Chapter 9 – Bankruptcy of a Municipality

Several well-known cities across the U.S., including Birmingham, have elected or discussed bankruptcy as an option. However, municipalities seeking to avail themselves federal bankruptcy relief discover that they are not in the same position as corporate debtors. Instead, municipalities can only resort to the uncommonly-used chapter of the Code–chapter 9. While chapter 9 has been infrequently used in the past, the recent financial crisis and prolonging local governmental practices suggest that chapter 9 may become a more commonly utilized tool in the future.

Financial Problem

Perhaps the single largest problem facing municipalities is the growing shortfall in public pension funds. Unlike private pensions, public pensions are not regulated by the Employee Retirement Income Security Act of 1974 and, therefore, are not subject to the rigorous vesting and funding rules imposed by ERISA. See § 4(b)(1), 29 U.S.C. § 1003(b)(1). Similarly, public pension participants do not enjoy the protections of the Pension Benefit Guaranty Corporation. Thus, municipalities have been free to make their own choices about vesting, benefits, qualifications, and funding, which has resulted in several decades of increasingly rich benefits packages.

The accounting practices employed by municipalities have exacerbated the pension problem by incorporating unrealistic assumptions into contribution calculations. The magnitude of the current under-funding problem is worse than expected, according to several commentators. 

Eligibility for Chapter 9

A municipality’s access to the Bankruptcy Code is not unrestricted. Unlike a corporation that has a largely unfettered right to choose from a variety of chapters of the Code (i.e., chapters 7 and 11), municipalities are eligible to seek protection only under chapter 9 of the Code. 

Eligibility under chapter 9 can sometimes be complicated and often requires a fact-intensive inquiry. As an initial matter, access to chapter 9 is limited to a “municipaliy,” which is defined as being a “political subdivision or public agency or instrumentality of a State.” “Public agencies or instrumentalities of a State” refers generally to any state-sponsored or controlled entity that raises revenues through taxes or user fees to construct or operate public projects.

Section 109(c) of the Code also sets forth 4 requirements that the potential municipal debtor must satisfy:

  • It must be authorized by state law to file. 
  • Its must be insolvent; commonly analyzed on a cash-flow basis.
  • It must propose to a plan to restructure its debts. 
  • It must satisfy at least one of four of the following conditions: (a) have obtained the consent of creditors holding at least a majority in amount of claims in impaired classes; (b) have failed to obtain consent after negotiating with creditors in good faith; (c) have been unable to negotiate with creditors because negotiations are impracticable; or (d) reasonably believed that a “creditor may attempt to obtain” a transfer that is avoidable.  

In addition, section 921(c) of the Code provides that, “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.”

The structure and purpose of many projects financed using so-called “conduit” or “special revenue” financing has, in some cases, blurred the line between a private entity, eligible for chapter 11, and a municipality, eligible only for chapter 9. These public-private projects often create such a link to a public purpose or body, usually to gain tax advantages, that the clear language of the documentation and the expectations of the parties often is that the project is, itself a municipality.

For example, in a recent decision in In re Las Vegas Monorail Co., Case No. 10-10464 (Bankr. D. Nev. Apr. 26, 2010), a bankruptcy court found that, despite explicit language in the relevant documentation identifying the debtor as an “instrumentality” of the state—seemingly establishing itself as a municipality for purposes of chapter 9—such debtor was not actually a “municipality,” pursuant to applicable law.

More Lenient Bankruptcy Provisions

The Tenth Amendment of the United States Constitution guarantees that certain powers will be reserved to the States with respect to the management of their affairs. Chapter 9 recognizes this reservation of power and limits the bankruptcy court’s power to regulate the day-to-day activities and operations of a municipal debtor. For example, section 904 of the Code states that, absent the consent of the municipality, the bankruptcy court may not interfere with (a) any political or government power of the municipality, (b) any property or revenue of the municipality, or (c) any income-producing property of the municipality.

As a result of these restrictions, the bankruptcy court is not able to take certain actions in a chapter 9 case that it can take in other bankruptcy cases. For example, a bankruptcy court cannot appoint a trustee to operate the municipality or allow a secured creditor to force the sale of assets to satisfy the secured creditor’s lien.

A municipality also does not need the approval of the bankruptcy court to use, sell, or lease property during its chapter 9 case. Thus, if a municipality determines that it would like to buy or sell a piece of real estate or make a significant capital improvement to its roads or infrastructure, it may do so without needing to ask the court for authority. By contrast, corporate chapter 11 debtors need court approval and must follow special procedures to take any action outside the ordinary course of business, such as selling assets or buying significant items.

Additionally, unlike chapter 11 corporate debtors, which must obtain bankruptcy court approval to retain or pay professionals to assist with the administration of their cases, municipal debtors are not subject to the same restrictions. Instead, a municipality may retain any professional(s) that it wants to assist with a chapter 9 case, and those professionals may be paid their customary fees without the need to file applications with the bankruptcy court. One of the requirements for the confirmation of a plan of debt adjustment in chapter 9, however, is that all amounts paid by the debtor for services in connection with the plan have to be fully disclosed and reasonable.   See 11 U.S.C. § 943(b)(3).

Confirmation of a Chapter 9 Plan

The goal of chapter 9 is for the municipality to emerge with a successful plan of debt adjustment. In a typical chapter 11 case, the debtor has a limited period of time during which it has the exclusive right to file and obtain approval of a plan of reorganization or liquidation, after which creditors or other parties in interest may propose their own plan(s). In a chapter 9 case, however, only the municipality may propose a plan of adjustment and the municipality is not subject to any statutory time constraints relating to the filing and confirmation of such a plan.

The plan of adjustment, itself, is simply a document that provides for the treatment of the various classes of creditors’ claims against the municipality. The municipality must prepare a disclosure statement that describes the plan and related matters, and the disclosure statement is sent with a ballot to all impaired creditors with an opportunity to vote on the plan. In order to be confirmed, the plan of adjustment must be accepted by one half in number and two thirds in amount of each class of claims that is impaired under the plan.

In addition, chapter 9 contains several other requirements for confirmation of a plan, which include that: (a) the municipality must not be prohibited by law from taking any action necessary to carry out the plan; (b) all postpetition administrative claims must be paid in full; (c) all regulatory and electoral approvals necessary to consummate the plan must have been obtained; and (d) the plan must be feasible.

Importantly, the plan of adjustment must also be in the “best interest” of all creditors, which has been interpreted to mean that a chapter 9 plan of adjustment need only be better than other alternatives such as dismissal of a case.

If a municipal debtor’s plan meets all of the confirmation requirements, except that it has failed to receive the support of an impaired class of creditors, the bankruptcy court can still confirm the plan through a “cram down” of the dissenting class(es). In order to accomplish a cram down, the municipality must show that at least one impaired class has accepted the plan and that the plan is fair and equitable and does not discriminate unfairly among creditors. A chapter 9 plan is considered “fair and equitable” if the amount to be received by the dissenting class is “all they can reasonably expect to receive under the circumstances.”

The ability to “cram down” a dissenting class of creditors can be an important tool for a municipality, especially if it is facing a group of creditors that is being unreasonable in their willingness to compromise to reach a consensual plan.

Restructuring Debts Under a Plan of Adjustment

There are relatively few cases or examples of previous plans of adjustment that can be used to help understand how municipal debt may be restructured in a chapter 9 case. The differences between chapters and 11, however, provide some insight into confirmable solutions.

For instance, impairment under a chapter 9 plan is not constrained by objective considerations of valuation or the “absolute priority rule,” but rather involves the particular facts and circumstances of the chapter 9 debtor. In many instances, this can mean that holders of secured obligations will be subject to significant impairment, such as the imposition of nonmarket rates of interest, extended repayment terms, less than full payment of principal and interest, and other reductions.

In the context of litigation claims or judgments against a municipality, a payment plan extending many years into the future, sometimes without interest, may be an acceptable method of adjustment. See, e.g., In re Westfall Township, Case No. 09-02736 (Bankr. M.D. Penn., March 2, 2010) (approving plan of adjustment that reduced $20 million judgment to $6 million and paid judgment through quarterly payments over the course of 20 years, without interest).

In the context of unsecured debt obligations (such as general obligation bonds), significant impairment is possible. See, e.g., In re City of Columbus Falls, Montana, Special Improvement District No. 25, 26, 28, 143 B.R. 750 (D. Mont. 1992) (approving plan that provided for less than full payment of general obligation bonds); In re Sanitary & Improvement Dist. #7, 98 B.R. 970 (Bankr. D. Neb. 1989) (explaining that general obligation bonds are general unsecured claims, subject to impairment); In re City of Camp Wood, Texas, Case No. 05-54480 (Bankr. W. D. Tex. June 13, 2007) (approving plan of adjustment that impaired prepetition general obligation bond debt through (a) a principal reduction; (b) a new 20-year amortization schedule; and (c) a new interest rate of 5 percent).

Restructuring a debt in chapter 11 is a possibility, even if the municipality has the ability to pay the obligation in full, through additional taxation or other measures. See Sanitary & Improvement Dist. #7, 98 B.R. at 974.

However, there are certain limitations as to what a municipality can do through a plan of adjustment. For example, to the extent new debt instruments are proposed to be issued to holders of prepetition debt, such new debt instruments must comply with applicable state law, pursuant to section 943(b)(4) of the Bankruptcy Code. See, e.g., Sanitary & Improvement Dist. #7, 90 B.R. at 974‑75.

Protection of Special Bond Revenues

Chapter 9 expressly provides protection to creditors holding liens on special project revenues of a municipal debtor. For example, municipalities often finance special projects, such as water and sewer plants, with bonds that are collateralized with the revenues and fees earned by such projects. Section 928 of the Bankruptcy Code states that the “special revenues” from these projects remain subject to the liens of the bondholders in the specific projects. Accordingly, these revenues must be used to fund the necessary operating expenses of the special project and may not be diverted to support the general obligations of the municipality. In contrast, this limitation does not apply in chapter 11 cases, where liens on future, post-filing revenues generally terminate upon the commencement of a case, pursuant to section 552 of the Code.

Rejection of Collective Bargaining Agreements

One of the more powerful tools that a chapter 9 debtor possess is the power to assume or reject contracts. As a result, a municipality in bankruptcy can determine which executory contract it wishes to assume or reject. While the non-bankrupt party to a contract will be entitled to damages, such damages will be treated as general unsecured claims (a lower priority than secured or priority claims).

Because employee payroll compensation and other employee benefits typically make up a substantial portion of a municipality’s budget, some of the most significant contracts that a municipality must consider in any restructuring are collective bargaining agreements with unionized workforce. Although section 1113 of the Code has special procedures that must be followed before a chapter 11 debtor may reject a CBA, that provision does not apply to chapter 9 cases. As a result, a CBA is easier to reject in a chapter 9 case than in other chapters.  There are still restrictions on rejection of CBAs, however, imposed by the U.S. Supreme Court decision of NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984).

In City of Vallejo, the municipal debtor moved to reject its CBAs less than one month after filing.  See 403 B.R. 72, 74 (Bankr. E.D. Cal. 2009), aff’d, Int’l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo, CA (In re City of Vallejo, CA), No. 2:09-cv-02603, 2010 WL 2465455 (E.D. Cal. Jun. 14, 2010). Consistent with Orange County, the court held that section 1113 was inapplicable to the municipalities rejection of its CBAs and that the Bildisco standard should govern.  Id. at 78. According to the court, if a municipality is authorized by the state to file a petition under chapter 9 of the Code, it “is entitled to fully utilize 11 U.S.C. § 365 to accept or reject its executory contracts.”  Id. 

The rejection of CBAs, outside of the specialized section 1113 regime, may not always be a good idea, however. Rejection of an executory contract under section 365 of the Code (the general rejection provision) can give rise to an unsecured prepetition claim for damages against the debtor by operation of section 502(g) of the Bankruptcy Code. In contrast, bankruptcy courts authorizing rejection of CBAs under section 1113 do not agree on whether rejection gives rise to a claim for damages.  Cf. In re Blue Diamond Coal Co., 160 B.R. 574, 577 (E.D. Tenn. 1993) (stating that “when Congress enacted [section] 1113, it intended that no claim for damages for rejection of such an agreement would be allowed”).  Ultimately then, the consequences of rejection for the municipal debtor, i.e., claims by union employees, may prove to be a significant deterrent against terminating CBAs.

No Clear Answers on Pension Liability

As mentioned above, current and future pension liability constitutes one of the largest problems facing municipalities. Considered to be virtually untouchable in states that treat pension benefits as “vested rights” (and therefore not subject to unilateral amendment or termination based upon various Constitutional concerns), most efforts to reduce or modify these obligations outside of chapter 9 end in failure or, at best, with minute changes.

The question remains, however, whether chapter 9 provides an opportunity to expand the circumstances under which the pension liability problems can be addressed. Few municipalities, if any, have truly tested these laws. In the City of Vallejo case—one of the most recent one–the political capital required to deal with this issue has been extraordinarily high. While the City of Vallejo was successful in achieving relief from its burdensome CBAs and certain of its retiree medical benefits, the City has yet to meaningfully attempt to reduce its pension obligations, one of its largest budget items. In fact, although the City may propose definitive steps to reduce its pension obligations in connection with its forthcoming plan of adjustment, the City’s required pension contributions actually have increased during the pendency of its chapter 9 case.

In contrast, in the chapter 9 case of the City of Prichard, Alabama, the municipal debtor has expressed more willingness to address its pension liability problems, and the results to date have been positive for the municipality. In particular, prior to the filing of its chapter 9 petition, the City failed to make certain contributions to its pension plan and continued to withhold contributions on a postpetition basis. The retirees asserted that such contributions must resume as administrative priority expenses of the estate, which is entitled to a higher recovery. Agreeing with the municipal debtor, the bankruptcy court determined that the obligation to make contributions to its pension plan, both unpaid prepetition amounts as well as ongoing postpetition amounts, were not entitled to administrative priority status but were, instead, general unsecured claims. See In re City of Prichard, Alabama, No. 09-15000 (Bankr. S.D. Ala., March 10, 2010).

Conclusion

A chapter 9 filing is a significant decision for a municipality that should not be taken lightly. However, once a decision is made, there are a number of strategies can be crafted by a municipality to utilize the tools offered by chapter 9.

As described above, potential advantages include the ability to reject burdensome executory contracts (including CBAs) or to impose a plan of adjustment without securing the unanimous consent of all creditors. In addition, the automatic stay set forth in section 362 of the Bankruptcy Code applies in chapter 9, which means substantially all litigation and other creditor collection efforts against the debtor must stop.  Moreover, chapter 9 provides a municipal debtor with a single forum in which to consolidate and address each of its various issues under the expert supervision of a bankruptcy judge.

While a chapter 9 filing may damage the municipality’s financial ratings and making bond and other financings more difficult in the future, empirical evidence suggests that, over the long term, a chapter 9 restructuring may actually improve a municipality’s standing with the financial markets. Orange County’s chapter 9 bankruptcy is a good example of a success story.

Nonetheless, because of limited precedent, the strategies discussed here and elsewhere still remain largely theoretical. Given the goals of chapter 9, however, the benfit of the doubt is likely to be in favor of the broad powers granted under chapter. For example, in the City of Vallejo case, the court held that section 903 of the Code permits states to “act as gatekeepers to their municipalities’ access to relief under the Bankruptcy Code” and therefore when a state authorizes a filing under chapter 9, “it declares that the benefits of chapter 9 are more important than state control over its municipalities.” Such strong language provides important tools to municiplities to craft and employ strategies such as the ones used by the City of Vallejo, California and the City of Pritchard, Alabama.



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