Many cities and counties are facing a coming financial crisis as their lack of foresight combines with the most difficult economic times since the great depression.  Some of those municipalities may consider what a few years ago was nearly unthinkable:  using bankruptcy (or at least the threat of bankruptcy) to break or renegotiate their commitments and to reject their collective bargaining agreements, cutting benefits and compensation for their public safety employees. 

Historically, Chapter 9 of the U.S. Bankruptcy Code, which applies to cities, counties and other government units and districts, has been rarely used.  When it has been used, the bankruptcy filings have usually been caused by an unanticipated emergency event - such as a large jury verdict in favor of a developer that could have otherwise resulted in seizure of the city's assets or (in the case of Orange County in the mid-1990s) when the county treasurer unexpectedly lost billions of dollars in complicated derivative investments he did not understand.

Growing Risks

The recent and still pending high-visibility bankruptcy of Vallejo, California was filed by the city for a different reason.  The city, after years of diverting millions of dollars from its general fund for other expenses, filed the case solely to get out from under its collective bargaining agreements with its police and firefighters.  That example has, in turn, inspired other municipalities to threaten bankruptcy filings in an attempt to strong-arm midterm concessions to their employee contracts.  The mere threat of bankruptcy - much less the actual filing of a municipal bankruptcy petition - poses serious risks to public employees.  Those risks arise from disturbing trends, the near-term impact of the global financial crisis, and gaps in basic statutory protections for many municipal worker benefits.

Long-Term Trends:  Health care costs continue to rise faster than the rate of inflation.  Cities and counties routinely commit to pay their retirees' health care costs for life, but often do not currently set aside funds for those future benefits.  The largest generation - the baby boomers - is now reaching typical retirement age for firefighters, police and other municipal workers, and because the typical retirement ages for these workers is earlier than age 65, the impact of this huge demographic wave of retirees will hit municipalities sooner than most private employers.

Short-Term Economic Challenges:  The current recession and credit crisis are likely to continue to reduce sales tax and property tax revenue.  Many of the companies that historically insured municipal bonds may not survive the credit crisis, further complicating municipal finance.  In addition, many governments - like the County of San Mateo, California, which reportedly lost over $100 million as a result of the Lehman Brothers bankruptcy - may have large investment losses because of imprudent risks they didn't understand. 

Special Risks:  Because of our constitutional structure, many of the federal statutory protections for private employees' benefits do not apply to municipal employees.  The Pension Benefit Guaranty Corporation typically does not stand behind city and county pension obligations, for example.  Various provisions of ERISA, the comprehensive federal statutory scheme protecting pension and health care benefits, also do not apply.  Finally, Chapter 9 of the Bankruptcy Code, which governs municipal bankruptcies, lacks many of the protections for workers that apply in the much more common Chapter 11 company bankruptcies.  Unlike Chapter 11, for example, there are no special statutory protections for collective bargaining agreements and retiree health care benefits, and there is less oversight and fewer restrictions on a municipality's operations while in bankruptcy.

Protective Steps

In the face of these risks, public employee unions should consider a variety of steps to protect their members from the risk of a bankruptcy by their municipal employer.

Negotiate for Pre-Funded Future Benefits.  There is a risk in having future benefits (retiree health care and pensions) funded only on a pay-as-you-go basis:  by the time the benefits are due, the employer may file a bankruptcy to avoid the obligation.  If benefits are actually funded (into a trust or the hands of a third party administrator) this risk diminishes.

Consider Lobbying for State Restrictions on Municipal Bankruptcy Filings.  To preserve state and local autonomy, the Bankruptcy Code permits municipal bankruptcies only if the municipality is specifically authorized to do so by applicable state law.  Some states provide blanket authorization for their cities, counties, and other districts to file bankruptcy.  Others do not, or require the consent of state officials or the state legislature to a filing, or require certain conditions to be met.  And, some states do not allow their cities and counties to file for bankruptcy at all.

A municipal bankruptcy is expensive, contentious and potentially damaging to the credit rating (and interest cost) not only of the government involved but also to other cities and counties in similar difficulty in the same state.  Local governments should not be able to threaten lightly the serious step of filing a bankruptcy as part of standard labor negotiations or because local politicians want to free up resources for other pet projects. 

Unions in states where local bankruptcies are broadly authorized (as they are in California) should consider lobbying efforts to impose restrictions or at least provide some state oversight of the decision to file.  For example, in one state where local bankruptcies were previously authorized in all cases, new statutory language like the following has been suggested by labor organizations:

Except as otherwise provided by statute, a local public entity in this state may with the approval of the Local Agency Bankruptcy Committee which is comprised of the state Treasurer, Controller and Director of Finance, under the terms and conditions that the committee may impose, file a petition and exercise powers pursuant to applicable federal bankruptcy law.

Others have suggested that state or federal law should be amended to explicitly provide that a debtor in Chapter 9 seeking rejection or modification of a collective bargaining agreement must first exhaust all state law procedures for the bargaining, implementation and amendment of a collective bargaining agreement.

Add a Bankruptcy Attorneys' Fees Clause to Your Collective Bargaining Agreement.  Historically, unlike bond, lease, loan, letter of credit and other standard financing documents, collective bargaining agreements do not routinely contain a clause requiring the employer to pay attorneys' fees for the union in any employer bankruptcy.  Until relatively recently, it also wasn't clear that a bankruptcy-specific attorneys' fees clause for an unsecured creditor would be enforceable.  In 2007, however, the U.S. Supreme Court overturned lower court decisions and held that attorneys' fees clauses may be enforceable in bankruptcy.  Travelers Casualty & Surety Co. v. Pacific Gas & Electric Co., 549 U.S. 443 (2007).  Since then, lower courts have interpreted the decision to permit an award of attorneys' fees spent in bankruptcy to unsecured creditors with attorneys' fees clauses in their documents.  See Centre Ins. Co. v. SNTL Corp. (In re SNTL Corp.), 380 B.R. 204, 222 (9th Cir. BAP 2007).

Unfortunately, municipal bankruptcies are now a greater risk than in the past.  Bankruptcies are expensive and lawyer-intensive, and there is inherently an imbalance of power in a municipal bankruptcy in particular.  Instead of using its resources to pay its obligations to public safety employees, for example, the employer may be spending those very resources on the bankruptcy lawyers who are seeking to eliminate those obligations.  A bankruptcy-related attorneys' fees clause provides some potential recovery for the union of its costs and also provides an additional deterrent to an employer filing.

These are difficult times, and there may be even more difficult times ahead.  Like many crisis situations, however, future bankruptcies can be anticipated, and advanced preparation is helpful in reducing the related risks of bad outcomes.

Dean Gloster and Kelly Woodruff are representing the International Association of Firefighters Local 1186, International Brotherhood of Electrical Workers Local 2376 and the Vallejo Police Officers Association in the Chapter 9 bankruptcy of Vallejo, California. They can be reached at 415.954.4400.