An Overview of Chapter 9 of the Bankruptcy Code: Municipal Debt Adjustments

As attention shifts from the global financial crisis of 2008–2009 to the global sovereign crisis that currently is affecting much of Europe, lawmakers are scrambling to create new laws and regulations designed to stave off the next financial crisis.1 Meanwhile, a different threat quietly has been growing in America's states, cities, towns, municipalities, and other political subdivisions. With each passing quarter, unsustainable budgetary shortfalls, record level unemployment, and deepening losses in financial markets threaten the ability of some municipalities to continue providing even the most basic of services to its constituents.2 Indeed, the problem has grown so severe in some areas that several well-known towns and cities, big and small, across the United States are openly discussing bankruptcy as an option, and dozens more are seen as viable candidates for a bankruptcy filing.3 Many of the corporate entities hit hardest by the financial crisis have used chapter 11 of the United States Bankruptcy Code, 11 U.S.C. §§ 101-1532 (the "Bankruptcy Code"), to address the financial, operational, and legal problems that threatened their existence. However, municipalities hoping to avail themselves of the same well developed body of law associated with chapter 11 will discover that they are not available to municipalities.4 Rather, municipalities must resort to the little-used (and little-understood) chapter 9 of the Bankruptcy Code, a patchwork of federal laws that borrows concepts and particular sections from other chapters of the Bankruptcy Code to create a forum of "last resort" to allow a municipality to deal with its problems outside of the confines of otherwise applicable state law. While chapter 9 has only been used approximately 560 times since its creation, the devastating results of the most recent global financial crisis, coupled with several decades of municipal government practices that did not always address fiscal imbalances, suggest that chapter 9 of the Bankruptcy Code will become a much more utilized tool in the coming months and years. This White Paper is intended to give municipalities and other interested parties a brief overview of some of the significant financial issues facing municipalities today, particularly the growing deficiencies in many public pension funds. This paper includes a description of the basic elements of a chapter 9 proceeding, including eligibility requirements, operations under bankruptcy supervision, and emergence from chapter 9 through a plan of adjustment. Finally, the pros and cons of a chapter 9 filing are examined, and a number of practical tips for municipalities considering such a course of action are provided.

Municipalities Face Myriad Financial Problems

The basic problems faced by municipalities are not difficult to identify. Similar to private entities, municipalities are in the midst of an extended cycle of declining revenues. Such shortfalls are to be expected in light of the reduced income and sales taxes that municipalities have been able to collect from citizens who have, themselves, experienced job losses and other significant financial hardships. Similarly, the declining value of real estate and the high rate of foreclosure have negatively affected property tax revenues. Moreover, in some cases, municipalities engaged in complex derivative transactions, such as interest rate swap agreements (primarily for the purpose of hedging against rising interest rates), only to discover now that such hedging devices require significant current payments and a costly final payment if terminated prior to their scheduled end date. Compounding the problem is that the cost of issuing debt for a municipality is going up. The low interest rates traditionally enjoyed by municipalities are rising, whether because of the general "tightening" of the credit markets as a result of the financial crisis or because investors are beginning to take notice of the confluence of factors currently threatening municipalities. In addition, the monoline insurance companies that provided relatively inexpensive credit enhancement for tax-exempt debt have completely disappeared from the market. Moreover, despite being traditionally considered a relatively "risk free" investment, the larger public issuers now find that their debt is the subject of an increasingly robust market in credit default swaps—one of the vehicles many claim was the culprit for some of the worst problems during the height of the domestic financial crisis and, indeed, during the current crisis in Europe. But perhaps the single largest problem facing municipalities today is the dramatic and growing shortfall in public pension funds—estimated to be between $1 trillion and nearly $4 trillion nationwide. In California alone, the shortfall could be as high as $500 billion.5 Unlike private pensions, public pensions are not regulated by the Employee Retirement Income Security Act of 1974 ("ERISA") and, therefore, are not subject to the rigorous vesting and funding rules imposed by ERISA. See § 4(b)(1), 29 U.S.C. § 1003(b)(1). Similarly, public pension participants do not enjoy the insurance-like protection of the Pension Benefit Guaranty Corporation. Thus, municipalities have been left in a largely unregulated vacuum, free to make their own choices about vesting, benefits, qualifications, and funding. This unregulated atmosphere has resulted in several decades of increasingly rich benefits packages, largely as a result of negotiations with a municipality's collective bargaining units, coupled with a less-than-rigid fiscal approach to paying for those benefits. As a result of these issues, when times get tough (as they are now), there are few rules or oversight agencies ensuring—with a threat of severe penalties, fines, and other sanctions—that public officials adequately fund their public pension plans and refrain from diverting money intended to fund a public pension to other necessary public services.6 Moreover, the accounting practices employed by many municipalities have exacerbated the pension problem by incorporating unrealistic assumptions into contribution calculations.7 Indeed, some commentators have noted that, if required to adopt a more realistic set of assumptions—revising their current assumed return on pension investments from the current 8 percent to something more realistic—the magnitude of the current under funding problem would undoubtedly increase.8 Thus, while current funding levels of public pensions may be sufficient to satisfy current obligations, the historical practices associated with public pensions suggest that a severe problem exists with respect to funding future obligations and that the true gravity of the problem has not yet been fully acknowledged or addressed. Further complicating the public pension issue is that, in many cases, the benefits are considered to be virtually untouchable. For example, in California, public pension benefits are considered a "vested right." See Kern v. City of Long Beach, 29 Cal. 2d 848 (1947); Betts v. Bd. of Admin., 21 Cal. 3d 859, 863 (1978). While case law on the issue has demonstrated that public pension benefits for active employees are subject to "reasonable modification" under certain fact-specific circumstances (see Abbott v. City of Los Angeles, 50 Cal. 2d 438, 453 (1958) (providing a two-part test for determining whether public pension plans may be modified)), public pension benefits for retirees are not subject to modification. See Terry v. City of Berkeley, 41 Cal. 2d 698, 702-03 (1953); Claypool v. Wilson, 4 Cal. App. 4th 646, 664 (Ct. App. 1992). Accordingly, even in circumstances where benefits under a public pension are pitted against the basic needs of a municipality's population, certain states' laws make clear that the public pension benefits win. The historic legal protection afforded to pension plans and their beneficiaries has not inhibited certain municipalities from challenging such protection in current legal proceedings,9 and such legal challenges can be expected to increase as the situation for many municipalities becomes more dire.

Elements of a Chapter 9 Case

Should a municipality determine that it needs to consider a chapter 9 filing to address its financial problems, such as the ones described above, the entity will need to understand the basic steps and elements of a proceeding. The basic elements of a chapter 9 filing are described below. Eligibility to File. As mentioned above, a municipality's access to the well-developed statutory and case law set forth in the Bankruptcy Code is quite limited. Unlike the traditional individual, corporate, or partnership debtor that has a largely unfettered right to choose from a variety of chapters of the Bankruptcy Code (i.e., chapters 7, 11, and 13), municipalities are eligible to seek protection only under chapter 9 of the Bankruptcy Code. Moreover, demonstrating eligibility under chapter 9 could be a difficult, time-consuming, and hotly contested process that may prove to be too difficult in many instances. Ultimately, if a bankruptcy court determines that the debtor has not proven its eligibility to be a debtor under chapter 9, the bankruptcy court will dismiss the case. As an initial matter, access to chapter 9 is limited to municipalities. A "municipality" is defined by section 101(40) of the Bankruptcy Code as a "political subdivision or public agency or instrumentality of a State." Although not defined in the Bankruptcy Code, "public agencies or instrumentalities of a State" refers, in general, to any state-sponsored or controlled entity that raises revenues through taxes or user fees to construct or operate public projects. Accordingly, the definition of "municipality" includes certain obvious examples, such as cities, townships, and villages. While significantly all of the attention and commentary on chapter 9 focuses on the more obvious examples of a "municipality,"...