Chapter 9 and Act 47– A Light at the End of the Tunnel for Debt Laden Municipalities?

By Kirk B. Burkley, Esq.

INTRODUCTION TO CHAPTER 9

A result of the Great Depression, in 1934 (Pub. L. No. 251, 48 Stat. 798 (1934)). Congress formulated the first version of Chapter 9 to protect debt laden cities and municipalities. Chapter 9 of Title 11 of the United States Code (the “Bankruptcy Code”) is only available to municipalities and provides municipalities protection from creditors while allowing the municipality to create a plan to restructure its debts.

Initially, the United States Supreme Court held the 1934 Act unconstitutional as an improper interference with the sovereignty of the states (Ashton v. Cameron County Water Improvement District No. 1, 298 U.S. 513 (1936)). In response to the Supreme Court’s decision, Congress enacted a revised Municipal Bankruptcy Act in 1937, Pub. L. No. 302, 50 Stat. 653 (1937), which was ultimately upheld on appeal to the Supreme Court (United States v. Bekins, 304 U.S. 27 (1938)). The law has been amended several times since 1937, most recently as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Since enacted in 1934, approximately 566 (See Nicholas McGrath and Ji Hun Kim, “The Next Chapter for Municipal Bankruptcy”, American Bankruptcy Institutes Journal, June 2010, Vol. XXIX, No. 5) cases have been filed under Chapter 9 of the Bankruptcy Code.

In the past, filing for Chapter 9 protection was considered a last resort because of the uncertain results for everyone involved including municipal employees and bondholders. However, in the current economic downturn, more and more debt laden cities and municipalities are finding themselves considering the Chapter 9 option. Many industry experts and commentators are now predicting that the coming financial crisis facing the Nation’s municipalities will dwarf the airline, auto industry and banking sector crises of the past decade. It is because of this brewing storm that lawyers, politicians and financial professionals should have a basic understanding of the tools available to financially distressed municipalities. The author has primarily dealt with Chapter 9 in filings by municipal hospital districts in western states. This article will provide a basic overview of Chapter 9 bankruptcy and its interplay with Pennsylvania’s Act 47.

CHAPTER 9 ELIGIBILITY

In order to be eligible for Chapter 9 protection several factors must be present. Those factors are found in Section 109(c) of the Bankruptcy Code. Upon the filing of a petition under Chapter 9, the bankruptcy Court will determine whether proposed debtor meets these requirements. Notably, the chief judge of the court of appeals for the circuit embracing the district in which the case is commenced shall designate the bankruptcy judge to conduct the Chapter 9 case.

Definition of Municipality

The first, and perhaps most important, step is to determine whether the entity meets the statutory definition of a municipality under the Bankruptcy Code. A municipality is defined as a “political subdivision or public agency or instrumentality of a state” (11 U.S.C. § 901). Municipalities include political subdivisions such as counties, parishes, cities, towns, villages, boroughs and townships. A municipality may also include public agencies or instrumentalities that are organized for the purpose of constructing, maintaining and operating revenue producing enterprises (Bankruptcy Act § 81(1), former 11 U.S.C. § 404 (1976); In re County of Orange, 183 B.R. (594)). Some courts have construed the definition of municipality under the Bankruptcy Code broadly. The United States Bankruptcy Court for the District of New Hampshire held that regional refuse disposal districts are considered instrumentalities of the state and were therefore held to be municipalities (In re Sullivan County Regional Refuse Disposal District, 165 B.R. 60, 73 (N.H. 1994)). In another instance, the United States Bankruptcy Court for the Southern District of Mississippi held that the Greene County Hospital was public agency and met the statutory definition of a municipality because county officers had control over the hospital (In re Greene County Hospital, 59 B.R. 388, 389 (S.D. Miss. 1986)). However, the bankruptcy court for the District of Nevada held that the Las Vegas Monorail did not meet the statutory definition of a municipality because the nature of the monorail was more in line with that of a private business rather than an instrumentality of the state (In re Las Vegas Monorail Co., Case No. 10-10464 (Bankr. D. Nev. Apr. 26, 2010), appeal docketed, No. 2:10-cv-00678 (D. Nev. May 11, 2010)).

Specific State Authorization

In addition to being defined as a municipality, a proposed Chapter 9 debtor must also have specific state authorization to be a debtor under Chapter 9. The authorization may be express and incorporated through state law or through a government organization empowered by state law. In the Commonwealth of Pennsylvania, the specific authorization for filing bankruptcy under Chapter 9 is found in the Financially Distressed Municipalities Act (53 P.S. §§11701.101 et seq.) which is commonly referred to as Act 47.

Insolvency Standard

Once the municipality has obtained specific authorization from the appropriate state authority the next factor is commonly referred to as the insolvency standard. A municipality must be financially insolvent to be a debtor under Chapter 9, meaning that the municipality cannot and has not been paying its debts as they come due. Determination of the municipality’s insolvency requires a full cash flow analysis of factors including multi-year cash flows, available reserves, ability to reduce expenditures to borrow and legal opportunities to postpone debt payments (The Public Affairs Research Council for Louisiana, The Bureau of Governmental Research, Municipal Bankruptcy in Perspective 4-5 (April 2006)). Another important factor in the insolvency analysis involves the municipality’s taxing capacity. The municipality must have considered reasonable tax increases prior to filing and must show that despite its best efforts to generate income through reasonable tax increases, the municipality cannot generate sufficient revenue to pay it debts. (In re City of Bridgeport, 129 B.R. 332 (D.Conn. 1991)).

Agreement of Creditors

11 U.S.C. § 109 defines who may be a debtor. In addition to the foregoing factors, the Bankruptcy Code in Section 109(c) requires that in order to be a debtor under Chapter 9 the municipality must have obtained the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter; have negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter; is unable to negotiate with creditors because such negotiation is impracticable; or reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under section 547 of this title.

The Plan of Adjustment

After the Court determines that a municipality is authorized to be a debtor under Chapter 9, the municipality is charged with presenting a plan of adjustment. The plan of adjustment must provide for the restructuring of the municipality’s debts similar to a Chapter 11 plan of reorganization for private entities (both businesses and individuals). Typically, Chapter 11 is utilized by corporations to restructure or liquidate pursuant to a confirmed plan. Unlike Chapter 11, there is no statutory deadline imposed on a Chapter 9 debtor for filing its plan of adjustment. However, the bankruptcy Court may dismiss the case if a plan of adjustment is not filed in a timely manner. In Chapter 9, like Chapter 11, creditors holding impaired claims are entitled to vote to accept or reject the plan of adjustment. In order to be confirmed the plan must receive votes accepting the plan by 51% in number of creditors voting and 2/3 in dollar amount of votes cast, as well as satisfy all of the other Bankruptcy Code.

In the event creditors do not vote to accept the plan of adjustment by the requisite numbers, the Chapter 9 debtor may move to “cramdown” the plan of adjustment. In order to cramdown a plan that has been rejected through balloting, the Court must find that the plan is fair and equitable. In order to be fair and equitable, the plan must be in the best interest of creditors, meaning in Chapter 9 that it is the best of all reasonable alternatives, and that the plan is feasible, meaning that the plan has a reasonable likelihood of success and the municipality won’t return to bankruptcy soon.

A plan will only be confirmed if it satisfies the following seven criteria set forth in 11 U.S.C. § 943:

  1. the plan complies with the provisions of this title made applicable by sections 103(e) (1) and 901 of this title;
  2. the plan complies with the provisions of this chapter;
  3. all amounts to be paid by the debtor or by any person for services or expenses in the case or incident to the plan have been fully disclosed and are reasonable
  4. the debtor is not prohibited by law from taking any action necessary to carry out the plan;
  5. except to the extent that the holder of a particular claim has agreed to a different treatment of such claim, the plan provides that on the effective date of the plan each holder of a claim of a kind specified in section 507(a)(2) of this title will receive on account of such claim cash equal to the allowed amount of such claim;
  6. any regulatory or electoral approval necessary under applicable nonbankruptcy law in order to carry out any provision of the plan has been obtained, or such provision is expressly conditioned on such approval; and
  7. the plan is in the best interests of creditors and is feasible (11 U.S.C. § 934(b)(1-7)).

Once the plan of adjustment is confirmed, the municipality and all of its creditors are bound by the terms of said plan. The municipality shall then be discharged of all its debts, except for the debts retained under the plan and the creditors who did not have prior notice or knowledge of the municipality’s Chapter 9 filing.

BENEFITS OF CHAPTER 9 BANKRUPTCY

Municipalities in Chapter 9 enjoy many benefits. It is often described as a protection of the public as much as a protection for the creditors primarily because if a municipality goes under, the people living there are going to suffer as well. The municipality’s financial woes affect all constituents and not just those running city hall. Chapter 9 allows a municipality to restructure debt and rebuild with minimal effect as possible on the people. It also provides a path for repayment of creditors while discouraging citizens from taking direct legal action against the municipality.

The automatic stay provisions of the Bankruptcy Code prohibit creditors from continuing their collections efforts against the municipality. In the Chapter 9 scenario, Court interference is also minimal. Generally, the Court does not interfere with the management and administration of a local government. The Bankruptcy Code does not afford the Court with the power to appoint a trustee or examiner to run the city or municipal government.

Another benefit to Chapter 9 protection is that the Court cannot force a city to sell assets nor restrict the hiring of professionals such as accountants or lawyers or auditors. The normal restrictions on “disinterestedness” of professionals found in Section 327 of the Bankruptcy Code do not apply to Chapter 9.

Further, the Court cannot limit the municipality’s ability to go out in the market and try to issue more unsecured debt. Even though the Court may not restrict the municipality’s ability to incur unsecured debt, the Court must approve any issuance of secured debt. The Chapter 9 plan of adjustment must come from the municipality and creditors cannot submit their own competing plans.

Perhaps one of the most controversial, yet beneficial, aspects of Chapter 9 is a municipality’s ability to reject onerous collective bargaining agreements (“CBA”) with its unionized workforce. Recently, the Eastern District of California in City of Vallejo, held that a municipality in Chapter 9 bankruptcy was empowered to reject and, hence, renegotiate an onerous CBA (In re City of Vallejo, California, 403 B.R. 72 (Bankr. E.D. Cal. 2009), aff’d, 432 B.R. 262 (E.D. Cal. 2010)). The Court held that the United States Constitution gives Congress the power to establish uniform laws with respect to bankruptcy (Id. at 75). While the various states are entitled to prohibit or restrict their political subdivisions from filing bankruptcy, once authorized to file a municipality can utilize Chapter 9 in its entirety. This includes the ability to reject onerous contracts, including CBA’s. This concept likely also applies to underfunded pension obligations. Pension claimants are creditors of the municipality and the same concepts of Federalism authorize a municipality to adjust its pension obligations under a confirmed plan of adjustment upon appropriate Court approval under the Bankruptcy Code.

CHAPTER 9 IN PENNSYLVANIA

While Pennsylvania generally follows the provisions set forth in Chapter 9 of the Bankruptcy code, there are some slight differences. In Pennsylvania, municipalities are specifically authorized by the state to pursue a Chapter 9 filing. Pennsylvania is one of nineteen (19) states with such an authorization (See Eric Montari, “Chapter 9 Bankruptcy: What it means for Pennsylvania’s Municipalities”, Allegheny Institute for Public Policy, Report No. 09-05, December 2009).
The city of Pittsburgh has the extra requirement of seeking the permission of the Governor to commence a Chapter 9 filing under terms of Act 11 of 2004 (Id). In Pennsylvania the specific state authorization that a municipality must obtain prior to filing for Chapter 9 protection is contained in Act 47 (Id). While the state specific authorization flows from Act 47, there has never been a definitive ruling or substantive opinion by a Court in this Commonwealth of whether the municipality had the right to appear before a judge in a Chapter 9 proceeding without first being in Act 47 (Id). Many public policy commentators suggest that the legislature needs to make Chapter 9 filings more accessible in Pennsylvania because state specific authorization for Chapter 9 filing is contained solely within the Act 47 statute. For example, the state might want to think about extending the permission to seek Chapter 9 bankruptcy to its authorities and school districts (See Allegheny Institute, “Getting Serious About Public Sector Pensions”, Allegheny Institute for Public Policy, November 11, 2010, accessible at http://www.alleghenyinstitute.org/component/content/article/547-
getting-serious-about-public-sector- pensions.html
).
because states are free to prohibit or place as many pre-conditions it wishes on its local subdivisions when it comes to Chapter 9 bankruptcy. Since Act 47 only applies to municipalities, school districts and authorities are not permitted to file (Id). for Chapter 9 protection.

Pennsylvania’s Act 47

Act 47 provides fiscally challenged Pennsylvania municipalities essential options for financial recovery. The Act details criteria for identifying distress and sets forth the powers and duties of the Department of Community and Economic Development (“DCED”) in assisting a municipality to improve its distressed status. Under Act 47, the Pennsylvania DCED will review the criteria as it relates the municipality at issue and determine whether to declare a municipality as financially distressed. Once this designation goes into effect, the municipality is eligible for, inter alia, debt restructuring, federal debt adjustment actions, bankruptcy actions and possible consolidations of neighboring municipalities to relieve financial distress.

Act 47 not only provides criteria for identifying distressed municipalities, it also outlines the authority and obligations of the DCED in aiding the distressed municipality in alleviating its distressed status. The Act allows numerous parties to request a determination that the municipality in question has financially distressed status, including, inter alia, the municipality’s governing body, the DCED itself or 10% of electors voting in the previous election. Once a party requests a determination of distressed status, the DCED will follow a detailed set of criteria in declaring a municipality as being distressed.

Once the DCED determines that the municipality requesting distressed status is in fact financially distressed under the Act, the newly named distressed municipality must formulate a fiscal recovery plan. This recovery plan should be specifically designed to meet the special needs of each individual municipality so it can emerge from its distressed status consistent with applicable law.

To assist in the formulation of the plan, the Secretary of the DCED shall appoint an Act 47 coordinator (In the majority of the cases, an Act 47 coordinator is appointed to develop and implement the plan, however in some cases the municipalities chief executive officer or the municipal governing body shall develop a plan and implement it). The Act 47 coordinator is responsible for developing a recovery plan that addresses all areas of municipal operations. The Act 47 coordinator will look to organizational structure, financial administration, municipal service levels, and overall economic base in creating a plan of financial recovery. The coordinator’s job consists of formulating the fiscal recovery plan and assisting in the implementation of the plan.

Once the municipality formulates and implements its recovery plan, the municipality will remain a distressed municipality under the Act until there is an official determination that the municipality is no longer eligible for distressed status. A municipality may have its distressed status terminated by petitioning the secretary of the DCED to rescind its Act 47 status. The secretary may issue a determination that the conditions which led to the earlier determination of municipal financial distress are no longer present and the determination shall rescind the status of municipal financial distress and shall include a statement of facts as part of the final order. (53 P.S. § 11701.253(a)). Upon receipt the petition, the secretary may issue a determination to rescind following a duly advertised public hearing with notices given as provided in section 203. (53 P.S. § 11701.253(b)). In sum, Act 47 is an open-ended designation and a municipality is in it until the Secretary of DCED determines that it has erased the conditions that led it into Act 47 in the first place. (See Allegheny Institute, “Pittsburgh’s Financial Overseers, The Issue: The City of Pittsburgh has been in Act 47 distressed status and under the watch of an oversight board for five years.”, Allegheny Institute for Public Policy, January 2010)

The City of Pittsburgh petitioned the state in 2007 to be removed from Act 47 status (Id). In rendering his decision in July of 2008, the Secretary of the DCED noted “rescission at this time would be premature and could subject the City to a return to distress status in the near future…many of the conditions that originally led to the distress determination have not been fully alleviated”. (Id). If Act 47 is unable to alleviate these concerns the municipality and in turn the DCED should seriously consider Chapter 9 bankruptcy.

CONCLUSION

Act 47 and Chapter 9 of the Bankruptcy Code are important processes that any financially distressed municipality in Pennsylvania should consider when debts become crippling to long term fiscal health. With the sharp economic downturn in the past decade, more and more municipalities are finding themselves in financially distressed situations. While not always politically popular, Act 47 and Chapter 9 can assist in financial recovery and provide a means for putting municipalities on sound financial ground for future generations.

Comments are closed.