EDITOR'S NOTE: Only 12 states authorize Chapter IX bankruptcy filings for their general-purpose governments, and 12 states conditionally authorize such filings. Twenty-six states have either no Chapter IX authorization or such filings are prohibited. Bankruptcies remain rare and are a last resort for eligible municipal governments. Since 2010, only nine out of 51 filings have been by general-purpose governments. The majority of filings have been submitted not by cities, but by lesser-known utility authorities and other narrowly-defined special districts throughout the country. Chapter IX of the federal Bankruptcy Code does not provide for any federal financial assistance and filing under this section of the law is not a request for federal funding. Learn more: 2020 State and Local Fiscal Facts
The economic impact of COVID-19 is coming into sharper focus, and governmental entities across the country are in the direct line of fire. For example, on May 14, 2020, California Governor Gavin Newsom released a budget proposal projecting a $54.3 billion deficit for the coming fiscal year.1 In California, the state’s deficit translates into projected deficits for counties, cities, and many special districts that are reliant on state and related variable tax revenues and are already projecting deficits.
Adding to these concerns, many municipalities across the United States are saddled with crushing bond and other debt and pension obligations. Chicago, Philadelphia, and Dallas have less than half the financial resources they need to pay existing pension liabilities.2 Most recently, Fairfield, Alabama, filed for Chapter 9 bankruptcy, saying it had “exhausted its options” after several years of declining revenues and outstanding financial obligations.3 Fairfield is located in Jefferson County, which itself went through Chapter 9 bankruptcy in 2011.4
The financial problems and declines in revenue are exacerbated in California, where one of the primary ways local governments have dealt with the revenue constraints of Proposition 13 has been to push a larger share of employee compensation to pensions and retirement benefits, leading to massive, unfunded, accrued liabilities. In the face of the looming recession, cities and counties will need to cover rising pension costs with less revenue coming in the door. For example, the city of Santa Monica—a city highly dependent on tourism revenues such as from hotel and sales taxes—adopted a Fiscal Year 2020–21 budget with a nearly 25 percent reduction and has moved to significantly restructure the city’s overall operations.5 In fact, the city is contemplating putting a local funding measure on the November 2020 ballot to raise additional revenue.6 Cuts of this magnitude and a move to refocus on core municipal services are unavoidable for most, if not all, local governments given the devastating economic impact of COVID-19.
While states are legally required to pass a balanced budget and cannot file for bankruptcy protection, municipalities and special districts that own, operate, and provide essential services to their residents and constituents may be forced to consider bankruptcy given the depth of the economic crisis.
Chapter 9 bankruptcy may provide an option for some local governments unable to otherwise survive the economic downturn and may help them more effectively restructure their operations, workforces, and debt. In addition, Chapter 9 may help struggling municipalities restructure their debt and pension obligations. While there are risks associated with filing for bankruptcy as a municipality, these risks may be offset by the benefits in the current and near-future fiscal environment.
The Law
Chapter 9 of the U.S. Bankruptcy Code permits municipal governments to declare bankruptcy when they are unable to pay their debt service due to a lack of income, generally due to declining tax revenues. This action protects financially distressed cities, counties, and special districts from creditors and allows the filing municipality to create a plan of adjustment to resolve its outstanding debt. Chapter 9 defines municipalities broadly to include a wide variety of governmental entities such as cities and counties, as well as special utility, tax, and school districts.7
Most importantly, courts and creditors in a Chapter 9 filing generally cannot interfere with the governmental or revenue powers of a municipality while in Chapter 9. Municipalities filing for Chapter 9 bankruptcy largely retain control of policy decisions, such as spending, municipal services, and public policy.8 And a municipality cannot be forced to sell property or otherwise dispose of assets.9 Thus, unlike in widely publicized and used Chapter 11 reorganizations, a municipality in a Chapter 9 proceeding maintains some measure of agency over its day-to-day decisions. The bankruptcy court overseeing a municipality’s Chapter 9 case cannot, for example, appoint a trustee to manage the municipality’s actions or force it to take specific legislative actions. This is particularly important to municipalities, which are both subdivisions of the state and independent political entities with their own priorities, sensibilities, and constituencies.
Municipalities in Chapter 9 bankruptcies also cannot be forced to liquidate. In a Chapter 11 reorganization bankruptcy, creditors can push to convert a restructuring into a liquidation so as to maximize their return from the debtor’s assets. Under Chapter 9, creditors do not have this right and must negotiate with the filing municipality (or ultimately accept a plan of adjustment as approved by the bankruptcy court). This provides municipalities more leverage than a corporation has in a traditional Chapter 11 reorganization.
Note, however, that municipalities must file their petitions in good faith.10 There are a number of factors that bankruptcy courts weigh in evaluating the good faith of a petition, and these factors can include whether the municipality engaged in prepetition negotiations or sought alternatives to filing, as well as the scope and nature of the financial problems.11
The Process
As a threshold matter, a municipality seeking to file for bankruptcy under Chapter 9 must be authorized by state law. This means that state law must include clear authority for such a filing and that permission must be “exact, plain, and direct with well-defined limits so that nothing is left to inference or implication.”12 There is wide variation in the latitude that states grant to their municipalities in the ability to use Chapter 9. California provides some of the broadest permissions, although it requires municipalities to participate in a mediation first.13 However, in several states, municipalities must seek individual authorization from the state legislature in order to file under Chapter 9.14 This can create an additional hurdle and add significant complexity to the bankruptcy process. For example, Pennsylvania effectively blocked its own capital city, Harrisburg, from filing bankruptcy under Chapter 9 by eliminating the statutory provisions enabling municipalities to file for bankruptcy under Chapter 9.15 And one state, Georgia, does not permit municipalities to file for bankruptcy at all.16
In order to use the protections of Chapter 9, a municipality must meet certain additional criteria:17
Insolvency
The municipality must be insolvent (defined as either “(i) generally not paying its debts 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”).18 In a typical Chapter 7 or 11 bankruptcy, insolvency is determined by the “balance sheet test” (although insolvency is not a requirement for filing under those chapters). Because municipal assets are both hard to value and hard to liquidate, in a municipal bankruptcy, insolvency is typically judged on a cash-flow basis, where the municipality cannot pay its debts as they come due. However, bankruptcy courts have also recognized insolvency in the delivery of services. For example, in the enormous Detroit bankruptcy case, Judge Steven Rhodes observed that the city was so insolvent that it was “unable to provide basic municipal services such as police, fire, and emergency medical services to protect the health and safety of the people.”19 Note that municipalities have more power to raise their cash flow than does a typical corporate debtor, and bankruptcy courts may consider factors such as the ability to raise taxes or fees when evaluating insolvency.20
Plan to Have a Plan
The municipality must intend to effect a plan to restructure its debt obligations.21 This requirement has been interpreted to mean that a Chapter 9 filing cannot be used to resolve short-term fiscal issues that would otherwise require tough political decisions or force the municipality to pay creditors it does not want to pay. It need not have a plan of adjustment ready to go when it files, but it must at least intend to execute one and have some basic outlines of a plan prepared.22
Consent (Or at Least Making an Effort)
Finally, the municipality must either obtain the agreement of creditors or, if it cannot, show evidence that it made a good faith effort to negotiate or that such a negotiation would be impractical or impossible. Specifically, the municipality must:
(a) have obtained the consent of creditors holding at least a majority in the number of claims in classes that will be impaired under the plan;
(b) have failed to obtain such consent after negotiating with creditors in good faith;
(c) be unable to negotiate with creditors because negotiation is “impracticable”; or
(d) reasonably believe that a creditor may attempt to obtain a transfer that is avoidable.23
In municipal bankruptcies, likely creditors include public sector employees (both current and retired) with pension benefits, employees subject to collective bargaining agreements, bondholders who have purchased municipal debt, and other entities such as institutional lenders that may be owed funds. While negotiations with these latter institutions in Chapter 9 bankruptcies may be more routine and similar to those in cases under Chapter 11, negotiations with public sector employees, pensioners, and their union representation bring politics into the equation and can create difficulties for a municipality seeking a quick exit from bankruptcy. Bankruptcy courts have noted that municipalities in particular may have difficulty negotiating with their diverse creditors and may not even be able to present an adequate initial proposal. For example, in the Detroit bankruptcy, Judge Rhodes pointed to the “sheer size of the debt and number of individual creditors,” as well as the difficulties inherent in negotiating with a large and disparate class of pension creditors.24
The Automatic Stay
As with other bankruptcy protections, filing Chapter 9 puts in place an automatic stay, which protects the municipality from actions to collect on outstanding debts.25 The protections of the automatic stay prevent a municipality’s creditors from rushing to the courthouse to satisfy their debts and/or interfere with streams of revenue, and (hopefully) to ensure an orderly adjustment process. For example, in the Chapter 9 bankruptcy filing of Mammoth Lakes, California, the automatic stay helped the town delay paying a legal judgment that would have overwhelmed its annual budget.26
Secured vs. Unsecured Claims
In the bankruptcy process, there are two primary classes of creditor claims: secured and unsecured. At the most basic level, secured claims are tied to specific collateral or a specific revenue stream. For example, a promissory note may be secured by a mortgage or deed of trust on a house in an individual bankruptcy. In the corporate context, various personal property assets including accounts receivable (or real estate) may serve as collateral for a note. In contrast, unsecured claims are generally tied only to a promise to pay.
In the municipal context, most debts other than wages are either pension obligations or municipally issued general revenue bonds, both of which are typically unsecured or obligations established by law.27 Only bonds tied to specific sources of revenue are treated as secured; otherwise, such debts are general obligations of the municipality.
Best Interest Standard
A bankruptcy court may confirm a plan of adjustment if it is “in the best interests of creditors and is feasible.”28 This amorphous standard is important in Chapter 9 proceedings because, unlike in other bankruptcy proceedings, there are no benchmarks against which to measure what is reasonable.29 Instead, courts have typically looked at whether the municipality’s plan gives its creditors a return that is as good as or better than what they currently have.30
History
There have been fewer than 1,000 Chapter 9 bankruptcies filed in the history of the country,31 as compared with over 22,000 business and 750,000 personal bankruptcies filed in 2019 alone.32 The most significant include Puerto Rico, Detroit, and Orange County, California. Puerto Rico’s complex bankruptcy, which was complicated by the large portion of its debt held by private-equity and other assertive investors, was only recently confirmed in 2019.33
Two of the nation’s largest and most complex Chapter 9 bankruptcies have been those of jurisdictions in California: the city of Vallejo in 200834 and the city of Stockton in 2012.35 In addition, one of the largest municipal bankruptcies in U.S. history was Orange County’s 1994 filing, in which the county sought to adjust $1.7 billion in debt.36
Special Districts
Special districts, such as those established under Local Area Formation Commission procedures to support local infrastructure, can also take advantage of Chapter 9.37 This is particularly important in California, where the budgetary constraints of Proposition 13 have pushed numerous municipal functions into special districts. For example, the Tulare Local Health District emerged from a two-year bankruptcy process in mid-2019.38
Special districts can also use Chapter 9 to adjust their debts, which typically take the form of bond issuances backed by specific revenues and are treated as secured obligations.39
Opportunity in the Midst of Crisis
Rahm Emanuel, someone particularly experienced with municipal budgets as the former mayor of Chicago and as President Obama’s former chief of staff during the Great Recession, famously echoed the line “never let a crisis go to waste.”40 While the current and looming economic crisis threatens enormous economic pain for individuals and businesses as well as local governments, it may also present an opportunity to adjust municipal debt and pension obligations.
Power to Reject Contracts
One particular opportunity available to municipalities in bankruptcy is the power to reject executory contracts.41 A debtor in bankruptcy, including a Chapter 9 debtor municipality, can reject contracts that were executed prior to the filing. While the other party to the contract will have a claim against the municipality for breach, this claim is treated as a general unsecured claim for damages (the lowest-priority claim in bankruptcy) and, thus, any payment on account of such claim is often significantly less than the contract value.
The most significant use of this power is in a municipality’s ability to reject collective bargaining agreements (CBAs) and other employment agreements with municipal workers. While there are certain steps that a municipality must take before rejecting a CBA, including making a reasonable effort to negotiate, this power can allow a municipality to escape particularly onerous agreements.42
Note that a municipality seeking to reject contracts may be required to comply with any additional state rules regarding modification or rejection of contracts, although the extent of this requirement has not been fully settled by the courts. For example, in California, municipalities may be required to satisfy state law as to when and how they can make emergency contract changes.43
Pension Liabilities
While a municipality can reject executory contracts in Chapter 9 bankruptcy, it was until recently less clear whether it could modify existing pension liabilities. Because pension obligations are settled debts and the benefits owed are “vested rights,” it was not certain whether they could be modified in the same fashion as other obligations. However, Judge Sandra Klein of the U.S. Bankruptcy Court for the Eastern District of California addressed this question directly in the Stockton bankruptcy. Specifically, the court addressed the question of whether, as a matter of law, pension contracts entered into by the city, including the pension administration contract, may be rejected pursuant to Bankruptcy Code § 365.44
Note, however, that the court in Stockton specifically focused on the role of the California Public Employees’ Retirement System (CalPERS) and the fact that the city’s pension was administered by the retirement system to provide third-party pension benefits to the city’s retired employees.45 Also note that the Stockton court made its decision despite California law prohibiting a municipal debtor in Chapter 9 from breaking a contract with CalPERS.46 The Stockton court found that the statute conflicted with the federal Bankruptcy Code.47 Thus, the Stockton court analyzed the CalPERS contract as a standard executory contract, which the city was entitled to terminate, and did not specifically address a situation where a municipality administers its own pension system without a third-party contractor.
Understanding the Risks
There are, of course, several significant risks, both fiscal and political, for a municipality filing for bankruptcy.
Top of mind in any bankruptcy is the risk to the municipality’s credit rating and the possibility of a downgrade. Filing for bankruptcy can reduce creditworthiness, make future borrowing more expensive, and limit the pool of willing lenders. While these risks are significant and should be carefully weighed by elected officials and municipal managers, they may prove less substantial when compared with similar impacts that may result from doing nothing at all.
In cities with more workforce or resident mobility, the negative publicity and attention generated from a Chapter 9 filing, as well as a fear of tax increases to cover municipal budget shortfalls, may drive residents or businesses to move to other jurisdictions, which could have negative impacts on the municipality’s future tax base.
In more extreme cases, significant restructuring and reductions in pension benefits and/or public sector salaries could cause municipal workers to seek greener pastures. Where strong local government unions are a major factor, these tensions could become significant.
As many commentators have observed, there are political risks to going after pension liabilities in Chapter 9. For example, Diane Lourdes Dick, a professor at Seattle University School of Law focusing on commercial finance and bankruptcy, notes that while recent case law has made clear that pension write-downs can be conducted in Chapter 9, “[b]ankrupt cities have mostly declined to use [C]hapter 9 to adjust their pension promises, instead advancing plans of adjustment that privilege pension claims over others […] the political economy of [C]hapter 9 has enabled large and prominent pension administrators to exert more power and influence over restructurings.”48
Many cities have chosen to avoid confrontation with pension holders. For example, the city of San Bernardino considered reducing its pension payments to CalPERS, but eventually decided to leave its pension obligations intact and to force reductions in other debt payments.49 Similarly, the final plan in the Detroit bankruptcy left pension payments whole while cutting related items such as cost-of-living increases and other minor benefits.50
Conclusion
While the looming recession and COVID-19-related financial crisis pose existential threats to municipalities across California, they also provide an opportunity. Cities and counties that take a proactive approach and act decisively can take advantage of this crisis to tackle debt and pension obligations that might pose greater problems down the road. With effective leadership and counsel, municipalities can work with local stakeholders to adjust their obligations and get their fiscal houses in order, while also finding a path to lead their residents out of the pandemic recession.
Endnotes and Resources
1 Governor Newsom Submits May Revision Budget Proposal to Legislature (May 14, 2020), available at https://www.gov.ca.gov/2020/05/14/governor-newsom-submits-may-revision-budget-proposal-to-legislature-5-14-20/.
2 Jen Sidorova, “Coronavirus Will Make America’s Cities Feel the Pressure of Pension Debt,” MarketWatch (April 23, 2020), available at https://www.marketwatch.com/story/coronavirus-will-make-americas-cities-feel-the-pressure-of-pension-debt-2020-04-20.
3 Amanda Albright, “Small Alabama City Says It’s Broke, Files for Bankruptcy,” Bloomberg Law (May 19, 2020), available at https://www.bloomberg.com/news/articles/2020-05-20/small-alabama-city-says-it-s-broke-files-for-bankruptcy.
4 Mary Williams Walsh, “In Alabama, a County That Fell Off the Financial Cliff,” New York Times (February 18, 2012), available at https://www.nytimes.com/2012/02/19/business/jefferson-county-ala-falls-off-the-bankruptcy-cliff.html.
5 See City of Santa Monica Department of Finance, FY 2020-21 Adopted Budget, https://finance.smgov.net/#:~:text=On%20June%2023%2C%202020%2C%20the,million%20in%20FY%202020%2D21.
6 See City of Santa Monica Local Funding Measure Fact Sheet, available at https://finance.smgov.net/Media/Default/home/LocalFundingMeasureFactSheet.pdf.
7 11 U.S.C. § 101(40) (defining “municipality” as a “political subdivision or public agency or instrumentality of a State”).
8 11 U.S.C. § 904.
9 See In re Valley Health System, 429 B.R. 692, 714 (Bankr. C.D. Cal. 2010) (the debtor “retains title to, possession of, and complete control over its property and its operations, and is not restricted in its ability to sell, use, or lease its property”).
10 11 U.S.C. § 921.
11 See, e.g., In re Villages at Castle Rock Metro. Dist. No. 4, 145 B.R. 76, 81 (Bankr. D. Colo. 1990); see also Rachael E. Schwartz, “This Way to the Egress: Should Bridgeport’s Chapter 9 Filing Have Been Dismissed?,” 66 Am. Bankr. L.J. 103, 130 (1992).
12 In re County of Orange, 183 B.R. 594, 604 (Bankr. C.D. Cal. 1995).
13 Cal. Gov’t. Code §§ 53760, 53760.3.
14 See John Gramlich, “Municipal Bankruptcy Explained: What It Means to File for Chapter 9,” The Pew Charitable Trust (November 22, 2011), available at https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2011/11/22/municipal-bankruptcy-explained-what-it-means-to-file-for-chapter-9.
15 Act of June 30, 2011, § 1601-D.1, Pa. Laws 159, No. 26 (“Notwithstanding any other provision of law, including section 261 of the Municipalities Financial Recovery Act, no distressed city may file a petition for relief under 11 U.S.C. Ch. 9 (relating to adjustment of debts of a municipality) or any other Federal bankruptcy law, and no government agency may authorize the distressed city to become a debtor under 11 U.S.C. Ch. 9 or any other Federal bankruptcy law.”).
16 Ga. Code Ann. 36-80-5(a).
17 See 11 U.S.C. § 109(c).
18 11 U.S.C. § 101(c)(32).
19 In re City of Detroit, 524 B.R. 147, 261 (Bankr. E.D. Mich. 2014).
20 See Vincent S.J. Buccola, “Law and Legislation in Municipal Bankruptcy,” 38 Cardozo L. Rev. 1301, 1319 (2017).
21 11 U.S.C. § 109(c)(4).
22 See In re City of Vallejo, 408 B.R. at 297 (“[W]e emphasize that while a complete plan is not required, some outline or term sheet of a plan which designates classes of creditors and their treatment is necessary.”).
23 11 U.S.C. § 109(c)(5).
24 In re City of Detroit, 504 B.R. at 17-79.
25 11 U.S.C. § 362.
26 Jim Christie, “Mammoth Lakes, California, Files for Bankruptcy,” Reuters (July 3, 2012), available at https://www.reuters.com/article/us-mammoth-lakes-bankruptcy/mammoth-lakes-california-files-for-bankruptcy-idUSBRE8621E920120703.
27 See David Skeel, “The Education of Detroit’s Pension and Bond Creditors,” 2 PENN WHARTON PUB. POL’Y INITIATIVE 1, 3 (2014), available at http://publicpolicy.wharton.upenn.edu/live/files/166-a.
28 11 U.S.C. § 943(b)(7).
29 For example, a bankruptcy court can evaluate the liquidation value of a debtor’s real estate to approximate its value and potential recovery for creditors, but such tools are unavailable where a municipal debtor cannot be required to liquidate.
30 See, e.g., In re Pierce Cty. Hous. Auth., 414 B.R. 702, 718 (Bankr. W.D. Wash. 2009) (“The ‘best interest of creditors’ requirement of § 943(b)(7) is ‘generally regarded as requiring that a proposed plan provide a better alternative for creditors than what they already have.’”).
31 https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-9-bankruptcy-basics.
32 https://www.uscourts.gov/news/2019/07/26/june-2019-bankruptcy-filings-fall-03-percent.
33 In re Fin. Oversight & Mgmt. Bd. for Puerto Rico, 361 F. Supp. 3d 203, 216 (D.P.R.), judgment entered, 366 F. Supp. 3d 256 (D.P.R. 2019), and reconsideration denied, No. 17 BK 3283-LTS, 2019 WL 8403509 (D.P.R. March 15, 2019).
34 In re City of Vallejo, 403 B.R. 72, 74 (Bankr. E.D. Cal. 2009), aff’d, Int’l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo, CA (In re City of Vallejo, CA), No. 2:09-cv-02603, 2010 WL 2465455 (E.D. Cal. June 14, 2010).
35 In re City of Stockton, California, 526 B.R. 35, 38 (Bankr. E.D. Cal.), aff’d in part, dismissed in part, 542 B.R. 261 (B.A.P. 9th Cir. 2015).
36 In re County of Orange, 179 B.R. 177, 184 (Bankr. C.D. Cal. 1995).
37 See Cal. Gov’t. Code §58000, et seq.
38 Sheyanne Romero, “Tulare Hospital District Completes Bankruptcy Filing: ‘A Remarkable Turnaround,’” Visalia Times Delta (August 22, 2019), available at https://www.visaliatimesdelta.com/story/news/2019/08/22/tulare-hospital-district-completes-bankruptcy-filing/2075686001/.
39 See Special District Formation Guide, California Special Districts Association, available at https://higherlogicdownload.s3.amazonaws.com/CSDA/b24702e8-8a42-4614-8c45-bc3cba37ea2c/UploadedImages/About_Districts/2016-Formation-Guide-WEB.pdf; see also Alexander D. Flachsbart, “Municipal Bonds in Bankruptcy: S 902(2) and the Proper Scope of “Special Revenues” in Chapter 9,” 72 Wash. & Lee L. Rev. 955, 969 (2015).
40 Rahm Emanuel, “Let’s Make Sure This Crisis Doesn’t Go to Waste,” The Washington Post (March 25, 2020), available at https://www.washingtonpost.com/opinions/2020/03/25/lets-make-sure-this-crisis-doesnt-go-waste/.
41 11 U.S.C. § 365.
42 See NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984).
43 In re County of Orange, 179 B.R. 177, 184 (Bankr. C.D. Cal. 1995); but see In re City of Vallejo, 403 B.R. 72, 74 (Bankr. E.D. Cal. 2009), aff’d, Int’l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo, CA (In re City of Vallejo, CA), No. 2:09-cv-02603, 2010 WL 2465455 (E.D. Cal. June 14, 2010).
44 In re City of Stockton, California, 526 B.R. 35, 38 (Bankr. E.D. Cal.), aff’d in part, dismissed in part, 542 B.R. 261 (B.A.P. 9th Cir. 2015).
45 Id., at 40.
46 Cal. Gov’t. Code § 20487.
47 Id.
48 “Bondholders vs. Retirees in Municipal Bankruptcies: The Political Economy of Chapter 9,” 92 Am. Bankr. L.J. 73, 74 (2018).
49 See Paloma Esquivel and Joe Mozingo, “San Bernardino’s Bankruptcy Plan Favors CalPERS,” Los Angeles Times (May 18, 2015).
50 In re City of Detroit, 524 B.R. 147, 179-81 (Bankr. E.D. Mich. 2014).
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