FEAR OF REJECTION –

HOW CHAPTER 9 OF THE US BANKRUPTCY CODE

CAN SOLVE THE PENSION SHORTFALL CRISIS

by James A. Chatz and Marc S. Zaslavsky

James A. Chatz, Partner

Arnstein & Lehr LLP 200 S. Biscayne Blvd.
120 S. Riverside Plaza Ste. 3600
Ste. 1200 Miami, Florida 33131
Chicago, Illinois 60606 305.428.4510
312.876.7171
jachatz@arnstein.com
www.arnstein.com

James A. Chatz is a senior partner and certified mediator with the Chicago-based law firm of Arnstein &
Lehr LLP. He has more than 50 years experience in the practice of law. Mr. Chatz has five decades of
experience in the field of commercial insolvency and creditors’ rights law, representing clients
throughout the United States. He also practices in the areas of corporate law and business law, mergers
and acquisitions, financial planning, and commercial litigation. Mr. Chatz spends a significant portion of
his time in South Florida with the firm’s Boca Raton, Fort Lauderdale, Miami, Tampa, and West Palm
Beach offices, providing his knowledge and experience as a resource to businesses and individuals with
significant interests in South Florida. Leveraging the skills of our Florida-licensed attorneys, he is able to
assist clients in understanding their alternatives the strategic direction of their matters and in other
phases of the relationship.

Marc S. Zaslavsky, Associate

Arnstein & Lehr LLP
120 South Riverside Plaza, Ste. 1200
Chicago, Illinois 60606-3910
312.876.7853
mszaslavsky@arnstein.com
www.arnstein.com

Marc S. Zaslavsky is an associate in the Chicago office of Arnstein & Lehr LLP who focuses his practice
on bankruptcy issues. Mr. Zaslavsky was a member of the Law Review at DePaul University College of
Law where he graduated magna cum laude. He was awarded the CALI Award for Excellence in Legal
Drafting: Transactions and was a recipient of the CALI Award for Excellence in Legal Writing I and II.
Mr. Zaslavsky was nominated to the Order of the Coif by the faculty at DePaul University College of
Law. He is also a member of both the Illinois State Bar Association and the Chicago Bar Association.
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
2

Since I’ve been a commercial and bankruptcy lawyer for the past 52 years, I recently

was asked by a member of an ad hoc committee of an Illinois city with less than

100,000 population if I could discuss and recommend some remedies to help solve the

city’s more than $100 million shortfall in their police and fire departments’ pension

funds.

In a world replete with a commerce-crippling volcano, disastrous earthquakes, ever-

rising taxes and ever-falling property values, its easy to push aside the pink elephant in

the room—unfunded public employee pension funds. But as surely as ashes from a

volcano in Iceland has the potential for affecting everything in its path, so too will the

looming pension crisis affect all of us for generations to come.

I recommended to the members of the ad hoc committee that they consider using the

threat of Chapter 9 of the Bankruptcy Code to bring representatives of the public

employees unions or leadership and city officials to the bargaining table. The

committee members did not accept the advice, and they took no action in the matter. In

contrast, the City of Vallejo, California, did seek relief for its pension obligations under

Chapter 9, a move I will discuss later in this article.

The State of California has been forced to take extreme measures to deal with its

colossal $500 billion dollar unfunded pension debt. Writing in the Los Angeles Times

(April 5, 2010), David Crane, a special adviser to California Governor Schwarzenegger,

explains why Chapter 9 of the Untied States Bankruptcy Code must be understood by
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
3

the movers and shakers of local government. Crane points to the “$5.5 billion diverted

[in California] from higher education, transit, parks and other programs in order to pay

just a tiny bit toward current unfunded pension and healthcare promises” as evidence

that California is facing real and shocking budget shortfalls. Crane warns that

California’s “real unfunded pension debt clocks in at more that $500 billion, nearly eight

times greater than officially reported.”

California’s budgetary pains are being experienced to some degree by local

governments throughout the United States. Considering these eye-opening crises

which face many local governments, in the near future, Chapter 9 of the Bankruptcy

Code may end up filling Bankruptcy court dockets just as Chapter 7 of the Code filled

the dockets with wage earner bankruptcies.

The purpose of this article is not to discuss the rights or wrongs of the enormous

shortfalls which are coming due for pension plans for public employees. Nor is it my

purpose to discuss the role of city councils in their granting liberal pensions which

include early retirement, payment at the highest level of previous income, and payments

to policemen and fire fighters who retire at age 50 or older. Since policeman and

firefighters put their lives on the line for the communities they serve, I have no reason to

think they don’t deserve as much as they can bargain for. However, they must be

realistic when it comes to the question of whether their pensions can be properly funded

in the future. One remedy may be the one I suggested to the Illinois city—the use of

Section 3651 in a Chapter 9 Bankruptcy to alter a municipality’s pension plans.

 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
4

Chapter 9 of the Bankruptcy Code is unique in that it has few operating provisions of its

own. Chapter 9 specifies which provisions of Chapter 3, 5, and 11 apply in a

municipality bankruptcy case.2 In order to file under Chapter 9, state law must

specifically authorize a municipality to file a bankruptcy case.3 Each state has the right

to enact laws that govern a municipality’s right to file for bankruptcy relief. Some states

have very broad statutes, while some require approval from the governor of the state.4

Yet other states require a municipality to pass a law authorizing a bankruptcy filing by

that municipality. In Illinois, a municipality can file a petition under Chapter 9 if a

financial planning and supervision commission recommends the filing and permission is

granted by the governor.5

In my recommendation to the ad hoc committee member who had asked for my opinion

regarding unfunded pension obligations, I set fourth an outline of Chapter 9, how to use

it and what the necessary basic requirements are for the municipality in question to file

Chapter 9 and take advantage of the Federal Bankruptcy Code. A landmark case from

the United States Bankruptcy Court for the Eastern District of California clearly

illustrates that once a municipality files and is deemed eligible for Chapter 9, any state

law or constitutional provision that attempts to limit or circumvent the provisions of the

Bankruptcy Code is preempted.

In In re City of Vallejo, the Bankruptcy Court of the Eastern District of California was

faced with the issue of whether Chapter 9 permits a municipality to reject collective
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
5

bargaining agreements with its public employee unions.6 The City filed a Motion for

Approval of Rejection of Collective Bargaining Agreements.7 The Court noted that “by

authorizing the use of Chapter 9 by its municipalities, California must accept Chapter 9

in its totality; it cannot cherry pick what it likes while disregarding the rest.”8

Article I, Section 8 of the United States Constitution authorizes Congress to enact

uniform bankruptcy laws. Pursuant to Article VI of the Constitution, federal laws are the

supreme law of the land, and state laws to the contrary must yield. Thus, the Court

stated that California may not superimpose its labor laws and modify the provisions of

Chapter 9, specifically, Section 365 of the Bankruptcy Code.9

The Court went on to hold that unexpired collective bargaining agreements are

executory contracts subject to rejection under section 365 of the Bankruptcy Code, and

a municipality may reject an unexpired collective bargaining agreement if the

municipality shows: (1) the collective bargaining agreement burdens the municipality’s

ability to reorganize; (2) after careful scrutiny, the equities balance in favor of contract

rejection; and (3) reasonable efforts to negotiate a voluntary modification have been

made, and are not likely to produce a prompt and satisfactory solution.10 Although the

Court recognized the municipality’s right to reject an unexpired collective bargaining

agreement, the Court refrained from deciding whether the City had met its burden,

noting that the City was involved in negotiations with the unions.11 Thus, the City of

Vallejo opinion demonstrates that by filing for bankruptcy, a municipality will gain the
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
6

protections of Chapter 9 of the Bankruptcy Code, and restrictive state laws will be

preempted.

In light of this opinion, local governments have an option to restructure their pensions.

In Illinois, for instance, Article 13, Section 5 of the Illinois State Constitution prohibits

municipalities from altering pension plans.12 Article 13 states, “[m]embership in any

pension or retirement system of … any unit of local government … shall be an

enforceable contractual relationship, the benefits of which shall not be diminished or

impaired.13 However, the City of Vallejo opinion demonstrates that this aspect of the

Illinois State Constitution, insofar as it conflicts with Chapter 9 of the Bankruptcy Code,

is preempted. Assuming local governments are authorized by State statute or

otherwise go through the proper channels to get state authorization to file, local

governments may utilize the federal bankruptcy code to restructure their pensions.

Local governments must be careful, however, to go through the proper procedures for

obtaining state authorization to file.14

One distinct advantage of Chapter 9, and one of the major departures from Chapter 11,

is the limited involvement of the Bankruptcy Court while cities or other local government

entities are debtors under Chapter 9.15 As such, a mayor does not need to seek court

approval and obtain court orders to continue governing his or her city. Mayors do not

need to seek court approval to expend monies for municipal services.16 The Court, in

essence, does what it is asked to do. The Chapter 9 debtor does, however, need to
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
7

obtain court approval for the assumption or rejection of executory contracts and

unexpired leases and for confirmation of a plan of adjustment.17

Chapter 9 provides arrows in a quiver for negotiations and some real weapons to create

leverage for settlement. Under Chapter 9, a Bankruptcy Judge can review and reject

previous pension plans and can provide temporary and long-term relief for monies going

into the program. A bargaining power is created between the citizens represented by

the city or suburb and the unions or leaders which represent the public workers, forcing

them to be realistic in terms of either past, present or future pensions as well as a

reasonable payout.

This bargaining power is clear in the City of Vallejo opinion. When the City filed its

Motion for Approval of Rejection of Collective Bargaining Agreements, the collective

bargaining agreements affected by the motion involved the Vallejo Police Officers

Association (“VPOA”), the International Association of Firefighters, Local 1186 (“IAFF”),

the International Brotherhood of Electrical Workers, Local 2376 (“IBEW”), and the

Confidential, Administrative, Managerial and Professional Association of Vallejo

(“CAMP”).18 Prior to the hearing on the Motion, an agreement was reached between

the City and the VOPA.19 Further, an agreement was reached between the City and

CAMP. Thus, unions and public employee leadership may be more willing to negotiate

supplemental agreements given the prospect of having their collective bargaining

agreement rejected under the authority of section 365 in a Chapter 9 Bankruptcy case.
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
8

It is important to note that in order to utilize Section 365 under Chapter 9 of the

Bankruptcy Code and reject an unexpired collective bargaining agreement, the City

must engage in meaningful negotiations with the unions.20 Only after it is determined

that negotiation is unlikely to produce a prompt and satisfactory solution is a

municipality permitted to reject an unexpired collective bargaining agreement.21 This

too may make unions and public employee leaders more willing to engage in

negotiations.

Despite the Court’s blessing, the City of Vallejo decided not to reject its existing

collective bargaining agreements. Instead, the city is attempting to reduce costs by

being conservative in its new contracts. For instance, in an Opinion piece in the Wall

Street Journal, Steven Greenhut noted that, “the city did approve a new firefighter

contract that trims pension benefits for its new hires and requires existing firefighters to

pay more into their pensions.”22 Greenhut said that the Vice Mayor indicated, “[t]he

majority [of council members] did not have the political will to touch the pink elephant in

the room—public safety influence, benefits and pay.”23

Given the current economic climate, other cities may too consider the prospect of

Chapter 9, or may seek to bargain with Chapter 9 in the foreground. Traditionally, sales

tax and property tax have been the big revenue generators for municipalities.24 With the

state of the economy, consumer spending is down and property values have

plummeted. Thus, these traditional sources of revenue have not been sufficient to meet

municipal and other state government budgets.25

 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
9

Pennsylvania’s state capital, Harrisburg, is faced with more than $2,500,000 in loan

payments on an incinerator. City Controller Daniel C. Miller advocated filing a Chapter

9, but the city’s Mayor disagreed.26 The mayor was concerned that a bankruptcy filing

would make the city unattractive to future lenders.27 Similarly, Cari Tuna reported that a

Stanford University study indicates that the three largest state-operated public-

employee pension funds in California have more that a $500 billion shortfall.28 Similar

to the approach taken by the City of Vallejo, the Stanford approach recommended

scaling back pension benefits for future employees, increasing contributions, and

investing in less risky assets.29

Detroit, Michigan faces similar problems. With a sharp decrease in population and large

increase in unemployment, the city’s budget is far from balanced. A report published by

The Citizens Research Council of Michigan entitled “The Fiscal Condition of the City of

Detroit” indicated that “Detroit city government must be restructured…[t]he new

structure must reflect both the reduced tax base and the limited ability of state

government to provide shared revenues.”30

The Illinois legislature recently passed pension reform that seeks to address the

shortfalls of Illinois’ current pension scheme.31 Governor Pat Quinn signed the

legislation into law, which will take effect on January 1, 2011. As one commentator

appropriately noted, “[p]erhaps bankruptcy concentrates the mind.”32 Based on a report

by Charles Wheeler of the University of Illinois Springfield, the State of Illinois has
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
10

roughly thirty-five cents per dollar of money it needs to fund its pension plans.33 The

pension reform passed by the Illinois legislature will increase the retirement age from 55

to 67, reduce the highest annual pension from $391,000.00 to $106,800.00 per year,

and prohibit those receiving a public paycheck from concurrently receiving pension

benefits.34 However, these reforms only apply to new employee hires.35 Interestingly,

police and firefighters were not affected by the pension reform.36

There is sharp disagreement within the media regarding the above mentioned

legislation. A Chicago Tribune editorial points out that, although the legislation prevents

fiscal problems from arising in the future, the legislation does nothing to alleviate the

problems facing government today: “[t]he state [of Illinois] still has unfunded pension

and retiree health obligations of some $130 billion, and its current annual pension costs

don’t decline. Legislators need to cut those current costs before their session ends.”37

The editorial notes that lawyers disagree as to whether the state can alter current

employee pension benefits.

In light of this background and with all parties knowing their rights under Chapter 9 of

the Bankruptcy Code, discussion and consideration of what is fair and reasonable is

essential at the outset. The “I will not negotiate” mindset will not work when local

government is beset by extreme financial difficulties. Good will and fairness must

prevail. The best solution is for each side to negotiate and reach an equitable

settlement. Mediators who are knowledgeable in bringing parties together must be

employed so that the negotiation process can begin. If all parties know the framework
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
11

of Chapter 9 and the likely outcomes that will come from a Chapter 9 filing, a settlement

can be achieved at the outset, thus avoiding the expense of going through bankruptcy.

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1
Section 365 of the Bankruptcy code allows a debtor to assume or reject, subject to
certain limitations, an executory contract or unexpired lease. 11 U.S.C. §365. As
illustrated in the City of Vallejo case, unexpired collective bargaining agreements are
executory contracts subject to rejection under section 365. See Note 6, infra.
2
See 11 U.S.C. §902.
3
11 U.S.C. §109(c)(2).
4
H. Slayton Dabney, Jr., et al., Municipalities in Peril: the ABI Guide to Chapter 9, 16,
American Bankruptcy Institute, 2010.
5
See the Local Government and Financial Planning Supervision Act, 50 ILCS 320 et
seq.
6
In re City of Vallejo, 403 B.R. 72, 75 (Bankr. E.D. Cal. 2009).
7
Id.
8
Id. at 76, citing In re County of Orange, 191 B.R. 1005, 1021 (Bankr. C.D. Cal. 1996).
9
Id. at 77.
10
Id. at 78.
11
Id. at 78-79
12
See Ill. Const. art XIII, §5.
13
Ill. Const. art XIII, §5.
14
As one “municipality” quickly learned, Courts are all too eager to dismiss a Chapter 9
filing for failure to obtain the proper Illinois state authorization. See In re Slocum Lake
Drainage Dist. Of Lake County, 336 B.R. 387 (Bankr. N.D. Ill. 2006).
15
Municipalities in Peril, p. 24.
16
Id.
17
Id.
18
In re City of Vallejo, 403 B.R. at 74.
19
Id. at 75.
20
City of Vallejo, 403 B.R. 78.
21
Id. at 78-79.
 Chatz and Zaslavsky: How Chapter 9
Can Solve the Pension Crisis
12

22
Vallejo’s Painful Lessons in Municipal Bankruptcy, Wall St. J., March 26, 2010.
23
Id.
24
Municipalities in Peril, 3.
25
In July, 2009 for example, the Village of Washington Park filed a Chapter 9 petition in
the Southern District of Illinois. See In re Village of Washington Park, Case No. 09-
31744 (Bankr. S.D. Ill. 2009).
26
Romy Varghese, Harrisburg, Pa. May Miss Loan Payment Tied to Troubled
Incinerator, Dow Jones Newswires; Deborah Lynn Blumberg, Harrisburg Misses Bond
Payment – Insurer Steps in as Pennsylvania City Considers Bankruptcy, Wall St. J.
April 30, 2010.
27
Id.
28
Cari Tuna, Shortfall Awaits California’s Big Pension Funds, Wall St. J, April 5, 2010.
29
Id.
30
Leonard Fleming, Detroit Needs Drastic Change to Avoid Bankruptcy, Report Says,
The Detroit News, April 5, 2010.
31
See Ill. Public Act 096-0889, S.B. 1946, 96th Gen. Assem., (Ill. 2010).
32
In Praise of Illinois: Democrats Take Baby Steps on Pension Reform, Wall St. J., April
8, 2010.
33
Id.
34
Id.
35
Id.
36
See Ill. Public Act 096-0889, S.B. 1946, Section 10, 96th Gen. Assem., (Ill. 2010).
37
Editorials, Don’t Run From a Fight, Chicago Tribune, Section 1, p. 20, Sunday, April
18, 2010.