Is Chapter 9 the Best Resolution Mechanism for Financially Distressed Schools or Are There Better Alternatives? – PART ONE
Why Financially Distressed School Districts Have Wisely Chosen Not to File Chapter 9 Bankruptcy
by James E. Spiotto*
This is Part One of a 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’s Chicago Public School Task Force on March 31, 2016, and a link to that presentation is provided here. As will be noted in the article, while financially distressed school districts are few, they do exist mainly as a product of financial cycles, the financial distress of a region or industry key to a community or unfortunate financial planning. Generally the question of whether a school district in any area will face financial distress is dependent upon the economic health of the community and the accuracy of its financial plan.
According to the Department of Education, in the United States of America, there are approximately 13,500 public school districts for K through 12 consisting of about 98,500 public schools, including approximately 6,100 charter schools, over 50 million students and over 3.1 million teachers. This does not include 30,900 private school schools, K through 12. The cost of annual funding of the operations of the elementary and secondary public schools is estimated to be over $634 billion (school year 2015-2016) or an average of $12,605 per student for the 2015-2016 school year. This is about 20% of all state and local government tax revenues for 2015.
In the last 60 years, we have had nine economic downturns, with the last one being the great recession of 2008. Obviously, the economic cycle places financial stress on school districts, especially those where funding is dependent on real estate, sales, income or other tax sources and sometimes premised on increasing economic activity. The ebb and flow of the number and location of the student population and evolving technologies stresses the increasing need for updated facilities and infrastructure from fixed assets to computers. It should come as no surprise that a few schools in virtually every state from time to time are subject to financial, operational or academic distress that needs a quick and effective solution.
The question is continually raised whether Chapter 9 municipal bankruptcy should be considered as one of the alternatives for a financially challenged school district and whether other alternatives should be explored before Chapter 9 bankruptcy is considered as a rare last resort.
Experience has shown Chapter 9 has rarely been used by School Districts for good reasons
Chapter 9 is Rarely Used. As of March 31, 2016, there have been only 666 Chapter 9 filings since 1937 (322 since 1954, 297 since 1980). This results in an average of 8.5 filings per year since 1937. Generally, most have been small special tax districts and utilities that rarely need to issue public debt. Since 1954, 60% of all Chapter 9 filings have been municipal utilities and special tax districts. Further, only 18% of the Chapter 9 filings since 1954 have been cities, towns, villages and counties which represent about 44% of the over 80,000 municipal entities that could be authorized to file. In contrast, corporate Chapter 11 reorganizations have numbered over 10,000 a year for virtually every year since 1985.
Only Four School Districts in the Last 60 Years Have Filed for Chapter 9 and Half of Those Dismissed the Case for Other Resolutions. No school districts have filed for Chapter 9 in the last 20 years. Since 1954, only four school districts for elementary and/or high school have filed for Chapter 9 relief namely:
- San Jose School District, California (case dismissed without a Plan of Debt Adjustment (“Plan”) filed July 1, 1983, case dismissed May 8, 1984);
- Copper River School District, Alaska (filed 1986, confirmed Plan 1988);
- Richmond Unified School District (case filed in 1991 and dismissed in 1991 without a Plan); and
- Chilhowee R-IV School District Missouri (case filed in 1992 and confirmed Plan June 16, 1993).
One Reason for the Rarity of Chapter 9 School District Filings is that the Problems of School Districts are More Technical and Complex than a Debt Adjustment. School district problems can be financial, operational or academic. Chapter 9 is merely debt adjustment with a stigma on future access to and cost of borrowing which school districts need to make capital improvements.
Chapter 9 When Used by School Districts Has Been More a Tool for Consensual Resolution. For example, the experience of San Jose School District in 1983 after filing Chapter 9, the process helped focus the parties on a resolution which, once reached Chapter 9 was of no further benefit once teachers agreed to affordable contract. San Jose School District in 1983, after losing a labor arbitration with teachers, filed Chapter 9, paid its bond debt throughout and used Chapter 9 to renegotiate an unaffordable arbitration award into an affordable settlement with teachers and then promptly dismissed the Chapter 9. There was no benefit to it to continue to be in Chapter 9.
The Experience of Richmond School District Was that the Filing of a Chapter 9 Created More Issues than it Solved and There are Better Solutions. The Richmond School District filed for bankruptcy and threatened to close schools. The Chapter 9 debt adjustment process gave no power to the bankruptcy court to deal with operational or educational issues. Parents filed lawsuits to prevent the closing of any school resulting in the dismissal of the bankruptcy and a $29 million rescue loan from the state. Richmond School District has changed its name to West Contra Costa School District and has paid off its debt while benefitting from a supervised turnaround.
The Other Two Chapter 9 Filings in the Last 60 Years, Copper River and Chilhowee, Were Too Small and Rural to be Good Examples Especially for Large Urban School Districts. Copper River School District had only 511 students, 8 schools (6 schools at the time of filing), 37 full time teachers with a students to teacher ratio of 14 to 1. The school district covers 25,000 square miles including Wrangell – St. Elias National Park. In the Chapter 9 bankruptcy proceeding, Copper River School District filed to reject the teachers union contract due to an inability to pay salaries. In the Plan of debt adjustment, the salaries of teachers were frozen and significantly reduced. The results in a Chapter 9 may very well portray the limited resource of the school district without further increase of tax revenues. Chilhowee R-IV School District had 164 students with 2 schools, 20 full time teachers and an 8 to 1 students to teacher ratio. The Chapter 9 filing was caused by a judgment of $200,000 in favor of five former teachers against the school district. The school district had an annual budget of $650,000 in 1992. The school board had been assessing the highest levy that could be levied prior to the judgment, and the bankruptcy court ruled it was a good faith filing by an insolvent school district with little ability to pay or increase the levy for the school district. These rural school districts are no comparison to larger urban school districts and their problems.
No School District of Size in the Last 60 Years Has Used Chapter 9 to Successfully Address Its School District Problems. For any school district of size, bankruptcy has been viewed as the third rail of solutions, too simplistic a financial adjustment and not suited to address the multi-year oversight experience of school reform, especially as to operational and academic issues. This has been the experience of the multi-year local or state oversight in such school districts as: Philadelphia schools and its School Reform Commission since 2001, Los Angeles Unified School Districts and efforts for reform over the last two decades and issues of local control, the efforts of the Cleveland schools to reform schools, including 2012 legislation, Missouri legislation as used by St. Louis or Kansas City schools and use of oversight for school districts in New Jersey, the use of Emergency Manager for the Detroit District Schools in 2009 and Michigan Heights and Highland Park schools with an Emergency Manager in 2012, nine school districts in California that required emergency loans from the state including Richmond since 1990, or the use of financial oversight panels or independent or finance authorities in Illinois such as for North Chicago School District 187 Independent Authority, East St. Louis School District 189 FOP and Independent Authority, Proviso Township High School District 209 FOP, Cairo Unit School District #1 FOP, Hazel Crest School District 152-5 School Finance Authority and Venice Community School District #3 FOP and Round Lake Area School District #116 School Finance Authority, but, in all cases, no Chapter 9 municipal bankruptcy.
Chapter 9 municipal bankruptcy of a School District may threaten financial recovery of the community by raising concern about the education level of the workforce.
Education is One of the Pillars of Economic Development. Recovery is created by increasing economic activity such as business in the community which creates new good jobs. If the work force is appropriately educated to fill those jobs, businesses will expand and be attracted to the community. Chapter 9 may send the wrong message. Further, the stigma of Chapter 9 could prevent new business development and creation of new jobs for school district graduates. The financial distress of Chapter 9 translates into the community not being a place that business wants to expand to or new business wants to move into.
The Adverse Affects of Chapter 9 Could Reduce the Tax Base and Threaten the Needed Funding Source for Schools. Anything that impedes economic development and threatens raising taxes beyond the reasonable ability to pay and drains the full funding of essential services in the community may contribute to the increased likelihood that taxpayers will move out (like in Detroit, Bridgeport, Connecticut and elsewhere), reducing the tax base and funding source for schools.
Chapter 9 Could be a Distraction to Efforts for School District Reform and Recovery. Chapter 9 is time consuming, expensive, and uncertain, which can have a negative effect on the school district’s ability to address operational and academic issues as well as financial problems. Chapter 9 involves all creditors, those whose relationship is valuable and essential to public services and those that are an issue and should be addressed. Both creditors whose relationship is a benefit and those where it is not will have their creditor status reviewed and possibly adjusted, even when not specifically decided by the school district. It has been said Chapter 9 and the controversies that it can involve are all-consuming and may prevent the administration from being able to address promptly and effectively operational or academic concerns.
In Chapter 9, the Bankruptcy Court Has Limited Jurisdiction. Unlike Chapter 11, where the bankruptcy court has to approve any action taken by the debtor out of the ordinary course of business such as new financings, settlements with creditors, any significant change in business operations, creating or modifying product models and sale or transfer of assets, including fixed assets and intellectual property rights, in a Chapter 9, the bankruptcy court’s jurisdiction is limited to debt adjustment and the court cannot, without consent of the debtor, interfere with the municipality’s (school district’s) property, revenue, exercise of governmental powers or affairs. (Section 904 of the Bankruptcy Code). Further, the municipality and the bankruptcy court cannot impair or limit the state control of a municipality (school district), by state legislation or otherwise, in the exercise of governmental power including as to expenditures. (Section 904 of the Bankruptcy Code). As a result, the bankruptcy court would not have jurisdiction over operations or academics, important factors in any recovery plan for a school district. Accordingly, Chapter 9 is not designed to deal with a school district’s problem in a holistic manner.
Chapter 9 of a School District is a Cloud on the Community that Likely Will Prevent Progress
The Chapter 9 Cloud Prevents Development of Plans for the Future for Those Who Reside There and Those Who Are Interested in Moving There. The cloud of Chapter 9 leaves local businesses and residents concerned about staying. Not only the tax base for financial support of the schools but the future plans for business expansion by employers or development of new neighborhoods for graduates are delayed, threatened or impeded during and after a Chapter 9.
The Filing of Chapter 9 May Lead to Loss of Good Teachers, Employees and Students. The cloud of Chapter 9 may cause the best teachers and employees to seek employment elsewhere before the situation gets worse. Those with skill and ability are the most likely to find new employment elsewhere. Likewise, those students whose parents can will look for a better, more stable educational provider most likely in another community.
Businesses and Individuals Looking for a New Home May Look Elsewhere. No one looking to relocate will want to move into an ongoing and uncertain Chapter 9 bankruptcy of a school district. One of the major factors in the decision to locate in an area is the quality of the schools for both employers and employees.
Traditionally, School Districts, Which are of Vital Importance to Local Government are Refinanced and Restructured under Local or State Supervision
The Most Tried and Effective Means of Addressing School District Financial, Operational and Academic Issues are Outside of Bankruptcy on the Local Level. Generally, Chapter 9 is the wrong tool for the delicate job of correcting the troubles of a school district. Chapter 9 lacks the ability to bring new liquidity or tax revenues to the school district and the limitations on the bankruptcy judge’s jurisdiction prevents the court from dealing with operational and academic issues. Virtually all successful school district rehabilitations have been outside of Chapter 9 and have been, in essence, locally produced with support from the state.
The Ability to Replace Administrators or the School Board and to Adjust Budgets, Operations, Personnel and Academic Programs and Standards Locally is More Effective than the Bankruptcy Court’s Ability to Adjust Debt. A school district is not only a financial matter but, more importantly, an operational and academic one so that the power to change the administrators, board members, to institute best practices and eliminate waste and ineffectiveness, and to institute successful or needed curricula may have more beneficial effect than rearranging the pieces of debt. The ability of oversight on the local basis to approve or modify budgets, expenditures, hiring and firing practices, curriculum, operations and standards is a proven method of addressing a failing school problem. Chapter 9 can involve, by the limitations on jurisdiction of the court, none of these necessary actions.
School Districts Require the Ability to Borrow Funds at a Low Cost for Needed Capital Improvements and Interim Financing of Operations that Chapter 9 Adversely Affects or Limits. Generally, school districts must borrow funds from the capital markets to fund uneven tax collections and capital improvements necessary to maintain quality education. Chapter 9 is a financial stigma which can increase future borrowing cost by at least 1% to 3% annually. Any benefit economically of Chapter 9 is more than overcome by the increased cost of borrowing for large urban school districts. Assuming refinancing or borrowing $10 billion to be repaid in 20 years with a bullet maturity, a 2% per year additional interest cost means $200 million more in interest cost a year or a net present value of approximately $2.5 billion over 20 years at a 5% discount rate. That additional cost could make all the difference to a financially troubled school district.
[Part Two will follow in a future issue of MuninetGuide and will discuss alternatives to Chapter 9: State Monitoring, Oversight, Intervention and Refinancing, The Chicago School Finance Model from 1979 and the Local Government Protection Authority Model of the Civic Federation of Chicago].
* 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.