By Franklin C. Adams
In the face of ever-dwindling revenues and, in spite of the increase in cities filing for Chapter 9 protection in California and across nation, most municipalities would still prefer to avoid the formal filing of bankruptcy. The stigma of filing holds many back as do the financial consequences tied to such drastic action. Naturally, most municipalities look for alternatives to formal bankruptcy filing.
For years, experienced insolvency attorneys have used informal “reorganization” as a tool to resolve the financial distress of their private clients without putting them through the agony, expense and uncertainty that always accompanies legal proceedings. The same tools used in these “private” arrangements are also useful in the public arena.
Transparency is a term that is used a lot these days and means different things to different people. In the context of debt resolution it really means just that. A common reaction of creditors learning for the first time that they are going to be paid less or not at all is incredulity; they simply do not believe that the debtor cannot pay. That becomes the creditor’s reality. Until the debtor shows its true financial condition, the creditor will continue to believe that it could be paid more than what is offered.
As a result, the first strategy of a debtor, municipal or otherwise, is to educate its creditors as to the true financial condition. How this is done is critical. In most cases it is preferable that the debtor take the lead in making the explanations rather than using an accountant or attorney. However, this is not always practical. In some situations the disclosures that would be most useful to relieve the disbelief is also sensitive and damaging if disclosed to a competitor. In these situations it would be best to use a third party who has credibility to report to creditors without having to disclose sensitive information. Most of the time, however, the degree of insolvency and its causes are not sensitive and need to be disclosed.
The process of education will take some time for the creditors to both understand and emotionally “catch up” to the intellectual understanding of the facts. Some will grasp it sooner than others. In situations where a good rapport is established, the creditors themselves may have useful suggestions or alternatives not considered by the debtor and may provide better solutions than originally conceived by the debtor and its professionals.
After establishing the true reality of the situation, the next strategy is to establish a working, trusting relationship between the creditors and debtor. Depending on the past history between the parties, that path may be a short and relatively painless one or it may be long and very painful. In order to stay out of court, however, it is a necessary and essential step.
Over the past five or six years the “reality” that everyone has had to accept is that the current economic “downturn” has been steeper and longer in duration than most have ever experienced. In the early years, it was difficult for many to believe that things were actually as bad as they were and that it would be some time before things got better. Whether in 2008 or now, the parties have to reach some consensus as to external realities and how such realities are going to affect the anticipated restructuring. This will go a long way toward improving the relationship between all parties.
Once the different constituencies have been able to find some common ground as related to both the internal and external problems, the third strategy is to work toward resolution. The process will work best as the parties begin to “own” the problem. If the parties view the construction of a resolution as a team effort in which everyone has a stake then things begin to move fairly well from that point on. For these discussions to be successful it is key for everyone at the table give up something and generally it must be something significant. Until all parties involved believe that everyone else is sacrificing as much as they are, there will be no consensus and no plan. If the parties are persistent and honest then the chances of reaching an agreement are high.
In California AB 506 has introduced the element of mediation or neutral evaluation as a predicate to public entities filing bankruptcy. This is not a bad thing. Truthfully, however, the bankruptcy code has always required, as a predicate to be eligible for Chapter 9, that the entity demonstrate that it has negotiated in good faith or that such negotiations would be futile.
Often the use of a “neutral” or mediator helps facilitate the process described above and should be seriously considered. A mediator can be helpful in quashing a phenomenon of this process: the tendency of parties to walk away from settlement discussions or at least threaten to do so. No one who has ever participated in difficult negotiations is troubled by this; it is simply part of the process. Mediators can help get past these hurdles as well as many others that arise in the context of a mediated settlement.
The truly unique challenge in the bankruptcy realm that is faced by municipalities is the “political” overlay. Virtually all of the parties to a municipal fiscal crisis have constituencies to whom they report. The most visible are the elected city officials, city council, mayor, etc. The unions and the bond trustees all have people that they also represent and to whom they have fiduciary duties. All of this makes the mediation process doubly difficult. When the people at the negotiation table have reached an agreement, it is not the end of the process. The parties are required to look to their respective constituencies for approval. The same principles apply here as with the first strategy. Everyone needs to know the truth about the economic realities they collectively face. All will have to sacrifice something. It will not be easy.
These are difficult times. Those representatives who can muster the courage needed to face the truth head on, work honestly with their counterparts at the negotiation table and have the leadership skills to help their constituencies understand will be the true heroes in the municipal arena today. The alternative is the bankruptcy court where it will take longer and will certainly be more costly.
Franklin C. Adams is a partner of Best Best & Krieger LLP’s Business Services practice group and serves as the chief bankruptcy counsel within the firm. Mr. Adams’ 25 years of bankruptcy experience includes Chapter 11 debtor representation; creditor representation; Chapter 11 committee representation; and representation of bankruptcy trustees. Mr. Adams has participated as a panelist, speaker and presenter in numerous programs sponsored by local bar associations and Inland Empire Bankruptcy Forum regarding bankruptcy and insolvency issues. He has served as a member of the Mediation Panel for the Central District of California since 1996. He has received numerous awards from that group for his participation as a mediator in that program. Mr. Adams can be reached at Franklin.Adams@bbklaw.com