Insights

Rediscovering Chapter 9 as Financial Woes of Municipalities Escalate

Even though chapter 9 of the Bankruptcy Code has been in effect for more than 30 years, fewer than 200 chapter 9 cases have been filed during that time. Municipal bankruptcy cases—or, more accurately, proceedings involving the adjustment of a municipality’s debts—are a rarity, compared to reorganization cases under chapter 11. The infrequency of chapter 9 filings can be attributed to a number of factors, including the reluctance of municipalities to resort to bankruptcy protection due to its associated stigma and negative impact, perceived or otherwise, on a municipality’s future ability to raise capital in the debt markets. Also, chapter 9’s insolvency requirement, which exists nowhere else in the Bankruptcy Code, actually discourages municipal bankruptcy filings.

As the enduring fallout from the subprime mortgage disaster and the commercial credit crunch that it precipitated continue to paint a grim picture, portending hard times ahead for the U.S. economy, municipalities are suffering from a host of troubles. Among them are skyrocketing mortgage-foreclosure rates and a resulting loss of tax base, bad investments in derivatives, and the higher cost of borrowing due to the meltdown of the bond mortgage industry and the demise (temporary or not) of the $330 billion market for auction-rate securities (“ARS”), which municipalities have relied upon for nearly two decades to float inexpensive debt. The cost of borrowing in the ARS market has almost doubled since January 2008, according to the Securities Industry and Financial Markets Association. This confluence of financial woes is likely to propel an increasing number of municipalities to the brink of insolvency and beyond. This, in turn, may mean a significant uptick in the volume of chapter 9 filings. In anticipation of chapter 9’s emergence from relative obscurity, it is important to understand the mechanics that federal bankruptcy law provides for addressing municipalities’ financial problems.

Constitutional Conflict

Ushered in during the Great Depression to fill a vacuum that previously existed in both federal and state law, federal municipal bankruptcy law suffered from a constitutional flaw that endures in certain respects to this day—the Tenth Amendment reserves to the states sovereignty over their internal affairs. This reservation of rights caused the U.S. Supreme Court to strike down the first federal municipal bankruptcy law as unconstitutional in 1936, and it accounts for the limited scope of chapter 9 as well as the severely restricted role that the bankruptcy court plays in presiding over a chapter 9 case and in overseeing the affairs of a municipal debtor.

Chapter 9 Eligibility

Access to chapter 9 is limited to municipalities. A “municipality” is defined by section 101(40) of the Bankruptcy Code as a “political subdivision or public agency or instrumentality of a State.” Section 109(c) of the Bankruptcy Code sets forth other prerequisites to relief under chapter 9:

  • A state law or governmental entity empowered by state law must specifically authorize the municipality (in its capacity as such or by name) to file for relief under chapter 9;
  • The municipality must be insolvent;
  • The municipality must “desire[] to effect a plan” to adjust its debts; and
  • The municipality must either: (a) have obtained the consent of creditors holding at least a majority in amount of claims in classes that will be impaired under the plan; (b) have failed to obtain such consent after negotiating with creditors in good faith; (c) be unable to negotiate with creditors because negotiation is “impracticable”; or (d) reasonably believe that a “creditor may attempt to obtain” a transfer that is avoidable as a preference.

The municipal debtor bears the burden of establishing that it is eligible for relief under chapter 9.

Prior to 1994, the authorization requirement had been construed to require general authority, rather than specific authorization by name, for a municipality to seek chapter 9 relief. However, the Bankruptcy Reform Act of 1994 amended section 109(c)(2) to require that a municipality be “specifically authorized” to be a debtor under chapter 9. As the bankruptcy court explained in In re County of Orange, 183 B.R. 594 (Bankr. C.D. Cal. 1995), courts construing the amended provision have concluded that state law must provide express written authority for a municipality to seek chapter 9 relief and that the authority must be “exact, plain, and direct with well-defined limits so that nothing is left to inference or implication.”

As noted, no other chapter of the Bankruptcy Code includes insolvency among the criteria for relief. “Insolvency” in the context of chapter 9 eligibility does not refer to balance-sheet insolvency. Instead, it requires a showing that as of the filing date, the debtor either: (i) is generally not paying its undisputed debts as they become due; or (ii) is unable to pay its debts as they become due.

The dictate that a municipality “desires to effect a plan to adjust” its debts requires that the purpose of the chapter 9 filing must not be simply to buy time or evade creditors. A debtor need satisfy only one of the disjunctive pre-filing requirements set forth in section 109(c)(5), all of which are unique to chapter 9. The pre-filing negotiation requirements were inserted by Congress to prevent capricious chapter 9 filings.

Good-Faith Filing Requirement

Section 921(c) states, “After any objection to the petition, the court, after notice and a hearing, may dismiss the petition if the debtor did not file the petition in good faith or if the petition does not meet the requirements of this title.” No other chapter of the Bankruptcy Code expressly incorporates a good-faith filing requirement. If the court does not dismiss the petition under section 921(c), it “shall” order relief under chapter 9. Notwithstanding its permissive language, section 921(c) has been construed as requiring dismissal of a petition filed by a debtor that is ineligible for relief under chapter 9. Factors that may be relevant in determining whether a chapter 9 petition has been filed in good faith include:

(i) The debtor’s subjective beliefs;
(ii) Whether the debtor’s financial problems can be addressed by chapter 9;
(iii) Whether the debtor’s motivation for filing is consistent with the purposes of chapter 9;
(iv) The extent of the debtor’s pre-petition negotiations, if practical;
(v) The extent to which the debtor considered alternatives to chapter 9; and
(vi) The scope and nature of the debtor’s financial problems.

Standing alone, a municipal debtor’s refusal to impose or raise assessments or to borrow funds is not sufficient to warrant a finding of bad faith. Dismissal of a chapter 9 case is the only option if the debtor does not seek chapter 9 relief in good faith or cannot confirm a plan—the assets of a chapter 9 debtor cannot be liquidated involuntarily.

Bankruptcy Court’s Limited Role

Due to constitutional restrictions, the bankruptcy court’s role in a chapter 9 case is quite limited. Section 903 of the Bankruptcy Code expressly reserves to the states the power to control municipalities that file for chapter 9 protection, with the caveat that any state law (or equivalent judgment) prescribing a method of composition among a municipality’s creditors is not binding on dissenters. Section 904 further provides that unless the debtor consents or the plan so provides, the court may not “interfere” with any of the debtor’s “political or governmental powers,” any of the debtor’s property or revenues, or the use or enjoyment of its income-producing property. Thus, unlike a chapter 11 debtor, a municipal debtor is not restricted in its ability to use, sell, or lease its property (section 363 does not apply in a chapter 9 case), and the court may not become involved in the debtor’s day-to-day operations.

In addition, control of a municipal debtor is not subject to defeasance in the form of a bankruptcy trustee (although state laws commonly provide a mechanism for transferring control of the affairs of a distressed municipality). A trustee, however, may be appointed to pursue avoidance actions (other than preferential transfers to or for the benefit of bondholders) on behalf of the estate if the debtor refuses to do so. A municipal debtor’s ability to borrow money outside of bankruptcy is not limited by chapter 9, and the municipal debtor is not subject to the reporting requirement and other general duties of a chapter 11 debtor.

A chapter 9 debtor enjoys many of the rights of a chapter 11 debtor-in-possession but is subject to few of the obligations. Pursuant to section 901, many provisions contained elsewhere in the Bankruptcy Code are expressly made applicable to chapter 9 cases. These include, among others, the provisions with respect to the automatic stay; adequate protection; administrative priority or secured post-petition financing; executory contracts; administrative expenses; a bankruptcy trustee’s “strong arm” and avoidance powers; financial contracts; the formation of official committees; and most, but not all, of the provisions governing vote solicitation, disclosure, and confirmation of a chapter 11 plan. Chapter 9 expands the scope of the automatic stay to enjoin actions against officers and inhabitants of the debtor that seek to enforce claims against the debtor. Nonrecourse special-revenue obligations do not become recourse debt in a chapter 9 case, but liens securing such obligations attach to the chapter 9 debtor’s post-petition revenues previously dedicated to the obligation in question. Municipal leases that are subject to termination if the debtor fails to appropriate rent are not treated as executory contracts in a chapter 9 case. Only administrative claims are entitled to priority in a chapter 9 case—the remaining categories of unsecured priority claims specified in section 507(a) do not apply in chapter 9.

Section 1113 does not apply to chapter 9 cases. Thus, it is unclear what standard would apply (i.e., the standard in section 1113 or the less restrictive requirements in section 365) if a municipal debtor were to attempt to reject a collective bargaining agreement. Section 1114 is also inapplicable, although state law would presumably govern any proposed changes to the benefits of a municipality’s retired employees.

Plan for Adjustment of Debts

As with chapter 11, the raison d’être of chapter 9 is confirmation of a plan (either consensually or otherwise), but with one significant difference—a municipal debtor may not be liquidated in chapter 9. Only the chapter 9 debtor has the right to file a plan, and indeed is obligated to file a plan, either with its petition or within such time as the court directs. The confirmation standards are comparable to those under chapter 11. As in chapter 11, creditor claims must be classified under a plan, and at least one impaired class of creditors must approve the plan for it to be confirmed. Chapter 9 also incorporates the cram-down confirmation rules, including the requirement that a plan not “discriminate unfairly” and that it be “fair and equitable” with respect to classes of secured and unsecured claims. The “fair and equitable” requirement, however, offers scant solace to unsecured creditors in a chapter 9 case. The absolute-priority rule in section 1129(b)(2)(B)(ii) provides little protection when the debtor has no shareholders whose interests can be wiped out due to less than full payment of creditor claims.

Section 943(b)(7) of the Bankruptcy Code provides that a chapter 9 case can be confirmed only if it “is in the best interests of creditors and is feasible.” Unlike in chapter 11, where the test compares creditor recoveries under a plan to what they would receive in a liquidation, the “best interests” requirement in chapter 9 mandates that a proposed plan provide a better alternative for creditors than what they already have. This is often fairly easy to demonstrate. Because creditors cannot propose a plan, the case cannot be converted to a liquidation, and a trustee cannot be appointed, the only alternative to a chapter 9 plan is dismissal (discussed below). Outside of bankruptcy, there is little possibility that unsecured creditors will be repaid, especially if the municipality’s debt burden is too high to be retired by taxes. Any possibility of payment under a chapter 9 plan is often perceived by creditors as a better alternative. Even so, courts are likely to compare what creditors are to receive under a chapter 9 plan with what they could reasonably expect to recover outside of bankruptcy if they were to exercise their remedies under applicable nonbankruptcy law. As noted by the bankruptcy court in In re Mount Carbon Metropolitan Dist., 242 B.R. 18 (Bankr. D. Colo. 1999), to be feasible, “a plan should offer a reasonable prospect of success and be workable.” In assessing feasibility, the court must evaluate whether it is probable that the debtor can both pay pre-petition debt and provide future public services at the level necessary to maintain its viability as a municipality.

Dismissal

If the debtor cannot confirm a plan, the only option available to the court (and creditors) is dismissal of the chapter 9 case. Under section 930, the court may dismiss a chapter 9 case for “cause,” which includes unreasonable delay by the debtor that is prejudicial to creditors, failure to propose or obtain confirmation of a plan, or material default under a plan after it has been confirmed. If the court refuses to confirm the debtor’s plan (either on the first attempt or after giving the debtor additional time to modify the plan or propose a new one), it “shall” dismiss the chapter 9 case. Dismissal is appropriate even if the debtor is clearly insolvent and the creditors would be better off if the chapter 9 case were not dismissed.

Outlook

The present-day legislative scheme for municipal debt reorganizations was implemented in the aftermath of New York City’s financial crisis and federal government bailout in 1975, but chapter 9 has proved to be of limited utility thus far. Only a handful of cities or counties have filed for chapter 9 protection. The vast majority of chapter 9 filings involve municipal instrumentalities, such as irrigation districts, public utility districts, waste-removal districts, and health-care or hospital districts. In fact, according to the Administrative Office of the U.S. Courts, fewer than 500 municipal bankruptcy petitions have been filed in the more than 60 years since Congress established a federal mechanism for the resolution of municipal debts. Until this year, Bridgeport, Connecticut (pop. 138,000), was the only large city even to have attempted a chapter 9 filing, but its effort to use chapter 9 in 1991 to reorganize its debts failed because it did not meet the insolvency requirement. In 1999, mid-sized Camden, New Jersey (pop. 87,000), and Prichard, Alabama (pop. 28,000), also filed for chapter 9. Camden’s stay in chapter 9 ended abruptly when the State of New Jersey took over the failing city in 2000. Prichard confirmed its chapter 9 plan in October 2000. More recently, the City of Vallejo, California (pop. 117,000), filed a chapter 9 petition on May 23, 2008, claiming that it lacked sufficient cash to pay its bills after negotiations with labor unions failed to win salary concessions from firefighters and police. The San Francisco suburb became the largest city in California to file for bankruptcy and the first local government in the state to seek protection from creditors because it ran out of money amid the worst housing slump in the U.S. in over a quarter century. Orange County, California (pop. 2.8 million), is the other prominent municipality to have taken the plunge. Having filed the largest chapter 9 case in U.S. history and confirmed a plan in 2005, Orange County stands alone as the only large municipal debtor to have navigated chapter 9.

Even so, the only alternative to chapter 9 is restructuring by the municipality under applicable state law, which may be difficult and require voter approval. The ability to bind dissenting creditors without obtaining voter approval may make chapter 9 preferable. Thus, as the financial problems of municipalities continue to mount, there may be a significant surge in chapter 9 filings. To be sure, chapter 9’s utility in dealing with some of these problems may be limited. For example, to the extent that a municipality’s questionable investments include securities, forward or commodities contracts, or swap, repurchase, or master netting agreements, bankruptcy (and the automatic stay) will not prevent the contract parties from exercising their rights. Also, although a chapter 9 debtor can restructure its existing debt, new long-term borrowing at any kind of favorable rate of interest is likely to be problematic. Still, the suspension of creditor collection efforts and the prospect of restructuring existing debt may mean that chapter 9 is the most viable strategy for many beleaguered municipalities.

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A version of this article was published in the May and June 2008 editions of The Bankruptcy Strategist. It has been reprinted here with permission.

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