Rediscovering Chapter 9

Ushered in during the Great Depression to fill a vacuum that previously existed in both federal and state law, federal municipal bankruptcy law suffered from a constitutional flaw that endures in certain respects to this day ' the Tenth Amendment reserves to the states' sovereignty over their internal affairs. This reservation of rights caused the U.S. Supreme Court to strike down the first federal municipal bankruptcy law as being unconstitutional in 1936, and it accounts for the limited scope of Chapter 9 as well as the severely restricted role that the bankruptcy court plays in presiding over a Chapter 9 case and in overseeing the affairs of a municipal debtor.

Chapter 9 Eligibility

Access to Chapter 9 is limited to municipalities. A 'municipality' is defined by ' 101(40) of the Bankruptcy Code as a 'political subdivision or public agency or instrumentality of a State.' Section 109(c) of the Bankruptcy Code sets forth other prerequisites to relief under Chapter 9:

• A state law or governmental entity empowered by state law must specifically authorize the municipality (in its capacity as such or by name) to file for relief under Chapter 9;
• The municipality must be insolvent;
• The municipality must 'desire[] to effect a plan' to adjust its debts and must either: 1) have obtained the consent of creditors holding at least a majority in amount of claims in classes that will be impaired under the plan; 2) have failed to obtain such consent after negotiating with creditors in good faith; 3) be unable to negotiate because negotiation is 'impracticable'; or 4) reasonably believe that a 'creditor may attempt to obtain' a transfer that is avoidable as a preference.
• The municipal debtor bears the burden of establishing that it is eligible for relief under Chapter 9. In re Sullivan County Reg'l Refuse Disposal Dist., 165 B.R. 60, 72-73 (Bankr. D.N.H. 1994).

Prior to 1994, the authorization requirement had been construed to require general authority, rather than specific authorization by name, for a municipality to seek Chapter 9 relief. See, e.g., In re Westport Transit Dist., 165 B.R. 93, 96 (Bankr. D. Conn. 1994) ('state law only needs to give 'some indication' that the entity is authorized to be a Chapter 9 debtor.'). However, the Bankruptcy Reform Act of 1994 amended section 109(c)(2) to require that a municipality be 'specifically authorized' to be a debtor under Chapter 9. Courts construing the amended provision have concluded that state law must provide express written authority for a municipality to seek Chapter 9 relief and that the authority must be 'exact, plain, and direct with well-defined limits so that nothing is left to inference or implication.' In re County of Orange, 183 B.R. 594, 604 (Bankr. C.D. Cal. 1995); accord Suntrust Bank v. Alleghany-Highlands Econ. Dev. Auth. (In re Alleghany-Highlands Economic Dev. Auth.), 270 B.R. 647, 649 (Bankr. W.D. Va. 2001).

As noted, no other chapter of the Bankruptcy Code includes insolvency among the criteria for relief. 'Insolvency' in the context of Chapter 9 eligibility does not refer to balance sheet insolvency. Instead, it requires a showing that, as of the filing date, the debtor either: 1) is generally not paying its undisputed debts as they become due; or 2) is unable to pay its debts as they mature. See 11 U.S.C. ' 101(32)(C); see also In re McCurtain Municipal Authority, 2007 WL 4287604 (Bankr. E.D. Okla. Dec. 4, 2007) (observing that the test for insolvency under section 101(32)(C)(i) looks to current, general nonpayment, while the test under section 101(32)(C)(ii) is an 'equitable, prospective test looking to future inability to pay.'); In re Mount Carbon Metropolitan Dist., 242 B.R. 18, 32-33 (Bankr. D. Colo. 1999) ('The insolvency requirement has a functional rather than a balance sheet focus; to be insolvent, a municipality either is not paying its debts as they come due or will be unable to do so.'); In re City of Bridgeport, 129 B.R. 332, 337 (Bankr. D. Conn. 1991) (although city was in financial distress, it was not insolvent and was thus ineligible to file for Chapter 9; using cash flow analysis, 'to be found insolvent a city must prove that it will be unable to pay its debts as they become due in its current fiscal year or, based on an adopted budget, in its next fiscal year.').

The dictate that a municipality 'desires to effect a plan to adjust' its debts 'requires that the purpose of the filing of the Chapter 9 petition not simply be to buy time or to evade creditors.' 2 Collier on Bankruptcy ' 109.04[d] (15^th ed. rev. 2008). A debtor need satisfy only one of the pre-filing requirements set forth in section 109(c)(5), see In re Ellicott Sch. Bldg. Auth., 150 B.R. 261, 265-66 (Bankr. D. Colo. 1992), all of which are unique to Chapter 9. The pre-filing negotiation requirements were inserted by Congress to prevent capricious Chapter 9 filings. 2 Collier on Bankruptcy ' 109.04[e].

Good-Faith Filing Requirement

Section 921(c) states that '[a]fter any objection to the petition, the court, after notice and a hearing, may dismiss the petition if the debtor did not file the petition in good faith or if the petition does not meet the requirements of this title.' No other Chapter of the Bankruptcy Code expressly incorporates a good-faith filing requirement. See Sullivan County, 165 B.R. at 80. If the court does not dismiss the petition under section 921(c), it 'shall' order relief under Chapter 9. 11 U.S.C. ' 921(d). Notwithstanding its permissive language, section 921(c) has been construed as requiring dismissal of a petition filed by a debtor that is ineligible for relief under Chapter 9. See In re Valley Health System, 2008 WL 616283, *2 (Bankr. C.D. Cal. Feb. 20, 2008); County of Orange, 183 B.R. at 599; see generally 6 Collier on Bankruptcy ' 921.04[4] at 921-7. Factors that may be relevant in determining whether a Chapter 9 petition has been filed in good faith include:

1. the debtor's subjective beliefs;
2. whether the debtor's financial problems can be addressed by Chapter 9;
3. whether the debtor's motivation for filing is consistent with the purposes of Chapter 9;
4. the extent of the debtor's prepetition negotiations, if practical;
5. the extent to which the debtor considered alternatives to Chapter 9; and
6. the scope and nature of the debtor's financial problems.

Id. at 921-6 (citations omitted). Standing alone, a municipal debtor's refusal to impose or raise assessments or to borrow funds is not sufficient to warrant a finding of bad faith. See McCurtain, 2007 WL 4287604, at *6; In re Chilhowee R-IV School Dist., 145 B.R. 981, 983 (Bankr. W.D. Mo. 1992). Dismissal of a Chapter 9 case is the only option if the debtor does not seek Chapter 9 relief in good faith or cannot confirm a plan ' the assets of a Chapter 9 debtor cannot be liquidated involuntarily.

Part Two of this article will discuss the bankruptcy court's limited role, a plan for adjustment of debts, the dismissal option, and the outlook for Chapter 9.

Erica M. Ryland is a partner in the Business Restructuring and Reorganization Practice of Jones Day in New York. Mark G. Douglas, a member of this newsletter's Board of Editors, is Jones Day's Restructuring Practice Communications Coordinator and Managing Editor of the Jones Day Business Restructuring Review. The views expressed in this article are the personal views of the authors and do not necessarily reflect those of Jones Day or its clients.

Even though Chapter 9 of the Bankruptcy Code has been in effect for over 30 years, fewer than 100 cases have been filed during that time. Municipal bankruptcy cases ' or, more accurately, proceedings involving the adjustment of a municipality's debts ' are a rarity, compared with reorganization cases under Chapter 11. The infrequency of Chapter 9 filings can be attributed to a number of factors, including the reluctance of municipalities to resort to bankruptcy protection due to its associated stigma and negative impact, perceived or otherwise, on a municipality's future ability to raise capital in the debt markets. Also, Chapter 9's insolvency requirement, which exists nowhere else in the Bankruptcy Code, actually discourages municipal bankruptcy filings.

As the enduring fallout from the sub-prime mortgage disaster and the commercial credit crunch that it precipitated continue to paint a grim picture portending hard times ahead for the U.S. economy, municipalities are suffering from a host of troubles. Among them are skyrocketing mortgage foreclosure rates and a resulting loss of tax base, bad investments in derivatives and the higher cost of borrowing due to the meltdown of the bond mortgage industry and the demise (temporary or not) of the $330 billion market for auction rate securities ('ARS'), which municipalities have relied upon for nearly two decades to float inexpensive debt. The cost of borrowing in the ARS market has almost doubled since January 2008, according to the Securities Industry and Financial Markets Association. This confluence of financial woes is likely to propel an increasing number of municipalities to the brink of insolvency and beyond. This, in turn, may mean a significant uptick in the volume of Chapter 9 filings. In anticipation of Chapter 9's emergence from relative obscurity, it is important to understand what degree of utility federal bankruptcy law has in addressing municipal financial problems.

Constitutional Conflict

Ushered in during the Great Depression to fill a vacuum that previously existed in both federal and state law, federal municipal bankruptcy law suffered from a constitutional flaw that endures in certain respects to this day ' the Tenth Amendment reserves to the states' sovereignty over their internal affairs. This reservation of rights caused the U.S. Supreme Court to strike down the first federal municipal bankruptcy law as being unconstitutional in 1936, and it accounts for the limited scope of Chapter 9 as well as the severely restricted role that the bankruptcy court plays in presiding over a Chapter 9 case and in overseeing the affairs of a municipal debtor.

Chapter 9 Eligibility

Access to Chapter 9 is limited to municipalities. A 'municipality' is defined by ' 101(40) of the Bankruptcy Code as a 'political subdivision or public agency or instrumentality of a State.' Section 109(c) of the Bankruptcy Code sets forth other prerequisites to relief under Chapter 9:

• A state law or governmental entity empowered by state law must specifically authorize the municipality (in its capacity as such or by name) to file for relief under Chapter 9;
• The municipality must be insolvent;
• The municipality must 'desire[] to effect a plan' to adjust its debts and must either: 1) have obtained the consent of creditors holding at least a majority in amount of claims in classes that will be impaired under the plan; 2) have failed to obtain such consent after negotiating with creditors in good faith; 3) be unable to negotiate because negotiation is 'impracticable'; or 4) reasonably believe that a 'creditor may attempt to obtain' a transfer that is avoidable as a preference.
• The municipal debtor bears the burden of establishing that it is eligible for relief under Chapter 9. In re Sullivan County Reg'l Refuse Disposal Dist., 165 B.R. 60, 72-73 (Bankr. D.N.H. 1994).

Prior to 1994, the authorization requirement had been construed to require general authority, rather than specific authorization by name, for a municipality to seek Chapter 9 relief. See, e.g., In re Westport Transit Dist., 165 B.R. 93, 96 (Bankr. D. Conn. 1994) ('state law only needs to give 'some indication' that the entity is authorized to be a Chapter 9 debtor.'). However, the Bankruptcy Reform Act of 1994 amended section 109(c)(2) to require that a municipality be 'specifically authorized' to be a debtor under Chapter 9. Courts construing the amended provision have concluded that state law must provide express written authority for a municipality to seek Chapter 9 relief and that the authority must be 'exact, plain, and direct with well-defined limits so that nothing is left to inference or implication.' In re County of Orange, 183 B.R. 594, 604 (Bankr. C.D. Cal. 1995); accord Suntrust Bank v. Alleghany-Highlands Econ. Dev. Auth. (In re Alleghany-Highlands Economic Dev. Auth.), 270 B.R. 647, 649 (Bankr. W.D. Va. 2001).

As noted, no other chapter of the Bankruptcy Code includes insolvency among the criteria for relief. 'Insolvency' in the context of Chapter 9 eligibility does not refer to balance sheet insolvency. Instead, it requires a showing that, as of the filing date, the debtor either: 1) is generally not paying its undisputed debts as they become due; or 2) is unable to pay its debts as they mature. See 11 U.S.C. ' 101(32)(C); see also In re McCurtain Municipal Authority, 2007 WL 4287604 (Bankr. E.D. Okla. Dec. 4, 2007) (observing that the test for insolvency under section 101(32)(C)(i) looks to current, general nonpayment, while the test under section 101(32)(C)(ii) is an 'equitable, prospective test looking to future inability to pay.'); In re Mount Carbon Metropolitan Dist., 242 B.R. 18, 32-33 (Bankr. D. Colo. 1999) ('The insolvency requirement has a functional rather than a balance sheet focus; to be insolvent, a municipality either is not paying its debts as they come due or will be unable to do so.'); In re City of Bridgeport, 129 B.R. 332, 337 (Bankr. D. Conn. 1991) (although city was in financial distress, it was not insolvent and was thus ineligible to file for Chapter 9; using cash flow analysis, 'to be found insolvent a city must prove that it will be unable to pay its debts as they become due in its current fiscal year or, based on an adopted budget, in its next fiscal year.').

The dictate that a municipality 'desires to effect a plan to adjust' its debts 'requires that the purpose of the filing of the Chapter 9 petition not simply be to buy time or to evade creditors.' 2 Collier on Bankruptcy ' 109.04[d] (15^th ed. rev. 2008). A debtor need satisfy only one of the pre-filing requirements set forth in section 109(c)(5), see In re Ellicott Sch. Bldg. Auth., 150 B.R. 261, 265-66 (Bankr. D. Colo. 1992), all of which are unique to Chapter 9. The pre-filing negotiation requirements were inserted by Congress to prevent capricious Chapter 9 filings. 2 Collier on Bankruptcy ' 109.04[e].

Good-Faith Filing Requirement

Section 921(c) states that '[a]fter any objection to the petition, the court, after notice and a hearing, may dismiss the petition if the debtor did not file the petition in good faith or if the petition does not meet the requirements of this title.' No other Chapter of the Bankruptcy Code expressly incorporates a good-faith filing requirement. See Sullivan County, 165 B.R. at 80. If the court does not dismiss the petition under section 921(c), it 'shall' order relief under Chapter 9. 11 U.S.C. ' 921(d). Notwithstanding its permissive language, section 921(c) has been construed as requiring dismissal of a petition filed by a debtor that is ineligible for relief under Chapter 9. See In re Valley Health System, 2008 WL 616283, *2 (Bankr. C.D. Cal. Feb. 20, 2008); County of Orange, 183 B.R. at 599; see generally 6 Collier on Bankruptcy ' 921.04[4] at 921-7. Factors that may be relevant in determining whether a Chapter 9 petition has been filed in good faith include:

1. the debtor's subjective beliefs;
2. whether the debtor's financial problems can be addressed by Chapter 9;
3. whether the debtor's motivation for filing is consistent with the purposes of Chapter 9;
4. the extent of the debtor's prepetition negotiations, if practical;
5. the extent to which the debtor considered alternatives to Chapter 9; and
6. the scope and nature of the debtor's financial problems.

Id. at 921-6 (citations omitted). Standing alone, a municipal debtor's refusal to impose or raise assessments or to borrow funds is not sufficient to warrant a finding of bad faith. See McCurtain, 2007 WL 4287604, at *6; In re Chilhowee R-IV School Dist., 145 B.R. 981, 983 (Bankr. W.D. Mo. 1992). Dismissal of a Chapter 9 case is the only option if the debtor does not seek Chapter 9 relief in good faith or cannot confirm a plan ' the assets of a Chapter 9 debtor cannot be liquidated involuntarily.

Part Two of this article will discuss the bankruptcy court's limited role, a plan for adjustment of debts, the dismissal option, and the outlook for Chapter 9.

Erica M. Ryland is a partner in the Business Restructuring and Reorganization Practice of Jones Day in New York. Mark G. Douglas, a member of this newsletter's Board of Editors, is Jones Day's Restructuring Practice Communications Coordinator and Managing Editor of the Jones Day Business Restructuring Review. The views expressed in this article are the personal views of the authors and do not necessarily reflect those of Jones Day or its clients.