by Kirk B. Burkley and Robert S. Bernstein
(Published in Financier Worldwide Magazine: Bankruptcy & Restructuring Global Reference Guide 2011)
Many corporations utilize Chapter 11 of the bankruptcy code to reorganize their business and financial affairs or to conduct an orderly sale or wind down. But what options are available to financially distressed municipalities to reorganize their financial affairs? Chapter 9 of the Bankruptcy Code may be available to afford municipalities’ protection from creditors and the ability to restructure debts. However, eligibility for protection under Chapter 9 is not automatic.
First and foremost, the entity seeking shelter under Chapter 9 must have specific and express state authorization to be a debtor and must actually be a municipality. Municipalities include political subdivisions such as counties, parishes, cities, towns, villages, boroughs and townships. Some courts have construed the definition of municipality under the Bankruptcy Code broadly. For example, the US 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). 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 consistent 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).
Further, in order for a municipality to be a debtor under Chapter 9 at least one of four factors must exist. First, a municipality-debtor under Chapter 9 must obtain the agreement of creditors holding at least a majority of the claims of each class that the municipality intends to impair under an eventual plan of reorganization. Second, the municipality must have negotiated in good faith with creditors and failed to obtain the agreement of such classes of creditors. Third, the municipality must demonstrate that it is unable to negotiate with creditors because such negotiation is impracticable. And fourth, the municipality must reasonably believe that a creditor may attempt to obtain a transfer that is avoidable under section 547 of the Bankruptcy Code.[related]
Finally, the municipality must be financially insolvent, 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.
With pressure on municipalities to fund burdensome legacy costs with dwindling revenue, Chapter 9 bankruptcy offers many attractive benefits. Chapter 9 is often described as a protection of the public as much as a protection for the creditors primarily because if a municipality goes under, municipality’s financial woes affect all constituents and not just those running city hall. Chapter 9 allows a municipality to restructure debt with minimal effect as possible on the people and provides a road map for repayment of debt while discouraging citizens from taking direct legal action against the municipality. 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 Court cannot limit the municipality’s ability to issue unsecured debt in the market, but court approval is required for the issuance of secured debt. Generally, the Court does not interfere with the management and administration of a local government and the Bankruptcy Code does not afford the Court with the power to appoint a trustee or examiner to run the city or municipal government.
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. In the landmark case 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 Eastern District of California held that a municipality in Chapter 9 bankruptcy was empowered to reject and, hence, renegotiate an onerous CBA. The Court held that because the US 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 is entitled to utilize Chapter 9 in its entirety. Once authorized to file, this includes the ability to reject CBAs. This concept also likely applies to underfunded pension obligations, as pensioners or merely creditors of the municipality and the same concepts of federalism authorize a municipality to adjust its pension obligations under a confirmed plan of adjustment with Court approval. Upon confirmation of the plan, 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. With the onset of budget cuts and ballooning costs, many municipalities are expected to take shelter under Chapter 9. Every financial professional and bankruptcy attorney should at least know the basics and prepare for this next wave of bankruptcy filings.