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  • Municipal Bankruptcy and Its Effect on Government ContractorsAuthor(s): Eric S. Pommer and Marc M. FriedmanSource: Public Contract Law Journal, Vol. 25, No. 2, [State and Local Government] (Winter1996), pp. 249-264Published by: American Bar AssociationStable URL: http://www.jstor.org/stable/25754212 .Accessed: 14/06/2014 11:28

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  • Municipal Bankruptcy and Its Effect on Government Contractors

    Eric S. Pommer and Marc M. Friedman

    I. Introduction 249 II. Overview of Municipal Bankruptcy 250

    A. Historical Overview of Municipal Bankruptcy Legislation 250 B. Chapter 9 Relief 252

    1. Entity Qualifications 252 2. Relief Accorded 254

    C. Applicability to Government Contractors 255 III. Government Contractor as Creditor 256

    A. Performance and Termination 256 B. Collecting Payments Owed 258

    1. Claims for Progress Payments and Payments Made 258 2. Claims for Work Completed 258 3. Return of Payments Made by the Municipality 261

    4. Property 262 IV. Subcontractor Issues 263 V. Conclusion 264

    I. Introduction One of the prime benefits of contracting with the government has always been the expectation of certain payment upon acceptable performance. Pres

    ently, however, a dramatic trend is developing under which government municipalities have been able to avoid making payment, even to the well

    performing contractor, by using the protection of the federal bankruptcy system.

    This trend received national attention in the wake of the bankruptcy of

    Orange County, California. By filing its bankruptcy petition, Orange County was afforded the power to control the flow of payment on most of its obligations. The contractors of Orange County, even those providing the most mundane supplies, found themselves caught in the costly and

    confusing procedures of the bankruptcy system without the assurance of full and timely payment. As a result, a contractor caught in a municipal

    bankruptcy can no longer tak;e for granted that payment automatically and

    promptly will be made on a government contract.

    Eric S. Pommer is a principal and Marc M. Friedman an associate in the firm of Noble & Pommer in Ventura, California.


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  • 250 Public Contract Law Journal Vol. 25, No. 2 Winter 1996

    II. Overview of Municipal Bankruptcy A. Historical Overview of Municipal Bankruptcy Legislation Since the first comprehensive bankruptcy statute passed in 1898,1 the basic

    purposes of the bankruptcy laws have been to permit the debtor to discharge his debts and to provide the most equitable distribution of any remaining assets among his creditors.2 Moreover, the intent of the legislation has consis

    tently been to provide relief to all parties, debtors and creditors alike. The

    courts, therefore, have interpreted the bankruptcy laws broadly in order to

    further industry and commerce and to promote the common good.3 Congress has regulated bankruptcies with these basic purposes in mind.4

    Congress has consistently given broad powers to federal bankruptcy courts to impair or avoid contract and property rights otherwise protected by state law and the U.S. Constitution.5 Even though Article I, Section 10, of the

    United States Constitution does not explicitly prohibit Congress from pass ing any law that impairs obligations of contract, this section, read together

    with the Fifth Amendment,6 serves to limit congressional powers. Conse

    quently, in the context of municipal debt, Congress must significantly nar row the scope of its legislation to avoid intrusion by the federal courts on

    the sovereign power of the states.

    Initially, Congress expressly rejected the application of bankruptcy law to municipalities, because, as one representative noted, "they are agencies of sovereignty."7 Even when Congress first acknowledged the public sector in the bankruptcy context in 1910, it expressly excluded municipal corporations from eligibility for bankruptcy protection.8

    Municipal debt adjustment became a political reality during the Great

    Depression. The real estate market and irrigation developments, which had

    provided booms for municipalities during the 1920s, suddenly collapsed.

    1. Bankruptcy Act, 30 Stat. 544 (1898) (repealed 1978). 2. See generally 4 william L. collier, collier on bankruptcy 11 900.01-900.03

    (Lawrence P. King ed., 15th ed. 1979 ck Supp. 1995) [hereinafter Collier]; Rachel E. Schwartz, This Way to the Egress: Should Bridgeport's Chapter 9 Filing Have Been Dismissed? 66 AM. bankr. L.J. 103, 114-22 (1992) [hereinafter Schwartz]; Barry Winograd, San Jose Revisited: A Proposal for Negotiated Modification of Public Sector Bargaining Agreements Rejected Under Chapter 9 of the Bankruptcy Code, 37 hastings L.J. 231, 269-84 (1985) [hereinafter Winograd]; Ronald D. Greenberg, Municipal Bankruptcy: Some Basic Aspects, 10 urb. law. 266, 268-83 (1978) [hereinafter Greenberg].

    3. See Greenberg, supra note 2, at 267.

    4. "Congress shall have Power ... to establish uniform Laws on the subject of

    Bankruptcies throughout the United States. ..." U.S. const, art. I, ? 8, cl. 4. 5. "No state shall. . . pass any . . . Law impairing the Obligation of Contracts...."

    U.S. Const, art. I, ? 10, cl. 1.

    6. "No person shall... be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation." U.S. const, amend. V.

    7. Charles Warren, Bankruptcy in United States History 142 (1935). 8. See Giles J. Patterson, Municipal Debt Adjustments Under the Bankruptcy Act, 90

    U. Pa. L. Rev. 520, 521 (1942).

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  • Municipal Bankruptcy and Government Contractors 251

    Municipalities, thus, could not service their bond indebtedness.9 In rural areas, taxpayers of irrigation and drainage districts could not pay real prop erty taxes because a depressed market and low prices meant they could not farm the lands profitably.10

    Tax foreclosures did not help the taxing districts as there were no buyers for the land.11 In fact, foreclosures removed substantial acreage from the tax rolls, thereby reducing the income of the taxing districts even further.12 Increased taxes did not cure the problem but rather caused more defaults and foreclosures, and, thus, less taxable acreage.13 By 1934, Congress esti

    mated that there were over 1,000 municipalities in default on their bonds.14 States could not force bondholders to alter the indebtedness of municipali

    ties. Even the refinancing of bonds through the newly formed Reconstruction Finance Corporation alleviated only some of the problems.15 As a result, Con

    gress declared a national emergency and, in 1934, passed emergency legislation attempting to meet the problems faced by municipal governments.16

    Despite congressional efforts to avoid infringing on the sovereignty of the

    states, the Supreme Court declared the legislation unconstitutional shortly after it became law.17 In 1937, Congress passed a revised version of the law,18 subsequently upheld by the Supreme Court in United States v. Be/cms.19

    As fiscal problems began to develop during the 1970s, the problems with the municipal bankruptcy laws began to emerge. A municipality could not file a petition in bankruptcy unless the petition included a proposed plan accepted by 51 percent of the creditors of the municipal debt.20 Also, munici

    pal debtors lacked the power to reject executory contracts. Cities, therefore, could not modify their labor contracts so as to alleviate a major concern

    for effective debt relief.21 Finally, the procedural requirements proved diffi cult for large municipal entities such as New York City.22

    9. See, e.g., Vallette v. City of Vero Beach, 104 F.2d 59 (5th Cir. 1938), cert, denied, 308 U.S. 586 (1939).

    10. See collier, supra note 2, at ?? 900.01-900.02.

    11. Id.

    12. Id.

    13. W.

    14. U.S. Rep. No. 407, 73d Cong., 2d Sess. 2 (1934). 15. The Congress created the Reconstruction Finance Corporation to aid the taxing

    districts by providing a source of funds to refund their bonds, such funds being available at a reasonable interest rate. See H.R. REP. No. 517, 75th Cong., 1st Sess. 3 (1937).

    16. Congress enacted the first municipal bankruptcy legislation by amending the

    Bankruptcy Act, supra note 1, to include chapter IX. See 48 Stat. 798 (1934). 17. See Ashton v. Cameron County Water Improvement Dist. No. 1, 298 U.S. 513

    (1936) (modification and impairment of contractual obligations of states and their subdivi sions authorized by the Act constituted impermissible interference with state sovereignty).

    18. Municipal Bankruptcy Act, 50 Stat. 653 (1937). 19. 304 U.S. 27 (1938). 20. See collier, supra note 2, ? 900.08. 21. See Winograd, supra note 2, at 274. See also Schwartz, supra note 2, at 116.

    22. See collier, supra note 2, ? 900.09.

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  • 252 Public Contract Law Journal Vol. 25, No. 2 Winter 1996

    To ameliorate these problems, Congress revised the bankruptcy laws, as

    they applied to municipalities, in 1976.23 Two years later, Congress incorpo rated the 1976 revisions into the Bankruptcy Reform Act, a comprehensive statutory overhaul known as the bankruptcy code.24 Chapter 9 of the code

    governs municipal bankruptcies and incorporates provisions from other

    chapters, making them applicable to municipal debt adjustment cases.25

    Through amendment in 1988, the definition of the term "insolvency"

    changed from a balance-sheet test to one based upon the ability of an entity to pay its debts as they become due, thus expanding the protection afforded to a municipality.26 In 1994, further amendments to the code refined and clarified the provisions of chapter 9.27

    Today, as a result of many of the legislative changes, a municipality facing severe economic hardships can use chapter 9 as an effective tool for resolving its fiscal woes, while retaining the benefits of political and other decision

    making powers. The provisions of chapter 9, therefore, raise special concern

    for government contractors, as creditors of a municipality.28

    B. Chapter 9 Relief 1. Entity Qualifications

    Only municipalities can seek chapter 9 protection.29 Chapter 9 defines a

    "municipality" as a "political subdivision or public agency or instrumentality

    23. The 1976 reforms evidenced congressional solicitude for state interests. This was

    especially true with respect to the issue of contract rejection, a focal issue of the times.

    See, e.g., H.R. REP. No. 686, 94th Cong., 1st Sess. 8-9 (1975). 24. Bankruptcy Reform Act of 1978, 92 Stat. 2549 (1978) (codified at 11 U.S.C.

    ?? 101-151, 326). Changes to municipal bankruptcies were largely stylistic, including renumbering and incorporating provisions of the prior law to conform to the new bank

    ruptcy code structure.

    25. This incorporation is accomplished in 11 U.S.C. ? 901 (a) (1995), which states: "Sections 301, 344, 347(b), 349, 350(b), 361, 362, 364(c), 364(d), 364(e), 364(f), 365, 366, 501, 502, 503, 504, 506, 507(a)(1), 509, 510, 524(a)(1), 524(a)(2), 544, 545, 546, 547, 548, 549(a), 549(c), 549(d), 550, 551,552,553,557,1102,1103,1109,1111(b), 1122,1123(a)(1), 1123(a)(2), 1123(a)(3), 1123(a)(4), 1123(a)(5), 1123(b), 1124,1125,1126(a), 1126(b), 1126(c), 1126(e), 1126(f), 1126(g), 1127(d), 1128, 1129(a)(2), 1129(a)(3), 1129(a)(6), 1129(a)(8), 1129(a)(10), 1129(b)(1), 1129(b)(2)(A), 1129(b)(2)(B), 1142(b), 1143, 1144, and 1145 of this title apply in a case under this chapter."

    26. See generally Schwartz, supra note 2.

    27. The Bankruptcy Reform Act of 1994, 108 Stat. 4106 (1994) (amending various provisions contained in chapters 1, 3, 5, and 11 of the bankruptcy code). Many of the changes only affect chapter 9 cases filed on or after October 22, 1994, by reason of the incorporation of these provisions into chapter 9 through sections 103(e) and 901 of the bankruptcy code. The Act also specifically amended section 109(c)(2) of the bankruptcy code dealing with the eligibility of municipalities to be a debtor under chapter 9. See infra note 34 and accompanying text.

    28. Before these concerns can manifest themselves, the municipality must demon strate that it has met certain conditions precedent to a filing under chapter 9. See infra

    partll.B.l. 29. 11 U.S.C. ? 109(c) (1995).

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  • Municipal Bankruptcy and Government Contractors 253

    of a [s]tate." 0 The definition includes cities, counties, townships, school

    districts, all types of public improvement districts, and revenue-producing bodies that provide services paid for by users rather than by general taxes, such as bridge or highway authorities and gas authorities.31

    A municipality must also meet four additional eligibility requirements to qualify for chapter 9 protection.32 First, chapter 9 conditions protection upon specific state authorization of the municipality.33 The state must specifi cally authorize the debtor-entity, either in its capacity as a municipality or by name, to seek relief under chapter 9, or a governmental officer or

    organization empowered by state law must authorize the entity to be a debtor under chapter 9.34

    Second, chapter 9 requires a municipality to be "insolvent" to qualify for relief.35 The statutory definition of insolvency means either that: (1) the

    municipality is "generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute," or (2) the municipality is "unable to pay its debts as they be...


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