Fall 2013

Adjustment of State and Municipal Debt Under Chapter 9 the Bankruptcy Code

J. Robert StollMayer Brown LLPVisiting ProfessorUniversity of Belgrade Faculty of Law

Aaron GavantMayer Brown LLP

U.S. Workout/Insolvency Law CourseUniversity of Belgrade Faculty of LawFALL 2014

Introduction

I. Who may file under Chapter 9II. Constitutional IssuesIII. Overview of Key ProvisionsIV. Advantages/Limitations

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• Under §109(c) of the Code, in order to file under Chapter 9, an entity must

– be a municipality;– be specifically authorized by state law to file under Chapter 9, in its

capacity as a municipality or by name;– be insolvent;– desire to effect a plan to adjust its debts; and– (i) have obtained the agreement of a majority of claims of each class the

entity intends to impair; or (ii) have negotiated in good faith with creditors and failed to obtain such a majority; or (iii) have been unable to negotiate with creditors because such negations would be impracticable; or (iv) must reasonably believe that a creditor may attempt to obtain a preferential transfer under § 547 of the Code.

Who May Be a Debtor under Chapter 9?

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• A “municipality” is defined as either a “political subdivision,” a “public agency,” or an “instrumentality of a state” and does not include states, the District of Columbia or any territories of the United States.

• The Bankruptcy Code does not further define any of these terms and the case law on the topic is sparse. Thus, what actually constitutes a municipality is “far from clear.”

• That being said, cities, towns, villages, special districts, school districts, counties, public authorities, public hospitals, and publicly owned airports are generally considered “municipalities” for purposes of the Bankruptcy Code.

Definition of Municipality

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Specific Authorization Under State Law

• Prior to the Bankruptcy Reform Act of 1994, under section 109(c)(2), municipalities were required only to be generally authorized to be a debtor under Chapter 9 by State law.

– According to the majority view at the time, this meant that municipalities could file under Chapter 9 so long as a state gave “some indication” that the municipality had that power.

• In 1994, Congress amended section 109(c)(2), requiring that municipalities be specifically authorized to file under Chapter 9.

– 14 states specifically, and unconditionally, authorize municipal bankruptcies.

– 11 states provide conditional or limited authorization.– 1 state prohibits filing in all circumstances. – Remaining states do not have any specific authorization for municipal

bankruptcies.

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Insolvency Requirement

• The insolvency requirement is particular to Chapter 9, and is one major factor which may discourage or stand in the way of many municipalities seeking bankruptcy relief.

• A municipality is considered “insolvent” when it is “generally not paying its debts as they become due” or “unable to pay its debts as they become due.”

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Constitutional Issues

• The Tenth Amendment to the U.S. Constitution states that “[t]he powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people,” U.S. CONST. AMEND. X.

– The interest of protecting state sovereignty under the Tenth Amendment limits the degree to which a federal bankruptcy court can intrude into municipal and state governance.

– Generally agreed that these constitutional issues have been adequately addressed in Chapter 9.

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Constitutional Tensions Recognized and Addressed in Chapter 9

• Only municipalities that are specifically authorized by a state can file for bankruptcy.

• Involuntary cases are not permitted under Chapter 9 because to do so “may constitute an invasion of State sovereignty contrary to the tenth amendment.” House Report No. 95-595, 95th Cong., 1st Sess. 321 (1977); Senate Report No. 95-989, 95th Cong., 2d Sess. 33 (1978).

• Section 903 of the Bankruptcy Code provides that Chapter 9 “does not limit or impair the power of a State to control, by legislation or otherwise, a municipality of or in such State in the exercise of political or governmental powers of such municipality, including expenditures for such exercise.”

• Section 904 sets forth limitations on the bankruptcy court’s power in the administration of a case commenced under Chapter 9.

• Section 941 provides that the Debtor has the exclusive right to propose a plan for adjustment of debts.

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Constitutionality of Specific Actions Taken in Chapter 9

• Caselaw indicates that by authorizing municipalities to file for bankruptcy, states also authorize municipalities not to comply with certain state laws.

– See, e.g., In re City of Columbia Falls, Montana, Special Improvement District No. 25, 143 B.R. 750, 759 (Bankr. D. Mont. 1992) (allowing municipality not to comply with state law which required it to fund a revolving fund until all bonds and interests were fully paid and discharged)

• Rejection of Contractual Obligations– The Bankruptcy Code authorizes a debtor to reject executory contracts,

such as collective bargaining agreements, in bankruptcy. – Questions have arisen with regard to whether bankrupt municipalities

must comply with state law provisions governing these contracts.

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Overview of Chapter 9

• Chapter 9 case is commenced by the voluntary filing of a petition by a municipality.

– The body that has the authority under state law to act for the municipality at issue, also has the authority to file the Chapter 9 petition (assuming, that state law otherwise specifically authorizes the entity to file).

• Objections to filing– Section 921(c) of the Bankruptcy Code permits objections to a municipal-

debtor’s Chapter 9 petition. See 11 U.S.C. § 921(c). – Pursuant to that section, the court may dismiss the petition, after notice

and a hearing, if the debtor did not file the petition in good faith or if the debtor failed to otherwise meet the requirements of Chapter 9 discussed above.

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Overview of Chapter 9 – Cont’d

• The automatic stay is applicable in Chapter 9. – Automatic stay protects not only the debtor itself, but also any “officer or

inhabitant of the debtor” and precludes the “enforcement of a lien on or arising out of taxes or assessments owed to the debtor.”

• Due to the restrictions placed on bankruptcy courts by sections 903 and 904, municipalities are given broad powers to operate as usual while functioning under Chapter 9.

– “The municipal debtor has broad powers to use its property, raise taxes, and make expenditures as it sees fit.” See 6A WEST'S FED. FORMS, Bankruptcy Courts § 10251 (4th ed. 2010).

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Overview of Chapter 9 – Cont’d

• Under Chapter 9, a municipal debtor has the exclusive right to file a plan for the adjustment of its debts.

• Section 941 assumes that in the ordinary case, a plan of adjustment will be filed with the petition.

– Assumption grew out of earlier versions of Chapter 9 which required the plan to be filed at that time.

– If plan is not filed with the petition, the court is free to set the time for its filing a plan either on its own motion on the request of the petitioner, though due to the debtor’s exclusive right to propose a plan, most agree that the court should not be overly demanding in fixing a short time period

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Overview of Chapter 9 – Cont’d

• Under section 943(b), a court must confirm a debtor’s plan of adjustment if

– the plan complies with the provisions of Chapter 9 (and other provisions of the Bankruptcy Code which are incorporated into Chapter 9);

– all amounts owed for expenses incurred during the case, or incident to the plan, have been fully disclosed and are reasonable;

– the debtor is not prohibited by law from taking any action necessary to carry out the plan;

– the plan provides for payment in full of administrative claims, except to the extent that the holders of such claims agree to different treatment;

– The regulatory and/or electoral approval necessary under applicable non-bankruptcy law in order to carry out the plan has been obtained; and

– the plan is in the best interests of creditors and is feasible.

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Benefits of a Chapter 9 Filing

• Power to amend or terminate collective bargaining agreements and pensions

• Plan of adjustment binding on all creditors; cram-down powers• Automatic Stay • A single, known forum and procedures• Familiarity and experience of bankruptcy courts in dealing with

similar issues • Leverage in negotiations with creditor constituencies • Way to force politically unpopular decisions • Avoid legislative process

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Limitations of a Chapter 9 Filing

• Limited number of municipalities authorized to file• Impact on credit markets • Cost• Time• Distraction• Stigma• Lack of Precedent

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Alternatives to a Chapter 9 Filing

• Raise taxes and cut spending• Issue more debt; privatize assets and services• Negotiate pay cuts and higher benefit contributions from unions• Legislation to curtail public-employee bargaining rights• Federal bailout

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