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Municipal debt adjustment under the bankruptcy court.

The rights and powers of the debtor, the state, the court, and the creditors in a chapter 9 case in bankruptcy court.

Chapter 9 of the Bankruptcy Code (the "Code") provides a mechanism for eligible governmental entities to restructure debt. Chapter 9 is designed to enable a financially distressed municipality to continue to provide essential services to residents while working out a plan to adjust its debts. The general policy considerations underlying chapter 9 are the same as those in chapter 11 bankruptcy reorganization for nongovernmental entities: to allow the debtor a breathing spell from debt collection efforts and an opportunity to establish a repayment plan with creditors. However, municipal bankruptcy is unlike bankruptcy reorganization for individuals, partnerships, or private corporations. In fact, application of the term "bankruptcy" to chapter 9 is a misnomer.

The primary differences between chapter 9 and chapter 11 of the Code are the result of the constitutional mandate of the Tenth Amendment to the United States Constitution guaranteeing state sovereignty. Congress has the power to establish uniform laws on the subject of bankruptcies throughout the United States. Moreover, the Constitution prohibits the states from passing any law that impairs the obligation of contracts. Accordingly, only federal law can provide the type of relief afforded by chapter 9. Chapter 9 seeks to reconcile the constitutional requirements guaranteeing state sovereignty and prohibiting impairment of contracts by the states by arming the debtor with an arsenal of bankruptcy powers to enable it to achieve financial rehabilitation with almost none of the corresponding restrictions and duties which are imposed on a chapter 11 debtor.

Resort to chapter 9 has been infrequent, and, until recently, public awareness of chapter 9's existence has been limited. For example, the first chapter 9 case in the Central District of California was filed by the Ventura Port District in August 1993. The recent chapter 9 filings by Orange County, California, and the Orange County Investment Pools have undoubtedly heightened awareness of chapter 9. This awareness, however, does not necessarily include an understanding of the differences between chapter 9 and bankruptcy under other chapters of the Code.


Access to protection under chapter 9 is limited. Only entities which meet the specific requirements of the Code may qualify for relief under chapter 9. The first requirement is that only a "municipality" is eligible for chapter 9 relief. The Code defines a municipality as a political subdivision or public agency or instrumentality of a state; however, the terms political subdivision, public agency, and instrumentality of a state are not defined in the Code. Courts have held that a public agency or authority is a municipality if it is subject to control by public authority, state or local.

Second, a municipality's access to chapter 9 protection is conditioned upon specific state authorization. The debtor must be specifically authorized, in its capacity as a municipality or by name, to seek relief under chapter 9, or by a governmental officer or organization empowered by state law to authorize the entity to be a debtor under chapter 9.

Third, a municipality must be "insolvent" in order to be eligible for relief under chapter 9. The definition of insolvent for purposes of chapter 9 eligibility requires that the debtor is 1) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute or 2) unable to pay its debts as they become due. The reference point when evaluating the debtor's solvency is the date of the filing of the chapter 9 petition. Thus, if at the time of the commencement of a chapter 9 case a municipality is generally not paying its undisputed debts as they become due, the insolvency requirement is satisfied. Alternatively, the determination of whether a municipality is "unable to pay" requires a prospective analysis of the debtor's ability to pay its debts in the near future. Courts have rejected the argument that, in order to satisfy the requirement that it is insolvent because it is "unable to pay its debts," a municipality must demonstrate that it is unable to raise the revenues required to meet its obligations through taxation, rate increases, or other efforts.

Fourth, a municipality must desire to effect a plan to adjust its debts. Moreover, in order to be eligible for relief under chapter 9, an insolvent municipality specifically authorized to file a chapter 9 petition must do more than desire to effect a plan to adjust its debts. At least one of four additional alternatives must be satisfied. The first of these alternatives is satisfied if the municipality has obtained the agreement of creditors holding at least a majority in the amount of the claims of each class that the municipality intends to impair under a plan in the chapter 9 case. Because obtaining a sufficient and satisfactory prepetition agreement is unlikely in most circumstances, municipalities generally satisfy one of the other three options. Each of these alternatives is discussed below.

The second option requires that the municipal debtor has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a chapter 9 plan. In instances where serious negotiations occurred prepetition between the municipal debtor and creditors holding sufficient debt, courts have found the municipality to have satisfied the requirement. Other courts have held that where the municipal debtor failed to engage in serious prepetition negotiations regarding a feasible payment plan, it failed to satisfy this alternative.

The third alternative is met if the municipal debtor is unable to negotiate with creditors because such negotiation is impracticable. Impracticability may be viewed as a matter of degree. At some point, however, the sheer number of creditors involved or, among other possibilities, severe time constraints facing a municipal debtor may make negotiation impracticable.

Finally, the last alternative is satisfied if a municipal debtor reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under section 547 of the Code as a preference. In order to fulfill this final Option, the debtor should demonstrate that both its belief that the creditor may attempt to obtain a transfer and its belief that such a transfer is avoidable are reasonable.

State Power to Control Municipalities

The reconciliation under chapter 9 of the constitutional requirements guaranteeing state sovereignty and prohibiting impairment of the obligation of contracts by the states is explicitly embodied in the Code. Under the Code, the power to control chapter 9 debtors is reserved for the states, and the jurisdiction and powers of the bankruptcy court are limited. Chapter 9 does not limit or impair the power of the state to control, by legislation or otherwise, the chapter 9 debtor in the exercise of the political or governmental powers of the debtor. Further, the bankruptcy court may not, without consent of the debtor, interfere with the political or governmental powers of the debtor, any property or revenues of the debtor, or the debtor's use or enjoyment of any income-producing property. Recognizing the constitutional prohibition against state impairment of obligations of contracts, chapter 9 repeats this prohibition by providing that state composition procedures may not bind nonconsenting creditors.

In order to avoid violating the Tenth Amendment's reservation for the states of all powers which are not specifically delegated to the federal government by the Constitution, chapter 9 is designed to avoid interference with state power. The rights and powers of an entity eligible for relief under chapter 9 are derived from the state under which the entity exists. Consequently, the severe limitations on the powers and jurisdiction of the court in a chapter 9 case compared to cases under other chapters of the Code preserve the constitutionality of chapter 9.

Unlike in a case filed under chapter 11 of the Code, the court cannot appoint a trustee to take over control and management of the chapter 9 debtor's operations. The assets of a chapter 9 debtor cannot be involuntarily liquidated. The chapter 9 debtor is free to use its property outside of the ordinary course of business, and the bankruptcy court cannot approve or disapprove of such use. A municipal debtor's authority to borrow money outside chapter 9 is not restricted in chapter 9. Further, only the chapter 9 debtor may file a plan. At the same time, the chapter 9 debtor obtains the benefits afforded debtors under other chapters of the Code, including the protection of the automatic stay, the right to assume or reject executory contracts, and the right to avoid certain transfers. Without the consent of the debtor, the only real power and control that the court has over a chapter 9 debtor is the power to reject confirmation of the plan if the requirements of the Code are not satisfied and/or the power to dismiss the case.


The court may dismiss the chapter 9 petition if the debtor did not file the petition in good faith or if the debtor does not meet the eligibility requirements discussed above. Chapter 9 is the only chapter under the Code which expressly imposes a good-faith requirement on the debtor; however, good faith is not defined in the Code. In chapter 9 cases, courts have found that where the debtor is using chapter 9 for legitimate reasons and not merely attempting to delay creditors, good faith is not lacking. One court held that good faith was not lacking where a municipality engaged in pre-chapter 9 planning in order to place itself in as good a position as it could for entering chapter 9 even when there may have been other alternatives available. Another court took a more restrictive view in considering good faith in the chapter 9 context, holding that the municipal debtor must demonstrate that it has used its powers to a reasonable extent or has committed to do so as part of a comprehensive and appropriate workout of its financial problems.

The court also may dismiss a chapter 9 case for "cause." While cause is not defined in the Code, examples of cause are provided. These examples include unreasonable delay by the debtor, failure by the debtor to propose a plan prior to any deadline that might be set by the court, denial of confirmation of a plan and denial of additional time for filing another plan or a modification of the plan, or a material default by the debtor under a plan.

Plan for Adjustment of Debts

Eligibility for relief under chapter 9 is conditioned upon, among other things, a municipality's desire to effect a plan to adjust its debts. The Code mandates that the debtor act on this required desire by filing a plan. Nonetheless, the Code does not set any definite deadline for the filing of a plan under chapter 9. The court may set a deadline. Unlike the situation in chapter 11, under all circumstances only the debtor can file a plan in a chapter 9 case. Ultimately, if the debtor fails to file a plan within a reasonable period of time, the court may dismiss the case.

The Code contains specific standards for confirmation of a plan under chapter 9. Many of the requirements for confirmation of a plan of reorganization under chapter 11 are incorporated into chapter 9. The court must confirm a plan if all of the requirements of the Code are satisfied. The primary conditions for confirmation of a chapter 9 plan require satisfaction of the best interests of creditors and feasibility tests. In addition, in order to confirm a chapter 9 plan over the objection of a nonconsenting class of creditors, the court will evaluate whether the plan is "fair and equitable" by determining whether the plan provides creditors with as much as creditors could reasonably expect under the circumstances.

Under chapter 11, the best interests of creditors test is designed to measure whether creditors will receive under a plan at least as much as would be received in a liquidation under chapter 7 of the Code. This analysis, however, is not applicable in the context of a chapter 9 case where the municipal debtor cannot be liquidated. The best interests of creditors test in the context of a chapter 9 case does not compare treatment under the plan to a liquidation, but rather to other realistic alternatives to the plan. The Court will generally determine whether or not the plan as proposed is better than the alternatives. Moreover, the debtor need not necessarily utilize all of its assets or resort to its taxing powers in order to satisfy the best interest of creditors test. Sometimes the court might find that the best alternative to confirmation of a plan of adjustment that is unconfirmable is the presentation of a modified plan, as opposed to dismissal of the case which would result in parties resorting to their state law remedies. In order to satisfy the feasibility test, the debtor must show that it can meet its obligations under the plan and still maintain its operations at a level satisfactory to the debtor. The court should simply review whether the evidence submitted shows that there is a reasonable likelihood that the debtor can perform its obligations under the plan.

Outside of chapter 9, a municipal debtor cannot bind a recalcitrant creditor who objects to any plan to restructure or otherwise adjust debt, even if a majority of creditors with the same type of claim accept the plan. A confirmed chapter 9 plan binds the municipal debtor and any creditor regardless of whether.the creditor has participated in the chapter 9 case in any way. Confirmation of a chapter 9 plan allows for complete adjustment of a municipal debtor's obligations. New obligations arise under the plan and preconfirmation obligations are discharged in accordance with the plan, the order confirming the plan, and the provisions of the Code.


The success of a chapter 9 case, to a greater extent than in a case under any of the other chapters of the Code, relies upon the debtor's desire to effect a plan to adjust its debts and the debtor's willingness to work with its creditors to achieve this goal. The control and power which the court and creditors have in a chapter 9 case are severely restricted when compared to the options available to the court and creditors in a reorganization case under chapter 11. As a result, the risks imposed on a municipality by the Code when it enters chapter 9 are minimal. The real dangers facing a municipality entering chapter 9 are potential damage to reputation, bond ratings, and public confidence. Nonetheless, it is only under chapter 9 that an eligible municipality can obtain some breathing space from debt collection efforts and the right, if the requirements of chapter 9 are satisfied, to adjust its debts even if it is unable to obtain the consent of all affected creditors.

DAVID S. KUPETZ is a member of Sulmeyer, Kupetz, Baumann & Rothman, a professional corporation which is actively engaged in representing clients in chapter 9 cases. He is an expert in insolvency, reorganization, and bankruptcy matters.
COPYRIGHT 1995 Government Finance Officers Association
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Copyright 1995 Gale, Cengage Learning. All rights reserved.

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Author:Kupetz, David S.
Publication:Government Finance Review
Date:Jun 1, 1995
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