Rediscovering Chapter 9 As Financial Woes of Municipalities Escalate

In addition, control of a municipal debtor is not subject to defeasance in the form of a bankruptcy trustee (although state laws commonly provide a mechanism for transferring control of the affairs of a distressed municipality). See Michael W. McConnell and Randall C. Picker, When Cities Go Broke: A Conceptual Introduction to Municipal Bankruptcy, 713 PLI/Comm 35, 75 (March 1995). A trustee, however, may be appointed to pursue avoidance actions (other than transfers to or for the benefit of bondholders) on behalf of the estate if the debtor refuses to do so. 11 U.S.C. ' 926. A municipal debtor's ability to borrow money outside of bankruptcy is not limited by Chapter 9 and the municipal debtor is not subject to the reporting requirement and other general duties of a Chapter 11 debtor. See David S. Kupetz, Muncipal Debt Adjustment: A Look at How Chapter 9 Allowed Orange County to Provide Essential Services While Undergoing Debt Restructuring, 42 Fed. Law. 18, 21 (May 1995); In re Richmond Unified School Dist., 133 B.R. 221, 224 (Bankr. N.D. Cal. 1991).

A Chapter 9 debtor enjoys may of the rights of a Chapter 11 debtor-in-possession, but is subject to few of the obligations. Pursuant to section 901, many provisions contained elsewhere in the Bankruptcy Code are expressly made applicable to Chapter 9 cases. These include the provisions with respect to the automatic stay, employment and compensation of professionals, adequate protection, post-petition financing, executory contracts, administrative expenses, a bankruptcy trustee's 'strong arm' and avoidance powers, financial contracts, the formation of official committees and most, but not all, of the provisions governing vote solicitation, disclosure and confirmation of a Chapter 11 plan. Chapter 9 expands the scope of the automatic stay to enjoin actions against officers and inhabitants of the debtor that seek to enforce claims against it. Non-recourse special revenue obligations do not become recourse debt in a Chapter 9 case, but liens securing such obligations attach to the Chapter 9 debtor's post-petition revenues previously dedicated to the obligation in question. 11 U.S.C. ” 927 and 928. Municipal leases that are subject to termination if the debtor fails to appropriate rent are not treated as executory contracts in a Chapter 9 case. 11 U.S.C. ' 929. Only administrative claims are entitled to priority in a Chapter 9 case ' the remaining categories of unsecured priority claims specified in section 507(a) do not apply in Chapter 9. 11 U.S.C. ' 901.

Section 1113 does not apply to Chapter 9 cases. Thus, it is unclear what standard would apply (i.e., the standard in section 1113 or the less restrictive requirements in section 365) if a municipal debtor were to attempt to reject a collective bargaining agreement. Section 1114 is also inapplicable, although state law would presumably govern any proposed changes to the benefits of a municipality's retired employees.

Plan for Adjustment of Debts

As with Chapter 11, the raison d”tre of Chapter 9 is confirmation of a plan (either consensually or otherwise), but with one significant difference ' a municipal debtor may not be liquidated in Chapter 9. Only the Chapter 9 debtor has the right to file a plan, and indeed is obligated to file a plan either with its petition or within such time as the court directs. 11 U.S.C. ' 941. The confirmation standards are comparable to Chapter 11. As in Chapter 11, creditor claims must be classified under a plan and at least one impaired class of creditors must approve the plan for it to be confirmed. Chapter 9 also incorporates the cram-down confirmation rules, including the requirement that a plan not 'discriminate unfairly' and be 'fair and equitable' with respect to classes of secured and unsecured claims. The 'fair and equitable' requirement, however, offers scant solace to unsecured creditors in a Chapter 9 case. The absolute priority rule in section 1129(b)(2)(B)(ii) provides little protection when the debtor has no shareholders whose interests can be wiped out due to less than full payment of creditor claims. In re Corcoran Hosp. Dist., 233 B.R. 449, 457-58 (Bankr. E.D. Cal. 1999).

A Chapter 9 case can be confirmed only if it 'is the best interests of creditors and is feasible.' 11 U.S.C. ' 943(b)(7). Unlike in Chapter 11, where the test compares creditor recoveries under a plan with what they would receive in a liquidation, the 'best interests' requirement in Chapter 9 mandates that a proposed plan provide a better alternative for creditors than what they already have. Mount Carbon., 242 B.R. at 35; Matter of Sanitary & Imp. Dist., No. 7, 98 B.R. 970, 974 (Bankr. D. Neb. 1989). This is often fairly easy to demonstrate. Because creditors cannot propose a plan, the case cannot be converted to a liquidation and a trustee cannot be appointed, the only alternative to a Chapter 9 plan is dismissal (discussed below). Outside of bankruptcy, there is little possibility that unsecured creditors will be repaid, especially if the municipality's debt burden is too high to be retired by taxes. Any possibility of payment under a Chapter 9 plan is often perceived by creditors as a better alternative. Mount Carbon., 242 B.R. at 35. Even so, courts are likely to compare what creditors are to receive under a Chapter 9 plan with what they could reasonably expect to recover outside of bankruptcy if they were to exercise their remedies under applicable non-bankruptcy law. See Kupet, Muncipal Debt Adjustment at 23. To be feasible, 'a plan should offer a reasonable prospect of success and be workable.' Mount Carbon, 242 B.R. at 35. In assessing feasibility, the court must evaluate whether it is probable that the debtor can both pay pre-petition debt and provide future public services at the level necessary to maintain its viability as a municipality. Id. at 34-35.

Dismissal

If the debtor cannot confirm a plan, the only option available to the court (and creditors) is dismissal of the Chapter 9 case. Under section 930, a court may dismiss a Chapter 9 case for 'cause,' which includes unreasonable delay by the debtor that is prejudicial to creditors, failure to propose or obtain confirmation of a plan or material default under a plan after it has been confirmed. If the court refuses to confirm the debtor's plan (either on the first attempt or after giving the debtor additional time to modify the plan or propose a new one), it 'shall' dismiss the Chapter 9 case. 11 U.S.C. ' 930(b). Dismissal is appropriate even if the debtor is clearly insolvent and creditors would be better off if the Chapter 9 case were not dismissed. See Richmond Unified, 133 B.R. at 225-26.

Outlook

The present-day legislative scheme for municipal debt reorganizations was implemented in the aftermath of New York City's financial crisis and federal government bailout in 1975, but Chapter 9 has proved to be of limited utility thus far. Only a handful of cities have filed for Chapter 9 protection. The vast majority of Chapter 9 filings involve municipal instrumentalities, such as irrigation districts, public utility districts, waste removal districts, and health care or hospital districts. Bridgeport, CT (pop. 138,000) is the only large city even to have attempted a Chapter 9 filing, but its effort to use Chapter 9 in 1991 to reorganize its debts failed because it did not meet the insolvency requirement. Mid-sized Camden, NJ (pop. 87,000) and Prichard, AL (pop. 28,000) also filed for Chapter 9 in 1999. Camden's stay in Chapter 9 ended abruptly when the State of New Jersey took over the failing city in 2000. Prichard confirmed its Chapter 9 plan in October 2000. Orange County, CA (pop. 2.8 million) is the other prominent municipality to have taken the plunge. Having filed the largest Chapter 9 case in U.S. history and confirmed a plan in 2005, Orange County stands alone as the only large municipal debtor to have navigated through Chapter 9.

More recently, the City Council of Vallejo, CA (pop. 117,000) voted unanimously on May 6, 2008, to file a Chapter 9 petition, claiming that the city lacks sufficient cash to pay its bills after negotiations with labor unions failed to win salary concessions from firefighters and police. If the filing goes forward as anticipated, the San Francisco suburb will become the largest city in California to file for bankruptcy, and the first local government in the state to seek protection from creditors because it ran out of money amid the worst housing slump in the U.S. in over a quarter century.'

Even so, the only alternative to Chapter 9 is restructuring by the municipality under applicable state law, which may be difficult and require voter approval. The ability to bind dissenting creditors without obtaining voter approval may make Chapter 9 preferable. Thus, as the financial problems of municipalities continue to mount, there may be a significant surge in Chapter 9 filings. To be sure, Chapter 9's utility in dealing with some of these problems may be limited. For example, to the extent that a municipality's questionable investments include securities, forward or commodities contracts, or swap, repurchase or master netting agreements, bankruptcy (and the automatic stay) will not prevent the contract parties from exercising their rights. Also, although a Chapter 9 debtor can restructure its existing debt, new long-term borrowing at any kind of favorable rate of interest is likely to be problematic. Still, the suspension of creditor collection efforts and the prospect of restructuring existing debt may mean that Chapter 9 is the most viable strategy for many beleaguered municipalities.

Erica M. Ryland is a partner in the Business Restructuring and Reorg- anization 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.

Last month, we discussed the fact that even though Chapter 9 of the Bankruptcy Code has been in effect for over 30 years, fewer than 100 Chapter 9 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. This, however, may be changing. We now continue that discussion.

Bankruptcy Court's Limited Role

Due to constitutional restrictions, the bankruptcy court's role in a Chapter 9 case is quite limited. Section 903 of the Bankruptcy Code expressly reserves to the states the power to control municipalities that file for Chapter 9 protection, with the caveat that any state law (or equivalent judgment) prescribing a method of composition among a municipality's creditors is not binding on dissenters. Section 904 further provides that, without the debtor's consent, the court may not 'interfere' with any of the debtor's 'political or governmental powers,' any of the debtor's property or revenues or the use or enjoyment of its income-producing property. Thus, unlike a Chapter 11 debtor, a municipal debtor is not restricted in its ability to use, sell or lease its property (section 363 does not apply in a Chapter 9 case), and the court may not become involved in the debtor's day to day operations.

In addition, control of a municipal debtor is not subject to defeasance in the form of a bankruptcy trustee (although state laws commonly provide a mechanism for transferring control of the affairs of a distressed municipality). See Michael W. McConnell and Randall C. Picker, When Cities Go Broke: A Conceptual Introduction to Municipal Bankruptcy, 713 PLI/Comm 35, 75 (March 1995). A trustee, however, may be appointed to pursue avoidance actions (other than transfers to or for the benefit of bondholders) on behalf of the estate if the debtor refuses to do so. 11 U.S.C. ' 926. A municipal debtor's ability to borrow money outside of bankruptcy is not limited by Chapter 9 and the municipal debtor is not subject to the reporting requirement and other general duties of a Chapter 11 debtor. See David S. Kupetz, Muncipal Debt Adjustment: A Look at How Chapter 9 Allowed Orange County to Provide Essential Services While Undergoing Debt Restructuring, 42 Fed. Law. 18, 21 (May 1995); In re Richmond Unified School Dist., 133 B.R. 221, 224 (Bankr. N.D. Cal. 1991).

A Chapter 9 debtor enjoys may of the rights of a Chapter 11 debtor-in-possession, but is subject to few of the obligations. Pursuant to section 901, many provisions contained elsewhere in the Bankruptcy Code are expressly made applicable to Chapter 9 cases. These include the provisions with respect to the automatic stay, employment and compensation of professionals, adequate protection, post-petition financing, executory contracts, administrative expenses, a bankruptcy trustee's 'strong arm' and avoidance powers, financial contracts, the formation of official committees and most, but not all, of the provisions governing vote solicitation, disclosure and confirmation of a Chapter 11 plan. Chapter 9 expands the scope of the automatic stay to enjoin actions against officers and inhabitants of the debtor that seek to enforce claims against it. Non-recourse special revenue obligations do not become recourse debt in a Chapter 9 case, but liens securing such obligations attach to the Chapter 9 debtor's post-petition revenues previously dedicated to the obligation in question. 11 U.S.C. ” 927 and 928. Municipal leases that are subject to termination if the debtor fails to appropriate rent are not treated as executory contracts in a Chapter 9 case. 11 U.S.C. ' 929. Only administrative claims are entitled to priority in a Chapter 9 case ' the remaining categories of unsecured priority claims specified in section 507(a) do not apply in Chapter 9. 11 U.S.C. ' 901.

Section 1113 does not apply to Chapter 9 cases. Thus, it is unclear what standard would apply (i.e., the standard in section 1113 or the less restrictive requirements in section 365) if a municipal debtor were to attempt to reject a collective bargaining agreement. Section 1114 is also inapplicable, although state law would presumably govern any proposed changes to the benefits of a municipality's retired employees.

Plan for Adjustment of Debts

As with Chapter 11, the raison d”tre of Chapter 9 is confirmation of a plan (either consensually or otherwise), but with one significant difference ' a municipal debtor may not be liquidated in Chapter 9. Only the Chapter 9 debtor has the right to file a plan, and indeed is obligated to file a plan either with its petition or within such time as the court directs. 11 U.S.C. ' 941. The confirmation standards are comparable to Chapter 11. As in Chapter 11, creditor claims must be classified under a plan and at least one impaired class of creditors must approve the plan for it to be confirmed. Chapter 9 also incorporates the cram-down confirmation rules, including the requirement that a plan not 'discriminate unfairly' and be 'fair and equitable' with respect to classes of secured and unsecured claims. The 'fair and equitable' requirement, however, offers scant solace to unsecured creditors in a Chapter 9 case. The absolute priority rule in section 1129(b)(2)(B)(ii) provides little protection when the debtor has no shareholders whose interests can be wiped out due to less than full payment of creditor claims. In re Corcoran Hosp. Dist., 233 B.R. 449, 457-58 (Bankr. E.D. Cal. 1999).

A Chapter 9 case can be confirmed only if it 'is the best interests of creditors and is feasible.' 11 U.S.C. ' 943(b)(7). Unlike in Chapter 11, where the test compares creditor recoveries under a plan with what they would receive in a liquidation, the 'best interests' requirement in Chapter 9 mandates that a proposed plan provide a better alternative for creditors than what they already have. Mount Carbon., 242 B.R. at 35; Matter of Sanitary & Imp. Dist., No. 7, 98 B.R. 970, 974 (Bankr. D. Neb. 1989). This is often fairly easy to demonstrate. Because creditors cannot propose a plan, the case cannot be converted to a liquidation and a trustee cannot be appointed, the only alternative to a Chapter 9 plan is dismissal (discussed below). Outside of bankruptcy, there is little possibility that unsecured creditors will be repaid, especially if the municipality's debt burden is too high to be retired by taxes. Any possibility of payment under a Chapter 9 plan is often perceived by creditors as a better alternative. Mount Carbon., 242 B.R. at 35. Even so, courts are likely to compare what creditors are to receive under a Chapter 9 plan with what they could reasonably expect to recover outside of bankruptcy if they were to exercise their remedies under applicable non-bankruptcy law. See Kupet, Muncipal Debt Adjustment at 23. To be feasible, 'a plan should offer a reasonable prospect of success and be workable.' Mount Carbon, 242 B.R. at 35. In assessing feasibility, the court must evaluate whether it is probable that the debtor can both pay pre-petition debt and provide future public services at the level necessary to maintain its viability as a municipality. Id. at 34-35.

Dismissal

If the debtor cannot confirm a plan, the only option available to the court (and creditors) is dismissal of the Chapter 9 case. Under section 930, a court may dismiss a Chapter 9 case for 'cause,' which includes unreasonable delay by the debtor that is prejudicial to creditors, failure to propose or obtain confirmation of a plan or material default under a plan after it has been confirmed. If the court refuses to confirm the debtor's plan (either on the first attempt or after giving the debtor additional time to modify the plan or propose a new one), it 'shall' dismiss the Chapter 9 case. 11 U.S.C. ' 930(b). Dismissal is appropriate even if the debtor is clearly insolvent and creditors would be better off if the Chapter 9 case were not dismissed. See Richmond Unified, 133 B.R. at 225-26.

Outlook

The present-day legislative scheme for municipal debt reorganizations was implemented in the aftermath of New York City's financial crisis and federal government bailout in 1975, but Chapter 9 has proved to be of limited utility thus far. Only a handful of cities have filed for Chapter 9 protection. The vast majority of Chapter 9 filings involve municipal instrumentalities, such as irrigation districts, public utility districts, waste removal districts, and health care or hospital districts. Bridgeport, CT (pop. 138,000) is the only large city even to have attempted a Chapter 9 filing, but its effort to use Chapter 9 in 1991 to reorganize its debts failed because it did not meet the insolvency requirement. Mid-sized Camden, NJ (pop. 87,000) and Prichard, AL (pop. 28,000) also filed for Chapter 9 in 1999. Camden's stay in Chapter 9 ended abruptly when the State of New Jersey took over the failing city in 2000. Prichard confirmed its Chapter 9 plan in October 2000. Orange County, CA (pop. 2.8 million) is the other prominent municipality to have taken the plunge. Having filed the largest Chapter 9 case in U.S. history and confirmed a plan in 2005, Orange County stands alone as the only large municipal debtor to have navigated through Chapter 9.

More recently, the City Council of Vallejo, CA (pop. 117,000) voted unanimously on May 6, 2008, to file a Chapter 9 petition, claiming that the city lacks sufficient cash to pay its bills after negotiations with labor unions failed to win salary concessions from firefighters and police. If the filing goes forward as anticipated, the San Francisco suburb will become the largest city in California to file for bankruptcy, and the first local government in the state to seek protection from creditors because it ran out of money amid the worst housing slump in the U.S. in over a quarter century.'

Even so, the only alternative to Chapter 9 is restructuring by the municipality under applicable state law, which may be difficult and require voter approval. The ability to bind dissenting creditors without obtaining voter approval may make Chapter 9 preferable. Thus, as the financial problems of municipalities continue to mount, there may be a significant surge in Chapter 9 filings. To be sure, Chapter 9's utility in dealing with some of these problems may be limited. For example, to the extent that a municipality's questionable investments include securities, forward or commodities contracts, or swap, repurchase or master netting agreements, bankruptcy (and the automatic stay) will not prevent the contract parties from exercising their rights. Also, although a Chapter 9 debtor can restructure its existing debt, new long-term borrowing at any kind of favorable rate of interest is likely to be problematic. Still, the suspension of creditor collection efforts and the prospect of restructuring existing debt may mean that Chapter 9 is the most viable strategy for many beleaguered municipalities.

Erica M. Ryland is a partner in the Business Restructuring and Reorg- anization 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.