By David S. Kupetz, J.D. and Frank V. Zerunyan, J.D.
The COVID-19 pandemic continues to devastate the national and global economies. The economic impact from the pandemic will disrupt California’s fiscal condition and harm local government revenues this year and, potentially, for years into the future. In a letter addressed to the California Legislature, the State’s Director of Finance predicts a recession and “significant negative effects on state revenues.”
Most municipalities predominantly depend on sales tax, property tax, transient occupancy tax, documentary transfer tax, gas tax, parking user’s tax as well as licenses, permits, and fees. Politico, in a recent article, estimates the loss from these sources due to the pandemic to be about $7 billion in revenue shortfalls for California local governments over the next two fiscal years, assuming the “stay at home orders” are lifted by June 1. The article warns that this estimate can grow exponentially should the “stay at home orders” last through the summer and beyond.
The market is another critical indicator of vulnerabilities for state and local governments. Any new economic downturn may particularly exacerbate the vulnerability of California’s already challenged pension system. California’s Legislative Analyst’s Office (LAO) estimates the State’s unfunded pension liabilities to be a total of 93.1 billion ($59.7 billion at CalPERS and $33.4 billion at CalSTRS). Adding retiree health unfunded liabilities to this figure increases the total to nearly $200 billion. These are significant unfunded liabilities, which continue to grow due to changing market assumptions. Even before COVID-19, these organizations decreased their rate of return by .5%. If markets further constrict, local government budgets will have to fill the gap.
There were already many local governmental entities facing significant financial challenges pre-pandemic. As identified by the California State Auditor and spotlighted on the Auditor’s website, some of these pre-existing problems plaguing various municipalities include insufficient liquidity, excessive debt burdens, inadequate reserves, declining revenues, and unsustainable employee retirement and health care obligations. These problems existed during a sustained period of economic expansion. With the onset of a recession, without proactive action, many local public entities will be hammered by reduced revenue collections coupled with escalating pension and healthcare expenses.
The California League of Cities developed a study surveying its member cities in California. Roughly 170 cities responded to the survey reporting that by 2024 they will spend an average of 15.8 percent of their general fund on pensions. About 10 percent of the cities anticipated spending more than 21 percent of their general fund. All these predictions were before COVID-19. These unfunded liabilities do not include California’s bonded debt.
The “silver tsunami” in the state and the decreasing birth rates pose demographic challenges to these systems by increasing the number of retirees and decreasing the number of active workers to pay for higher pension costs. Stay at home orders for California’s most productive age workers further exacerbates the problem. A recent study by MIT scholars, published in the National Bureau of Economic Research Journal, quantifies this in terms of national GDP and proposes better social and economic outcomes with more “targeted policies.” Half of the State’s employer contributions to these state retirement systems come from local governments; therefore, California’s local governments are particularly affected by demographic shifts, effective workforce, current volatility in costs and investment returns.
The consequences of the pandemic make it imperative that California’s local governments, with limited tools to raise revenues or limited capacity to spend (constrained by the “debt limit” under Article XVI, Section 18 of the California Constitution and Proposition 4 “Gann Limit”), immediately focus on economic policy for the general public good. Local governments must tap existing state and federal recovery resources, which will most likely not be sufficient to close the gap. They must engage their unions, bondholders, retiree representative, CalPERS, financial institutions, service providers, plaintiffs in lawsuits, creditors, and other stakeholders. This engagement must focus on interests, must be collaborative to achieve a win/win negotiation frame to deliver local governments’ paramount mission of serving the public, especially in more vulnerable and underserved communities. Traditional competitive negotiation frameworks in these difficult times will only mean devastation for the public that local governments serve. A local government has a substantial chance of being subjected to a crisis by failing to agree. This fragility requires a different frame than the usual competition, self-interest, and political blame.
Local governments must develop policies and implement them to deal with unprecedented circumstances. Most likely, a vaccine is 12-18 months away. Negative impacts on sales taxes, hotel taxes, user fees, and other municipal revenue sources are certain. Moreover, with a recession probably already having been triggered, and considerable uncertainty regarding the timing of recovery, future years’ property taxes are also likely to be negatively impacted.
Immediate actions are needed by local governments to protect reserves, maintain essential services, and retain their workforce intact to the extent feasible. Without early and immediate action, many local governments will soon approach insolvency and then rapidly find that they are unable to pay debts when they come due. In this scenario, local governments may be unable to repay internal borrowings before the end of the year. While financial officers generally have immunity from personal liability, this protection disappears when there are known violations of the law. Moreover, local government officials cannot allow employees to come to work if they know the municipality will be unable to pay them.
Municipal officials must recognize that fund balances do not necessarily equate to available cash. The accuracy of underlying data (existing financial, budget information, audits, and other available material) is critical. The fundamental cash flow analysis is only as good as the underlying data and assumptions. City managers and treasurers must examine the danger of structural deficits burning through reserves.
The extent of federal and state assistance accessible for local governments is an ongoing issue. As of now, the municipal bond market has essentially frozen. For local governments that do not currently have a bank line of credit, obtaining one now may be difficult. Short-term borrowings may be possible through notes in anticipation of tax or other revenues (TRANs, RANs), or by internal borrowing from pooled cash. In both cases, the impact of COVID-19 on revenues may impede or limit these potential short-term fixes.
The pathway forward requires that local governments:
- Evaluate significant sources of revenue and expense categories to understand vulnerabilities (another factor to consider is the unemployment rate);
- Pinpoint major revenue streams at risk, identify anticipated timing of impacts, discuss available options, and focus on cash collections;
- Consider effects on General Fund (reduction of sales tax, TOT, impact fees, and facility usage, the potential reduction in assessed values, and likely CalPERS losses and increases in future unfunded liabilities), Enterprise Funds (reduction in commercial usage, no shut-off enforcement, decrease in new connections, “stay-at-home” orders and reduction in usage fees, and Successor Agencies (potential decrease in assessed value and reduction of future tax increment);
- Build consensus within governing council, commission, or board that early action is a necessity, not a choice;
- Initiate discussions with labor unions and other key creditor stakeholders, including opening the books and recognizing the impact on revenues during the pandemic and in the post-pandemic era; and
- Determine how to provide first-response services in the event of inability to fund staffing.
Upon establishing policy, identifying potential impacts, and meeting with labor groups and other key creditor groups (if any), local governments should be prepared to take early action, including:
- Placing contracts not critical to the government’s mission on hold;
- Reducing capital spending;
- Having local businesses jump in to cover the gaps in services where possible and economic; and,
- Reducing personnel costs, such as by eliminating leave cash-outs, placing planned wage increases on hold, and considering implementing furloughs and, as a final resort, layoffs of non-essential positions.
Local public entities facing severe financial straits must explore, debt restructuring, moratoriums, and adjustment as potential solutions. Such exploration takes place in the shadow of the resolution of last resort: Chapter 9 of the Bankruptcy Code. However, the initial focus should be on accomplishing the necessary restructuring outside of court. As part of attempting to successfully negotiate, resolve issues, and achieve an out-of-court restructuring, local governments must:
- as discussed above, evaluate cash flow, finances, and availability of unrestricted funds and develop financial and operational plans;
- commence discussions with key stakeholders (the reality of a potential Chapter 9 filing encourages negotiation and creates leverage for an agreement);
- prepare the outlines of a possible Chapter 9 plan of debt adjustment or term sheet (to help facilitate negotiations and make use of the leverage); and
- retain experienced professionals to provide guidance and representation.
Under constitutionally framed police powers, local governments may use fiscal emergency declarations constructively. The Contracts Clause under the U.S. and State constitutions ordinarily precludes contract impairment. However, the Contracts Clause does not bar a state or municipality from enacting its legislation impairing municipal contracts if required by a financial emergency.
The four factors required for legislative impairment of contracts include:
- There must be an actual emergency from which the contract modification arises.
- There must be a public interest at stake.
- The modification must be tailored to the emergency.
- The modification must be temporary and limited to the extent necessary to address the crisis.
The U.S. Supreme Court has said that a contract impairment may be constitutional if it is reasonable and necessary to serve an essential public purpose.
Local governments can constructively use a fiscal emergency declaration to commence, promote, and positively leverage negotiations with labor and other key stakeholders. However, any non-consensual modifications that arise out of a fiscal emergency declaration are temporary and, therefore, would not address long-term systemic problems such as unsustainable pension and retiree health care obligations.
Chapter 9 provides a framework for eligible governmental entities to restructure debt. While Chapter 9 is federal law, state law governs the gateway to Chapter 9. For example, California law (AB 506) requires municipal debtors to engage in “neutral evaluation” (mediation) before being eligible to file for Chapter 9, except in the case of a declared statutory fiscal emergency under AB 506. The likelihood that payment and other obligations will be suspended during the chapter 9 case and reduced and/or modified under a Chapter 9 plan can create significant leverage that can lead to negotiated changes that may be adequate to allow the local public entity to avoid Chapter 9.
The mediation process allows “confidential” negotiations out of court and within the exceptions of Brown Act. It provides a format for attempting to shape perceptions of liquidity and feasibility of go-forward plans. If an agreement is reached with some or all key creditors, Chapter 9 may be avoided or made more efficient if still necessary. AB 506 was enacted after the Chapter 9 filing of Vallejo, and Stockton first used the mediation process before its Chapter 9 filing. In contrast, San Bernardino discovered it was out of cash, could not negotiate with creditors, declared a fiscal emergency, and entered Chapter 9. Unlike in Chapter 9, there is no automatic stay of litigation or other creditor action as part of the AB 506 process and, accordingly, where an immediate stay is needed, the mediation process will not be a viable option.
Chapter 9 is designed to enable a municipality that is unable to pay its debts as they come due to continuing to provide essential services to residents while working out a plan to adjust its obligations. To avoid disruption of necessary services, Chapter 9 facilitates the continuance of insolvent municipalities rather than their dissolution. Not unlike Chapter 11 bankruptcy reorganization for non-governmental entities, two primary benefits of a Chapter 9 filing are (1) breathing spell imposed by the automatic stay, and (2) the ability to adjust creditors’ claims through the planning process.
To avoid the point of a fiscal emergency post COVID-19, and to address their budgetary challenges, local public entities must act proactively. If a proactive approach is not taken in time or is not sufficient, it may become necessary for a local public entity to engage in debt restructuring. Debt restructuring should be conducted outside of court if possible, with Chapter 9 lurking in the shadows and only entered as a last resort. Most importantly, in these times of fiscal distress, local governments must govern. Governance requires a different mindset with collaborative efforts to search for the common good.
David S. Kupetz is a partner in the law firm, SulmeyerKupetz. He is an expert in municipal debt adjustment, business reorganization, restructuring, bankruptcy, and other fiscal crisis solutions and related litigation. email@example.com
Frank V. Zerunyan is a Professor of the Practice of Governance, Director of Executive Education, and Director of USC Reserve Officer Training Corps (ROTC) Programs at the University of Southern California Sol Price School of Public Policy. firstname.lastname@example.org
- Acemoglu, D. Chernozhukov. V et al. “A Multi-Risk SIR Model with Optimally Targeted Lockdown” NBER Working Paper no. 27102April 2020.
- Duzert, Y. and Zerunyan, F.V. Newgotiation for Public Administration Professionals, Vandeplas Publishing-2019
- California Constitution Article XI, Section 7
- Sonoma County Organization of Public Employees v. County of Sonoma, 23 Cal. 3d 296 (1979).
- United States Trust Company of New York v. New Jersey, 432 U.S. 1 (1977).
- California Government Code section 53760