

[3] Why Chicago’s New Debt Scheme is Dangerous, Crain’s, October 11, 2017.

[4] 65 ILCS 5/8-13-20.

[5] Court Ordered Tax Increases for Pensions Begin In Illinois, Wirepoints, August 23, 2017.

[6] Harvey, the first domino in Illinois: Data shows nearly 400 other pension funds could trigger garnishment –Wirepoints Special Report, Wirepoints, April 18, 2018.

[7] 11 U.S.C. § 109(c).

[8] How Strong Are Your Cities Finances? 116 Cities Ranked. Fiscal Times, January 9, 2017.

 

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Erik

Great public service Mark. Thank you for your efforts.

Mike

What are the background details?

You and Ted discovered a House City and Villages Committee Hearing was scheduled for 3PM on May 8th and proactively scheduled to testify about the frightening direction of some Illinois municipalities and their need for a bankruptcy option?

Or were invited to the meeting?

No, we did not. We were asked to testify. Please don’t make things up and post them here. It was a subject matter hearing on this topic. The Dem chair of the meeting and most of the committee listened intently and asked fair questions. Anybody was welcome to attend.

Mike

People can ask to testify at committee meetings, or they can be asked to testify. The article didn’t specify which occurred, and the information was nowhere to be found. So I asked. Well I could have been more blunt and not guessed what happened, but that second sentence was phrased in the form of a question not a statement of fact. The only mention on the myILGA website for the House City and Villages Committee on May 8th was a 3PM meeting at which a vote was taken 4 senate bills, none of which pertained to municipal money problems, and… Read more »

jaherzrent

If I am a public employee anticipating bankruptcy, don’t I want to escalate my accrued benefit as much as possible in the time that remains? Won’t my ultimate distribution from the bankruptcy estate be determined by a fraction of my entitlement (present value) divided by the total that is owed? So even if bankruptcy is the most likely outcome, won’t public employees be better off making their pension claims as large as possible to increase the numerator in the fraction? So … the worse things look, the greater the incentive to make the pension part of the problem as great… Read more »

NB-Chicago

fantastic writing-thank you Mark! one would think as more and more impoverished municipalities become subject to pension tax intercepts duken it out with bond holders while the residences get crushed or just plain walk away from there homes, somebody on the progressive left would be outraged. but instead silence?