Experts assess how Chapter 9 could reshape LA insolvency battles

Read the Daily Journal's full series on municipal bankruptcies:

Part 1: LA and Santa Monica: Looming bankruptcy?

Part 2: Cities weigh Chapter 9 as liability pressures strain municipal budgets

If a fiscal sinkhole opens beneath Los Angeles, swamping local governments in red ink, what might happen in federal bankruptcy court?

Budget stresses on Los Angeles city and county, and on Santa Monica--the wildfire recovery costs, the legal liability payouts, the tax revenue shortfalls--have raised the economic threat level and forced government risk managers to eye Chapter 9, the U.S. Bankruptcy Code's escape hatch for insolvent public entities.

It's a sensitive topic. No one in the Los Angeles city attorney's office, the Los Angeles County counsel's office or at Santa Monica city hall responded to queries about possible preparations for a Chapter 9 filing. A Santa Monica municipal spokeswoman said the City Council's Sept. 9 declaration of fiscal distress has led to a budget stabilization plan.

Orange County used Chapter 9 in 1994 after its treasurer made risky investments that led to $1.64 billion in losses. The county entered what was then the largest municipal bankruptcy in U.S. history.

The Chapter 9 process was a success. "Orange County got back to investment grade in two years," said Bruce S. Bennett, a Jones Day authority on distressed government finances. At 36, he was Orange County's lead debtor's counsel in its successful effort in bankruptcy court to restructure its debt and restore its credit rating. In re: County of Orange, 183 B.R. 594 (C.D. Cal., filed Dec. 6, 1994).

Since then, Bennett has led Detroit in its debt adjustment case and represented holders of bonds issued by the U.S. Territory of Puerto Rico in its insolvency case. 

Those Chapter 9 proceedings moved more slowly. "Within about five years, it was pretty clear that the Detroit restructuring succeeded in getting the city back on its feet," he said. Puerto Rico, which filed for a form of bankruptcy in 2017, is still working on restructuring some of its $120 billion in total debt. It's now attained the status of largest U.S. municipal bankruptcy and, "It's not over yet," Bennett said.

Few are openly predicting that L.A. city or county or Santa Monica will go bust, though Bennett noted the county's recent staggering settlements for decades-old sex abuse claims. The county counsel said it settled two cases without discovery for a total of $4.8 billion, covering 11,400 plaintiffs. Another case of 2,500 plaintiffs is pending.

"I hope the county had a plan for paying the settlement amount before it concluded that deal," Bennett said.

Experts pointed out that when it comes to a municipal insolvency, Chapter 9 procedures differ from the way bankruptcy court operates when people or businesses suffer financial failures.

The power balance between federal bankruptcy judges and the city officials appearing before them is often in dispute. 

"Bankruptcy judges can't force a restructuring plan on a municipality in Chapter 9," said bankruptcy lawyer and former lawmaker Robert A. Wieckowski. While in the Legislature, he drafted a California requirement that Chapter 9-bound municipalities undertake negotiations before filing in federal court. 

"Bankruptcy judges in Chapter 9 procedures don't have the same mojo as in personal bankruptcies. There's no absolute priority rule in Chapter 9," he said, referring to requirements in personal and business bankruptcies that strictly rank asset distribution.

Bankruptcy judges have less power in municipal cases than in Chapter 7 or Chapter 11 because the 10th Amendment's state sovereignty provisions mean judges cannot issue orders to raise taxes, sell public property or otherwise interfere with officials' political powers.

Instead, insolvent public entities call many of the shots, then petition for court approval. "These are reorganizations done by municipalities themselves under the supervision of a federal judge," said a bankruptcy law professor, Mary Jo Wiggins of the University of San Diego School of Law. 

A bankruptcy judge to oversee a Los Angeles Chapter 9 filing would be appointed by the 9th U.S. Circuit Court of Appeals' chief judge, currently Mary H. Murguia, who would probably avoid any conflict by going outside the Central District to find a candidate, Wiggins said.

"Municipal bankruptcies are political animals, with tension often arising between judicial decision-making and powerful public officials," Wiggins added.

Under Chapter 9, creditors or the judge cannot propose plans that compete with the municipal debtor's own plan of debt adjustment. 

"That can lead to litigation within the bankruptcy procedure around labor and collective bargaining agreements," Wiggins said. "Unions and employee organizations often litigate over how property owned by the public entity is used and managed and whether it can be sold."

Those side conflicts can slow and complicate the process. "It tends to be messy," Wiggins said, "but you ask: messy compared to what?"

When Stockton went bust in 2012, a major fight developed over pensions. The California Public Employees' Retirement System cut a deal to leave its pensions untouched, causing a major creditor to strenuously protest any reorganization plan under which bondholders took huge losses.

The creditor, Franklin Templeton Investments, became a major holdout and appealed the plan approved by the judge.

The appeal failed, but by the time it passed through the Bankruptcy Appellate Panel and was rejected by the 9th U.S. Circuit Court of Appeals it had extended the process to 2018.

One of the lawyers representing unions in the Stockton case was Gary M. Kaplan, chair of the restructuring, insolvency and creditors rights practice group at Farella Braun + Martel LLP.

He noted that one feature of Chapter 9 could halt the payouts on Los Angeles County's nearly $5 billion settlement with sexual abuse survivors. 

"Legal settlements don't get renegotiated, but how much actually gets paid out can be adjusted, and sometimes it's pennies on the dollar," he said. 

"All unsecured creditors are in the same boat, but municipal debtors are sometimes tempted to treat their vendor creditors better than their litigation creditors," he explained. "If Los Angeles County said it wanted to pay its trade creditors, its vendors, 100% of what they're owed and its litigation creditors 50% of what they're owed, there'd be strong opposition, of course, and the judge would get involved."

Kaplan is a fan of California's pre-filing negotiation requirement that lowers court costs and streamlines litigation before the bankruptcy judge in Chapter 9 cases.

There's a mandatory 60-day mediation period with creditors and other stakeholders before a filing can proceed, though this can be waived if municipalities in distress declare a fiscal emergency.

"It forces the parties to come to the table," said Kaplan, who credits the requirement with having led in several cases to negotiations on the down-low between unions and city officials that have kept formal Chapter 9 filings sparce in the state.

"I wouldn't be surprised if Los Angeles or Santa Monica and their unions and others are even now having quiet talks to try to stave off the trouble an actual Chapter 9 filing could cause," Kaplan said.