Savvy indenture trustees and bondholders familiar with the Chapter 11 process understand that being ahead of the curve often provides key advantages. What is less understood is that proactivity is even more important in Chapter 9 (municipal) bankruptcy situations, and often must predate any bankruptcy filing by several months.

The difference in approach is dictated by fundamental differences between Chapter 11 and Chapter 9. Simply put, bondholders that are unprepared for a Chapter 9 filing may find themselves having lost an opportunity to take advantage of their position.

One of the most significant differences between a Chapter 11 and Chapter 9 bankruptcy filing is that a municipality must satisfy several distinct eligibility hurdles to file a Chapter 9 case. Therefore, in such a case, the critical fight often occurs over whether the municipality is even eligible to commence a bankruptcy. Early involvement is critical to staking your position - whether you support or oppose the debtor's efforts.

Only a municipality may file for Chapter 9 and it must show that it has been authorized to file under applicable state law. Individuals states' rules vary significantly on that point. For example, California requires a local government to either participate in pre-filing a "neutral evaluator process" - effectively mediation - or make a declaration of fiscal emergency.

Unless extended, the mediation is a 60-day process and the municipality must give only 10 days business notice to all creditors with non-contingent claims of at least $5 million, or claims that comprise more than 5% of the local government's total debt, before the mediation commences.

California law provides that creditors that hold or may have claims that exceed $5 million, or constitute more than 5% of the total amount of the debt, must be invited to participate in mediation. Notice must also be given to indenture trustees and other enumerated parties, along with other interested parties that may also participate.

Trustees and bondholders may benefit significantly through participation by remaining as informed as possible. But to influence the mediation, you must have at least a basic understanding of critical facts, strategies and the players before the mediation actually commences.

Similarly, for governments in California choosing the alternative pre-filing route - making a declaration of fiscal emergency - a municipality must hold a public hearing and the governing board must find that, absent a Chapter 9 filing, the financial state of the local public entity jeopardizes the health, safety or well-being of the residents, and that the public entity is, or will become unable to, pay its debts within 60 days.

If you want to contest any element of this declaration, you must be prepared to take the municipality on early in its case, especially as there is no defined waiting period to file.

There are other grounds for dispute early in a Chapter 9 filing. In order to demonstrate its eligibility for Chapter 9, a municipality must establish its insolvency, which is not a requirement to file under any other chapter. Insolvency is generally defined as not paying undisputed debts as they come due or being unable to pay as they come due.

If a municipality argues that it is unable to pay its obligations as they come due, a number of factual questions arise. For example, is raising taxes a possibility?

A municipality must also show that it "desires to effect a plan to adjust such debts" and that it has (a) obtained the agreement of a majority of claims in each class to be impaired, (b) attempted to negotiate in good faith, (c) been unable to negotiate with creditors because they were impracticable, or (d) has a reasonable belief that a creditor is trying to beat a preference.

Since this is a requirement to show eligibility, municipalities are in effect required to begin plan negotiations pre-filing and may have reached agreements with various groups of creditors prior to a filing. Waiting until after a petition is filed to engage a potential Chapter 9 debtor risks being left out in the cold while others seize key tactical, financial and legal positions.

Early awareness and involvement also provides an opportunity for early investigation of important reorganization plan-related issues.

Finally, some issues to investigate in advance include:

  • Successor liability obligations across all redevelopment agency obligations and the impact on the municipality's fiscal health.
  • Whether the tax base is eroding or tax rates cannot be raised.
  • Interfund borrowings, particularly those from restricted funds.
  • Sources of funds
  • Off balance sheet liabilities
  • Pension obligations.

Jeffrey Reisner is a partner in the Los Angeles and Newport Beach offices
of Irell & Manella, a former member of the firm's executive committee,
and leads its bankruptcy, reorganization and creditor's rights practice.
Kerri Lyman 
is an associate with the firm in the Newport Beach office
and a member of the bankruptcy, reorganization and creditor's rights practice.