Bankruptcy Rules, Politics Make Chapter 9 Rare Event for Cities

A nearly 90-year-old chapter of the US Bankruptcy Code created to aid cities and other municipalities in restructuring their debt remains rarely used and difficult to access due to stringent eligibility requirements.

About 700 Chapter 9 cases have been filed since the Municipal Bankruptcy Act of 1937 was enacted, compared to the thousands filed by corporate Chapter 11 debtors annually, according to Nuveen LLC, an investment solutions company that deals with municipal bonds.

The insolvency standard municipalities must meet to qualify for Chapter 9 is part of why so few have taken advantage of the tool, bankruptcy professionals and academics say.

The only entity to file for Chapter 9 in 2023, San Benito Health Care District in California, discovered in March that proving eligibility is no small feat. It was thrown out of bankruptcy after a court determined it wasn’t in financial distress because it was paying some debts as they came due.

Even Detroit, with more than $18 billion in debt, secured Chapter 9 relief only after a nine-day trial over its eligibility more than a decade ago. But it’s come a long way since then, having conducted a competitive auction this month for a $46 million bond sale after earning its first investment-grade rating in March.

And more so than Chapter 11 bankruptcies, Chapter 9—enacted following the Great Depression—is often influenced by politics. The municipal section of the bankruptcy code will “remain limited” as long as the power over who is allowed to file stays with the individual states, said Samuel Maizel, a partner at Dentons.

“All the political issues about cities filing get sucked into the evaluation of Chapter 9,” Maizel said. “It becomes a state law question.”

There have been about 80 Chapter 9 filings in the past 20 years, according to BankruptcyData, a company that tracks bankruptcy information. Before Detroit filed for bankruptcy in July 2013, around 80% of the filings over the prior decade were cities or municipalities. Since November 2014, when Detroit emerged from bankruptcy, towns and cities dropped to about 18% of the recently filed Chapter 9 cases.

“Many municipalities get into Chapter 9 with no idea of what it’s going to cost,” said Karol Denniston, a partner at Squire Patton Boggs. “It’s a time-consuming process which starts with having to prove that they’re eligible to be a Chapter 9 debtor.”

Politics Versus Business

No Chapter 9 bankruptcies have been filed this year so far. San Benito was the latest to file, in May 2023.

The district, which operates a 25-bed hospital and a number of rural health care facilities, is appealing its dismissal after the US Bankruptcy Court for the Northern District of California said it wasn’t sufficiently distressed. Judge Stephen L. Johnson found that the district was paying its debt as it came due and rejected claims that its pension liabilities and failure to pay deferred taxes contributed to its alleged insolvency.

The definition of a municipality, for the purpose of Chapter 9 eligibility, includes cities, towns, school districts, and hospital districts, among other entities that receive municipal funding. About half of the country authorizes municipalities to file for bankruptcy, although some states have additional requirements beyond those in the bankruptcy code.

While the most high-profile Chapter 9 cases are for cities, public hospital districts have been increasingly filing Chapter 9 bankruptcies over the last 20 years. Since 2015, 13 public health districts or medical centers have filed for bankruptcy, up from nine the decade before.

Hospitals are a severely distressed sector, Denniston noted. “If you look at the size of health care districts or hospitals, you’ll see that they are serving smaller communities,” she said. “It doesn’t take much to figure out the reason they are where they are is because of cash flow. It costs more to maintain the operations than the people are there to use them.”

Elected officials tend to push off or avoid being the person to permit Chapter 9 cases, especially those involving cities or towns, bankruptcy professionals and academics say.

Some states don’t allow Chapter 9 filings because no one wants “to have your legacy be that you filed the bankruptcy case,” said Marc Levinson of Orrick, Herrington & Sutcliffe LLP.

A municipality’s financial problems were typically created well before a current city council took office. That means municipal leaders tend to “do everything” to “kick the can down the road,” Levinson said.

Public health care districts, which are governed by an elected or appointed board of directors, face the same eligibility requirements that cities and towns do. But those systems can be viewed as more like businesses than municipalities—making a bankruptcy less politically fraught.

“Generally the public views a hospital as more akin to a business than a city like Detroit,” said Laura Coordes, a professor at Arizona State University’s Sandra Day O’Connor College of Law. “When you’re going to a hospital, you’re not necessarily thinking about, ‘Who’s running this? The government?’ On some level, broadly, people are sort of more accepting” of public health care district bankruptcies, she said.

Some municipalities try to reach arrangements with their creditors without filing to reduce bankruptcy-related expenses, said Lawrence Larose, a partner at Sheppard Mullin. That contributes to the lower amount of filings.

The municipal bankruptcy “process is sort of punishing enough in and of itself, that people aren’t just filing Chapter 9 on a whim,” Coordes said.

Chapter 9 Wins

The US Bankruptcy Code’s municipal chapter has had its share of success stories, despite the relatively low number of cases that have been filed. Detroit has shown that Chapter 9 can have a dramatic effect, though it may take some time to achieve.

Jefferson County, Ala., filed in 2011, and was one of the biggest municipal borrowers to go bankrupt with about $4 billion in debt before Detroit filed. The county—whose seat is Birmingham—received its investment-grade credit rating and sold $2.3 billion of bonds in January to refinance debt that helped it emerge from Chapter 9. And Orange County, Calif.'s 1994 filing serves as a “seminal case” that “established a number of legal principles that are still useful to this day,” Larose said.

Congress tried to replicate Chapter 9 when it created a law in 2016 to assist Puerto Rico in restructuring its $70 billion debt stack. The court-supervised process for the commonwealth took five years and more than $1 billion in legal fees to complete. Litigation is ongoing for the island’s main utility, which is still battling creditors over its debt-cutting proposal.

State Law Versus Bankruptcy Reform

Bankruptcy experts are split by what, if anything, can be done to make Chapter 9 more accessible and user-friendly. Maizel said the issue is at the state law level, while some say general bankruptcy reform is necessary.

Additionally, “there has to be some willingness on the part of state officials to consider the benefits of Chapter 9 to maybe not look at it as a last resort, only to be used after everything else has failed,” Coordes said.

Conditions that tend to lead cities, towns, and hospital districts, among other municipalities and special interest entities, to file still exist. Pension liabilities and health benefit costs “continue to balloon,” Larose said.

“There will be inevitably more Chapter 9s coming down the road,” Larose said. “Who knows, other states may find themselves in a position where politically they need to permit their cities and towns to file, and change the legislation.”

It’s hard to say “there’s a magic bullet” that can fix a municipality’s troubles, Denniston said. “We have more expertise in this country in dealing with Chapter 11 private sector companies than we do Chapter 9.”

Softened eligibility requirements could help municipalities file more easily. Fighting over eligibility wastes a lot of time and money for debtors who are trying to get out of dire straits, Levinson said.

“But Congress almost never amends the bankruptcy code,” Levinson said.