CLIENT ALERT: Chapter 9 — Municipal Bankruptcy

With a recent uptick in Chapter 9 filings and news stories about various municipalities exploring filing for Chapter 9 protection, we thought it would be helpful to give a short overview of certain Chapter 9 issues and how they differ from traditional Chapter 11 cases.  Holders of municipal bonds should be familiar with the issues that they may face in distressed situations.

Eligibility to File Chapter 9

Chapter 9 of the United States Bankruptcy Code provides cities, towns and other political subdivisions the ability to obtain bankruptcy and debt adjustment relief.  Chapter 9 filing requirements are far more stringent than Chapter 11’s requirements.

To be eligible to file a Chapter 9 case, the entity filing must demonstrate that it:

1. is a municipality;
2. is specifically authorized to be a debtor under state law or by a government officer or organization empowered by the State to authorize an entity to be a debtor;
3. is insolvent;
4. has a desire to effect an adjustment of debts; and
5. has obtained the agreement of creditors holding at least a majority in amount of the claims in each class or failed to obtain the agreement of such creditors after good faith negotiations or demonstrated that such negotiations are impractical.

All of the above present are issues peculiar to Chapter 9, but most qualification disputes revolve around whether the filer is a “municipality” within the meaning of the Bankruptcy Code and arise when the filer is something other than a city, town or county.^[1]  Under Bankruptcy Code Section 101(40) a “municipality” is defined as a “political subdivision or public agency or instrumentality of a State.”  For example, the New York Off-Track Betting organization was ruled a municipality based on its state-created charter as a public benefit corporation with the purpose of raising revenue for the state and reducing organized crime.  In re NYC Off-Track Betting Corp., No. 09-17121 (Bankr. S.D.N.Y. March 22, 2010).  The Las Vegas Monorail Company, however, was determined not to be a municipality because the court ruled that it was organized as a nonprofit corporation to build a monorail using special revenue bonds, had competition from government agencies and its creditors never expected to be creditors of the state.  In re Las Vegas Monorail Co., No. 10-10464 (Bankr. D. Nev. Feb. 17, 2010).

Another sometimes contested qualification issue is the “specific authorization” prong.  No municipality may file for bankruptcy unless the state expressly allows it.  Typically, that would be through a statute expressly authorizing the municipality to file.  In Harrisburg, Pennsylvania, the Chapter 9 petition that was filed was dismissed because its city council that authorized the filing did not have authority to do so under state law.  In the Off-Track Betting case, however, the Bankruptcy Court ruled that, under New York State law, the Governor had authority to authorize the filing by executive order, where there was no statute that specifically authorized such filing.

Limited Bankruptcy Court Involvement

Under the 10th Amendment of the U.S. Constitution, the powers not delegated to the federal government are “reserved to the States, respectively or to the people.”  This constitutional limitation impacts federal bankruptcy law directly and significantly.  As observed by the Bankruptcy Court in the Off-Track Betting case: “Bankruptcy courts should review Chapter 9 petitions with a jaded eye.  Principles of dual sovereignty, deeply embedded in the fabric of this nation and commemorated in the 10th Amendment of the United States Constitution, severely curtail the power of bankruptcy courts to compel municipalities to act once a petition is approved.”  In re NYC Off-Track Betting Corp., 427 B.R. 256, 264 (Bankr. S.D.N.Y. 2010).

As can be seen from this quote, the Bankruptcy Court in a Chapter 9 case is far less involved in the conduct of the case and the municipal debtor’s operations than the traditional Chapter 11 corporate debtor.  In fact, unless the municipality consents, Bankruptcy Code Section 904 limits the Bankruptcy Court’s power by prohibiting it from interfering with, among other things, “any of the property or revenues of the debtor” or “the debtor’s use or enjoyment of any income-producing property.”  Thus, unlike in a corporate Chapter 11 case, which generally requires the debtor to seek court approval for many types of post-petition transactions (such as DIP financings, use of cash collateral, sales of assets), Section 904 makes clear that the municipal debtor’s day-to-day activities are not subject to bankruptcy court approval.

Automatic Stay

The automatic stay is one of the most powerful tools a debtor has in Chapter 11 cases, as it operates to stay or enjoin most actions against the debtor for claims arising prior to the filing date.  The automatic stay applies in Chapter 9 cases and is expanded to prohibit actions against any officer or inhabitant of the debtor if the action seeks to enforce a claim against the debtor or actions to enforce a lien arising from taxes or assessments owed to the debtor.  Importantly, however, the automatic stay in Chapter 9 does not operate to stay application of pledged “special revenues” to payment of indebtedness secured by such revenues.  Such “special revenue bonds” receive special treatment in Chapter 9, as explained below.

Bondholders:  What Kind of Bond are You Holding?

There are two primary types of municipal bonds: general obligation bonds and special revenue bonds.  In the case of “general obligation bonds,” the municipality issues a bond and promises to pay out of its general fund pool—the same pool from which the remainder of most of the city’s obligations are paid.  “Special revenue bonds” are usually issued to fund a particular project, such as the construction of a waste treatment plant, and the bonds are paid out of a segregated pool of funds generated from the project.  Outside of bankruptcy, general obligation bonds are often considered safer investments, but in a bankruptcy case, the opposite may be true.  General obligation bonds are treated as general unsecured debt under Chapter 9, and are subject to adjustment and restructuring.  The municipality that issued the general obligation bonds is not required to make payments of either principal or interest on account of general obligation bonds during its Chapter 9 case.  Unlike general obligations bonds, special revenue bonds receive special treatment in Chapter 9 by, generally, (i) preserving any lien securing such bonds post-petition and (ii) requiring the post-petition payment on such bonds during the pending Chapter 9 case if special revenues are available.

Bankruptcy Code Section 928(a) provides that “special revenues acquired by the debtor…shall remain subject to any lien” securing such bonds, thus ensuring the bond holder that its liens will be preserved.  However, Section 928(b) provides that such lien may be subordinated to the debtor’s “necessary operating expenses of such project or system, as the case may be.”  Thus, in the case of project financing or system financing, the liens on special revenue bonds will be subject to “necessary operating expenses” of the project or system.  The term “necessary operating expenses” is not defined and bondholders should take care to understand how the municipal debtor defines this term.  This is another area for significant dispute in Chapter 9 cases and has become front and center in Alabama’s Jefferson County Chapter 9 proceeding where holders of $3.14 billion in revenue bonds have objected to the county’s use of special revenues to significantly upgrade its sewer system and to pay related litigation costs.

Nevertheless, the enhanced treatment of special revenue bonds under Chapter 9 (i.e. continuation of payments post-petition and preservation of liens) may be one reason some commentators have observed increased demand recently in special revenue bonds as compared to general obligation bonds.  See Benjamin Gonzalez, et al. For All the Hype, Chapter 11 Filings Will Likely Stay Rare,” The Bond Buyer, Aug. 29, 2011.  However, it should be observed that, while special revenue bonds may receive better treatment under Chapter 9, the strength of the bond is dependent upon the revenues of the specific project.  If those special revenues are not sufficient to service the bond, unlike in Chapter 11, Section 927 of the Bankruptcy Code prevents the municipal debtor from using “general funds” to pay special revenue bonds.  Thus, Section 927 prevents special revenue bonds from being paid from the general revenue pool. 

Bondholders Will Not be Liable for “Preferences”

Bondholders can take comfort in knowing that under Section 926 of the Bankruptcy Code, any transfer to a holder of a bond may not be avoided as a “preference” under Section 547 of the Bankruptcy Code.  This assures bondholders that any payment received, even during a period when the debtor was insolvent, will not be “clawed back” as a preference.

Unions and Collective Bargaining Agreements

Bondholders considering to adjust or restructure their debts in Chapter 9 cases may take particular interest in understanding what, if any, impact the Chapter 9 debt adjustment plan has on existing labor and union costs.

In general, collective bargaining agreements may be rejected as “executory contracts” in bankruptcy.  The process of “rejecting” a collective bargaining agreement in Chapter 11 is difficult, costly, and time consuming under Bankruptcy Section 1113, which contains detailed ground rules for a complex negotiation.  Only after this process is exhausted may a debtor seek rejection of a collective bargaining agreement, and only if the debtor then demonstrates that the equities “clearly favor” rejection.

Notably, Section 1113 does not apply in Chapter 9 cases.  Recent case law has made it reasonably clear that the standard to reject a collective bargaining agreement is lower in Chapter 9 than it is in Chapter 11.  This may be one of the more significant battle grounds in future cases, given the significant unfunded public pension and retiree liabilities with which municipalities are struggling.

Confirming a Plan

To successfully emerge from bankruptcy, Section 941 requires a Chapter 9 debtor to file an adjustment plan, which may be filed “with the petition…[or] at such later time as the court fixes.”  Unlike in Chapter 11, there is no statutory deadline for filing a debt adjustment plan.  There is also no provision in Chapter 9 to allow creditors to move to terminate exclusivity or to propose a competing plan, if the debtor is incapable of filing its own confirmable plan.  Similarly, as Chapter 7 is not an option for municipalities, there is no authority of a bankruptcy judge to convert the case to Chapter 7.

In order to be confirmed, a plan of adjustment must meet seven standards set forth in Section 943 as well as other confirmation criteria also found in Chapter 11 cases.  As in Chapter 11, a Chapter 9 plan must be accepted by all classes of impaired creditors, or, if not all classes accept the plan, confirmation is possible if at least one impaired class accepts the plan and the plan is deemed to not discriminate unfairly and to be fair and equitable.

Conclusion

With insolvent municipalities making headlines, we believe that many municipalities will explore Chapter 9 as a possible solution to their lack of liquidity and severe current and projected future deficits.  However, it remains uncertain whether Chapter 9 will provide a meaningful forum for municipalities to successfully make the difficult legal and political choices necessary for long-term rehabilitation.

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Please feel free to contact any of the attorneys listed below or any partner with whom you work if you would like to discuss this case and its implications.

^[1] Notably, municipalities are ineligible to file for Chapter 7 or Chapter 11 protection.  Thus, bankruptcy is unavailable to municipalities that do not meet all of the eligibility criteria.

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