Beware: Chapter 9 Is Not Just for Cities and Counties

Natural disasters affect and impair the assessable tax base, the ability of homeowners and business owners to timely pay real estate and other ad valorem taxes, while at the same time, increasing the strain on a municipality's budgeted expenses. When revenue decreases and expenses increase, municipalities are forced to either increase taxes or decrease expenditures ' neither of which are popular or may be acceptable alternatives in today's political climate. Add to that the need to restructure pension benefits, health care benefits and job security, and a political firestorm is created.

If a municipality as defined in the Bankruptcy Code enters a Chapter 9 proceeding, it is permitted to restructure most of its secured debts, all of its unsecured trade and commercial debts, most of its bond obligations, all pension and health and welfare benefits, and is permitted to reject executory contracts and collective-bargaining agreements in order to complete a financial restructuring. This type of court-mandated restructuring is sometimes the only alternative when the constituent parties are unwilling and/or unable to reach a negotiated restructuring.

Legislative Bodies

Since the U.S. Constitution provides a supremacy of bankruptcy proceedings over state law, there is little that can be done by legislative bodies to impair a municipality's rights once it has entered a Chapter 9 proceeding. However, a state legislature can prohibit a municipality from entering Chapter 9, or, in some cases, a governor can refuse to provide the necessary consent under applicable law to enter a reorganization proceeding. While this preclusion may be politically expedient, it does nothing to solve the underlying problem. As a result, other than a denial of the right of a municipality to file a Chapter 9 proceeding, there is nothing that the executive or legislative branches of a state government can do to modify a municipality's rights to file and proceed under the Bankruptcy Code. Likewise, state courts should generally be powerless to modify rights available under Chapter 9.

The situation in Detroit where the Michigan Constitution precludes the modification of pension benefits to former governmental employees raises an interesting and unresolved issue concerning the interplay of a state constitution versus the supremacy clause of the U.S. Constitution. This presents a unique issue of first impression that this author believes will be decided in favor of the supremacy of the Bankruptcy Code to enable the bankruptcy court to authorize the modification of pension and retiree benefits.

Another interesting provision in Chapter 9 is the fact that while secured debts may be modified by a Chapter 9 plan, special revenue bonds that are subject to liens or tied to a defined revenue stream, such as bridge or tunnel bonds that are funded by and secured with toll revenue, may not be affected or impaired by the Chapter 9 proceeding on a post-petition basis, and interest on these bonds must continue to be paid during the proceeding after payment of operating expenses.

As in Chapter 11, the municipality may reject executory contracts. There is no limitation on the rejection of collective-bargaining agreements as contained in Section 1113 of the Bankruptcy Code which affects only Chapter 11 proceedings. Also in Chapter 9, the municipality has the Chapter 5 avoidance powers such as for preferences, fraudulent transfers, etc., and there is an additional provision that if the municipal debtor is unwilling to pursue any of these causes of action, a special trustee can be appointed by the bankruptcy court for the limited purpose of pursuit of these avoidance actions.

As a safe harbor to the municipalities' bondholders and noteholders, while the future payment of interest and/or principle on the bonds may be modified or eliminated as part of the reorganization plan, there is a specific prohibition against pursuit of pre-petition bond or note payments as preferential transfers.

The above unique provisions of Chapter 9 provide an unusual legislatively created power and authority in the hands of the municipality to create its own restructuring, subject only to judicial review and approval (based upon feasibility and best interests), which should mandate pre-filing cooperation by the constituent creditor parties. However, recent experience has shown this not to be the case, and it is expected that there will be a proliferation of new filings.

Orange County, CA

The prior Chapter 9 proceeding of Orange County, CA, as well as the current Chapter 9 proceeding of Jefferson County, AL, provide excellent examples of the difficulties encountered with the financial restructuring of a large municipal entity. However, these cases may not establish good precedent for much smaller municipal agencies that need to seek bankruptcy relief such as towns, school districts, water and sewer districts and hospital districts where revenue sources are severely limited.

All of this will test the bankruptcy court's authority and ability to confirm a Chapter 9 plan that meets the requirements of Section 943 of the Bankruptcy Code. Similar to a Chapter 11 proceeding, in order to confirm a Chapter 9 plan, among other things: 1) all priority creditors must be paid in cash and in full on confirmation of the plan unless the creditor agrees to a deferred payment arrangement; 2) any regulatory or electoral approval necessary under applicable nonbankruptcy law in order to carry out any provision of the plan has been obtained; and 3) the plan must be feasible and meet the best-interest tests. Striking-ly, unlike Chapter 11, there is no creditor vote on the plan, and as such, there is no need for a cramdown provision. This grants to the bankruptcy judge virtual unfettered discretion, subject to appellate review, to approve or disapprove the reorganization plan. It is suspected that this perceived unlimited power and authority may cry out for congressional limitation in the near future.

Other Municipalities

Currently, published reports that dramatize the travails of communities along the New Jersey shore, Eastern New York and Long Island demonstrate the frustrations and problems created by a natural disaster. With most of the homeowners and businesses in the affected areas not having wind and/or flood insurance, rebuilding may not be an option. Thus, for every destroyed home or business that is not promptly rebuilt, the county, city/town and its taxing constituents face an unpredicted loss of tax revenue. At the same time, these municipal agencies are being asked to provide additional services to help rebuild the beach communities and the infrastructures that were destroyed by the storm. Since the municipal entities can only increase revenue by raising and collecting taxes, this creates a Catch 22 situation for everyone involved.

Experience with Superstorm Sandy, recent tornadoes, prior earthquakes and prior hurricanes has demonstrated ongoing and increasing strain on municipalities that are already hard-pressed and still recovering from the recent economic downturn. Although a few parts of the country have manifested a robust increase in real estate activity, this is not universally the case. Thus, tax roles remain depressed, and the ability to increase income is severely limited.

Conclusion

Since politicians have universally demonstrated an unwillingness or an inability to amicably resolve such situations, it is believed that there may be a substantial increase in the utilization of Chapter 9 proceedings throughout the country as a result of these natural disasters, as well as in those areas where the ravages of the financial recession are still being felt. Such proceedings impact many constituencies in a dramatic way. Bondholders, previously relying on the perceptive security of municipal bonds, can have their investments wiped out. This can have a dramatic effect on individuals that have invested in municipal bonds for their retirement accounts.

Vendors of goods or services to these municipal agencies may find that their debts are wiped out or they receive cents on the dollar. Retirees and current municipal workers may have their source of income dramatically impacted. However, as draconian as this may be, when these unexpected natural disasters occur, prudence on the part of the municipalities may mandate a prompt consideration of Chapter 9 as the only alternative to financial survival.

It does not take an economist to recognize the domino effect that is created with such municipal catastrophes. Chapter 9 of the bankruptcy code is alive and well, and its use in the future may be exponentially greater than in the past.

Charles M. Tatelbaum is a partner in the Fort Lauderdale, FL, office of Hinshaw & Culbertson LLP. He is certified in business bankruptcy law by the American Board of Certification, and has for 47 years concentrated his practice in the areas of secured creditor representation in domestic and international bankruptcy and insolvency proceedings, the defense of lender liability actions and international business transactions. Tatelbaum has represented parties in a number of Chapter 9 proceedings.'

With the recent filing of the Chapter 9 proceeding by the city of Detroit, public attention has been drawn to this little-known provision of the U.S. Bankruptcy Code. In the past, there is been limited attention paid outside of a small part of the bankruptcy community to cases involving the handful of cities and counties (mostly in California) that have utilized this reorganization process. However, as a result of recent natural disasters such as Superstorm Sandy, attorneys, bankruptcy and restructuring professionals and ordinary citizens throughout the country as well as bondholders, labor unions, pensioners and trade creditors may all need to become intimately familiar with this procedure.

What Is Chapter 9?

Chapter 9 deals with bankruptcies of municipalities. The Bankruptcy Code's definition of a municipality is not limited to cities and counties. The Code defines a “municipality” as any political subdivision, public agency or instrumentality of the state. Thus, a school district, a water and/or sewer district, a hospital district or any other instrumentality of a state that has the ability to tax may seek reorganization under Chapter 9 as needed. These public agencies and instrumentalities already face severe budgeting issues with the increase in wages, pension benefits and operational costs along with the unwillingness of politicians and voters to approve tax increases. When a natural disaster such as Superstorm Sandy, a hurricane, a blizzard, a tornado, an earthquake and the like affects the continuing revenue stream and expenses of such a government agency, circumstances are right for a “financial super storm” and the need for court intervention with a financial restructuring.

Natural disasters affect and impair the assessable tax base, the ability of homeowners and business owners to timely pay real estate and other ad valorem taxes, while at the same time, increasing the strain on a municipality's budgeted expenses. When revenue decreases and expenses increase, municipalities are forced to either increase taxes or decrease expenditures ' neither of which are popular or may be acceptable alternatives in today's political climate. Add to that the need to restructure pension benefits, health care benefits and job security, and a political firestorm is created.

If a municipality as defined in the Bankruptcy Code enters a Chapter 9 proceeding, it is permitted to restructure most of its secured debts, all of its unsecured trade and commercial debts, most of its bond obligations, all pension and health and welfare benefits, and is permitted to reject executory contracts and collective-bargaining agreements in order to complete a financial restructuring. This type of court-mandated restructuring is sometimes the only alternative when the constituent parties are unwilling and/or unable to reach a negotiated restructuring.

Legislative Bodies

Since the U.S. Constitution provides a supremacy of bankruptcy proceedings over state law, there is little that can be done by legislative bodies to impair a municipality's rights once it has entered a Chapter 9 proceeding. However, a state legislature can prohibit a municipality from entering Chapter 9, or, in some cases, a governor can refuse to provide the necessary consent under applicable law to enter a reorganization proceeding. While this preclusion may be politically expedient, it does nothing to solve the underlying problem. As a result, other than a denial of the right of a municipality to file a Chapter 9 proceeding, there is nothing that the executive or legislative branches of a state government can do to modify a municipality's rights to file and proceed under the Bankruptcy Code. Likewise, state courts should generally be powerless to modify rights available under Chapter 9.

The situation in Detroit where the Michigan Constitution precludes the modification of pension benefits to former governmental employees raises an interesting and unresolved issue concerning the interplay of a state constitution versus the supremacy clause of the U.S. Constitution. This presents a unique issue of first impression that this author believes will be decided in favor of the supremacy of the Bankruptcy Code to enable the bankruptcy court to authorize the modification of pension and retiree benefits.

Another interesting provision in Chapter 9 is the fact that while secured debts may be modified by a Chapter 9 plan, special revenue bonds that are subject to liens or tied to a defined revenue stream, such as bridge or tunnel bonds that are funded by and secured with toll revenue, may not be affected or impaired by the Chapter 9 proceeding on a post-petition basis, and interest on these bonds must continue to be paid during the proceeding after payment of operating expenses.

As in Chapter 11, the municipality may reject executory contracts. There is no limitation on the rejection of collective-bargaining agreements as contained in Section 1113 of the Bankruptcy Code which affects only Chapter 11 proceedings. Also in Chapter 9, the municipality has the Chapter 5 avoidance powers such as for preferences, fraudulent transfers, etc., and there is an additional provision that if the municipal debtor is unwilling to pursue any of these causes of action, a special trustee can be appointed by the bankruptcy court for the limited purpose of pursuit of these avoidance actions.

As a safe harbor to the municipalities' bondholders and noteholders, while the future payment of interest and/or principle on the bonds may be modified or eliminated as part of the reorganization plan, there is a specific prohibition against pursuit of pre-petition bond or note payments as preferential transfers.

The above unique provisions of Chapter 9 provide an unusual legislatively created power and authority in the hands of the municipality to create its own restructuring, subject only to judicial review and approval (based upon feasibility and best interests), which should mandate pre-filing cooperation by the constituent creditor parties. However, recent experience has shown this not to be the case, and it is expected that there will be a proliferation of new filings.

Orange County, CA

The prior Chapter 9 proceeding of Orange County, CA, as well as the current Chapter 9 proceeding of Jefferson County, AL, provide excellent examples of the difficulties encountered with the financial restructuring of a large municipal entity. However, these cases may not establish good precedent for much smaller municipal agencies that need to seek bankruptcy relief such as towns, school districts, water and sewer districts and hospital districts where revenue sources are severely limited.

All of this will test the bankruptcy court's authority and ability to confirm a Chapter 9 plan that meets the requirements of Section 943 of the Bankruptcy Code. Similar to a Chapter 11 proceeding, in order to confirm a Chapter 9 plan, among other things: 1) all priority creditors must be paid in cash and in full on confirmation of the plan unless the creditor agrees to a deferred payment arrangement; 2) any regulatory or electoral approval necessary under applicable nonbankruptcy law in order to carry out any provision of the plan has been obtained; and 3) the plan must be feasible and meet the best-interest tests. Striking-ly, unlike Chapter 11, there is no creditor vote on the plan, and as such, there is no need for a cramdown provision. This grants to the bankruptcy judge virtual unfettered discretion, subject to appellate review, to approve or disapprove the reorganization plan. It is suspected that this perceived unlimited power and authority may cry out for congressional limitation in the near future.

Other Municipalities

Currently, published reports that dramatize the travails of communities along the New Jersey shore, Eastern New York and Long Island demonstrate the frustrations and problems created by a natural disaster. With most of the homeowners and businesses in the affected areas not having wind and/or flood insurance, rebuilding may not be an option. Thus, for every destroyed home or business that is not promptly rebuilt, the county, city/town and its taxing constituents face an unpredicted loss of tax revenue. At the same time, these municipal agencies are being asked to provide additional services to help rebuild the beach communities and the infrastructures that were destroyed by the storm. Since the municipal entities can only increase revenue by raising and collecting taxes, this creates a Catch 22 situation for everyone involved.

Experience with Superstorm Sandy, recent tornadoes, prior earthquakes and prior hurricanes has demonstrated ongoing and increasing strain on municipalities that are already hard-pressed and still recovering from the recent economic downturn. Although a few parts of the country have manifested a robust increase in real estate activity, this is not universally the case. Thus, tax roles remain depressed, and the ability to increase income is severely limited.

Conclusion

Since politicians have universally demonstrated an unwillingness or an inability to amicably resolve such situations, it is believed that there may be a substantial increase in the utilization of Chapter 9 proceedings throughout the country as a result of these natural disasters, as well as in those areas where the ravages of the financial recession are still being felt. Such proceedings impact many constituencies in a dramatic way. Bondholders, previously relying on the perceptive security of municipal bonds, can have their investments wiped out. This can have a dramatic effect on individuals that have invested in municipal bonds for their retirement accounts.

Vendors of goods or services to these municipal agencies may find that their debts are wiped out or they receive cents on the dollar. Retirees and current municipal workers may have their source of income dramatically impacted. However, as draconian as this may be, when these unexpected natural disasters occur, prudence on the part of the municipalities may mandate a prompt consideration of Chapter 9 as the only alternative to financial survival.

It does not take an economist to recognize the domino effect that is created with such municipal catastrophes. Chapter 9 of the bankruptcy code is alive and well, and its use in the future may be exponentially greater than in the past.

Charles M. Tatelbaum is a partner in the Fort Lauderdale, FL, office of Hinshaw & Culbertson LLP. He is certified in business bankruptcy law by the American Board of Certification, and has for 47 years concentrated his practice in the areas of secured creditor representation in domestic and international bankruptcy and insolvency proceedings, the defense of lender liability actions and international business transactions. Tatelbaum has represented parties in a number of Chapter 9 proceedings.'