Municipal Bankruptcy: Coming Soon to a Court Near You

Another attraction is the limited role of the bankruptcy court and limited options available to creditors in Chapter 9. A bankruptcy court's jurisdiction in a Chapter 9 proceeding is limited as a result of the Tenth Amendment's grant to the states of the exclusive right to control the affairs of their municipalities. See 11 U.S.C. ' 904. This limiting principle is also embodied in 11 U.S.C. ' 901, which excludes from Chapter 9 key supervisory provisions such as ' 363 of the Bankruptcy Code and provisions allowing appointment of a trustee and competing creditor plans. Thus, the bankruptcy court is far less involved and creditors have little leverage to take the initiative. Meanwhile, the debtor has broad powers during the case to use its property, and to make or defer expenditures as it sees fit.

Chapter 9 Eligibility

While by no means a Shangri-La, Chapter 9 is, after all, about financial distress. Eligibility is far more restricted than in Chapter 11, and objections to eligibility must be resolved before the order for relief is entered. 11 U.S.C. ' 921(d).

Only a “municipality” may file for relief under Chapter 9. 11 U.S.C. ' 109(c)(1). The question of what defines a municipality was the subject of a recent ruling in In re Las Vegas Monorail Company (Las Vegas Monorail), a Chapter 11 case where a creditor moved to dismiss on the ground that the case should have been filed under Chapter 9.

The entity must be “specifically authorized” under state law or by an authorized government official to file a Chapter 9 petition. 11 U.S.C. ' 109(c)(2). This eligibility requirement was recently addressed in In re New York Off-Track Betting Corp. (OTB), a Chapter 9 case. Many states do not authorize municipalities to resort to Chapter 9, or impose conditions or other restrictions. California's blanket authorization may be restricted by a pending bill, AB 155.

The municipality must also be insolvent, according to 11 U.S.C. ' 109(c)(3), which is not a requirement for Chapter 11. This and other eligibility issues were addressed in In re City of Vallejo, 408 B.R. 280 (9th Cir. BAP 2009).

What Is a 'Municipality'?

On April 26, 2010, the Bankruptcy Court for the District of Nevada denied a motion to dismiss the Chapter 11 case of Las Vegas Monorail Company (LVMC) filed by Ambac Assurance Corp. In re Las Vegas Monorail Company (Las Vegas Monorail), Case No.: BK-S-10-10464 (Bankr. D.Nev. April 26, 2010). Ambac, which insured tax-exempt bonds issued by the State of Nevada to construct the monorail, alleged that LVMC was a municipality under the Bankruptcy Code and therefore ineligible to file under Chapter 11.

The Bankruptcy Code provides that only “a person that may be a debtor under Chapter 7″ may be a Chapter 11 debtor. Under 11 U.S.C. ' 101(41), the definition of “person” specifically excludes a “governmental unit,” which in turn is defined in ' 101(27) to include a “municipality.” Thus, if LVMC was a municipality, it could file under Chapter 11.

Judge Bruce Markell recognized the absence of precedent as to when a particular organ of state government would be a “municipality” or not. Section 101(40) of the Code provides that the term “municipality” means a “political subdivision or public agency or instrumentality of a State.” The challenge was to further define these three terms. Judge Markell quickly concluded that LVMC is not a “political subdivision,” such as a city, county, town or village; nor is it a “public agency,” as it was formed by private parties under general nonprofit corporation statutes, rather than by the Nevada legislature. That left “instrumentality of the state.”

After reviewing the history of federal statutes governing municipal insolvencies and relevant case law, Judge Markell distilled the determination as to whether an entity qualifies as an “instrumentality of a State” into three inquiries: 1) the extent to which the entity has traditional governmental attributes or engages in traditional governmental functions; 2) the extent to which the state controls the entity's operations, with elements that go to control of the state's finances having more weight than general regulation; and 3) the extent to which the state itself categorizes the entity as a municipality or instrumentality.

With respect to the first inquiry, LVMC was formed under general nonprofit corporation statutes rather than of a specific legislative enactment, demonstrating that LVMC does not possess traditional governmental attributes.

On the second inquiry, although the State of Nevada has general regulatory oversight over LVMC, such as veto power over its rates and budget, it does not exercise control of day-to-day operations.

For the third inquiry, Judge Markell found that although tax-exemption filings with the Internal Revenue Service described LVMC as an instrumentality of the state, Nevada does not so treat LVMC for any other purpose. LVMC has no taxing powers, no power to issue obligations which bear tax-free interest, and must apply to other Nevada state agencies for its licenses and permits. Therefore, LVMC was not an instrumentality of the state, and thus, not a municipality under the Bankruptcy Code.

Consequently, LVMC was indeed eligible to file for Chapter 11. Interestingly, because Nevada does not authorize municipalities to file under Chapter 9, had LVMC's Chapter 11 bankruptcy case been dismissed, LVMC would have had no recourse other than to be subject to Nevada's state insolvency regime.

On May 10, 2010, Ambac and its court appointed rehabilitator appealed the Las Vegas Monorail decision. Assuming it is upheld, the decision is a welcome judicial guide to analyzing whether a particular organ of a state is a municipality under the Bankruptcy Code, and likely to be cited by courts addressing future controversies in this area.

State Authorization

State authorization was addressed in the Bankruptcy Court for the Southern District of New York's opinion overruling objections of creditors to the Chapter 9 petition of New York City Off-Track Betting Corporation (“OTB”). In re New York Off-Track Betting Corp., Case No. 09-17121 (Bankr. S.D.N.Y. March 22, 2010). The objecting creditors argued that OTB could not satisfy the eligibility requirements under Chapter 9 of the Bankruptcy Code and that OTB did not file its petition in good faith.

Judge Martin Glenn examined whether OTB met the requirements under ' 109(c) of the Bankruptcy Code to file for protection under Chapter 9. Judge Glenn readily found that OTB was a “municipality” as it is a public benefit corporation “created by the State for the general purpose of performing functions essentially governmental in nature.”

The objecting creditors had conceded as much. But even if the creditors had challenged whether OTB is a municipality, Judge Glenn would likely have come to the same conclusion. OTB is a public benefit corporation created by state statute, unlike LVMC, which was created by private parties under Nevada's general nonprofit corporation laws. Given OTB's authorization and creation by the New York State legislature, Judge Markell's analysis in Las Vegas Monorail confirms Judge Glenn's conclusion that OTB is a “municipality” within ' 109(c)(2).

The focus of the NYC OTB decision was whether OTB had state authorization to file for Chapter 9 protection. Three months prior to its bankruptcy petition ' and 30 years after the creation of OTB ' the Governor of New York issued an Executive Order specifically authorizing OTB to file for bankruptcy protection under Chapter 9. The objecting creditors argued that this Executive Order did not meet ' 109(c)(2)'s specific authorization requirement because it was not authorized by the legislature. Judge Glenn, however, found that under New York law, the Governor possesses the power to authorize a Chapter 9 filing on behalf of the state.

Judge Glenn went on to find that OTB met the final ' 109(c) requirements as well: 1) OTB was insolvent when it filed for Chapter 9 protection; 2) it had expressed a desire to effect a plan to adjust its debts; and 3) it had met each of the ' 109(c)(5) requirements with respect to its creditors. Finally, Judge Glenn ruled that OTB filed for Chapter 9 in good faith after examining alternatives. His decision in NYC OTB was appealed on April 5, 2010 by the New York Racing Association, Inc.

Insolvency

Unlike corporate debtors, a municipality must be insolvent to be eligible for Chapter 9. 11 U.S.C. ' 109(c)(3). Insolvency, with respect to a municipality, means: “financial condition such that the municipality is (i) generally not paying its debt as they become due unless such debts are the subject of a bona fide dispute; or (ii) unable to pay its debts as they become due.” 11 U.S.C. ' 101(32)(C).

The first test for insolvency looks at whether, at the present time, the debtor is in fact not paying its undisputed debts as they come due. The second test looks to the future. City of Bridgeport, 129 B.R. 332 (Bankr. D. Conn. 1991) is instructive. There, the city filed for Chapter 9 relief, and the state challenged its eligibility, contending that the city, which had been paying its debts as they came due, was not “insolvent.”

The court heard testimony from city officials about current budget cuts and that the budget for the following fiscal year showed a deficit of $16 million. Nevertheless, the court held that the budget gap did not necessarily equate to inability to pay debts as they come due in the future. The court noted that the city had a reserve of $27 million that could be used to cover the deficit during the fiscal year. The court rejected the argument that the city would surely run out of cash in the subsequent year, arguing that any projection beyond the next fiscal year would be too unreliable. The debtor's inability to pay its debt had to be “imminent and certain, not merely a possibility or speculation.” Accordingly, the court dismissed the case.

In contrast, the Ninth Circuit Bankruptcy Appellate Panel, in In re City of Vallejo, 408 B.R. 280 (9th Cir. BAP 2009), took what appears to be a more relaxed view of the “insolvency” requirement. In City of Vallejo, the unions objected to Vallejo's eligibility for Chapter 9 relief, contending, among other things, that Vallejo could have operated for another fiscal year if it had adopted certain budget measures proposed by the union.

The Ninth Circuit BAP rejected that argument, noting that even if the union's proposal could keep Vallejo out of bankruptcy for another fiscal year, it would not “provide long term solvency beyond the first year.” This willingness to look beyond the current fiscal year appears to relax the requirement set forth in City of Bridgeport that the debtor's inability to pay its debts be “imminent and certain.”

Conclusion

As each of these cases illustrates, eligibility for Chapter 9 is a threshold issue that each municipality can expect to face shortly after any petition is filed. The three eligibility tests, status as a municipality, state authorization, and insolvency, are not exhaustive. Additional grounds for contesting eligibility include a desire to confirm a plan of adjustment and the effect of any pre-filing negotiations or their impracticality, 11 U.S.C. ' 109(c)(4), (5), as well as issues of good faith.

Establishing eligibility, however, only serves to raise a host of other unanswered questions about the near- and long-term consequences if a municipality resorts to Chapter 9. The standards for confirmation of a plan of adjustment provide little guidance to the parties in interest, leaving the path out of bankruptcy uncertain. Whether Chapter 9 will provide long-term solutions to insolvent municipalities remains to be seen.

Richard Lapping ([email protected]) is a partner in the San Francisco office of Winston & Strawn LLP. Sarah Trum ([email protected]) is a senior associate in the firm's New York office. Both are members of the Restructuring and Insolvency Group, and represent debtors, creditors, trustees, committees and other participants in bankruptcy-related transactions and litigation. Winston & Strawn LLP represents a creditor in the City of Vallejo case, but was not a participant in the decisions discussed in the article.

One effect of the recent recession is a heightened focus on past overspending by municipalities that now face some tough financial choices. As tax revenues have declined in the face of falling incomes, sales and property values, more cities small and large have disclosed that resort to Chapter 9 of the Bankruptcy Code, the municipal bankruptcy law, has made it onto their agendas.

Why Chapter 9?

One of the attractions of Chapter 9 is the perceived ability to reject expensive union contracts, a benefit recently underscored by an appellate decision in the City of Vallejo, CA, case, In re City of Vallejo, CA, Case No. 2:09-cv-02603 (E.D.Cal., June 14, 2010). Other benefits include the protection of the automatic stay and the ability to impair contracts in a plan of adjustment.

Another attraction is the limited role of the bankruptcy court and limited options available to creditors in Chapter 9. A bankruptcy court's jurisdiction in a Chapter 9 proceeding is limited as a result of the Tenth Amendment's grant to the states of the exclusive right to control the affairs of their municipalities. See 11 U.S.C. ' 904. This limiting principle is also embodied in 11 U.S.C. ' 901, which excludes from Chapter 9 key supervisory provisions such as ' 363 of the Bankruptcy Code and provisions allowing appointment of a trustee and competing creditor plans. Thus, the bankruptcy court is far less involved and creditors have little leverage to take the initiative. Meanwhile, the debtor has broad powers during the case to use its property, and to make or defer expenditures as it sees fit.

Chapter 9 Eligibility

While by no means a Shangri-La, Chapter 9 is, after all, about financial distress. Eligibility is far more restricted than in Chapter 11, and objections to eligibility must be resolved before the order for relief is entered. 11 U.S.C. ' 921(d).

Only a “municipality” may file for relief under Chapter 9. 11 U.S.C. ' 109(c)(1). The question of what defines a municipality was the subject of a recent ruling in In re Las Vegas Monorail Company (Las Vegas Monorail), a Chapter 11 case where a creditor moved to dismiss on the ground that the case should have been filed under Chapter 9.

The entity must be “specifically authorized” under state law or by an authorized government official to file a Chapter 9 petition. 11 U.S.C. ' 109(c)(2). This eligibility requirement was recently addressed in In re New York Off-Track Betting Corp. (OTB), a Chapter 9 case. Many states do not authorize municipalities to resort to Chapter 9, or impose conditions or other restrictions. California's blanket authorization may be restricted by a pending bill, AB 155.

The municipality must also be insolvent, according to 11 U.S.C. ' 109(c)(3), which is not a requirement for Chapter 11. This and other eligibility issues were addressed in In re City of Vallejo, 408 B.R. 280 (9th Cir. BAP 2009).

What Is a 'Municipality'?

On April 26, 2010, the Bankruptcy Court for the District of Nevada denied a motion to dismiss the Chapter 11 case of Las Vegas Monorail Company (LVMC) filed by Ambac Assurance Corp. In re Las Vegas Monorail Company (Las Vegas Monorail), Case No.: BK-S-10-10464 (Bankr. D.Nev. April 26, 2010). Ambac, which insured tax-exempt bonds issued by the State of Nevada to construct the monorail, alleged that LVMC was a municipality under the Bankruptcy Code and therefore ineligible to file under Chapter 11.

The Bankruptcy Code provides that only “a person that may be a debtor under Chapter 7″ may be a Chapter 11 debtor. Under 11 U.S.C. ' 101(41), the definition of “person” specifically excludes a “governmental unit,” which in turn is defined in ' 101(27) to include a “municipality.” Thus, if LVMC was a municipality, it could file under Chapter 11.

Judge Bruce Markell recognized the absence of precedent as to when a particular organ of state government would be a “municipality” or not. Section 101(40) of the Code provides that the term “municipality” means a “political subdivision or public agency or instrumentality of a State.” The challenge was to further define these three terms. Judge Markell quickly concluded that LVMC is not a “political subdivision,” such as a city, county, town or village; nor is it a “public agency,” as it was formed by private parties under general nonprofit corporation statutes, rather than by the Nevada legislature. That left “instrumentality of the state.”

After reviewing the history of federal statutes governing municipal insolvencies and relevant case law, Judge Markell distilled the determination as to whether an entity qualifies as an “instrumentality of a State” into three inquiries: 1) the extent to which the entity has traditional governmental attributes or engages in traditional governmental functions; 2) the extent to which the state controls the entity's operations, with elements that go to control of the state's finances having more weight than general regulation; and 3) the extent to which the state itself categorizes the entity as a municipality or instrumentality.

With respect to the first inquiry, LVMC was formed under general nonprofit corporation statutes rather than of a specific legislative enactment, demonstrating that LVMC does not possess traditional governmental attributes.

On the second inquiry, although the State of Nevada has general regulatory oversight over LVMC, such as veto power over its rates and budget, it does not exercise control of day-to-day operations.

For the third inquiry, Judge Markell found that although tax-exemption filings with the Internal Revenue Service described LVMC as an instrumentality of the state, Nevada does not so treat LVMC for any other purpose. LVMC has no taxing powers, no power to issue obligations which bear tax-free interest, and must apply to other Nevada state agencies for its licenses and permits. Therefore, LVMC was not an instrumentality of the state, and thus, not a municipality under the Bankruptcy Code.

Consequently, LVMC was indeed eligible to file for Chapter 11. Interestingly, because Nevada does not authorize municipalities to file under Chapter 9, had LVMC's Chapter 11 bankruptcy case been dismissed, LVMC would have had no recourse other than to be subject to Nevada's state insolvency regime.

On May 10, 2010, Ambac and its court appointed rehabilitator appealed the Las Vegas Monorail decision. Assuming it is upheld, the decision is a welcome judicial guide to analyzing whether a particular organ of a state is a municipality under the Bankruptcy Code, and likely to be cited by courts addressing future controversies in this area.

State Authorization

State authorization was addressed in the Bankruptcy Court for the Southern District of New York's opinion overruling objections of creditors to the Chapter 9 petition of New York City Off-Track Betting Corporation (“OTB”). In re New York Off-Track Betting Corp., Case No. 09-17121 (Bankr. S.D.N.Y. March 22, 2010). The objecting creditors argued that OTB could not satisfy the eligibility requirements under Chapter 9 of the Bankruptcy Code and that OTB did not file its petition in good faith.

Judge Martin Glenn examined whether OTB met the requirements under ' 109(c) of the Bankruptcy Code to file for protection under Chapter 9. Judge Glenn readily found that OTB was a “municipality” as it is a public benefit corporation “created by the State for the general purpose of performing functions essentially governmental in nature.”

The objecting creditors had conceded as much. But even if the creditors had challenged whether OTB is a municipality, Judge Glenn would likely have come to the same conclusion. OTB is a public benefit corporation created by state statute, unlike LVMC, which was created by private parties under Nevada's general nonprofit corporation laws. Given OTB's authorization and creation by the New York State legislature, Judge Markell's analysis in Las Vegas Monorail confirms Judge Glenn's conclusion that OTB is a “municipality” within ' 109(c)(2).

The focus of the NYC OTB decision was whether OTB had state authorization to file for Chapter 9 protection. Three months prior to its bankruptcy petition ' and 30 years after the creation of OTB ' the Governor of New York issued an Executive Order specifically authorizing OTB to file for bankruptcy protection under Chapter 9. The objecting creditors argued that this Executive Order did not meet ' 109(c)(2)'s specific authorization requirement because it was not authorized by the legislature. Judge Glenn, however, found that under New York law, the Governor possesses the power to authorize a Chapter 9 filing on behalf of the state.

Judge Glenn went on to find that OTB met the final ' 109(c) requirements as well: 1) OTB was insolvent when it filed for Chapter 9 protection; 2) it had expressed a desire to effect a plan to adjust its debts; and 3) it had met each of the ' 109(c)(5) requirements with respect to its creditors. Finally, Judge Glenn ruled that OTB filed for Chapter 9 in good faith after examining alternatives. His decision in NYC OTB was appealed on April 5, 2010 by the New York Racing Association, Inc.

Insolvency

Unlike corporate debtors, a municipality must be insolvent to be eligible for Chapter 9. 11 U.S.C. ' 109(c)(3). Insolvency, with respect to a municipality, means: “financial condition such that the municipality is (i) generally not paying its debt as they become due unless such debts are the subject of a bona fide dispute; or (ii) unable to pay its debts as they become due.” 11 U.S.C. ' 101(32)(C).

The first test for insolvency looks at whether, at the present time, the debtor is in fact not paying its undisputed debts as they come due. The second test looks to the future. City of Bridgeport, 129 B.R. 332 (Bankr. D. Conn. 1991) is instructive. There, the city filed for Chapter 9 relief, and the state challenged its eligibility, contending that the city, which had been paying its debts as they came due, was not “insolvent.”

The court heard testimony from city officials about current budget cuts and that the budget for the following fiscal year showed a deficit of $16 million. Nevertheless, the court held that the budget gap did not necessarily equate to inability to pay debts as they come due in the future. The court noted that the city had a reserve of $27 million that could be used to cover the deficit during the fiscal year. The court rejected the argument that the city would surely run out of cash in the subsequent year, arguing that any projection beyond the next fiscal year would be too unreliable. The debtor's inability to pay its debt had to be “imminent and certain, not merely a possibility or speculation.” Accordingly, the court dismissed the case.

In contrast, the Ninth Circuit Bankruptcy Appellate Panel, in In re City of Vallejo, 408 B.R. 280 (9th Cir. BAP 2009), took what appears to be a more relaxed view of the “insolvency” requirement. In City of Vallejo, the unions objected to Vallejo's eligibility for Chapter 9 relief, contending, among other things, that Vallejo could have operated for another fiscal year if it had adopted certain budget measures proposed by the union.

The Ninth Circuit BAP rejected that argument, noting that even if the union's proposal could keep Vallejo out of bankruptcy for another fiscal year, it would not “provide long term solvency beyond the first year.” This willingness to look beyond the current fiscal year appears to relax the requirement set forth in City of Bridgeport that the debtor's inability to pay its debts be “imminent and certain.”

Conclusion

As each of these cases illustrates, eligibility for Chapter 9 is a threshold issue that each municipality can expect to face shortly after any petition is filed. The three eligibility tests, status as a municipality, state authorization, and insolvency, are not exhaustive. Additional grounds for contesting eligibility include a desire to confirm a plan of adjustment and the effect of any pre-filing negotiations or their impracticality, 11 U.S.C. ' 109(c)(4), (5), as well as issues of good faith.

Establishing eligibility, however, only serves to raise a host of other unanswered questions about the near- and long-term consequences if a municipality resorts to Chapter 9. The standards for confirmation of a plan of adjustment provide little guidance to the parties in interest, leaving the path out of bankruptcy uncertain. Whether Chapter 9 will provide long-term solutions to insolvent municipalities remains to be seen.

Richard Lapping ([email protected]) is a partner in the San Francisco office of Winston & Strawn LLP. Sarah Trum ([email protected]) is a senior associate in the firm's New York office. Both are members of the Restructuring and Insolvency Group, and represent debtors, creditors, trustees, committees and other participants in bankruptcy-related transactions and litigation. Winston & Strawn LLP represents a creditor in the City of Vallejo case, but was not a participant in the decisions discussed in the article.