Talking Chapter 9

Fall 2012Articles Journal of the National Association of Bankruptcy Trustees

Seemingly overnight, the Eastern District of California has become a hot spot for Chapter 9 filings. The City of Stockton, which filed at the end of June after negotiations with its labor unions and bondholders reached an impasse, eclipsed the City of Vallejo as the largest in the United States ever to file for Chapter 9 protection. Just one week later in early July, the resort town of Mammoth Lakes filed for protection to protect itself from a $43 million judgment, which is more than twice the ski hamlet's $18 million general fund expenditure in 2010-1011. These two West Coast filings come the year after the highly pulicized East Coast Chapter 9 filing of Harrisburg, PA (which was subsequently dismissed), and Jefferson County, AL. And in early July the City of San Bernardino, CA, authorized a filing within a month. Naturally, people are asking whether we are witnessing the beginning of a Chapter 9 trend.

Chapter 9 has been around since the Great Depression, but its protections are very infrequently sought. There have been fewer than 700 filings in nearly 70 years, resulting in a dearth of decisional authority that leaves many significant questions unanswered. For example, a District Court decision in the Vallejo case made important rulings that a Chapter 9 debtor can reject collective bargaining agreements under Bankruptcy Code § 365 and that state law requirements for determining whether public labor agreements may be rejected are preempted by federal law. Int’l Bhd. Of Elec. Workers v. City of Vallejo did not go so far as to attempt to impair pension obligations or bonds, and no other court has ruled on such attempts to restructure debts of those types. Thus, any attempt by Chapter 9 debtor to do so is likely to be highly contested.

Eligibility for Chapter 9 is also limited. Under Code §109(c), a debtor must (1) be a municipality (as defined in the Code – broader than cities); (2) be authorized to file under state law (only abut half of the states allow Chapter 9 filings and many that do place additional eligibility requirements on municipalities); (3) be insolvent; (4) desire to effect a plan of debt adjustment; and (5) have attempted to avoid filing or be left with no option but to file as a result of: (a) reaching agreement to a plan from a requisite amount of to-be impaired creditors; (b) failing in good faith negotiations to achieve sufficient consents of creditors because of impracticability (e.g., sheer number of creditors); or (d) believing reasonably that a creditor may attempt to obtain a transfer under § 547.

A Chapter 9 case is similar in many ways to a Chapter 11 case is similar in many ways to a Chapter 11 case under the Code. A successful debtor will emerge from bankruptcy under a plan through which it restructures its debts – in this case a “plan of adjustment” as opposed to a “plan of reorganization.” However, because of the state sovereignty limitations under the Tenth Amendment to the United States Constitution, Chapter 9 creates a delicate dance between state and federal law.

While the bankruptcy code controls much about the case, there are significant differences from Chapter 11 cases. For example, a failed Chapter 11 case will frequently lead to conversion to Chapter 7 and liquidation, as opposed to dismissal. However, a government entity cannot be liquidated, which means that a failed Chapter 9 case simply results in a dismissal. A bankruptcy judge cannot appoint a trustee for a debtor in Chapter 9. Similarly, a judge in a Chapter 9 case must defer to state law when considering such things as debtor’s attempt to raise revenue through fees or taxes. Finally, the Tenth Amendment limitations prevent a judge from compelling a municipality to accept a plan formulated by other parties or the court.

Another unique aspect of Chapter 9 is the mechanism for assigning judges to oversee cases. While cases under other chapters are randomly assigned to judges in the court where the case is properly filed, the chief judge for the circuit in which the debtor is located makes the judicial assignment in a Chapter 9 case.

As in a Chapter 11 case, a plan in a Chapter 9 proceeding can be approved by the consent of creditors or through a cramdown on non-consenting creditors. The confirmed chapter 9 plan will be similar to a chapter 11 plan in many (but not all) ways. For example, there is no requirement that an impaired creditor receive more than it would in a Chapter 7 liquidation; rather, the plan must be “in the best interests of creditors” without further specification. §943 (b) (7). A Chapter 9 plan also requires the debtor to obtain all necessary regulatory or electoral approvals to carry out any provision of the plan.

Whether we are experiencing an upward trend in Chapter 9 filings is unclear. While the recent high-profile filings in California have people wondering whether municipal bankruptcies will become widespread, the data set is too small to definitely say whether there is an actual trend. What is clear, however, is that local governments are struggling. Cities that rely heavily on property taxes to cover general fund expenses (as opposed to cities with a more diversified revenue base) have seen revenue stagnate – or even drop – in the housing bust, while the costs of operating cities continues to rise. Not only do day-to-day costs continue to increase, but many cities also have huge unfunded liabilities tied to prior commitments to contribute to employee pensions and cover retiree health care costs.

The City of Stockton, for example, estimated on the eve of its bankruptcy filing that while salaries would increase by about 15 percent in the next decade, the city’s share of pension contributions and cost of retiree health care would close to double. Revenue during the same period is projected to increase by only 11 percent. The city’s annual revenue shortfall was projected to grow from $8.7 million in 2011-12 to $35.5 million in 2020-21.

Other cities across the country face similar projected revenue shortfalls, which makes operating municipalities on such shoestring budgets unsustainable. Whether Chapter 9 is a panacea, however, remains to be seen. What is certain is that as local governments find themselves with smaller coffers to meet increasing demands of and obligations to their constituencies, more municipalities will likely consider debt restructuring under the bankruptcy code as a more thinkable option for relief.

Reprint by permission from NABTalk, Journal of the National Association of Bankruptcy Trustees, Fall 2012, pp. 42-43.