Chapter 9 for Municipalities
California Lawyer

Chapter 9 for Municipalities

by David S. Kupetz

April 2013

Last August, Moody's Investors Service reported that more than 10 percent of California's 482 cities have declared fiscal crises. The limited power of those cities to raise revenue makes the problem particularly challenging.

A significant number of cities will need to realign their resources and obligations in order to remain solvent, and local public entities may find it necessary to file for bankruptcy to achieve long-term financial sustainability. But beware: Bankruptcy procedures for public entities are significantly different than those applicable to private businesses.

The federal bankruptcy code provides a framework for eligible government entities to restructure debt. Chapter 9 of the code enables a municipality that is unable to pay its debts as they come due to continue to provide essential services to residents while working out a plan to adjust its debts. (See 11 U.S.C. ยงยง 901- 946.) To avoid disruption of necessary services, Chapter 9 is intended to facilitate the continuance of insolvent municipalities rather than their dissolution. Similar to Chapter 11 bankruptcy reorganization for nongovernmental entities, two primary benefits of a Chapter 9 filing are (1) the breathing spell imposed by the automatic stay, and (2) the ability to adjust creditors' claims through the plan process.

But there are fundamental differences between municipal debt adjustment and bankruptcy reorganization of nongovernmental entities. A city is not a business enterprise operating for a profit. Local public entities exist to provide residents with public services. And unlike a corporation, a municipality has no shareholders. Furthermore, a municipality may not be completely liquidated, with the proceeds used to pay its creditors.

A municipality must be insolvent to invoke bankruptcy protection. That being said, it should also be noted that Chapter 9 is designed to balance the powers provided under federal bankruptcy law to restructure a municipality's debt against the constitutional mandate that guarantees state sovereignty. (See U.S. Const., Amend. X.)

Though the standards for confirmation of a Chapter 9 plan incorporate many of the Chapter 11 requirements, the key confirmation requirements diverge. Under a Chapter 9 plan of adjustment, the "best interests of creditors" test requires that the plan provide creditors with what they might realistically obtain had there not been a bankruptcy. In addition, the "feasibility" standard dictates that the debtor show it can meet its obligations under the plan and that it can continue to provide public services. Also, because Chapter 9 debtors do not have equity holders, Chapter 9 does not require full payment of nonconsenting creditor classes in order for the debtor to retain its assets. Instead, to "cram down" a plan over the objection of a class of creditors, a Chapter 9 plan must provide creditors with as much as can be reasonably expected under the circumstances. As the court noted in the Stockton bankruptcy case, for a plan of adjustment to be confirmed as to a dissenting class of creditors, it must be "fair and equitable" and "not discriminate unfairly." (In re City of Stockton, 478 B.R. 8, 26 (Bankr. E.D. Cal. 2012).)

Creditors should not expect that under a plan of debt adjustment all excess cash will go to payment of their claims. Indeed, as the court made clear in the Stockton case, loyal employees with long-standing claims for benefits may well see their status compromised. "[E]ven if the plaintiffs' benefits are vested property interests," said the court, "the shield of the Contracts Clause crumbles in the bankruptcy arena." (In re City of Stockton, 478 B.R. at 16.)

One of the looming issues is what ability, if any, a local entity has to restructure its relationship with the state pension system, commonly known as CalPERS. The Stockton decision - which dealt with suspension of local retiree health care benefits, not pensions administered by CalPERS - can be viewed as applying equally to suspension of pension benefits. Also, the decision recognizes that retiree benefits can potentially be modified on a permanent basis, subject to meeting the requirements for confirmation of a Chapter 9 plan. But stay tuned; this issue may well arise in a future case.

Although the procedure differs somewhat from Chapter 11, the end goal in a municipal bankruptcy is much the same; the expectation is that a municipal debtor will emerge from Chapter 9 having made the adjustments necessary to achieve long-term financial sustainability.

David S. Kupetz is a member of Sulmeyer Kupetz in Los Angeles, where he specializes in business reorganization, restructuring, bankruptcy, and other insolvency matters and related litigation.

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