Chapter Nine: What You Might Need to Know About Municipal Bankruptcies

by Lesley Anne Hawes May/June 2011
More and more, we hear news of the genuine risk of insolvency for some local governments, increasing the likelihood that some may seek relief under Chapter 9 of the Bankruptcy Code. Lesley Hawes’ article provides a general overview of Chapter 9 and its unique provisions applicable to municipal bankruptcies.

Economists all seem to agree that the Great Recession is over and the economy is growing again. Yet, unemployment remains high, tax revenues are still below pre-recession levels and demands on state and local government resources continue to increase. Unlike the budget deficits at the federal level, the budget deficits faced by state and local governments cannot be resolved by printing more money or going into debt. There is a genuine risk of insolvency for some local governments, increasing the likelihood that some might seek relief under Chapter 9 of the Bankruptcy Code. This article will provide a general overview of Chapter 9 and its unique provisions applicable to municipal bankruptcies.

What Qualifies as a ‘Municipality’ Eligible for Chapter 9 Relief?
Only a “municipality” may be a debtor under Chapter 9 of the Bankruptcy Code. A municipality is defined under the Bankruptcy Code as a “political subdivision or public agency or instrumentality of a State.” 11 USC §101(40). This definition includes not only cities, but also counties, parishes, towns, villages and boroughs. In addition, the definition includes public agencies such as school districts, transit districts and public improvement districts. These local agencies are equally or perhaps more likely to face insolvency and the possibility of bankruptcy with federal budget tightening. Conspicuously absent from the definition of a municipality under the Bankruptcy Code is a “state.” While an instrumentality of a state may be an eligible debtor, the states themselves are not as the Code is presently enacted.

Prerequisites to a Municipality Becoming a Debtor Under Chapter 9
The Bankruptcy Code prescribes the requirements for a municipality to be a debtor under Chapter 9. See 11 USC §109(c). In addition to the requirement that the debtor filing under Chapter 9 be a municipality as defined in the Code, the debtor must have express authorization to file a petition for relief under the Bankruptcy Code. For example, in California, a statute authorizes Chapter 9 filings by public entities. California Government Code §53760 states that: “A local public entity in this state may file a petition and exercise powers pursuant to applicable federal bankruptcy law.” In other instances, the governing body of the municipality may authorize the bankruptcy filing.

Another requirement is that the municipality is insolvent within the special definition applicable to municipalities. For the purposes of filing under Chapter 9, insolvency means that the municipality is not paying its debts as they come due or will be unable to pay its debts as they come due.

The municipality must also want to implement a plan to adjust its debts and must finally meet one of four of the following alternative tests: 1.) the debtor either has obtained an agreement to a debt adjustment plan with the majority in amount of claims of each class of creditors, 2.) the debtor tried to obtain a consensual debt adjustment plan supported by the majority in amount of claims of each class but failed despite good faith negotiations, 3.) the debtor was unable to negotiate with creditors to try to reach a consensual debt adjustment plan because it was impracticable to do so under the circumstances, or 4.) the debtor reasonably believes a creditor may attempt to obtain a preference in payment over other creditors, warranting the debtor’s filing.

Municipal Bankruptcies are for Debt Adjustment, Not Liquidation
The purpose of Chapter 9 is to allow a city or other public agency or instrumentality of a state that is in financial distress to obtain relief by adjustment of its debts through a plan approved by the majority of its creditors. Filing for relief provides the Chapter 9 debtor the same “breathing spell” that Chapter 11 debtors obtain through the Bankruptcy Code’s automatic stay of creditor action. There is no provision for a court or creditors to compel the liquidation of the municipality or its assets.

Limitations on Court’s Supervisory Role and Restraint on ‘Political’ Decisions
Unlike Chapter 11 cases, the supervisory powers of the bankruptcy court in a Chapter 9 proceeding are curtailed by constitutional limitations, specifically the provisions of the Tenth Amendment. Political or governmental powers of the municipality are left to the State to control (11 USC §903), and the bankruptcy court cannot “interfere with 1.) any of the political or governmental powers of the debtor; 2.) any of the property or revenues of the debtor; or 3.) the debtor’s use or enjoyment of any income-producing property” unless the debtor under Chapter 9 consents to the court entering such an order or the plan provides for such relief. 11 USC §904.

Automatic Stay and Assumption/Rejection of Executory Contracts and Leases
The provisions of §362 governing the automatic stay and relief from the stay are generally applicable in Chapter 9 cases, and Chapter 9 includes a special provision that expands the scope of the stay in municipal cases. Section 922 provides that the automatic stay in a Chapter 9 case also operates as a stay of actions against an officer or inhabitant of the debtor as part of enforcement of a claim against the debtor. However, under the same statute, the stay in Chapter 9 does not stay application of pledged special revenues to pay debts secured by those revenues.

Section 365 governing assumption and rejection of executory contracts and unexpired leases also applies in Chapter 9. The ability of the municipal entity to shed burdensome contracts, including labor contracts, is clearly a powerful attraction for a municipality facing disastrous financial circumstances. However, the provisions of §365 are subject to a special provision of Chapter 9, §929, concerning municipal leases, which are a common means of municipal financing.

Section 929 was added to the Code to provide that a lease to a municipality will not be treated as an executory contract or unexpired lease “solely” based on the fact the lease can be terminated if the debtor fails to appropriate rent. This provision recognizes that financial leases are a common part of municipal finance and are generally marketed and treated as debt obligations, although municipal law and practice may require an annual rent appropriation to be passed to fund the lease payments. This section ensures those leases will be treated as debt instruments as the parties intended.

Plan Confirmation or Dismissal
Section 941 of the Bankruptcy Code mandates that the debtor file a plan by the date set by the court if a plan is not filed concurrently with the debtor’s petition. Only selected provisions of Chapter 11 pertaining to the contents, provisions and standards for confirmation of a plan apply to a case under Chapter 9. Those incorporate provisions are listed in §901(a). To confirm a plan in Chapter 9, the debtor must prove that either all classes of claims have accepted the plan or are unimpaired (§1129(a)(8)) and that if there is an impaired class of claims, at least one impaired class has accepted the plan. The debtor also can seek to confirm the plan by a cramdown over the objection of a class of secured or unsecured creditors under the standards of 11 USC §1129(b)(1) and §1129(b)(2)(A) and (B). Section 1111(b) generally applies in Chapter 9 to convert debts that generally are nonrecourse to recourse status except that under §927, the holder of a debt against the municipality payable solely from special revenues is not treated as having recourse against the debtor generally so as to avoid revenue bonds as to which recourse is limited to a specific project becoming general obligations of the municipality.

There is no “best interests of creditors” test applicable to a Chapter 9 plan, and the feasibility standards under the plan confirmation provisions of Chapter 11 are not incorporated into Chapter 9. But the list of requirements for the court to confirm a Chapter 9 plan do include a requirement that: “the plan is in the best interests of creditors and is feasible.” The municipality must also obtain any electoral or regulatory approval that may be necessary as a condition to confirmation of the plan. If the plan is confirmed, then confirmation will discharge the debtor from debtors owed at the time of confirmation, except for those expressly excepted from discharge under the plan or any debts owed to an entity that, “prior to confirmation, had neither notice nor actual knowledge of the case.” The Code expressly authorizes the court to retain jurisdiction over the Chapter 9 case for as long as necessary for the plan to be successfully implemented. 11 USC §945.

Section 930 authorizes dismissal of a Chapter 9 case for “cause.” Section 930 identifies a list of non-exclusive factors constituting cause to dismiss the case, including failure to prosecute or unreasonable delay in the case, failure to propose a plan with the time limit set by the court or to obtain confirmation of the plan within the deadline set by the court and denial of confirmation of a plan by the court coupled with denial by the Court of additional time to propose a new or modified plan.

Summary
Municipal bankruptcies are similar to Chapter 11 reorganizations only without the possibility or threat of liquidation. Failed reorganization efforts in a municipal bankruptcy will result in dismissal of the case. There are a limited number of reported decisions involving municipal bankruptcies, and some of those limited number of decisions have been criticized by commentators. The limited body of decisional law makes it more difficult to predict how a court may interpret and apply the Code’s provisions in a Chapter 9 case but also offers the opportunity for creative arguments to be advanced based on the policies and purposes of the Code, the equitable considerations arising based on the debtor’s status as a governmental unit and arm of the State, and the special role the court must play in a municipal proceeding.


Lesley Anne HawesLesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies. Hawes is a regular contributor to the Monitor and other legal journals, and she has lectured for numerous organizations. She graduated Order of the Coif from University of Southern California law school and earned her undergraduate degree in political science magna cum laude from University of Southern California.

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