Is Chapter 9 the Best Resolution Mechanism for Financially Distressed Schools or Are There Better Alternatives? – PART TWO
STATE MONITORING, OVERSIGHT, INTERVENTION, REFINANCING AND, IF NECESSARY, DISSOLUTION OF FINANCIALLY DISTRESSED SCHOOL DISTRICT
by James E. Spiotto*
This is Part Two of the two part series on the alternatives available to a financially distressed school district. This series is taken from a presentation to the Civic Federation of Chicago in March of 2015 and a link to that presentation is provided here. You can also click to view Part One.
Oversight and Refinancing as an Alternative to Chapter 9 Municipal Bankruptcy. Generally, each state provides for a variety of monitoring, oversight, intervention, refinancing and, if necessary, take-over or dissolution of a distressed school district as an alternative to Chapter 9 and as the preferred and intended means of rehabilitating and assisting a school district. While each state may by its statutes and regulations fashion its own formula to address distress, there are some common themes. Most states provide for periodic monitoring of financial, operational and academic performance of a school district following by increased oversight and development of a rescue plan if necessary.
The Evolving Intensity of School District Oversight. Based on the results of monitoring, some states establish a watch list or group for further oversight on the local, county or state level with review of budgets and operations with outside advisors or assistance from local or state agencies. If the situation is not corrected, the oversight and review becomes more intense, with the use of loans, grants and refinancing to address liquidity issues, and with the ability to prohibit non-salary expenditures, cancel purchase orders, require interim or additional financial reports or development of a recovery plan, often with the assistance of external or state consultants or advisors, all subject to school board and superintendent approval. If those efforts are not successful, then a more hands on approach of the state replacing the superintendent or even replacing the school board, or consolidating or dissolving the school district, may be considered.
For the Most Part, States Have a Solid Track Record of Success Dealing with Troubled School Districts, Many Times Building on the Interactive and Collaborative Review and Oversight Process They Have Developed. This is Best Demonstrated by a Quick Review of a Few Approaches Taken by Some States
California Approach. California has a multi-tiered process (Cal. Educ. Code § 1240 et. seq. and § 42131 et seq.) of (a) proactive monitoring of periodic reports and fiscal operation policy, (b) support of technical advisors on local and state level, (c) financial management, from oversight to assumption of financial management and control over the local school board with the possibility of financing additional funds as needed, and (d) state administrative control, where the school board is advisory, with the state assuming leadership of the school duties with a state appointed administrator and the ability to make emergency loans from the state general fund. All of this is aimed at avoiding bankruptcy and replacing ineffective management.
Ohio Approach. Ohio passed legislation in 2007 and 2015 (Ohio Revised Code § 3302.10) that reflects increased intervention efforts of states over school districts in distress. In 2007, Ohio established an academic distress commission to be triggered when the academic performance of the school district is low. There is normally a direct correlation between financial, operational and academic distress. The academic distress commission, once estimating poor academic performance, assists the school district. The five-member commission has three members appointed by the state superintendent and two by the president of the local school board, with the chair designated by the state superintendent. The commission must adopt a recovery plan and has some additional managerial power such as reassigning or appointing school administrators, terminating contracts, developing a budget, but these are permissive powers, not mandatory. The commission exists to assist the school district in developing a recovery plan. The local elected president and school board remain in place so there is potential tension between the board and the commission. The 2015 legislation gave the commission more power by allowing the commission to appoint the district’s chief executive officer (“CEO”) with this CEO having full managerial power and control. It reduced the local school board appointments to the commission to one from two. Further, the commission will be responsible for expanding higher quality schools with additional funds being available from the state.
Illinois Approach. In Illinois, the approach is more ad hoc and local in nature through the Illinois State Board of Education (105 Ill. Comp. stat. 5/1B-1 et seq.). Annual financial information is required with evaluation of the categories of risk. The State Board of Education can investigate and determine if a school district is in financial difficulty. (105 Ill. Comp. Stat. 5/1A-8(b)). For school districts in cities of 500,000 or more inhabitants (Chicago) if the State Board of Education finds the district to be in financial difficulty it sends a letter to the Governor and the Mayor of the city. For school districts of less than 500,000 inhabitants, the State Board of Education can provide further monitoring in oversight including requiring a financial plan and required compliance as follows. The lowest category is Financial Watch. Distressed school districts are given technical assistance to determine whether a deficit reduction plan is necessary. If the district does not follow its plan or is still at risk, then the state may seek a financial oversight panel (“FOP”). While the school board remains in operation, the FOP may approve or veto all financial decisions. The FOP can petition the state for emergency grants and loans if needed. If the FOP is not successful, the state can take stronger action such as consolidating or dissolving the school district or a more direct role in the management of the school district with a school financial authority or independent authority, which would include financial, operational and academic oversight. A school district with less than 500,000 in population that have been certified by the State Board of Education to be in financial difficulty is prohibited from incurring debt unless and until the State Board approves the district’s financial plan.
Conclusion. Accordingly, while states may vary in approach, there is an almost universal recognition that schools are so important and of such a sensitive nature that state and local monitoring, oversight, refinancing and recovery assistance has generally proven to be the effective means of resolution especially compared to the virtually never used Chapter 9 alternative.
The Chicago Public School Finance Authority
Creation of SFA. In the wake of the Chicago Public School’s (“CPS”) 1979 financial crisis, the State of Illinois created the Chicago School Finance Authority (“SFA”). The SFA was directed to exercise financial control over and furnish financial assistance to the Chicago Board of Education. The goal stated in 105 ILCS 5/34-102 was to provide a secured financial basis for the continued operation of Chicago’s public schools. In the thirty years of its existence, the SFA issued over $1.1 billion in bonds and $1.4 billion in refunding and defeasance transactions.
Governance and Responsibility of SFA. The SFA, with a board of five directors appointed by the Governor of Illinois and the Mayor of Chicago, had the power to issue bonds for CPS expenses and then levy a separate property tax for the debt service. The principal responsibility for the education policies of the public schools remained with the Chicago Board of Education.
Financial Oversight of SFA and Transfer of Control. In addition to its bond and tax levy authority, the SFA was also charged with approving the budgets, financial plans and contracts submitted to the Board of Education. The bulk of this review took place during the 1980s and 1990s. In 1993, the Illinois General Assembly expanded the SFA’s financial review duties to include an independent management assessment and audit in response to growing budget deficits. Once control of the Chicago public school system was transferred to the Mayor of Chicago in 1995, the actions of the SFA primarily involved administration and oversight of its outstanding bonds.
Transition from SFA. Illinois statutes state that the SFA will dissolve one year after all of the financial obligations incurred by SFA have been fully paid, discharged or otherwise provided for. SFA discharged its remaining debt on June 1, 2009. Upon dissolution of SFA in 2010, all the rights, assets and property of the SFA were transferred to and vested in the Chicago Board of Education (105 ILCS 5/34A-604). The statue also required liability insurance for the board members to be maintained for an additional two years past the date of dissolution (105 ILCS 5/34A-602). The SFA levied its final property tax in tax year 2007, payable in 2008.
What is the Best Mechanism for Addressing a Financially Distressed School District Like Chicago Public Schools – Chapter 9 – Municipal Bankruptcy, Another Chicago School Finance Authority or a version of the Local Government Protection Authority?
As Noted in Part One of this Series, Chapter 9 for School Districts is Rare for Good Reasons.
These reasons include the following:
- No Interim Financing. The bankruptcy court is limited in its jurisdiction. It has no ability to provide additional needed interim financing and loans and grants. DIP financing requires assured source of repayment and generally school districts in financial difficulties have picked all the low hanging fruit and have used their tax authority up to its legal or practical tax limit. What is needed is state legislation for increased debt and tax limits and providing new vehicles for interim financing to keep the school operating and fund the restructuring and recovery.
- A Bankruptcy Court Has No Control Over Operations, Academics or the Basic Causes of the Systemic Problems of a School District. Chapter 9 is a process of debt adjustment and not a solution to systemic problems. Generally, unaffordable debt is a symptom of financial distress and not the root cause. Bankruptcy courts, given the limitation of jurisdiction under the federal bankruptcy code, have no power over the revenue, property or governmental powers or affairs of the school district, namely operation, purchasing, personnel, academics, planning or supervision and implementation of decisions. Accordingly, Chapter 9 is ineffective in addressing operational, hiring, firing, contractual, structural, logistical and educational problems. However, the reductions of debt provided by Chapter 9 do give the school district more time or runway to develop a recovery plan.
- The Stigma of Chapter 9. As noted in Part One, the use of Chapter 9 by a school district has consequences. There is a financial stigma in the capital markets, which normally includes increased borrowing cost when the school district can least afford it, and a cloud on the public perception of the economic future of the community and the school district so good teachers and employees who can find jobs elsewhere are at least tempted if not gone. Businesses in the community think twice about expanding and new businesses hesitate to move in given the school district’s problem may be reflective of the education level of the graduates, their future employees. Resident taxpayers who are concerned they are paying more for less consider moving to a better school district.
The Chicago School Finance Authority Was Successful Over Thirty Years Ago But Circumstances Have Changed.
In 1979 the Problems Were Financial and Not Necessarily Operational or Academics. In 1979, there was an accounting and financial crisis that required financial oversight and supervision as well as refinancing and financial support to keep the schools operating. There was not the level of teacher, operational and academic issues that have been raised or identified today.
The Powers of the School Finance Authority Were Limited and Not Intended to be a Holistic Approach.
First, SFA’s Purpose was Intended to be Financial. The SFA Statute was created for “sound financial structure”, “effective access to the private market to borrow short and long term funds” and “to promote financial integrity” for the continued operation of the schools. Questions of teachers hiring, retention, compensation and benefits, operational issues on number, type, location of schools, academic issues of structure, supervision and coordination of schools and future employment were not central to the legislation or problems of over thirty years ago. In fact, the SFA’s purpose was to provide financial supervision, oversight and discipline for the CPS.
Second, SFA Had No Authority Over Operations or Academics. There was no authorization over non-financial operations or academics. The limited focus was on approval of financial plans and budgets to ensure a balanced budget, financial credibility in the financial markets, best practices in financial affairs and financial management and continued ability to borrow needed funds through issuing bonds and levying taxes for continued operations. The Chicago Board of Education continued to have day-to-day operational control and decision-making of the schools subject to the financial oversight.
Third, SFA’s Authority was Limited to Financial Matters, Budgets and the Ability to Assure Funding of Operation to Levy Taxes and Issue Bonds with a Statutory Lien. SFA was intended to build financial credibility in the market place by establishing affordable and sustainable budgets with assured financial backup. Interestingly, the bonds issued by SFA had a statutory lien on the pledged revenues that were levied by the SFA to ensure payment of the dedicated revenues to the debt holders. This was intended to address any credit concerns of the financial marketplace. The debt issued by SFA was not the debt of the state, city or board.
The Civic Federation’s “Local Government Protection Authority” Offers a Holistic Approach to Address Systemic Causes of Financial Distress and Development of a Feasible and Sustainable Recovery Plan
LGPA. The Local Government Protection Authority (“LGPA”) provides a forum for a holistic approach to address systemic financial and operational distress in which the local government (school district), taxpayers, elected officials, the public employees and creditors (including vendors and public debt) can address issues relating to essential governmental services (education), to financial difficulties regarding costs, judgments, liabilities and post-employment benefits and payment structures and to ensuring essential services and needed infrastructure are funded at an acceptable level along with transparency to the public as to the affordability and sustainability of these services, costs and benefits as an alternative to Chapter 9. Link to LGPA presentation of Civic Federation.
Creation of Authority and Process for a LGPA Consist of the Following Necessary Steps and Procedures:
- Creation of Financial and Operation Oversight for a Distressed School District (“Authority”). LGPA legislation would establish an oversight authority for a distressed school district consisting of at least three trustees who would (a) provide financial and operational oversight of finances and operations including budgets, contracting, hiring and firing, performance of its educational mission to encourage financial and operational transparency and best practices and (b) assist CPS to develop a holistic, integrated and consensual (if possible) recovery plan that would resolve the systemic problems, be sustainable and affordable, assure financial and operational efficiency, provide needed improvements in educational services and infrastructure and resolve all issues of outstanding debt obligations.
- Phases of Authority’s Oversight Process is as Follows:
(a) Phase One: Initiation and investigation and determination of needed educational services, infrastructure and debt financing and, given projected revenues and expenses, what is sustainable and affordable (“Sustainability Determination”).
(b) Phase Two: Development of recovery plan (“Recovery Plan”) for the distressed school district consistent with the Sustainability Determination. The Recovery Plan should demonstrate the efficient and effective providing of educational programs and operational services at a level deemed acceptable that would provide educated students, who would be capable of being employed in needed and available jobs, as well as education curriculum matched to such job needs to encourage increase in business activity. Further, there will be creation of jobs (through economic development and stimulus and the job multiplier) and increase in GDP and tax revenue so that assurances can be given to creditors as to the recovery and increasing tax base for payment of the debt owed to the lenders.
(c) Phase Three: Presentation of Recovery Plan after creditors’ opportunity to comment, negotiate and raise objection to Recovery Plan proposals. If, through the Authority’s oversight and mediation, the desired agreement on a Recovery Plan cannot be reached by the distressed school district and the creditors, then the less preferred quasi-judicial determination and hearing stage would proceed, similar to Chapter 9. There would be creditor voting by affected class and the approval of the Recovery Plan by the Authority with any modifications or changes the Authority believes necessary to be consistent with the Sustainability Determination. The goal of the Recovery Plan and this process is a permanent resolution of the systemic financial and operational issues of the distressed school district in order to avoid the recurrence of the systemic problems of the past and to provide a fresh start.
- Authority’s Operations. The Authority shall consist of at least three trustees and a professional staff with experience in education, finance, government, accounting and governmental and financial restructuring sufficient to fulfill its mission. The Authority shall initially have an oversight and technical assistance function which, if not successful, would progress into a quasi-judicial function as final arbiter of open issues. The Authority shall be funded by its ability to levy taxes to fund debt financing and the Authority’s operations. It shall be completely independent of state, city, the distressed school district or any interested party.
- The Process.
(a) Initiation. Petition by the distressed school district or significant creditors (as defined in the legislation) that a governmental function emergency exists and one of the Trigger Events set forth in the legislation has occurred, such as the distressed school district has defaulted on a designated percentage of debt, cannot pay its debts as they will mature and will default within 6 months, or there is a serious irreparable harm to the health, safety or welfare of city and its residence due to the failure to perform by distressed school district. (See LGPA Civic Federation paper for suggested triggers). The Authority can request a response from the distressed school district if initiated by designated percentage of creditors. Within a short period of time, the Authority will decide if a governmental function emergency or government financial distress exists and if so the Authority will take jurisdiction. If the Authority takes jurisdiction, then it will immediately issue an order to:
(i) Stay all litigation involving the distressed school district or actions to obtain a preference by one creditor over others.
(ii) Schedule discussions, discovery, negotiations or mediation as the Authority deems necessary to first determine what debt and expenses of educational services are sustainable and affordable. The Sustainability Determination is to be made first and then the Recovery Plan, including debt adjustment determination.
(iii) Specify dates for hearing on sustainability and, if necessary, the process of voting on the proposed Recovery Plan and dates for hearing on objections to Recovery Plan.
(iv) Set dates when the Authority will make its determination of sustainability and ruling on Recovery Plan with any Authority-imposed modifications to the Recovery Plan.
(b) Authority Management of the Process. The Authority is to manage the collection of information necessary to the determination of sustainability of a Recovery Plan and supervise and facilitate negotiation, mediation and resolution of issues and development of a Recovery Plan. The process will start more like a financial oversight authority assisting and facilitating negotiations and resolutions of issues in a Recovery Plan. (Requires approval of: 13 week rolling budget, interim and long-term operational plans, expenditures and capital improvements as well as fostering mediation and resolution of issues). If agreement is not reached, the oversight turns to a quasi-judicial determination of issues binding on all parties with the power of the Authority to enforce its decisions on all parties in (state or federal, if possible) courts. The Authority consists of at least three trustees who would be designated as:
(i) The Chair who would preside over hearings and be the ultimate determination of designated matters and the Recovery Plan;
(ii) The Trustee for Mediation who would be in charge of supervising and establishing the procedures and rules for mediation and appoint a special master or the mediators to preside over mediation and settlements to be recommended to the Authority and parties in interest; and
(iii) The Trustee for Sustainability Determination who would be in charge of the Sustainability Determination process and the work of the professional staff of the Authority as well as disclosure of all necessary discovery and collection of information from the government and creditors necessary for the Sustainability Determination and the Recovery Plan.
The Authority is a blend of the benefits of a Financial Oversight Authority (such as Act 47 in Pa., Financial Control Board in N.Y. and Emergency Manager in MI) and Chapter 9 with expanded powers and no appeal. This strong medicine if agreement is not reached is intended to encourage early agreement to avoid a harsher judicial result.
(c) The Authority Shall Have the Power to:
(i) Subpoena or request information required to fulfill its mission from the sovereign or creditors.
(ii) Engage any professionals necessary to fulfill its mission.
(iii) Mediate and determine, if necessary, issues related to budget and appropriation, appropriate levels of governmental services, costs, taxes, pension funding and benefits to ensure sustainability during the process and ability of the distressed school district to pay its debts (as adjusted if necessary) and provide essential services to its citizens.
(iv) Encourage and approve settlements between the distressed school district and creditor groups or individual creditors.
(v) Recommend or approve interim financing and continued financing with, if necessary, super priority protection to ensure liquidity and funding during the process at the lowest borrowing cost possible. The Authority would be authorized to levy taxes dedicated to pay debt service and the costs of the Authority’s operations. The Authority may act as a conduit issuer of the debt. If necessary, the Authority would be the final arbiter in negotiating and obtaining necessary funding.
(vi) Recommend cuts in the distressed school district’s spending and tax increases as necessary for continued operation of the distressed school district.
(vii) Recommend mediation by the distressed school district and any creditor or creditor group and require attendance and participation of affected creditors.
(viii) Require update on mediation discussion with creditors and distressed school district, progress reports and status of Recovery Plan and resolution with creditors.
(ix) Recommend the approval or disapproval of contracts, expenditures, loan creation or elimination of certain positions or operations.
(x) Recommend staffing levels in relation to determination of sustainability and adjustment to staffing, hiring and compensation.
(xi) Recommend or require sale or other transfer of any asset, right or claim of distressed school district including privatization and lease.
(xii) Power under state law to enforce rulings and determination of the Authority in court including the power to authorize the filing of Chapter 9 to implement the approved Recovery Plan as a prepackaged or pre-negotiated Chapter 9 plan of debt adjustment with determination by the Authority that the requirements under the Bankruptcy Code to confirm the Recovery Plan as a plan of debt adjustment have, in its opinion, been met.
(xiii) Monitor compliance with the Recovery Plan to prevent financial distress from reoccurring.
(xiv) Take any other action necessary for the fulfillment of its mission.
(d) Authority to Encourage the Distressed School District and its Creditors to Resolve Matters Before Having to Issue a Ruling Binding on all Parties. The distressed school district and creditors are encouraged to use the process to quickly and effectively resolve their issues, develop a sustainable and affordable Recovery Plan that stimulates growth and development of business, provides for essential governmental services and the best return to creditors consistent with the Sustainability Determination. Only if the distressed school district fails to act in good faith or fails to reach agreement on a Recovery Plan shall the Authority rule and be the final word binding on all without the right to appeal.
(e) Recovery Plan. The Recovery Plan shall provide for:
(i) Consistent with the Sustainability Determination, the continued operation of the distressed school district at level of enhanced educational services to all that is acceptable and desired.
(ii) Payment of the debt (as adjusted, if necessary).
(iii) Any necessary modification, rejection, termination, renegotiation or replacement of contracts including educational programs and public workers pensions paid for by the distressed school district.
(iv) Justification of any reduction in services or adjustment of debt, the reinvestment in the educational services and matching student education with needed skills and courses to obtain jobs.
(v) Any other matters that the Authority or the circumstances may require to allow the distressed school district to alleviate the financial emergency and accept the Recovery Plan.
(f) Final Approval and Continuing Oversight. The Authority may require as a condition of its approval continued oversight of operation, budgeting, tax collection or any other matters as a post approval of the Recovery Plan. This continued oversight may be by a board or overseer selected by the Authority or by periodic reports to the Authority.
- Sovereign Immunity for Authority. Authority and its trustees, employees, agents and professionals shall all have global sovereign immunity from any claim or damage suffered.
- Enforcement and Implementation of the Recovery Plan as Approved by the Authority. If the Recovery Plan is approved by the Authority but not all interested parties or creditors have consented to it, the Authority may authorize the distressed school district to file a Chapter 9 proceeding with the Recovery Plan as approved being a pre-packaged or pre-negotiated plan and with consenting creditors bound to voting for that plan and with the limitation that only the Recovery Plan as approved by the Authority can be proposed as a plan of debt adjustment. The Recovery Plan and Sustainability Determination will provide a determination of what greater amount of consideration would be available to creditors. If all parties agree and the use of a prepackaged plan in Chapter 9 is avoided as an enforcement mechanism, accordingly, these would be more recovery distribution for creditors given the reduced costs of no Chapter 9. If parties do not all consent then the Recovery Plan, as approved by the Authority, would be a prepackaged plan in a Chapter 9 and there would be a lesser amount available to creditors if a prepackaged Chapter 9 plan would have to be pursued due to the stigma of Chapter 9, anticipated higher borrowing costs, anticipated delay, uncertainty and costs of a Chapter 9 and the lack of an universal creditor agreement on the path forward and the accompanying costs of implementation and coordination.
- Chapter 9 Municipal Bankruptcy is not a Practical Resolution. As previously noted, Chapter 9 is rarely used for school districts, with only 4 school districts filing for Chapter 9 in the last sixty years and none in the last twenty years, with the two larger ones being dismissed without a plan of adjustment being filed. Chapter 9 provides no new source of funds, no supervision, oversight or jurisdiction over revenues, operations, academics or exercise of a distressed school district’s power or use of its property. Chapter 9 has always been a last resort. Chapter 9 lacks a holistic approach to address a distressed school district’s financial, operational and academic issues.
- The Resurrection of the School of Finance Authority Could Be Helpful But Only Deals with Financial Issues. The SFA was designed to deal with financial supervision and oversight and not operational issues or academics. Accordingly, the resort to SFA may not be sufficient to fully address all the issues of the distressed school district. While the 1979 crisis for CPS was financial, the current crisis appears to be multifaceted, including financial, operational and academic issues that need to be addressed. An enhanced version of the School Finance Authority model with the expanded reach of the LGPA model may well be worth considering for a distressed school district.
- The Use of a Version of LGPA May Well Assist a Distressed School District like CPS in Addressing its Problems in a Holistic Mechanism. The use of an oversight authority under LGPA would allow financial, operational and academic issues to be addressed simultaneously and effectively. The Authority would promote transparency in budgets and financial information, encourage resolution of creditor issues by negotiation and mediation, determine what is sustainable and affordable and what is not, help promote best practices in educational programs and finance, and foster the development of courses and programs focused on the educational skills needed for jobs in the market place so students can obtain their desired jobs. If consensual resolution on issues and a Recovery Plan cannot be reached, then the Authority as a quasi-judicial entity would make binding decisions as to open issues and whether the Recovery Plan should be approved with possible modification as determined by the Authority. The Authority’s decision would be enforceable in court and, if consent of all major creditors to the Recovery Plan is not possible, the approved Recovery Plan will become a prepackaged or pre-negotiated Chapter 9 plan of adjustment to be confirmed by the bankruptcy court and thereby binding on all. A distressed school district that needs a permanent fix may achieve it through the use of LGPA rather than one of a series of band-aids through Chapter 9 or a limited school finance authority. This could be the best and most viable alternative worth considering for CPS and other school districts that are experiencing financial or operational distress.
The Final Word. The above examples of mechanisms for distressed school districts to address their financial, operational and academic difficulties are those that appear most promising. However, it is also important to note that, for a distressed school district like CPS, with skilled leadership and constructive cooperation by teachers and their unions, vendors and bondholders, a reasonable, feasible recovery plan can on a concensual basis be developed and implemented. While this consensual resolution may be the best and most desired mechanism, it is not the easiest or most assured. Accordingly, the consideration of other resolution mechanisms, as noted above, may provide the reality check necessary to assure one way or the other a quick, effective and appropriate resolution will be reached.
* James E. Spiotto is the Co-Publisher of Muninet Guide and a retired partner of Chapman and Cutler LLP as well as Managing Director of Chapman Strategic Advisors LLC. The views expressed herein are solely those of the author and do not reflect the position, opinion or views of Chapman and Cutler LLP or Chapman Strategic Advisors LLC.