Whether or not you are in the camp of those who expect to see increased numbers of municipalities filing for Chapter 9 bankruptcy protection, it is important for every muni bond investor, and those who advise them, to have a basic understanding of the benefits available to a municipality seeking relief under Chapter 9 and the role of creditors in such a case.

Relief under Chapter 9 of the Bankruptcy Code is available exclusively to “municipalities” and offers certain protections to permit the development of a plan to restructure and adjust a municipality’s debt so it will be able to continue providing essential services.

However, unlike the more familiar Chapter 11 cases under the Bankruptcy Code, the role of creditors in Chapter 9 cases is quite limited. For example, there is no requirement for a first meeting of creditors, creditors are not permitted to propose competing plans, and there is no provision for the forced liquidation of municipal assets for distribution among creditors.

Aside from serving on an official committee of creditors — if one is appointed, which does not happen in every case — there are only two significant opportunities for creditors to influence a Chapter 9 case. The first is at the commencement of the case, when a creditor can object to a municipality’s petition. The second is the opportunity to support or challenge a proposed plan of adjustment at the conclusion of the case.

A creditor’s influence can be limited at this stage, however, because subsets of the creditor body, such as bondholders, can be isolated through classification as a separate class of creditors under the plan of adjustment. Subject to certain requirements, a class of creditors impaired by the plan can have the plan terms imposed over its objections if another class of impaired creditors votes to accept the proposed plan. Once the plan of adjustment is confirmed, it is binding on the municipality’s creditors, including any impaired classes.

Commencing a Chapter 9 Case

A municipality, the only entity that may be a Chapter 9 debtor, is defined by the Bankruptcy Code as a “political subdivision or public agency or instrumentality of a state.” The legislative history indicates Congress intended to make Chapter 9 relief available to a broad spectrum of governmental entities, including cities, counties, townships, school districts, and public improvement districts, as well as such entities as bridge and highway authorities.

The stringent eligibility standards of Chapter 9 require a municipality to have the requisite state-law authorization to file a petition (24 states either prohibit their municipalities from filing, or have not enacted a statute specifically authorizing Chapter 9 filings) and to be insolvent. Insolvency is defined for a municipality as a “financial condition such that the municipality is … generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or … unable to pay its debts as they become due.”

Creditors cannot force a municipality, unlike a corporation, into bankruptcy. A Chapter 9 bankruptcy can only be commenced by the filing of a voluntary petition, and once the petition is filed, creditors can challenge whether the eligibility requirements are satisfied. A bankruptcy court, upon such an objection, may conclude that a municipality did not file its petition in good faith, or does not satisfy the eligibility requirements, and dismiss the case.

A number of recent decisions illustrate the complexity of the eligibility requirements of Chapter 9. In In re New York City Off-Track Betting Corp. the bankruptcy court overruled objections that OTB did not have the necessary authorization to file a Chapter 9 petition, and ruled that an executive order issued by the governor of New York was sufficient.

In a Chapter 11 case, In re Las Vegas Monorail Co., certain creditors asserted the debtor should be considered a “municipality” and ineligible for Chapter 11 relief. The court first concluded that LVM did not have the typical powers of sovereignty, such as eminent domain, taxing power or sovereign immunity.

It then considered whether the monorail’s public purpose was sufficient for it to be treated as a municipality even though it lacked sovereign powers typical of municipalities. Here the court concluded that although LVM had a public purpose, the level of Nevada’s control over it was too low for the entity to qualify as a municipality.

Finally, the court concluded that the designation and treatment of the monorail under Nevada law would likely not imbue it “with sufficient municipal qualities to make [LVM] a municipality.”

Even more recently, the South Carolina Department of Transportation objected to the Chapter 9 petition filed in June by the Connector 2000 Association, a nonprofit corporation licensed to operate a 16-mile toll road. The SCDOT has argued that the toll road operator is not a municipality and is not specifically authorized to file a Chapter 9 case.

The department’s objection has not yet been decided. However, what is clear from this case and others, including OTB and LVM, is that resolution of Chapter 9 eligibility and authorization issues requires careful consideration of the legal characteristics of the debtor entity and the unique factual circumstances of each case.

Conducting a Case

A Chapter 9 debtor enjoys the benefits of the automatic stay, is able to use its property (e.g. borrow and spend money) without the need for court approval, and can make use of assorted statutory bankruptcy powers. These include the power to avoid preferences, subject to certain exceptions for payments to bondholders; set aside fraudulent conveyances; reject executory contracts, including labor contracts; and bind creditors with a confirmed plan of adjustment. A Chapter 9 debtor is not required to go through the same rigorous statutory process as a Chapter 11 debtor to reject collective bargaining agreements and retiree benefit plans. As a result, and subject to applicable state law, a Chapter 9 debtor may enjoy a greater ability to modify or abrogate such agreements.

The carefully watched Chapter 9 case of Vallejo, Calif., illustrates the way in which high labor costs can factor into the decision to seek bankruptcy protection. According to pleadings filed in the city’s bankruptcy case, increasing operational costs and declining general fund revenues resulted in a deficit that would have entirely depleted Vallejo’s reserves.

Labor costs established under collective bargaining agreements had consumed the majority of Vallejo’s general fund revenues each year, and May 2008 the city filed for Chapter 9 protection. The efforts to address labor costs, which have continued during the bankruptcy case, highlight how complex financial problems are made more difficult in the highly political context where officials must negotiate against labor organizations representing the same voter constituencies that elected them.

Vallejo reached agreements with all but one labor organization, the International Brotherhood of Electrical Workers. Recently, following extended litigation, the bankruptcy court’s decision to grant the city’s motion to reject the collective bargaining agreement with the IBEW was affirmed.

The Vallejo case also underscores some of the risks for buyers of certain municipal bonds. In Chapter 9, a municipality is not required to make payments of either principal or interest on account of general obligation bonds. In fact, the liabilities attributable to general obligation bonds are subject to negotiation and possible restructuring pursuant to a plan of adjustment.

Vallejo’s payments on general obligation bonds were entirely suspended for brief periods during the bankruptcy, and then made at reduced rates during subsequent periods. How the city will service its GO bond debt going forward will ultimately depend upon the outcome of its bankruptcy case.

Concluding a Case

Chapter 9 is generally intended to culminate with the confirmation of a plan of adjustment. The primary purpose of adjusting the debt of a municipality is the continued provision of public services, rather than profit. Unlike in Chapter 11, in Chapter 9 the inability to reorganize cannot result in liquidation of the municipality’s assets under Chapter 7.

Potential outcomes, other than confirmation of a plan of adjustment, include involuntary dismissal or voluntary dismissal at the request of the debtor. Voluntary dismissal in favor of an alternative means of restructuring, such as under state law, may avoid the time and expense of confirming a plan of adjustment. A municipality, as a governmental unit, is not eligible to be a Chapter 11 debtor and therefore a Chapter 9 case cannot be converted to a Chapter 11 case.

Only a Chapter 9 debtor may propose a plan of adjustment. Creditors are not permitted to file competing plans because of Tenth Amendment concerns about federal interference with state sovereignty. Otherwise, creditors would be able to control a municipality’s tax and spending authority, which are powers reserved to the states.

In addition, because of such constitutional concerns, Chapter 9 generally does not provide for the appointment of a trustee with authority over the assets of the debtor.

A Chapter 9 plan of adjustment is similar in some respects to a Chapter 11 plan of reorganization, and must be confirmed if various conditions are met. These include obtaining any regulatory or electoral approval necessary under applicable nonbankruptcy law in order to carry out any provision of the plan, or such provision is expressly conditioned on such approval; and that the plan is in the best interests of creditors and is feasible.

Similar to a Chapter 11 plan, a Chapter 9 plan can be approved over the objections of dissenting creditors, provided that at least one class of impaired claims votes to accept the plan, it does not discriminate unfairly, and is fair and equitable with respect to each impaired class of claims that has not accepted the plan.

An important aspect of the fair and equitable requirement is consideration of reasonable expectations. A plan under Chapter 9 is fair and equitable if the amount to be received by the bondholders is all that they can reasonably expect in the circumstances.

When all classes of creditors accept a plan of adjustment, confirmation still requires that it be feasible and in the best interest of creditors. The best-interest test has been characterized as a “floor requiring a reasonable effort at payment of creditors by the municipal debtor” and the feasibility standard as a “corresponding ceiling which prevents the Chapter 9 debtor from promising more than it can deliver.” (This from a reported decision involving the Mount Carbon Metropolitan District.)

As the foregoing illustrates, Chapter 9 bankruptcy involves a wide variety of issues. It is therefore important for purchasers of municipal bonds, and those who advise them, to be familiar with Chapter 9 and its implications.

If the predictions by some of disruption in the municipal bond market and a surge of Chapter 9 filings prove to be even moderately accurate, developing an understanding of municipal bankruptcy in advance of such events should prove to be an extremely worthwhile endeavor.

 

Melanie Cyganowski, a member of New York City-based Otterbourg, Steindler, Houston & Rosen PC, is former U.S. chief bankruptcy judge for the Eastern District of New York. Scott Hazan is a member of Otterbourg and chairs its bankruptcy and creditors’ rights practice, where John Wright is an associate. The law firm’s website is www.oshr.com.