Chapter 9 Municipality Bankruptcy

Chapter 9 provides bankruptcy relief to municipalities, which includes counties, cities, towns, villages, municipal utilities, school districts, and other taxing districts. Eligibility is also extended to public projects that produce revenue directly from users rather than from taxes, such as toll roads and gas and water authorities. Only about 619 cases of Chapter 9 have been filed since the original Municipal Bankruptcy Act was enacted in 1937, the 1st such law that was adjudged by the Supreme Court to not infringe on the 10th Amendment's guarantee of state sovereignty. The largest case so far has been the filing by Orange County, California in 1994.

The primary purpose of municipal bankruptcy is that it allows the municipality to extend the time it needs to pay debt, or to reduce or eliminate debt, especially debt incurred because of mismanagement by municipal officers. There is no liquidation under Chapter 9, since a municipality provides necessary services and is a creation of the state, and, thus, protected under the state's sovereignty.

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Because of state sovereignty, the bankruptcy court does not manage a Chapter 9 case as actively as it would a Chapter 11. Basically, the municipality files, then submits a repayment plan for approval by the court. However, the municipality can elect to subject itself to the exclusive jurisdiction of the bankruptcy court, so that it can handle its debt by dealing only with the bankruptcy court rather than litigating in multiple forums.

To be eligible for Chapter 9, the debtor must be a municipality, defined in the bankruptcy code as a political subdivision, agency or other instrumentality of a state. Consequently, states, United States (US) territories, and local governments in the US territories are not eligible for Chapter 9. So, for instance, Puerto Rico or any of its subdivisions are ineligible for chapter 9. Other chapter 9 eligibility requirements include:

  1. the municipality must be authorized to be a debtor by state law;
    • 25 states do not allow their municipalities to file Chapter 9;
  2. the municipality must be insolvent;
  3. the municipality must want to adjust its debts;
  4. and must deal with its creditors in 1 of 4 ways:
    1. successfully obtain a repayment agreement with impaired creditors in each class holding most of the debt;
    2. if the debtor failed to reach such an agreement, then it at least negotiated in good faith;
    3. be unable to negotiate an agreement because it is impracticable;
    4. or if the municipality reasonably believes that a creditor will try to obtain a preference.

Chapter 9 Procedure

A Chapter 9 case is managed much the same way as a Chapter 11 reorganization. The debtor must file a payment plan and issue a disclosure, approved by the court that is sent to creditors and other parties in interest. Impaired creditors can vote on the submitted payment plan or file objections to the plan. The court holds a confirmation hearing to decide on whether to approve the plan.

How Chapter 9 Differs from Chapter 11

Although Chapter 9 most closely resembles Chapter 11 used by most corporations, it has some differences. Only a Chapter 9 debtor can commence its bankruptcy—there are no involuntary provisions that would allow creditors to force the municipality into bankruptcy.

A Chapter 9 case is assigned to a bankruptcy judge selected, not by the court clerk as under other chapters, but by the chief judge of the court of appeals for the district. The purpose of this provision is to remove politics from the selection and to ensure that the selected judge will have the time, experience, and resources to handle the case, especially for a major municipality.

The court must publish a notice of the bankruptcy in a major newspaper served by the municipality, and in at least 1 other publication that is likely to be read by the bondholders of the municipality. The court will also designate whom to mail a notice of the bankruptcy. The notice allows parties to object to the filing. The grounds of most objections are that the municipality has not conducted negotiations with creditors in good faith or that the petition was not filed in good faith, or it may be argued that the state has not authorized the municipality to file for bankruptcy; however, courts commonly accept that unless the state specifically prohibits the filing of bankruptcy by the municipality, then it tacitly consents to it.

Parties in interest, which includes state officials, municipal officials, taxpayers, local residents, non-resident owners of property in the municipality, securities firms, local banks, and even officials of the Security and Exchange Commission, have a right to be heard concerning the Chapter 9 bankruptcy.

The automatic stay prevents creditors from taking any action to collect their debts, but it also prohibits any collection efforts directed at officers of the municipality or against people who reside within the municipality. For instance, the creditor cannot bring a mandamus action against any municipal officer. The automatic stay does not, however, prevent the municipality from paying bondholders from pledged revenue.

A proof of claim is deemed filed if the creditor is listed in the petition with undisputed, noncontingent, unliquidated claims; if the creditor is not listed, then the creditor must file a proof of claim.

As a creation of the state and its service to the people, the court's power over the municipality is much more limited than it is for other debtors. The court cannot interfere with any of the municipality's governmental powers and duties or with any property or revenues; nor can the court limit the debtor's use of income-producing property. The debtor can continue borrowing money without court approval and does not require approval for any of its operations. Congruent with the autonomy of the municipality and the fact that there is no bankruptcy estate to administer, no trustee is appointed, except in special circumstances. Although the United States Trustee appoints a creditors committee, there is no meeting of the creditors, nor does the U.S. Trustee have any other duties with respect to the Chapter 9 case.

A creditors committee is formed to represent the interests of the creditors. Some of its duties are hiring professionals, such as attorneys and accountants, to investigate the conduct, assets and liabilities, and the financial condition of the debtor, but the committee cannot submit any payment plans for the debtor—only the debtor can submit a plan.

Municipalities often suffer financial stress because they signed expensive contracts or leases, or they granted too generous benefits, particularly pensions, to its employees.

With court approval, it can reject executory contracts and unexpired leases. Under bankruptcy, the municipality can also reject collective bargaining agreements and retirement benefit plans for its employees more easily than a debtor under Chapter 11.

The municipality has the power to continue borrowing money so that it can finance its operations. It doesn't need court approval for the debt or its amount, or for the employment of professionals. However, the debt that the municipality does incur while in bankruptcy is treated as an administrative expense, which gives creditors that lend to the municipality during the bankruptcy the highest priority for repayment, so that they are willing to continue lending to it.

Grounds for Dismissal

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There are various grounds for the dismissal, after notice and a hearing, of a Chapter 9 petition, which includes:

Payments to Bondholders

Holders of special revenue bonds will continue to be entitled to payments that are secured by the revenue of the municipality. However, general obligation bonds are treated as unsecured debt—the municipality does not have to pay either principal or interest.

However, the municipality can continue paying bondholders without violating the automatic stay. The automatic stay does not apply to payments to bondholders nor will payments made to bondholders right before bankruptcy be treated as a preference, which is a payment by a debtor to a preferred creditor while the debtor was insolvent.

Payment Plan and Confirmation

The municipality must file a payment plan, either with the bankruptcy petition or at a time determined by the court. However, the Supreme Court has ruled that, because of the 10th Amendment, a municipality must remain in control of its finances, so neither the court nor creditors may dictate any aspects of the payment plan. Of course, the municipality still has to get the plan confirmed to receive a discharge.

Confirmation of the plan is given if the plan satisfies the statutory requirements of both federal bankruptcy law and also any state requirements, including getting the necessary regulatory or electoral approval to carry out the plan; all amounts paid by or to the debtor are fully disclosed and are reasonable; and the plan is considered feasible and to be in the best interests of creditors.

Under Chapter 9, the best interests of creditors has a different meaning than under Chapter 11, since the assets of a municipality cannot be liquidated to pay creditors. If the creditors would be better off under the payment plan than if the case were dismissed, then it is considered in the best interests of creditors.

Parties in interest can object to the confirmation of the plan. The court may also revoke the order for confirmation and therefore the discharge if, within 180 days after confirmation, the court has determined that the confirmation was obtained by fraud.

Discharge

A municipality receives a discharge of its debts by receiving the order for confirmation of its payment plan and by issuing new securities that are distributed to creditors by a disbursing agent appointed by the court, and after the court determines that the new securities will constitute a valid legal obligation of the municipality and that any provision to pay or to secure payment of the new obligations is valid.

Notes