Chapter 9: Bondholders Beware—It’s Not Business As Usual

Municipal distress is rampant. There is little debate that many cities in the U.S. cannot meet their obligations as they come due. Pending and future pension liability looms with the threat of bringing well managed cities to their knees. The perfect storm of a bad economy, lower tax revenues, rising employment costs and planning for future obligations can only mean one thing—many municipalities will need to restructure in the very near future.

While the private sector has been through any number of restructuring cycles and participants are comfortable operating in Chapter 11 bankruptcies ¹11 U.S.C. §§ 1101-1174 (2006), municipal distress brings new challenges. There have been few municipal bankruptcies and as a result there is limited precedent. As a practical matter, recent Chapter 9 ²11 U.S.C. §§ 901-946 (2006) filings should give any potential Chapter 9 debtor pause to consider whether the most efficient and cost-effective way to restructure is through a Chapter 9 filing. Plus, there is the complex intersection between federal and state law. The Tenth Amendment allows states to determine whether or not they will permit their governmental entities to access federal bankruptcy proceedings.

Municipalities who are permitted to file should be wary of Chapter 9, it’s no panacea for a municipal restructuring. Recent cases such as Jefferson County ³In re Jefferson County, Alabama, No. 11-05736-9 (Bankr. N.D. Ala. Filed Nov. 9, 2011)(23 BBLR 1423, 11/17/11) and Vallejo ⁴In re City of Vallejo, California, No. 2008-26813 (Bankr. E.D. Cal. Filed May 23, 2008)(20 BBLR 649, 5/29/08) illustrate the point. Vallejo spent several years in Chapter 9, spent an estimated $13 million in legal fees and now faces, in its first post bankruptcy budget, a deficit of $3.4 million. Jefferson County is an extraordinary case for many reasons, not the least of which is the fraud that more or less led to the County’s financial distress. Jefferson County is a good example of just how limited the bankruptcy court’s powers are in a Chapter 9 filing. Other than dismissing the case, there is little a judge can do when a plan of adjustment is not forthcoming. For example, the municipal debtor’s day-to-day operations are not subject to court approval, and the debtor may incur additional debt without authority. From the private sector’s view, Chapter 9 is likely to be a long and very expensive conversation among the municipality, the creditors and the court. Each dollar a Chapter 9 debtor spends on its Chapter 9 proceeding is a dollar forever lost. It is a truly sunk cost. This matters, because unlike the private sector where a debtor in a Chapter 11 case figures out ways to increase revenue, a municipal debtor doesn’t have that option. Chapter 9’s cost a lot of money and it’s difficult to see how these administrative costs benefit creditors.

Getting Into Chapter 9: Establishing Eligibility

Only a “municipality” as defined by Chapter 9 as a “political subdivision or public agency or instrumentality of a state” is allowed to file. And that is only if the state permits a filing. Once the Chapter 9 debtor establishes that it is a “municipality” as defined by the Bankruptcy Code, it must meet additional “eligibility requirements”. They include establishing:

• (1)  “Specific Authorization” by state law or by a governmental officer or organization empowered to authorize the municipality to be a debtor. For example, municipalities in California must participate in a statutory mediation process with creditors or declare a fiscal emergency before filing. New York debtors must follow the statutory requirements and have the consent of its emergency financial control board. In Illinois a Chapter 9 debtor must obtain the consent of the Financial Planning and Supervision Commission.

• (2)  Insolvency: the municipality must be insolvent under Bankruptcy Code Section 101 (32)(C)—t must not be able to pay its debts as they come due. Courts usually look to the debtor’s cash flows rather than using a balance sheet test.

• (3)  Voluntary: the municipality must desire to implement a plan to adjust its obligations. A municipality cannot be put into bankruptcy involuntarily.

• (4)  Attempted to avoid filing: the municipality must: (a) Obtain the agreement of creditors holding at least a majority in the amount of claims of each class the debtor intends to impair under the plan; (b) negotiate in good faith with creditors and be unable to obtain the agreement of creditors holding at least a majority in amount of the claims of each class the debtor intends to impair; (c) be unable to negotiate with creditors because such negotiation in impracticable; or (d) reasonably believe that creditors may attempt to obtain a preference.

Of course, creditors have the right to object to eligibility, it runs to whether the bankruptcy court can take jurisdiction over the municipal debtor and the ensuing Chapter 9 case. Vallejo creditors challenged eligibility, it took 18 months, an appeal and who knows how much in legal fees to resolve. Jefferson County creditors appealed eligibility.

Creditors’ Role is Limited—As Compared to Chapter 11

Assuming the debtor meets the “eligibility showing,” creditors should be aware that their role is limited—nothing like their role in a Chapter 11. The exclusivity period during which only the debtor may file a plan never ends in a Chapter 9. Creditors are not permitted to file a competing plan of adjustment. Instead, if certain requirements are met, including acceptance by at least one impaired class of creditors, the debtor’s plan is binding on dissenting creditors. A committee can be formed, but the debtor must agree to payment of the committee’s counsel fees. It is not automatic.

Municipal Debtors Have Broad Powers

A municipal debtor maintains complete control of most of its operations, including finances. The debtor can use its property, raise taxes and make expenditures. It is permitted to reject executory contracts and leases subject to court approval. It may also reject collective bargaining agreements and retiree health plans without going through the usual procedures required in a Chapter 11 case. The court does not have supervisory authority over a municipal debtor’s decision to incur additional debt during a Chapter 9 case.

Bondholder Treatment

For general obligation bonds, a municipal debtor is not required to pay either principal or interest during the case. General obligation bonds are subject to negotiation and restructuring under the municipal debtor’s plan of adjustment. General obligation bondholders may not present a competing plan.

Special revenue bonds (bonds backed by a dedicated revenue source) continue to be secured and serviced during a Chapter 9 bankruptcy. Special obligation bondholders will receive debt service payments (principal and interest) so long as the special revenues are sufficient to make the payments and the lien on the special revenues is subordinate to the operating expenses of the project or system that generates the revenues. Special revenues may not be diverted to pay unrelated debts.

Plan Confirmation Requirements

The court must confirm the municipality’s plan of adjustment so long as at least one class of impaired creditors has accepted the plan and the plan does not discriminate unfairly and is fair and equitable to each non-consenting class. Post bankruptcy claims must be paid in full unless the creditor agrees to some other treatment. Creditors must receive as much under the plan of adjustment as they would if the case were dismissed.

The plan of adjustment must be in the “best interests of creditors.” The test is different from Chapter 11. In a Chapter 9 case, the debtor must show that the plan of adjustment is a better alternative for creditors than dismissal of the case. The alternative of dismissal would permit every creditors to pursue its own interests.

Why Bondholders Need to Monitor Municipal Holdings

The level of municipal distress is significant. Meredith Whitney was right about the depth and breadth of municipal insolvency. That leaves the open question of when and how municipal restructurings will arise. Monitoring performance and reporting on EMMA is going to be important to bondholders who stand to bear significant losses if they are not proactive in the restructuring process. That means reaching out to indenture trustees and other bondholders to work through restructuring strategies. It also means reaching out to the municipalities to encourage restructuring strategies that do not involve freefall bankruptcy filings. Unplanned Chapter 9 filings are likely to increase the costs of the restructuring process, a cost that will inevitably be borne by the general obligation bondholders. To prevent these potential losses, bondholders need to monitor municipalities’ performance and be proactive in opening up negotiations, seeking current financial and operating information and seeking to force the potential Chapter 9 debtor to participate in a vigorous pre-bankruptcy process that complies with the requirements of the Bankruptcy Code—to reach agreement regarding a plan of adjustment before filing.