APPENDIX D. Bankruptcy Issues Analysis

Transcription

1 APPENDIX D

2 Page 2 NOSSAMAN, GUTHNER, KNOX & ELLIOTT, LLP MEMORANDUM TO: FROM: Thomas D. Long Allan H. Ickowitz DATE: RE: San Diego Unified Port District (the Port ) (File No ) - The following are the bankruptcy issues relating to the Orange County ( OC ) Chapter 9 bankruptcy proceeding and bankruptcy law generally that have been asked with respect to the UPD retirement system: 1. With respect to the OC bankruptcy, whether the retirement plan assets of the various government entities in the OC retirement system protected in the bankruptcy. 2. Also in connection with the OC bankruptcy, whether the various local entities that participated in the OC retirement system required to be signatories to the pension funding bonds that were issued following the OC bankruptcy. 3. More generally, what changes are needed to the existing agreements and laws governing the SDCERS handling of the Port s assets to assure that the Port s assets are protected in the event of a bankruptcy by the City of San Diego, SDCERs or both? Although additional research and analysis, including an extensive survey of bankruptcy authority other than developments during the Orange County bankruptcy case, should be undertaken, our preliminary analysis of the above issues is as follows: 1. The retirement assets in the Orange County Employees Retirement System (OCERS), which we assume was the principal retirement asset fund, were deposited into the Orange County Investment Pools ( OCIP ) established by the Orange County Treasurer as a vehicle for the pooling of deposited funds for investment purposes. OCERS is identified as a pool participant whose funds were deposited, invested and held by the OCIP. OCIP also received funds from a number of County and non-county agencies and entities including cities located inside and outside of the County. The County invested OCIP funds in what were described during the bankruptcy case a risky and volatile manner lacking in liquidity. In broad terms, the strategy involved leveraging billions of dollars to obtain cash for investments which Page 2 of 5

3 Page 3 included the use of reverse repos and the purchase of derivatives known as inverse floaters. In addition, the OCIP purchased long-term securities with short-term borrowings creating further risk. As a result of an increase in interest rates which caused the value of the collateral pledged to secure the OCIP portfolio to decline accompanied by corresponding collateral calls and threatened liquidation of collateral by brokers, the County and OCIP filed bankruptcy petitions. (The OCIP s separate bankruptcy filing ultimately was dismissed but the assets of the OCIP and related claims by pool participants were resolved through the County s bankruptcy case.) The funds deposited by OCERS and other pool participants were commingled in the OCIP (except for certain bond proceeds not relevant to the retirement system funds) with the funds of other pool participants as well as the County s own funds held for investment. Pursuant to the terms of a Comprehensive Settlement Agreement ( CSA ) which ultimately was included together with additional provisions in the County s bankruptcy plan of adjustment approved by the Bankruptcy Court in 1996, pool participants received their share of the reduced cash value of the total assets in the OCIP in the form of a cash distribution. (The treatment of school pool participants differed from that of non-school pool participants such as the OCIP OCERS in terms of the total realization and payment terms with respect to their claims.) As a result of the depreciation in the value of the OCIP s investments, the cash value of the pools assets declined to only approximately 79% of the total funds deposited in the commingled (non-bond proceeds) portion of the pools, a loss of approximately $1.5 billion. Under the CSA and plan of adjustment, pool participants received a cash distribution based upon their pro rata share of that reduced value together with additional payments under notes issues by the County as well as proceeds of OC s litigation claims against Merrill Lynch and other firms in connection with OCIP s investment activities and practices. The total package of cash plus ongoing payment obligations including payments dependent upon proceeds of the County s litigation relating to OCIP were to total 100% of their deposit amounts. Pool participants were given the option of accepting the cash plus payment package or opting to receive their pro rata share of the total cash value only and instead litigating their legal claims for losses against the County and proceeding against the County s share of funds in the OCIP if they prevailed. The Bankruptcy Court in the Orange County case rendered a decision in connection with the County s lawsuit against Merrill Lynch & Co., Inc. and affiliated companies for, among other things, damages resulting from the brokers role in the OCIP s investment activities. Although it did not affect the amounts actually recovered by investor entities in the County s bankruptcy case, the decision illustrates the risks inherent in commingling funds of pool participants, including OCERS, with each other as well as with funds belonging to the County itself. In In re County of Orange (County of Orange, et als vs. Merrill Lynch & Co., Inc, et als.), 191 B.R (Bankr. C.D. Cal. 1996), the Merrill Lynch parties asserted that the underlying transactions involved in the litigation were never property of the County and that, therefore, the County could not state a claim for relief with respect thereto. Specifically, Merrill Lynch argued that California Government Code ("CalGov. Code") requires that the County Treasurer, not the County, hold in trust all funds deposited by non-county participants in the investment pool (the "OCIP") and the trust nature of these funds is not destroyed by the County's bankruptcy filing regardless of the level of commingling of County and non-county Page 3 of 5

4 Page 4 funds in the OCIP, the solvency of the County, or the inability to trace the trust funds in the OCIP. The Merrill Lynch parties also pointed out that 11 U.S.C. 541, which establishes what property is deemed to constitute property of a bankruptcy debtor s estate, as well as other Bankruptcy Code provisions respecting the priorities of creditors in bankruptcy cases, do not apply to Chapter 9 bankruptcy cases in which municipalities are the debtors. As a result, Merrill Lynch argued, determinations of property rights are made exclusively under state law, in this case the California statute, CalGov. Code , which establishes that funds deposited by pool participants are held in trust. The Bankruptcy Court disagreed holding instead that the Bankruptcy Code provisions excluded from application to Chapter 9 municipality bankruptcy cases are not the exclusive bankruptcy law determining rights in property and that state law such as CalGov. Code is preempted by federal bankruptcy law which provides that the commingling of trust and trustee funds and the inability to trace funds may operate to defeat the trust character of the subject assets. The effect of the Bankruptcy Court s conclusion in the County case was to give the County a basis for alleging that the OCIP assets were the County s property for purposes of asserting the claims and counterclaims involved in the litigation against the Merrill Lynch parties. (Those claims involved issues respecting the legal effect of setoffs conducted by the Merrill Lynch parties under bankruptcy law and procedure which did not affect the issue of how the OCIP funds actually were distributed in the County s bankruptcy case.) Although the treatment of pool participants, including the OCERS, was the result in large part of negotiations, the outcome clearly was affected in part by the fact that funds paid into the pools were commingled not only among different participants but also between non- County participants, on the one hand, and County accounts, on the other hand. The outcome probably was affected by the argument raised by the County that the effect of this commingling could be a loss of any trust character of the funds and that assets remaining in the OCIP could simply be made available to all of the County s creditors with pool participants becoming merely unsecured creditors. An offsetting argument raised by pool participants during the bankruptcy case was that only the County should lose its share of the funds in the pools since it was the County s negligence and misconduct which caused the losses suffered by the pooled assets. 2. The provisions of the OC Plan of Adjustment do not impose an obligation upon OCERS or any local pension fund or system to become obligated on the pension funding bonds (covering OC s contribution funding obligations and actuarial requirement shortfalls) issued by the County. 3. The most preferable option would be to separate the Port retirement funds from the other SDCERS assets completely. There is some risk that such a transfer and separate maintenance going forward could be challenged to the extent that other interested parties could assert that the transfer at this time involves assets that had been commingled and in which they had an interest. The facts respecting the SDCERS assets even as presently constituted under existing ordinances and agreements expressly provide that the funds are held in trust solely for Page 4 of 5

5 Page 5 the benefit of retirees and separate and apart from the City s assets. Unlike the OCIP, the governing documents with respect to the SDCERS assets expressly provide for the funds trust status and are limited to pension assets rather than the mixed uses characterizing the OCIP. Unlike the OCIP, it appears that there are no general funds of the City or other agencies or municipalities commingled with the retirement system assets or those of the Port s retirement plan. To the extent that the Port continues to retain its assets within the SDCERS, the governing documents (and actual practices) should be amended to provide that Port funds will be segregated from any other funds, physically and for accounting purposes. While the status of SDCERS assets as trust assets in which the City has no beneficial interest or right should exclude those assets from treatment as assets of the City in the event of a bankruptcy proceeding in which the City of San Diego is the debtor, there is a potential risk to the beneficiaries of the trust if all of the funds therein are commingled. The general rule in bankruptcy cases involving trust property is that a claimant to a commingled trust fund bears the burden of ascertaining and tracing the trust property. If the funds are dissipated and cannot be traced, then the claimant stands in the position of a general creditor with regard to those funds. See, e.g, In re County of Orange; Orange County Investment Pools, 183 B.R. 594, 606 (Bankr. C.D. Cal. 1995); Kupetz v. United States (In re California Trade Technical Schools, Inc.), 923 F.2d 641, 648 (9th Cir. 1991). AHI Page 5 of 5