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Henes: Top 5 Questions About the Central Falls, RI Bankruptcy

Yesterday (Monday), Central Falls, Rhode Island, the smallest city in the smallest state in the nation, commenced a chapter 9 bankruptcy case. On July 12, I wrote about the fiscal struggles of Central Falls, which largely are the result of large unfunded pension obligations.

Central Falls, like so many other states and municipalities, made retirement promises to its firefighters and police officers that it couldn't keep. As its pension fund will run out of money in October and as it was unable to reach an agreement with its police and firefighters' unions, Central Falls decided it had no choice but to file for bankruptcy and try to use chapter 9 to alleviate some its unsustainable pension obligations. It is unusual for a city to file for bankruptcy (since 1980, only 47 cities, towns, villages or counties have done so), but due to the issues facing Central Falls, which are the same issues being faced by many cities across the country, this chapter 9 bankruptcy case should be watched closely by governors' offices, mayors' offices and public unions.

As the chapter 9 bankruptcy of Central Falls is being watched, here are the top five questions to be answered.

1 - Will Chapter 9 Help Central Falls Fix its Fiscal Issues? Probably yes (if done right). Plain and simple, Central Falls has an unfunded public pension problem. In many ways, this problem is devastating to a community: The police officers and firefighters who protected Central Falls' citizens were made promises and relied on these promises.

Yet, Central Falls does not have the money to make good on these promises. As a result, Central Falls, its taxpayers and its retirees face a terrible conundrum and an impossible situation. When faced with this type of situation, discussions and negotiations are necessary to try to resolve the situation in a fair way. And Central Falls and its unions did try to negotiate a solution to this problem, but the negotiations were unsuccessful. Now that it has commenced a chapter 9 bankruptcy case, it can attempt to use the tools found in the Bankruptcy Code to solve its problem. This can be achieved in one of two ways.

Either Central Falls and its unions can negotiate a settlement in chapter 9 or Central Falls can ask the bankruptcy judge to impose a solution on the unions. As the latter imposes risks on both Central Falls (the bankruptcy judge may decide he or she cannot impose reductions to vested pension obligations) and the unions (the judge may decide that federal bankruptcy law allows him or her to impair the pension obligations to retirees), it would be prudent for the city and its unions to get into a conference room and work out their issues consensually. This is the beauty of bankruptcy. It creates uncertainty, risks and a forum for resolution, which often leads to negotiated and amicable results.

2 - Will Other Cities Follow Central Falls' Lead? Depends. Central Falls is not alone in its struggles to deal with unfunded pension obligations. States and cities across the nation face massive unfunded public pension obligations. These obligations, depending on rate or return assumptions made, range from $1 trillion to more than $3 trillion. (It is important that states and cities publicly disclose their unfunded pension liabilities.)

At the same time, cities and states are making their pension payments to retirees, as a result of structural budget deficits and requirements to balance their budgets (49 states are required to balance their budgets annually), states are cutting services dramatically and failing to fund their pension funds. While pension funds with decreasing assets are making payments to retirees, municipalities are failing to make contributions to the pension funds, thereby depleting the funds.

In other words, pension plans are paying out more money than they are bringing in.

As a result, many pension funds are at risk of running out of money in the relatively near future. As the day of reckoning gets closer, cities will need to either negotiate resolutions with their public retirees, cut services even more than they already have, increase taxes or commence chapter 9 cases (if their states authorize it). The result of the Central Falls chapter 9 bankruptcy may influence cities' decision making processes.

3 - Will States Protect Municipal Bondholders With Legislation? Some may. Last month, Rhode Island enacted legislation protecting municipal bondholders in the event of a bankruptcy filing by a city. Specifically, notwithstanding a bankruptcy filing, the legislation guarantees that bondholders will be paid in full. This was done to protect Rhode Island's ability to borrow without worrying about rates increasing due to a city's bankruptcy filing.

While the bond-market impact of a city's bankruptcy filing may be overblown, this legislation demonstrates that unfunded pension obligations, not municipal bond debt, need to be restructured to help states get back on strong fiscal footing. Other states attempting to address financial issues facing their cities may enact similar legislation to remove municipal bonds from the restructuring table.

4 - Does Chapter 9 Work? Maybe, maybe not. During the Great Depression, many municipalities were unable to service interest on their public debt. Voluntary readjustment negotiations frequently were productive, but often times a small number of holdout bondholders precluded the consummation of consensual workouts. Municipalities needed a mechanism to bind these holdouts, but the U.S. Constitution prohibits states from passing any "Law impairing the Obligation of contracts." As a result, the Municipal Bankruptcy Act, the precursor to Chapter 9, was enacted to deal with the holdout problem.

Today, municipalities are not facing a bondholder holdout problem. Today, municipalities are facing an unfunded pension obligation problem. Chapter 9 was not set up specifically to address this problem, although certain sections of the Bankruptcy Code (sections 365, 1113 and 1114) may provide municipalities with the tools to address it. Based on the initial reports about the Central Falls bankruptcy, it appears that we will find out if chapter 9 can help a municipality fix its unfunded public pension problems. If it doesn't, it may be time for Congress to amend chapter 9 to address today's problems.

5 - Are the Fiscal Issues Facing Cities Solely a Local Problem? No. As Rhode Island Gov. Lincoln Chafee stated, "this is not simply a Central Falls issue, this is a state-wide issue and even a national issue." States and municipalities make up 12 percent of GDP. As states and municipalities are struggling to deal with their issues and are cutting spending significantly, they are acting as a drag on the national economy and, due to layoffs, contributing to our stubbornly high unemployment rate. In addition, as public retirees rely on pension payments to live, if payments are cut, retirees will have less to spend, increasing the drag on the economy. At the end of the day, we are going to live with slow economic growth for some time. But with the cities' fiscal issues staring us in the face (not to mention the states' and nation's fiscal issues), it is critical that we address these issues holistically and comprehensively. This will result in short term pain, but it is the only real way to build the economic foundation for long term gain.

The Central Falls bankruptcy case is important to watch. Hopefully, it will allow Central Falls to resolve its issues in a fair way and get back on its fiscal feet. Many cities will be watching to determine if chapter 9 is a viable restructuring tool. If the Central Falls bankruptcy is successful, it could become a model for restructuring a municipalities' fiscal issues.

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Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP where he has led some of the most complex restructurings in the United States and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state and local fiscal issues.