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Chapter 9 bankruptcy and unsecured creditors.

Over the past five years credit executives have struggled through an extraordinarily difficult economic period as scores of established regional and national corporations sought Chapter 11 refuge in an attempt to restructure their finances. There was some relief in 1994, when the pace of corporate Chapter 11 filings finally slowed. However, December 6, 1994 marked a new period in a credit executive's life - the mega-Chapter 9 bankruptcy filing. Orange County, with a population of 2.3 million and one of the highest per-capita incomes in the nation, was forced to file two Chapter 9 bankruptcy petitions, one for the county itself and one for the county's investment pool, when its $20 billion investment pool, represented by over $12 billion of leveraged borrowing, suffered losses currently estimated at upwards of $2 billion.

Caught up in the Chapter 9 filings were 187 county agencies, school districts, and cities that had invested in the pool. At the time of the bankruptcy filings, approximately 19,000 trade creditors were owed approximately $270 million for goods and services rendered to the county. Suffering a severe cash shortage, Orange County reviewed its vendor lists to determine which vendors were "critical" to keep county government operating; e.g., those vendors that provided goods and services necessary to maintain the health and safety of its inhabitants. Those vendors not found to furnish such critical goods and services had their agreements terminated or postponed indefinitely.

One of the effects of the bankruptcy filings was to immediately freeze the county's agencies', school districts', and cities' access to their investments in the pool. This resulted in those entities likewise terminating or postponing indefinitely vendor agreements that did not provide goods or services considered of a critical nature.

Orange County is not alone with its financial problems. Counties from Texas to Ohio have leveraged their investment pools. The Orange County bankruptcies precipitated runs on these investment pools, raising the threat of more counties being forced to file Chapter 9. This article will examine Chapter 9 and its impact on trade creditors.

The Chapter 9 Debtor

Chapter 9 of the Bankruptcy Code provides for municipalities to obtain bankruptcy protection, with the primary purpose to permit debt adjustment. The definition of an eligible Chapter 9 debtor is broad and includes cities, counties, school districts, and port or highway authorities. A municipality may not be a Chapter 7 or Chapter 11 debtor, nor may an involuntary bankruptcy be commenced against a municipality.

Chapter 9 is the public sector's equivalent to Chapter 11. A condition for Chapter 9 eligibility is that the municipality be insolvent. A basic principle of Chapter 9 is that the municipality continues operations while it reorganizes its affairs and adjusts its debts through a "plan of adjustment."

Chapter 9 is a "hands-off" reorganization from the viewpoint of court or creditor involvement in the municipality's operations as neither the bankruptcy court nor creditors may interfere with expenditures or revenues generated by the municipality.

Trade Creditors' Rights Under Chapter 9

Creditors and creditors' committees' leverage in Chapter 9 is found to be more restricted when compared to Chapters 7, 11, or 13 of the Bankruptcy Code. Upon the filing of a Chapter 9, an injunction or automatic stay goes into effect enjoining any creditor from taking any action against a municipality's property without first obtaining relief from stay. For trade creditors, the automatic stay enjoins lawsuits to collect on pre-petition obligations.

Chapter 9 provides for the appointment of an official creditors' committee. As with Chapter 11, those creditors holding the seven largest unsecured claims will likely qualify to serve on the committee. However, the powers and duties of a creditors' committee under Chapter 9 is more limited than under Chapter 11. Under Chapter 11, a creditors' committee has a fiduciary duty to investigate the debtor's financial condition, which requires the committee to consult with the debtor and dig into its business affairs.

Moreover, a creditors' committee under Chapter 11 has a duty to assist in the formulation of a plan of reorganization and has standing to request the appointment of a trustee or examiner.

On the other hand, under Chapter 9, the municipality has complete control over its operations and a creditors' committee is greatly restricted in its involvement in the administration of the case. In Chapter 11, the ability of a creditors' committee to seek appointment of a trustee or examiner is one of its most important weapons against untrustworthy or highly incompetent management.

However, under Chapter 9, a trustee or examiner may not be appointed as the appointment would interfere with the municipality's political or governmental affairs. In the Orange County cases, two official committees were formed, one for the Orange County case and one for the investment pool case. Because many of the non-trade creditors in the two cases hold individual claims in excess of $100 million, the trade creditors' interests were represented on one committee (the county case) by a single designate.

Beyond the restrictions Chapter 9 imposes on the powers and duties of creditors' committees, there may be certain advantages for individual trade creditors under Chapter 9. Many of the risks associated with selling on credit to an account in Chapter 11 may not exist in Chapter 9. For example, in Chapter 11, a debtor that ultimately cannot reorganize may not be able to pay trade creditors in full for goods sold post-petition should the case convert to Chapter 7 liquidation.

Likewise, a super-priority creditor, one who lends to the debtor on a secured priority basis, may prevent trade creditors who provide goods or services post-petition from being paid in full. In contrast, Chapter 9 does not provide for the liquidation of a municipality. Moreover, as the bankruptcy court has no authority over expenditures by the municipality, post-petition operating expenses incurred in favor of trade creditors may not even qualify as an administrative expense. As the court does not supervise what debts the municipality may incur during the case, such claims should not be discharged and should remain liabilities of the municipality after confirmation of a plan.

As with Chapters 7, 11, and 13, those creditors holding unsecured, non-priority claims in a Chapter 9 must file proofs of claims prior to the bar date. Should a trade creditor not timely file proof of its claim, the claim will be disallowed. Preference, fraudulent conveyance, and other kinds of pre-bankruptcy transfers are avoidable in Chapter 9. The municipality holds these avoiding powers. Where a municipality refuses to pursue avoidance actions, however, a trustee may be appointed to do so.

The Plan of Adjustment

With Chapter 9, the municipality is the only party who may file a plan to restructure its obligations, which is referred to as a "plan of adjustment." To permit another entity, such as a creditors' committee, to file a plan of adjustment would interfere with the municipality's right to control its political and governmental affairs.

Chapter 9 does not establish a deadline as to when a municipality must file its plan; rather, the bankruptcy court sets the deadline. The bankruptcy court should give a municipality sufficient time to restructure its obligations in setting a "drop-dead" date for the municipality to file its plan. Depending on the complexity of case, this time period could run from perhaps several months to over a year. Should the municipality fail to file its plan by the court-imposed deadline, the court may dismiss the case.

As with Chapter 11, a plan of adjustment is the vehicle by which a municipality discharges its pre-petition obligations and provides the method for repayment of its obligations. Chapter 9 imposes seven conditions on a municipality for its plan to be confirmed. Those conditions include that amounts paid by the municipality under the plan are "reasonable;" the municipality has authority to carry out the terms of the plan, and the plan is in the best interest of creditors.

Prior to any vote on a plan, a municipality must first obtain bankruptcy court approval of its disclosure statement. The purpose of the disclosure statement is to provide creditors with adequate information as to their treatment under a plan. Creditors can agree to any treatment of their claims under a Chapter 9 plan. Trade creditors whose claims are affected by the plan of adjustment have standing to object. The plan must segregate creditors' claims into classes and describe how such creditor classes are to be treated.

The municipality, through the terms of the plan, may offer cash, securities, or other property to trade creditors in satisfaction of their claims. A plan of adjustment may be confirmed by consent of the creditors or over the objection of one or more creditor classes. With objection by one or more creditor classes, the cram-down provisions of Chapter 11 apply. A cram-down plan provides for confirmation of a plan notwithstanding its rejection by one or more creditor classes.

However, as the nature and purpose of Chapter 9 is to achieve consent between the municipality and its creditors, the likelihood of a cram-down plan is unlikely. As with Chapter 11, when the municipality's plan is confirmed, trade creditors are bound by the terms of the plan. With the confirmation order, the municipality's debts are restructured and its pre-petition obligations discharged, pending bankruptcy court approval of the securities the municipality will offer pursuant to its plan.


Trade creditors who have relied exclusively on county dollars are unable to pay their suppliers. The Orange County bankruptcy filings raise issues that should cause credit executives throughout the country to re-evaluate the amount of their credit lines to public agencies, as well as the percentage of their accounts they have with public agencies.

The Orange County filings undermine the notion that public agencies always pay their obligations, which notion is often employed by public agencies to justify their demands that trade creditors accept lower profit margins on their contracts when compared to contracts in private industry. The Orange County bankruptcy filings may provide the impetus to alter their business mix and move to selling to both public agencies and private industry.

Scott E. Blakeley is an attorney in the Los Angeles office of Bronson, Bronson & McKinnon, where he specializes in bankruptcy and creditors' rights law.
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Author:Blakeley, Scott E.
Publication:Business Credit
Date:Mar 1, 1995
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