Chapter 9 Is a Very Tough Slog

The hassles associated with Chapter 9 municipal bankruptcies will suppress the number of filings, despite municipal revenues still being well below pre-recession levels, ­experts say.

The costs of paying lawyers and staying bogged down in motions, pleas, and appeals for years is enough to entice municipalities to find other avenues to relieve debt struggles.

If corporations can routinely file for bankruptcy protection and emerge a few months later, why does it frequently take municipalities years?

Ironically, the very feature that might make a Chapter 9 filing most appealing to a municipality could be what makes it take so long.

Chapter 9 gives bankruptcy judges little authority to force a municipality to do anything.

While that may sound tempting for a municipality incapable of paying its debts, what ends up happening is neither debtors nor creditors have much incentive to budge in their negotiations.

Perhaps the defining difference between a Chapter 9 bankruptcy for a municipality and a Chapter 11 reorganization for a corporation is that a corporation can be liquidated.

If corporate restructuring proposals aren’t panning out, a Chapter 11 bankruptcy can threaten to convert to a Chapter 7 bankruptcy, in which a company’s assets are sold off and the proceeds used to repay creditors, frequently at a loss.

The threat compels both debtors and creditors to resolve disputes fast. The debtor knows if it does not keep creditors happy, it can be dismantled; creditors know if they demand too much, they could end up taking a bigger loss in a liquidation.

Under a Chapter 9 bankruptcy, the judge has no authority to liquidate a municipality.

All the judge can do is rule on whether a reorganization proposal is fair to all creditors. That places creditors in a game-theory stalemate: without the threat of liquidation, creditors often have nothing to lose by insisting on repayment in full.

“There’s no real meaningful threat from that municipality that they’ll liquidate,” said Scott Hazan, partner at Otterbourg, Steindler, Houston & Rosen. “There are so few checks and balances in Chapter 9. It’s kind of a wild, wild west.”

Throw in the fact that many creditors in municipal bankruptcies are political constituents, and reorganizations can become messy and prolonged.

“Unlike Chapter 11, where people are pretty much focused on economics, in Chapter 9 there is an entirely, and additional, political process,” said Riley Walter, the lawyer representing Sierra Kings Health Care District in its bankruptcy. “There are always constituencies that have to be considered, even if they are not owed any money.”

For example, if a town wanted to sell an asset to raise money to repay creditors, it must go through an “elaborate process of public meetings and even citizen votes,” before the sale might happen, he said.

A reading of Chapter 9 of the U.S. bankruptcy code suggests it ought to be easy for municipalities.

All it does is freeze legal claims against an insolvent government while the municipality negotiates a restructuring of its debts.

Unlike a Chapter 11 reorganization or Chapter 7 liquidation, the judge can’t interfere with the operations of the debtor. The 10th Amendment limits the authority of federal courts to meddle in local governments’ affairs, except for powers specifically enumerated in the Constitution.

The court cannot force the municipality to fire people or discontinue services. It cannot make the municipality pay its debts, nor can it prevent the government from paying its debts. It cannot even block the municipality from borrowing more money, if anyone is willing to lend.


Vallejo, Calif., has been mired in bankruptcy proceedings since May 2008.

In the years leading up to the city’s filing, expenses were growing 11% a year while revenues were only growing 3%.

Costs to pay police and firemen, which represented 74% of the city’s spending, overwhelmed Vallejo’s $85.3 million general fund budget.

When the city petitioned for Chapter 9 bankruptcy protection, it was in for a costly and cumbersome slog.

Vallejo’s intention was to renegotiate its contracts with its four unions. Thanks mainly to an impasse with one of them — the International Brotherhood of Electrical Workers — the negotiations are still nowhere near completion.

This year, the judge invalidated the IBEW union contract that was in place. The union appealed. Vallejo said that appeal alone may take two years.

The city has already spent $9 million on lawyers in these proceedings. It had to undergo an eight-day trial plus an appeal over whether it was even eligible for Chapter 9 bankruptcy protection. The bankruptcy case has 825 filings, and counting.

“The Vallejo case got very expensive because the unions contested everything,” said Marc Levinson, who represents Vallejo for Orrick, Herrington & Sutcliffe. “We’ve just been slowed because of the constant fights. ... It’s this big fight over who gets the most, but we only have so much to go around, and of course everyone wants to be paid in full.”

When debtors and creditors cannot agree on a restructuring in a corporate bankruptcy, the solution is well-known. Because of the infrequency of Chapter 9 cases, Levinson said the ultimate outcome in this kind of situation is a mystery. It’s a given that Vallejo will continue to exist, he said, but who can say what happens if debtors and creditors never agree on how to share a limited amount of resources?

“In Chapter 11, there’s always the threat that if you can’t propose a plan that works, the assets are liquidated,” Levinson said. “The problem here [in Chapter 9] is that nobody really knows what happens if it doesn’t work. We don’t have a clue.”

The thought keeps him up at night.

Chapman and Cutler’s James Spiotto, the foremost expert on Chapter 9 bankruptcies, said municipalities usually have more effective ways than bankruptcy to cure distressed debts.

Spiotto said one reason municipal bankruptcies are more onerous than people expect is they do not deal specifically with the liability from which a government needs protection. They deal with all liabilities.

Consider the case of Westfall Township, Pa., population 2,430. In 1999, a federal judge ordered Westfall to pay $20.8 million to a real estate developer who was improperly barred from building homes on property he owned there.

For a town with a $1 million annual budget, this sum was, as Westfall put it in its bankruptcy petition, “of a magnitude that is vastly beyond the ability of the township to pay, now or ever.”

Westfall needed protection from only one creditor, whose judgment represented 99.9% of all the money the town owed to unsecured creditors.

To restructure the claim under bankruptcy protection, Westfall had to list all its unsecured creditors, which included an exterminator, a uniform and linen-supply company, the garbage collector, and Staples Inc.

The biggest claim besides the real estate developer’s behemoth: $6,059, to the regional police department.

The town owed $6 to the Pennsylvania One Call System, a not-for-profit entity established to ensure builders don’t demolish underground pipes.

The list of creditors in the Vallejo bankruptcy petition was 45 pages long.

Chapter 9 forces municipalities to take a “shotgun” approach to their debts rather than a “rifle-shot” approach, Spiotto said.

Even if a municipality knows exactly which creditor it needs to deal with, it still has to organize all claims into classes.

Westfall ended up paying $600,000 in attorney and accountant fees during its bankruptcy — 60% of its annual budget. And the town’s lawyer, in an editorial earlier this year, called that “about as straightforward a case as you can get.”

“It becomes a very difficult, longer, more extenuated negotiation, that normally will involve their counsel, and add expense to it,” Spiotto said. “That’s why you have refinancing authorities, that’s why you have financial control boards, that’s why you have all sorts of other mechanisms. ... There are ways of solving these problems, and they are somewhat effective and they address the problem they had, rather than every single relationship.”

A large number of creditors is not exclusive to municipal bankruptcies. The Lehman Brothers bankruptcy has tens of thousands of creditors.

Dealings with creditors, though, can be more complicated when they become political, as any municipal bankruptcy is bound to be.

These complexities are one reason why Moody’s Investors Service expects muni bankruptcies to remain rare. Sierra Kings’ is the only Chapter 9 bankruptcy since the beginning of 2009.

“The highly publicized 2008 ­bankruptcy filing of the city of Vallejo, Calif., demonstrates to other municipalities the high financial and operational costs of bankruptcy,” Naomi Richman, managing director at Moody’s, wrote in a report this week. “Moreover, the renegotiation of union contracts that the city sought to accomplish through the ­bankruptcy process could have been achieved without bankruptcy and without the risk of reputational damage in the capital markets.”

Considering the Census Bureau designates as “governments” almost 89,500 entities in the U.S., the number of municipal bankruptcies is minuscule.

According to the American Bankruptcy Institute, 234 municipalities have sought Chapter 9 bankruptcy protection since 1980, or about eight per year.


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