By Nicholas B. Bangos, Esq.   

The prevailing economic winds have not discriminated amongst their casualties.  Whether they are participants in private commerce or the public governmental sector, all economic players have been affected by the forces of economic gravity in some way, shape or form. 

Commercial entities and natural persons, whether or not in dire financial straits, may resort to Chapter 11 to restructure various obligations.  The Bankruptcy Code, 11 U.S.C. § 101, permits businesses and individuals to, among other things, restructure secured (and unsecured) obligations; reject burdensome leases contracts and agreements; dispose of assets; and compromise claims. 

These powers and the remedial purposes of the Bankruptcy Code and Chapter 11, in particular, are aimed at preserving the debtor as a going concern. 

Chapter 9 of the Bankruptcy Code incorporates the same goals and several aspects of the Chapter 11 plan confirmation process.  However, a bankruptcy court’s powers to facilitate the adjustment of a municipality’s debts are limited by constitutional concerns and the practical differences between the rights of parties in commercial financing and those in municipal financing.    

With political considerations added to the mix, the landscape upon which municipalities operate to adjust their debts in bankruptcy proceedings is dramatically different from the one facing private entities with access to relief under Chapter 11.  

In many respects, Chapter 9 is unexplored frontier.  Despite the existence of municipal bankruptcy laws since the 1930s, several key areas have yet to be etched in stone.  Such matters include: 

•           Eligibility. 

•           The powers or influence bankruptcy courts may exercise during the pre-confirmation period. 

•           The parameters of bond restructuring. 

•           The limits on classifications of claims. 

These are just a few examples of issues that will determine how effective of a tool Chapter 9 of the Bankruptcy Code is for municipalities seeking to avoid the brunt of extraordinary liabilities or negative economic conditions and cycles.    

Constitutional concerns 

The limitations on the relief available under Chapter 9 are a necessary balance between Congress’ power to enact uniform bankruptcy laws and the respect for states’ sovereignty under the 10th Amendment.  

Whereas bankruptcy courts often carry a heavy hammer in Chapter 11 proceedings, bankruptcy judges’ ability to administer Chapter 9 cases is limited by the concern that they should not interfere with a municipality’s sovereignty.  The restraints are also designed to encourage financially distressed municipalities to attempt to resolve their differences with creditors amicably and to use the relief available under the Bankruptcy Code as a last resort.  

These limitations are found in Bankruptcy Code Sections 903 and 904 and by virtue of the inclusion and exclusion, as the case may be, of certain provisions applicable in cases filed under Chapters 7 and 11. 

Section 903, titled “Reservation of State Power to Control Municipalities,” provides that Chapter 9 does not limit or impair the power of a state to control municipalities in the exercise of its political or governmental powers. 

Section 904 is titled “Limitation on Jurisdiction and Power of Court” and provides that unless the debtor consents or the plan provides, the court may not interfere with the political and governmental powers of the debtor, any of the property or revenues of the debtor or the debtor’s use of any income-producing property. 

Eligibility  

Bankruptcy Code Section 109(c) establishes the eligibility requirement for filing a petition for relief under Chapter 9.  To be eligible, the prospective debtor must: 

•           Be a municipality; 

•           Be specifically authorized to seek and obtain relief under the Bankruptcy Code; 

•           Be insolvent; 

•           Desire to effectuate an adjustment of debts; and 

•           Have: 

Obtained an agreement from most of the creditors who will be impaired under the plan; 

Attempted in good faith to obtain an agreement from majority of creditors who are going to be impaired under the plan but did not succeed; or 

Found it was impracticable to negotiate such a plan. 

Municipalities are defined under Bankruptcy Code Section 109(c) to include a “political subdivision or public agency or instrumentality of a state.”  Specific authority must come from either a specific statutory power or governmental authority with power to authorize the filing. 

Examples of municipalities that have sought relief under Chapter 9 include cities, counties, housing authorities, school districts, improvement districts, hospital districts, and waste and sanitation districts. 

The insolvency analysis for Chapter 9 eligibility has been applied by several courts differently than in cases under Chapters 7 and 11.1  Courts examining insolvency in the context of Chapter 9 eligibility have found that it requires proof of a debtor’s non-payment of bills as they are coming due and ability to pay as they come due.  This requires an analysis of prospective cash flow.  

For example, in In re City of Bridgeport, 132 B.R. 85 (Bankr. D. Conn. 1991), the debtor had excess funds of $28 million and an expected budget shortfall.  The court concluded that the debtor was not insolvent because it could use the $28 million to fund the shortfall and maintain $12 million in cash at the end of the fiscal year.  

Good-faith efforts and impracticality 

The eligibility requirement that the debtor obtained an agreement of the majority of creditors impaired under the plan, attempted in good faith unsuccessfully to obtain such an agreement, or could not negotiate such an agreement because it was impractical to do so has and will likely continue to result in substantial litigation.  This requirement embodies Congress’ intention that resort to Chapter 9 ought to be the last option and that more stringent requirements are necessary to preserve constitutional boundaries. 

Most courts reviewing these efforts have not required debtors to prove that the pre-petition efforts concerned “the plan.”2  However, they appear to be looking for sincere, legitimate and comprehensive efforts that evidence that the respective municipality explored a variety of options.  Those options include reducing costs, raising revenues by tax or assessment, and seeking cooperation from affected parties.  Courts also look to see if the debtors have identified or considered the various issues necessary for the development of a comprehensive plan and took the steps to implement them.3 

Alternatively, courts examining the“impracticality” prong of the eligibility test have focused on the size of the potential creditor body, the existence of exigent circumstances and the need to avoid public harm.4     

In a case of damned if you do, damned if you don’t, in In re City of Colorado Springs Spring  Creek General Improvement District, 177 B.R. 684 (Bankr. D. Colo. 1995), the court found that the debtor’s prepackaged Chapter 9 plan was not confirmable even though it was accepted by a majority of creditors.  The court found that the plan and disclosure statement violated, among other things, disclosure statement requirements and the due process rights of several creditors who did not vote on the plan.5  

Apples and oranges  

One of the most important provisions in Chapter 9 is Section 901.  Whereas Section 103 specifies which provisions and subchapters apply in others, Section 901 specifically enumerates which provisions of will apply in Chapter 9 proceedings.  

Even though Chapter 9 utilizes various aspects of the Chapter 11 plan confirmation process, the absence of many provisions available to debtors and trustees in Chapter 11 proceedings demonstrates the stark differences between the two chapters.  It also shows the extent to which Congress was walking a fine line in making uniform procedures for the adjustment of municipalities’ financial affairs.  

As one court emphasized, Chapter 9 involves a comprehensive procedure for the adjustment of municipal obligations according to state law, not federal law.6 

First and foremost, while there is no requirement of insolvency in Chapter 11 cases, a finding of insolvency is a prerequisite to eligibility for relief under Chapter 9.  Also, unlike Chapters 7 and 11 of the Bankruptcy Code, there is no provision for the filing of an involuntary bankruptcy proceeding.  

Nor are there any provisions for the appointment of a trustee, the conversion of the case to a liquidation proceeding under Chapter 7 or the termination of the debtor’s exclusive right to file a plan.  These latter three remedies of Chapter 11 creditors frequently serve as a form of check-and-balance in Chapter 11 cases. 

Furthermore, there are no debtor reporting requirements, and the bankruptcy court has no authority to award interim compensation to professionals or approve or deny budgets without the debtor’s consent.  These are just a few examples that illustrate the substantive differences between Chapters 9 and 11. 

Confirmation standards 

Section 943(b) provides as follows: 

The court shall confirm the plan if- 

(1)        The plan complies with the provisions of this title made applicable by sections 103(e) 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 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 non-bankruptcy 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)        And the plan is in the best interests of creditors and is feasible. 

At least one court has concluded that the feasibility standard typically applied in Chapter 11 cases does not apply in Chapter 9 cases.  Bankruptcy Code Section 1129(a)(10) requires in substance that confirmation is not likely to be followed by liquidation or the need for further financial reorganization.  The argument goes that since a Chapter 9 debtor cannot be forced into liquidation, a different standard applies.7 

Insofar as Section 943(b)(7)’s good-faith test is concerned, the court used equitable considerations found in Chapters 11 and 13 and reviewed whether: 

•           The plan complied with the provisions and purposes of the Bankruptcy Code and the chapter under which it is proposed. 

•           The plan was feasible. 

•           It was proposed with honesty and sincerity. 

•           Terms of the plan or the confirmation process were fundamentally fair.8 

The ‘death spiral’  

An economic phenomenon some have referred to as the “death spiral” illustrates both the dilemma municipalities face when looking for additional sources of revenue in the form of taxes and assessments and the limitations on Chapter 9’s ability to remedy certain economic issues.9 

To provide necessary services and fund present and future obligations, a municipality will likely evaluate the efficacy of increasing assessments or taxes in order to satisfy its obligations under, among other things, municipal bonds.  

As a practical matter, the power to increase revenues from such measures must be balanced between purely economic considerations and practical political realities.  This is due to the elasticity that exists between the value of the property subject to the assessment or tax and the owner’s willingness to pay for such increases.  

Frequently, there is an inverse relationship between millage rates and property values; the higher the value, the lower the millage rate and the lower the value, the higher the millage rate.  Consequently, a municipality that deems increased taxes, assessments or charges as necessary but politically impracticable will find itself with few options other than to attempt to restructure its obligations.    

Since the “death spiral” is intertwined with real estate values, the ability to modify municipal bonds, in turn, becomes critical.  For example, a development district with the purpose of funding infrastructure improvements may have obtained bond financing before a downturn in the real estate market or some natural disaster.  It may either find itself with or project to have insufficient revenues to fund obligations because of various economic factors influencing real estate values.  Consequently, the manner and extent to which various bond obligations may be modified in Chapter 9 cases will likely garner judicial attention.  

For example, in In re City of Colorado Springs Spring Creek General Improvement District, the court found that the debtor’s plan was not confirmable because, among other things, under Section 943(b)(6), the debtor lacked the authority to modify the bonds.  The bonds proposed to be issued under the plan required the increase of taxes that could only occur with voter approval that was not contemplated by the plan.10 

In In re Mount Carbon Metropolitan District, 242 B.R. 18, 36-39 (Bankr. D. Colo. 1999),the court found that the projections associated with the debtor’s ability to fund bonds issued pursuant to a proposed plan were not feasible, and therefore it did not confirm the plan. 

In Matter of Sanitary & Improvement District No. 7 of Lancaster County, Neb., 79 B.R. 877 (Bankr. D. Neb. 1989), the court permitted separate classification of bondholder claims from warrant holder claims but not separate classification of bondholder claims. 

Collective bargaining agreements  

Since there are two sides to the revenue-expense equation, cost-cutting measures will also need to be explored.  Legacy obligations and other obligations that arise under collective bargaining agreements with union employees frequently will come into focus.   

Since Bankruptcy Code Section 1113, which sets strict standards and procedures for the rejection of union contracts, is not among the provisions incorporated into Chapter 9 by virtue of Section 901, collective bargaining agreements are subject to rejection as executory contracts under 11 U.S.C. § 365.11  

In In re City of Vallejo, 432 B.R. 262 (E.D. Cal. 2010), the District Court applied the Supreme Court’s analysis in National Labor Relations Board v. Bildisco & Bildisco, 465 U.S. 513 (1984).  In Bildisco, the Supreme Court required a debtor to prove that the agreement burdens the estate, the equities favor rejection and the debtor made reasonable efforts to negotiate a voluntary modification before the proposed rejection.  

Consequently, while uncertainty exists with the ability to modify some municipal obligations, Chapter 9 enables municipalities to modify these obligations under the appropriate conditions. 

Conclusion  

Chapter 9 of the Bankruptcy Code demonstrates the extent to which constitutional concerns guided Congress in enacting a uniform mechanism to address municipal bankruptcies while  wrestling with issues associated with respect for sovereignty.  

The eligibility requirements for municipalities under Section 109 are designed to serve as a breaker, stemming any potential incoming tide of municipal bankruptcy proceedings by creating a higher bar to entry. 

The confirmation standards under Section 943 and the Chapter 11 provisions incorporated in Section 901, in turn, are designed to avoid infringing upon these constitutional borders.  Unfortunately, the current state of the law offers little solace for municipalities facing challenges and restrictions with which entities engaged in private enterprise either never have to contend or can navigate with greater ease. 

Whether a municipality is confronted with issues associated with economic cycles, natural disasters or extraordinary liabilities such as adverse civil rights judgments, the ability to restructure these obligations must begin with pre-petition planning, with consideration given to inherent state powers to modify obligations and political practical concerns.  

The power of bankruptcy courts to facilitate this process, although statutorily defined as limited, presently remains undefined as a practical matter.  Caught between mediator and arbitrator, bankruptcy courts may find themselves crafting creative solutions to enable distressed municipalities to continue to provide the necessary services and functions as the number of cases increases and the need for effective relief becomes more pronounced. 

It is likely that the current economic cycle will help answer some of these questions and provide more guidance to those municipalities seeking the breathing spell that the Bankruptcy Code affords all debtors. 

Nicholas B. Bangos, of counsel at Diaz, Reus & Targ in Miami, is an international bankruptcy counselor and litigator skilled in using bankruptcy laws and other commercial tools to acquire and dispose of substantial assets in real estate, lending, transportation, telecommunications and manufacturing, as well as for individuals.  He can be contacted at (305) 375-9220 or nbangos@diazreus.com. 

Notes 

 1          See, e.g.,In re N.Y. City Off-Track Betting Corp., 427 B.R. 256 (Bankr. S.D.N.Y. 2010); In re Pierce County Hous. Auth., 414 B.R. 702 (Bankr. W.D. Wash. 2009); and In re City of Vallejo, Cal., 408 B.R. 280 (Bankr. E.D. Cal. 2009).   

2          See, e.g.,In re City of Vallejo, 408 B.R. at 289.  Cf. In re Cottonwood Water & Sanitation Dist., 138 B.R. 973 (Bankr. D. Colo. 1992). 

3          The issue of the exercise of a municipality’s ability to increase taxes in order to increase revenues affects both eligibility for relief and confirmation of a plan of adjustment.  See, e.g., In re Cilhowee R-IV Sch. Dist., 145 B.R. 981 (Bankr. W.D. Mo. 1992) (fact that district could have increased levies was not dispositive of good faith); and In re Corcoran Hosp. Dist., 233 B.R. 449, 459 (Bankr. E.D. Cal. 1999) (attempts to raise assessment taxes would have been futile exercise). 

4          In re City of Vallejo, 408 B.R. at 289.  See alsoIn re Valley Health Sys., 383 B.R. 156, 162-63 (Bankr. C.D. Cal. 2008). 

5          In addition, the court found that the debtor’s plan was not feasible because it included projections on bond revenues that were unrealistic.    

6          In re City of Colo. Springs Spring Creek Gen. Improvement Dist., 177 B.R. 684, 693-94 (Bankr. D. Colo. 1995). 

7          In re Mount Carbon Metro. Dist., 242 B.R. 18, 32-36 (Bankr. D. Colo. 1999). 

8          Id. at 40-41.   

9           In re City of Colorado Springs, 177 B.R. at 690. 

10        Id. at 692-695. 

11        See, e.g., In re City of Vallejo, 432 B.R. 262, 270-72 (E.D. Cal. 2010).