ISCAL EMERGENCIES, AB506 AND MEDIATION€¦ · squirepattonboggs.com 7 Meeting Chapter 9 Eligibility The City’spetition for bankruptcy eligibility (i.e., proof of insolvency) wasstructured

FISCAL EMERGENCIES, AB506

AND MEDIATION

November 13, 2018

10:00 – 11:30 a.m. (PT)

2squirepattonboggs.com

Agenda

1. Introduction and Overview: Karol Denniston

2. Lessons Learned from San Bernardino: Michael Busch

3. Update from the League of California Cities: Dane Hutchings

4. Declaration of Fiscal Emergency: Sonia Carvalho

5. Out-of-Court Restructuring Process: Peter Morrison and Karol Denniston

6. Closing and Q&A

LESSONS LEARNED FROM

SAN BERNARDINO

Michael Busch


Why Did San Bernardino Need

Chapter 9 Protection?

The simple answer, a combination of poor accounting and high structural

spending (labor costs, public safety commitments, inefficient service delivery

models, etc.) lead to multiple years of deficit spending, and the City’s Charter

provided no one with the power to assert control and facilitate much needed

fiscal policy changes.

In 2007, the City was first put on notice that continuing existing fiscal policies

and practices could lead to insolvency, despite recent passage of ¼ cent

sales tax measure.

City declared a fiscal emergency on July 18, 2012, and filed for Chapter 9

protection on August 12, 2012.

As an emergency filing, the AB 506 process approved in March 2011 was not used.

City was able to avoid running out of cash.


Why Did San Bernardino Need

Chapter 9 Protection?

While a number of factors contributed to the crisis, by far the most significant

was increasing operating costs (primarily due to City Charter approved salary

and benefit increases) at a time when City revenues continued to decline.

As the chart below depicts, over two years (from fiscal years 2009-2010 to

2011-2012), the City’s “fund balance” declined to negative $1.2 million. Cash

balances were negative $15 million.

Without substantial and immediate restructuring of the organization, both

operationally and financially, the City was not be able to provide basic

services. 5 Year Budget and Fund Balance Estimates

(300.00)

(200.00)

(100.00)

-

100.00

200.00

2008-092009-102010-112011-122012-132013-142014-152015-162016-17

Millio

ns

Expenditures

Revenue

Fund Balance


Cash Flow – All Funds FY 12-13

($10,000,000)

$0

$10,000,000

$20,000,000

$30,000,000

$40,000,000

$50,000,000

$60,000,000

Expenditures

Revenue

Ending Cash


Meeting Chapter 9 Eligibility

The City’s petition for bankruptcy eligibility (i.e., proof of insolvency) was

structured around its inability to provide essential services without the court-

ordered fiscal relief from various obligations.

The City’s position comports with the definition of “financial condition” adopted

by the International City/County Management Association (ICMA).

Specifically, ICMA defines a municipality’s financial condition as the ability to (1)

maintain existing service levels, (2) withstand local/regional economic

disruptions, and (3) meet the demands of natural growth, decline, and change.

ICMA also categorizes financial solvency in 4 distinct ways:

1. Cash solvency: government’s ability to generate enough cash over a 30 to 60 day period to

meet its obligations.

2. Budgetary solvency: government’s ability to generate enough revenues over its normal

budgetary process to meet its expenditures and not incur deficits.

3. Long-run solvency: government’s ability to meet expenditures that may not be addressed as

part of the normal recurring annual budgetary process.

4. Service-level solvency: government’s ability to provide services at the level and quality that

are required for the health, safety, and welfare of the community and to meet its citizens’

desires.


Meeting Eligibility: On to Mediation

One contributing factor to the City’s year long fight for bankruptcy eligibility

was the lack of time to complete AB 506 process negotiations with its creditors

due the City’s cash flow insolvency – the City needed protection ASAP.

The City’s major creditors included CalPERS, police and fire unions, bond

holders and bond insurers, and individual claimants (wrongful death &

excessive force).

Judge Jury ordered the City into mediation in Reno, Nevada with Judge Zive.

Judge Zive ordered the City’s major creditors to attend a mediation kick-off

meeting.

Attendees included the police and fire labor groups, CalPERs, bond holders and

insurers, City staff, Chapter 9 counsel, bankruptcy consultants, and a few elected

officials (Mayor and Mayor pro-tem).

The City learned the significant data required to support its eligibility petition

and to validate specific creditor treatment (i.e., impairment) was deficient.


San Bernardino’s Introduction to Mediation

Judge Zive asked all creditors, including City staff and consultants, for ideas

the City should consider for restructuring (A total of 38 options were put on

the table).

The process to meet a good faith effort to evaluate the options represented

an organizational challenge. The City needed a structure to evaluate each

option as well as a realistic expectation for fiscal & operational change.

We defined the study areas into two (2) basic categories:

Cost Containment: Process of maintaining organizational costs within a specified

budget; restraining expenditures to meet organizational or project financial targets.

Cost Recovery: Recoupment of the purchase price of a capital or qualified asset or

service provided through depreciation, user fees and taxes over a prescribed period.

Our analysis further assumed the City would return to the basics of

governmental services.


Fiscal and Operational Change

Where Do We Begin?

Guiding Principles

ORGANIZATIONAL INTEGRITY: We agree to the adherence of moral and

ethical principles placing emphasis on the betterment of the organization

over individual results.

SOCIAL RESPONSIBILITY: We agree to the principle that the organization

serves the betterment of the community and not be solely devoted to

interests of the organization.

TRANSPARENCY: Transparency permits employees, elected officials, and

the community a greater understanding of a City’s operations, including the

parts of the organization that are most and least efficient. This, in turn, places

greater pressure on the organization to communicate openly and to produce

acceptable results in all facets of the City’s operations and negotiations.


Meeting the Mediation Challenge

Evaluation Process

How do we measure organizational priorities and provide a good faith

evaluation of the 38 options presented in mediation?

The City developed an evaluation criteria based on the adopted guiding principles:

each option was ranked and evaluated on how well the option minimized impacts to

community while maximized savings to the general fund.

Because the 38 recovery options included a variety of options, the options

were separated into “study areas.” Three study areas were developed:

1. Policy Opportunities

• Contracting Out for City Services (Refuse and Fire).

2. Administrative Opportunities

• Service Consolidation and Reduction in Workforce.

3. Voter Approved Opportunities

• Charter Reform and Voter Approved Revenue Measures.

Cost Containment (Contracting For Services)


Meeting the Mediation Challenge (con’t)

Strategic Planning Structure

We made a decision to use a familiar process to help the City understand its

options and to evaluate / defend its future. The typical stages of a strategic

plan include:

Readiness Phase – This includes interviews with internal and external

stakeholders and leaders leading to assess the City’s readiness to develop

and implement a transformative plan.

Self Assessment – This is a comprehensive assessment of the strengths

and weaknesses of the current City environment – both internal to the

organization an external within the community. This phase evaluates, at a

high level, various attributes such as the organizational culture, level of

accountability, capacity and performance, and what is supporting or getting in

the way of high performance and/or achieving the goals of the Council and

Mayor.


Meeting the Mediation Challenge (con’t)

Strategic Planning Structure (con’t.)

Examining The Future – This stage describes the City’s future assuming no

change-of-effort from the status quo. It not only describes the internal

organization but also the community, in terms of how both will look and feel if

the current course is stayed.

Creating The Future – This stage involves the organization (Council, Mayor

and City Manager) and possibly community leaders and describes a realistic

vision on what San Bernardino can be in 2 years, 5 years or more. This

shared vision is then compared to the previous phase, the status quo future.

Where there are unacceptable differences between the two, we then propose

specific new strategic initiatives that optimize the strengths and remove

obstacles.


Measuring the Options and Defending

Our Position

Policy Opportunities

Franchise Refuse Services / Contracting or Selling Sanitation

Impact Low Medium High

Department x

Organization x

Ward x

Community x

Financial Savings x


Final Thoughts & Take Aways

Chapter 9 bankruptcy is not a good fit for most fiscal or operational

challenges.

Its expensive and should be used only as a last resort.

The implementation of best practices of public financial management were

created through a “lessons learned” process.

Fight the push to run a political organization in favor of fiscal transparency.

Organization discipline is key to the City’s ability to stay the course and not

fall back into old risky habits.

A progressive city can move forward through a series of story telling from one

budget message to the next and never forget the lessons learned along the way.

UPDATE FROM THE LEAGUE OF

CALIFORNIA CITIES

Dane Hutchings


Why Cities Are On The Frontline of

Pension Reform

Why are Cities on the Frontline?

CalPERS 101

League of Cities Amicus Brief

What Can Cities do Today?

Questions



Pension Reform

Cities will feel the cost pressures more so than counties, special districts

and the like.

Cities provide the most direct public services to residents (e.g. most

employees).

Cities face future revenue issues.

Cities receive little to no revenue from the state.

City officials are closest form of government (e.g., none of the praise and all

of the blame).

For cities, it is not about year 30. It is about years 1-20.



Pension Reform

CALPERS 101

How the Fund Operates

• Pooled investments called the Public Employee Retirement Fund (PERF).

• All 3000+ employers’ money is pooled together and invested in a series of asset

classes (e.g., growth, equity, real estate, infrastructure etc.).

• BUT… each employer has their own independent pool with their own “funded level”

(think Honeycomb).

• If one pool (Agency) is terminated, they move to the Terminated Agency Pool (TAP)

fund and benefits may be reduced.

• “Discount Rate” equals the floor that CalPERS must earn. Anything below the

employer must pick up the difference. Note: Discount rate is determined by a 60 year

average.

23¢

13¢ 61¢



Pension Reform

CALPERS 101 CONT.

By the numbers – according to CalPERS:

In 2001 there were 2 active workers for every retiree.

In 2016 there were 1.3 active employees for every retiree.

It is projected that within the next 10-20 years there will be 0.6 workers for every

retiree.

Source: (CalPERS 2016 Annual Review of funding levels and Risk September

20, 2016).


Why Cities Are On The Frontline of Pension

Reform

Discount Rate Phase in Timeline (Local Agencies)

Fiscal Year Fractions of Rates

18-19 1/5 of 7.375

19-20 2/5 of 7.375 and 1/5 of 7.25

20-21 3/5 of 7.375, 2/5 of 7.25, 1/5 of 7.00

21-22 4/5 of 7.375, 3/5 of 7.25, 2/5 of 7.00

22-23Full impact of 7.375, 4/5 Impact of 7.25, 3/5

impact of 7.00

23-24Full Impact of 7.375, Full Impact of 7.25, 4/5

Impact of 7.00

24-25Full impact of 7.375, full impact of 7.25, Full

Impact 7.00

CalPERS has lowered its discount rate from 7.50% to 7.00%.

Phased in over time.



Pension Reform

CALPERS 101 Cont.

• PERF, Currently 71% funded.

• CalPERS exceeded discount rate at 8.6% (target for locals 7.375%).

• In February, CalPERS BOA adopted a 20 year amortization schedule for all

future gains and losses. League staff has been working with CalPERS staff

to establish a hardship criteria for cities needing to remain at 30 year

amortization.

• Movement on Fire JPA’s first approval in nearly a decade.

• PERS fixating on what constitutes an FTE vs. Contractor.



Pension Reform

League Files Amicus Brief on Cal Fire Case.

Cal Fire Local 2881 v. California Public Employees’ Retirement System.

“Vested Rights” are a laws established through judicial precedent, not statute

and must be clarified by as circumstances change.

There is a clear and distinct difference between benefits earned and benefits

yet to be earned vis-a-vis vested rights.

Even if there is a vested right, the legislative body has the power to modify

that right without providing a comparable new advantage without an agency

demonstrating a significant financial hardship.

League Amicus Fact Sheet can be found HERE

Note: Even if the “California Rule” is modified, it will take likely legislative

action to permit cities from making adjustments.

https://www.cacities.org/Resources-Documents/Policy-Advocacy-Section/Hot-Issues/Retirement-System-Sustainability/LCC-Cal-Fire-Ver2.aspx



Pension Reform

What Can Cities Do Today?

The toughest decisions will be made locally. Each agency will need to make

their own decisions on how to use best practices to stabilize their budgets.

• Identify New Sources of Revenue.

• Reduce Plan Benefits (OPEB).

• Review Services and Staffing Models (regional approach to service

delivery, JPA’s, etc.).

• Establish Rate Stabilization 115 Trust and/or UAL Pre-Payments

• Reduce UAL Amortization Period.

• Pension Obligation Bonds (not recommended by CSFMO or GFOA).

DECLARATION OF FISCAL

EMERGENCY

Sonia Carvalho


AB506 – California Government Code

Sections 53760 and 53760.1

Government Code Section 53670 states that a local public entity,

other than a school district, can file a petition for bankruptcy only if:

1) the public agency (city) has participated in a neutral evaluation

(mediation) process that is set forth in detail in the statute; OR

2) the public agency (city) declares a fiscal emergency and adopts a

resolution by a majority vote of the governing body (city council).

Government Code Section 53760.1 provides several definitions,

including for obvious terms such as “debtor,” but it doesn’t define a

“fiscal emergency.”


Declaration of Fiscal Emergency

What is a Fiscal Emergency?

Who decides when a public agency is in a fiscal crisis?

Does the public agency have to actually default on debt?

Does the public agency have to demonstrate a lack of funds to pay

employees?

Does the public agency have to conclude that it has a structural deficit?

Is there an objective standard in California?


Fiscal Emergencies Referenced

in Other California Laws

Public Resources Code Section 21080.32(d) –

For purposes of this subdivision, fiscal emergency, when applied to a publicly

owned transit agency, means that the agency is projected to have negative working

capital within one year from the date that the agency makes the finding that there is

a fiscal emergency pursuant to this section. Working capital shall be determined by

adding together all unrestricted cash, unrestricted short-term investments, and

unrestricted short-term accounts receivable and then subtracting unrestricted

accounts payable. Employee retirement funds, including Internal Revenue Code

Section 457 deferred compensation plans and Section 401(k) plans, health

insurance reserves, bond payment reserves, workers compensation reserves, and

insurance reserves, shall not be factored into the formula for working capital.

AB506 – Government Code Section 53670.

California Constitution Article XIII C, Section 2.


Cities Declare Fiscal Emergencies

for Different Reasons

Cost savings are not enough to avoid reductions in city services.

The State took our redevelopment money.

We adopted a balanced budget, but need additional revenue to build

infrastructure.

We never recovered from the recession.

Sales tax revenue has decreased.

General fund operating reserves will be depleted in 2020.

We cut staff, we cut salaries by 10% and increased employee contributions

for health and pension benefits.

City’s operating costs exceed our revenues.


Practical Implications of Declaring

a Fiscal Emergency

More and more cities are declaring a fiscal emergency in order to propose

general tax ballot measures to the voters.

Council Members may have some explaining to do – people who live in

wealthy communities do not want to hear that their city is in a fiscal crisis.

If you “cry wolf” too many times, no one will believe you – has an impact on

the ability to negotiate and bargain with labor groups.

Impacts a city’s ability to attract highly qualified staff, developers and

partners.

If you make the findings for AB506 purposes you better mean it.

OUT-OF-COURT

RESTRUCTURING PROCESS

Peter Morrison and Karol Denniston

Mediation


Mediation

We discussed in detail in our last webinar.

Step 1 – Engage All Creditors.

Negotiating with only a single or limited number of creditors unnecessarily restricts

potential out-of-court restructuring outcomes.

Look to unions, public debt holders, trustees, private lenders, insurers of public debt,

appropriate state officials, and contract counterparties.

Step 2 – How to Engage.

Might begin with informal negotiations with principal stakeholders and move on to

formal negotiations.

California AB 506 - This law limits the ability to file for chapter 9 without first

participating in a “neutral evaluation process.”


Mediation

Step 3 – Be Prepared.

Understand the capital stack, identify all principal stakeholders, consider go-forward

plans prior to meeting with creditors.

Engage professionals (financial advisor and counsel) early.

Step 4 – Potential Outcomes.

Meeting of the minds on a definitive agreement, such as a restructuring support

agreement, one-off modifications to debt terms and other contracts, or a standstill or

forbearance agreement.

No agreement reached, in which case you can continue the negotiation process with

other creditors and revisit dissenting parties later or commence a chapter 9

proceeding.

Restructuring Support Agreements



Also known as a plan support agreement, lock-up agreement, or voting

agreement.

Agreements negotiated by debtors and sophisticated key creditors to secure

their votes on a pre-negotiated plan.

RSAs began in the corporate restructuring context but are now being

employed in the municipal setting—notably in Puerto Rico.

Basic premise of an RSA is that the debtor will agree to propose a certain

form of plan and, in turn, creditors will agree to support that plan. The RSA is

not a plan but will usually include a detailed terms sheet containing the basic

form of a proposed plan.



Benefits

Usually negotiated prepetition, giving the debtor the necessary time to consider its

options.

The negotiation process will illuminate the position of each of the principal creditors.

An RSA might give the debtor the opportunity to negotiate DIP financing.

The RSA process might help a debtor wrangle a dissenting creditor—it is easier to

obtain agreement when a creditor knows others are on board.

• RSAs can be particularly helpful when negotiating with unions because there is certainty

and defined rights in the agreement. It is also helpful to negotiate with historically litigious

parties prior to commencing a bankruptcy proceeding.

A successful RSA will substantially reduce the amount of time that a municipality will

stay in chapter 9.

Reassures lenders, investors, and trading partners that the debtor is pursuing a

feasible reorganization strategy.

RSAs can be scaled to any size and are frequently easier to negotiate than a fully-

baked prepackaged plan of reorganization.

RSA’S SAVE TIME AND MONEY!



Common RSA Terms

Each creditor-party to the RSA must represent that it is the holder of the claim with

the right to vote that claim.

• This is important as holders of securities will likely have transferred the right to vote to a

trustee and that trustee might have transferred the right to vote to an insurer. Know your

creditors!

Each creditor-party will agree to support a plan that is consistent with the term sheet

attached to the RSA.

• Vote in favor of the plan and not withdraw votes

• Not object to confirmation

• Not vote to reject the plan

• Not vote for, propose, consent to, pursue, support, or participate in the formulation of any

competing plan

• Not attempt to convert or dismiss the case

• Use best efforts to assist in confirmation



Milestones

The RSA will often contain a set of milestones, consisting of deadlines for certain

actions to occur, to ensure that the confirmation process stays on track. Common

milestones include:

• The deadline to commence the bankruptcy proceeding,

• Court approval of disclosure statement,

• Commencement of solicitation for votes on plan,

• Confirmation hearing, and

• Effective date of plan.

Milestones help insure that case moves quickly and the creditors get the

benefit of a cheaper, streamlined process.

If the debtor fails to achieve the milestones, creditors can usually terminate

the agreement and consider other alternatives.



Fiduciary Outs

For a debtor to assume an RSA and a court to enforce it, there must a fiduciary out

for the debtor so that it retains its fiduciary duties to maximize the value of the estate

for the benefit of all creditors.

Creditors Fiduciary Outs

RSAs often contain fiduciary out language for the benefit of any creditor who many

wish to serve on the creditors’ committee.

This language typically states that the terms of the RSA should not be construed to

limit the creditor’s exercise of its fiduciary duties arising from its service on the

committee and exercising these duties should not be deemed a breach of the RSA.



Strategies for Entering into RSAs

Must have support of key creditor constituencies.

Negotiate with most senior creditors while allowing for flexibility to then negotiate

with juniors.

Act in good faith and provide the locked-up creditors with the same or more

information than what is eventually included in the court-approved disclosure

statement.

The RSA should require something less than an agreement to vote for or against a

specific plan (i.e., agreement not to vote for any other plan, not vote to reject, use

best efforts to confirm).

Provide the debtor a meaningful fiduciary out.

Must include a provision that the RSA is not a solicitation.


Contact Information

Karol K. Denniston

Partner

Squire Patton Boggs

[email protected]

Sonia R. Carvalho

Partner

Best Best & Krieger

[email protected]

Michael Busch

Chief Executive Officer

Urban Futures, Inc.

[email protected]

Peter R. Morrison

Senior Associate

Squire Patton Boggs

[email protected]

Dane Hutchings

Legislative Representative

League of California Cities

[email protected]

https://www.squirepattonboggs.com/en/professionals/d/denniston-karol-k

mailto:[email protected]

https://www.squirepattonboggs.com/en/professionals/d/denniston-karol-k

mailto:[email protected]