UNDERSTANDING CHAPTER 9 BANKRUPTCY, By Michael R. Sment

The Great Economic Recession has resulted in many problems. They include the loss of jobs, millions of American homes, consumer savings, and the creation of a huge national deficit (with an impending self-imposed federal “fiscal cliff ”). Revenue losses, and reductions at all levels have also accompanied municipal government tax, fee and property tax share losses and a general severe decline of municipal income. More problems have followed those decreases, including huge operating deficits, forced service reductions and layoffs, and deferred maintenance in most California cities.

Loss of income, growing expenses, increasing employee payroll and benefits, unfunded pension liabilities, loss of redevelopment funds – the problems just keep adding up for cities. Municipal areas with large numbers of foreclosed homes have additional expenses for neglected properties, graffiti, crime, fencing, and extra security. Some towns face climate-related problems and growing expenses related to wild animals, floods and drainage, and firefighting. California cities and towns face more, and more expensive, problems and liabilities than ever before, with even less state help.  

California cities also face expensive issues relating to increased labor costs, union agreements, and liabilities for unfunded or under-funded government employee pensions. The recession, a volatile stock market, and internal investment problems caused the California Public Employees Retirement System (CalPERS) to demand increased contributions from its member California municipal agencies. Many cities have higher CalPERS bills just as their revenues are severely depressed. Unlike businesses or corporations, California cities cannot issue stock or take on loans to raise funds; they may, mostly, only extend the time to repay their debts or force creditors (unions) to accept less. 

As a result, California cities are exploring, authorizing and filing municipal bankruptcy cases under Chapter 9 of the United States Bankruptcy Code. California is one of only ten states which expressly allow the filing of a municipal bankruptcy, as required by Congress. Under 11 U.S.C. §109(c)(2), to be eligible to file a Chapter 9, a municipality must be specifically authorized to do so “by State law” (See also, 11 U.S.C. §903: a state has the power to restrict a bankruptcy filing by a municipality; Gov’t Code §§53760, 53760.3: a municipality must engage in 60 day pre-filing good faith mediation) In 2008, near the beginning of the recession, Vallejo filed one of the longest-running municipal bankruptcy cases. Its amended plan of adjustment was not approved until late 2011. In June 2012, Stockton commenced the then-largest municipal bankruptcy filing in U.S. history (In re City of Stockton, USBC Case No. 12-32118), owing $800 million for unfunded liabilities and with a $26 million operating deficit. In August 2012, San Bernardino commenced its Chapter 9 case in Riverside County (In re City of San Bernardino, USBC Case No. 12-28006), listing assets and debts “totaling $1 Billion Dollars” and a $46 million budget deficit. Other California cities like MammothLakes, San Diego and San Jose, possibly as many as 20 at present, have also explored, authorized, or face a municipal bankruptcy filing.

The United States Bankruptcy Code – Title 11 of the United States Code – provides a specific mechanism for a municipal bankruptcy filing in its Chapter 9 procedures. Titled “Adjustment of Debts of a Municipality,” the provisions of Chapter 9 were part of the 1978 revisions to United States federal bankruptcy law.

A precursor to the present Chapter 9 proceedings had been created through a 1934 Depression-era amendment to the prior U.S. Bankruptcy Act. That amendment created a new Chapter X proceeding (later changed to Chapter IX) and sought to provide non-tax raising relief to, and authorized a bankruptcy filing by, a municipality that could not pay its creditors. The amendment and the new Chapter IX were upheld as constitutional by the Supreme Court. United States v. Bekins, 304 U.S. 27 (1938). In 1976, in response to the huge bankruptcy filing by the City of New York, Chapter IX was amended to add “Voluntary Reorganization Procedures.”

 Those changes were mostly carried over into the Chapter 9 provisions of the bankruptcy code.

In a Chapter 9 municipal bankruptcy proceedings the municipality is required, among other things, to be insolvent and to have tried in good faith, and failed, to negotiate a pre-bankruptcy agreement with its creditors. The municipality must then seek to have a “plan of adjustment” approved. 11 U.S.C. §109(c). Creditors and “taxpayers” may object to the plan, and any plan must be confirmed by the U.S. Bankruptcy Court. Elements required for confirmation include: the municipality is not prohibited by law from carrying out the plan; any needed regulatory approval has been obtained; the plan is in the best interests of creditors; and the plan is feasible. (11 U.S.C. §943(b).

Despite all the recent attention, California does not lead the nation in municipal bankruptcy filings. Due to quirks in state and local law, Nebraska (45) has had almost one- fifth of the 220 or so municipal bankruptcies filed in the United States since 1981. California (39) had the second most filings, followed by Texas and Alabama. Only a few of the Chapter 9 bankruptcy filings actually involve cities, towns or  counties – California only had five, Nebraska none. Most Chapter 9 bankruptcies were for other types of districts, particularly special tax districts created for residential subdivisions. The total of 220 municipal bankruptcies since 1981 is mostly de minimus when compared to the more than 20,000 corporate Chapter 11 cases filed during that same period. 

Some cities believe that negotiations with unions and other groups and the use of outsourcing will mitigate some of the increasing municipal expenses and obligations. The more intriguing question is what can a city legally do to reduce, slow or eliminate its unfunded, under-funded or future liabilities for employee pensions and to CalPERS or to retirees. Are pension benefit debts to CalPERS subject to impairment under a  municipal bankruptcy restructuring plan? Some have argued that those issues have “put federal bankruptcy law on a collision course with the U.S. and state constitutions.” The answers may directly affect dozens of California cities and hundreds of other school districts, agencies and public entities that will owe hundreds of millions of dollars in pension liabilities over the next several years.

It may no longer be true that retirement benefits are guaranteed by the state constitution. California has authorized municipalities to seek protection and debt relief under the United State Bankruptcy Code. If California cities continue to have budget problems, reductions in revenue and increased expenses, will the “economic repair” option of a municipal bankruptcy be too attractive to pass up or ignore? Only time and the general economy will determine that.

Michael Sment is a member of the CITATIONS Editorial Board, and Chair of the VCBA Bankruptcy Section. Mr. Sment has handled bankruptcy matters since 1981, and is a long-standing mediator for the U.S. Bankruptcy Courts. 

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