Municipal Bankruptcy

8/8/2019 Municipal Bankruptcy

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Avoiding and Using Chapter 9

in Times of Fiscal Stress

Municipal Bankruptcy:

john knoxand marc levinson


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DISCLAIMER: Nothing in this booklet should be construed or relied upon as legal or nancial

advice. Instead, this booklet is intended to serve as an introduction to the general subject of

municipal bankruptcy under chapter 9 of the Bankruptcy Code and related mattters, from which

better informed requests for advice, legal and nancial, can be formulated.

Published by Orrick, Herrington & Sutcliffe LLP

All rights reserved.

Copyright 2009 by Orrick, Herrington & Sutcliffe LLP

No part of this book may be reproduced or transmitted in any form or by any means, electronic or

mechanical, including photocopying, recording or any information storage and retrieval system,

without permission in writing from the publisher.


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Municipal Bankruptcy:Avoiding and Using Chapter 9in Times of Fiscal Stress

john knox and marc levinson


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Municipal Bankruptcy:Avoiding and Using Chapter 9 in Times of Fiscal Stress

Introduction 1

Chapter 1 Avoiding Chapter 9 3

AssessingtheProblem(s) 3

CashPositionandSpecialFunds 5

AcknowledgementbyStakeholders 7

Chapter 2 Advantages and Disadvantages of a Chapter 9 Filing 9

Advantages 9

Disadvantages 11

Chapter 3 Preparing for Chapter 9 13

TheImportanceofNegotiations 13

AuthorizationtoFile 13

FederalSecuritiesLawConsiderations 14

Timing 15

DealingWithVendorsandTradeCreditors 16

Chapter 4 Seeking Bankruptcy Protection 17

Pre-FilingRequirements 17

AssignmentoftheBankruptcyJudge 18

Chapter 5 The Tenth Amendment and Limitations on the Role of the Court 21

TenthAmendmentLimitations 21

RoleoftheBankruptcyJudge 22


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Chapter 6 The Chapter 9 Case 23

InitiatingtheChapter9Case 23

OfcialCommittees 24

EffectonLitigation 24

AssumptionandRejectionofContractsandLeases 25

SpecialRevenues 26

FinancingLeases 27

Chapter 7 Emerging From Bankruptcy 29

DismissaloftheCase 29

ThePlanofAdjustment 29

Chapter 8 Yes, There Is Life After Bankruptcy 33

CapitalMarketsIssues 33

Avoidingachapter18 33

Chapter 9 Conclusion 35

About the Authors 36


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Avoiding and Using Chapter 9 in Times of Fiscal Stress 1

Introduction

Municipalities1 have been increasingly squeezed between the cost o providing basic

services (which in general has been increasing at a rate signicantly higher thaninfation) and fat or declining revenues (due to the economic slowdown and in

particular the diculties in the housing market aecting property tax revenues and

spending patterns). In the ace o these pressures, the possibility that some may want

or need to seek protection under chapter2 9 o the United States Bankruptcy Code

has become more real. In May 2008, the City o Vallejo, Caliornia led a chapter 9

petition, and several other Caliornia municipalities have been reported in the media

to be considering a ling. Jeerson County, Alabama, also has been reported to beon the edge o ling or several months due to nancial problems with its sewer

system, among other things. Whether this is the start o a larger trend remains to

be seen, but it is clear that the stresses that can produce the drastic step o ling or

bankruptcy protection currently are aecting many municipalities.

We intend this pamphlet to provide an overview o chapter 9 or those who

manage and govern municipalities. We oer some thoughts on how to avoid ling

as well as how to successully navigate a bankruptcy case and emerge in strongernancial health. This pamphlet does not provide an exhaustive technical exposition

o the law. Due to its size and ormat, this pamphlet only briefy summarizes, and in

some cases omits entirely, areas that in particular cases might be very signicant, but

which we eel would not be o interest to the majority o our audience.

1 Throughout, we use the term municipality to reer to a local government entity that may lea chapter 9 case. The term covers a wide variety o local governments that may or may not beconsidered municipalities under state law.

2 The observant reader will note that chapter is not capitalized when reerring to the chapters othe Bankruptcy Code. This is the standard convention.


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2 Municipal Bankruptcy:

Accordingly, this pamphlet does not purport to provide legal advice or serve as

a template or a practitioner seeking to advise a client considering a chapter 9 ling

or to prosecute the case once there. Rather, what we hope to achieve in this eort

is to provide a basic ramework to consider the chapter 9 alternative and enoughbackground to enable decision makers and managers to ask inormed questions o

their advisors and appropriately consider the alternatives. Bankruptcy is a complex

area o the law, and the adage dont try this at home should be heeded. Any

municipality seriously considering a chapter 9 ling should obtain expert legal

counsel as well as nancial advisory help.


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chapter one

Avoiding Chapter 9

I the reader takes away only one thing rom this pamphlet, it should be that ling

or bankruptcy protection under chapter 9 should be considered a last resort, to beeected only ater every eort has been made to avoid it. As we discuss below, there

are several signicant downsides to such a ling, and in the end, the problems that

brought the municipality to the point o ling will have to be solved anyway, so it

is ar better to resolve them, i possible, outside o bankruptcy.

Assessing the Problem(s)

The initial step in trying to avoid bankruptcy is to clearly and dispassionatelyassess the underlying problem(s) that are pushing the municipality in that

direction. The degree o sel awareness and transparency among municipalities

can vary widely, and or some, one o the main problems may be just getting

a good handle on the real drivers o nancial stability and solvency. Not

being nancial managers, we will leave it to those more qualied to get into

the technical details, but suce it to say that i a municipality cannot identiy

in clear terms the specic actors that are driving revenues down and/orexpenses up, it has some serious homework to do beore venturing into

bankruptcy court.

Municipalities that have been orced to the brink o, or into, bankruptcy,

generally experience one or both o two types o scal problems. The rst is a large

and extraordinary one-time nancial hit that cannot be absorbed by the budget or

covered out o reserves. This could be a sudden and catastrophic investment loss

(such as that experienced by Orange County, Caliornia, leading to its chapter 9ling in 1994) or a large judgment rendered against the municipality (such as that

experienced by Desert Hot Springs, Caliornia, leading to its chapter 9 ling in


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2001). In each case, these signicant one-time

liabilities orced the municipality into seeking

bankruptcy protection.

The second kind o problem is a structuraloperating decit that continues long enough

to burn through reserves and is not resolved

by revenue increases or spending cuts quickly

enough or the municipality to avoid running

out o cash as it attempts to meet necessary and

xed expenses such as debt service and payroll. A

municipality with this type o problem could bepushed over the edge by a relatively small one-

time expense or drop in revenues, as it may have

little or no cushion available to absorb even a

modest setback. For example, the City o Vallejo,

which had spent down its reserves in order to meet its obligations over a period

o several years, became insolvent as a result o Caliornias economic slowdown

and the concomitant drop in real estate and sales tax revenues, combined withsignicant employee salary and benet cost increases dictated by collective

bargaining agreements.

In general, scal stress related to one-time problems can be resolved by

nancing the cure costs over a long enough period so that those costs can be

absorbed in the budget over time. And while bankruptcy protection may be

necessary to buy time to get such a nancing done and delay disruptive collections

eorts or the orced liquidation o collateral, all eorts should be made to convincecreditors to be patient and not to cause the municipality to incur the signicant

costs associated with a bankruptcy ling.

Fiscal stress related to ongoing structural decits and lack o reserves is much

more dicult to tackle because a nancing will have little impact on solving

the underlying structural problem: in act this tactic will likely make things

worse by kicking the can down the road and increasing the overall costs to

the municipality. In these circumstances, painul cuts in service levels, employeecompensation and other expenses may be required, as well as increased revenues

through higher taxes or ees. Bankruptcy protection may be needed to avoid

... ling for

bankruptcy

protection under

chapter 9 should

be considered

a last resort, to

be effected only

after every effort

has been made to

avoid it.


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immediate sanctions or breaching contracts, including labor agreements, missing

debt service payments or ailing to provide required levels o service.

Cash Position and Special FundsMost municipalities (particularly general purpose entities such as cities and

counties) maintain scores o separate unds within their treasuries, each having a

particular unction and source o revenues, and each burdened by legal or grantor

restrictions as to the use o the unds. For example, in Caliornia, revenues rom

municipal utilities such as water and sewer systems may be used only to pay the

costs o operating and maintaining those systems or or capital improvements

(including debt service) to those systems. Many states require that special undsbe held in trust and not diverted or unrelated uses. Similarly, moneys received

in grants and state subventions may be restricted or particular uses by the terms

o the grants, or by statutes or regulations. Careul analysis must be made o the

various unds held by the municipality to determine what diversions can legally

be made and, more importantly, how limitations on the uses o unds will aect

the true available cash position o the municipality. While it is not uncommon or

all o these unds to be commingled or investment purposes into a pooled cashaccount, a signicant positive balance in pooled cash can mask a serious problem

in the municipalitys underlying nancial condition.

Typically, the only und completely unrestricted as to its use is the

municipalitys general und. It is common and accepted practice or

municipalities to use their pooled cash accounts as a source o cash fow within a

scal year to carry unds that have intra-yearcash infows that do not match their

cash outfows;provided, that the budget and reserves are sucient3 to ensure thatat the end o the scal year, restricted unds are not in a position o having unded

items not permitted within their restrictions. For example, the general und may

receive large inusions rom property tax revenues twice a year, but have a monthly

cash outfow that is relatively even. Generally, it is not improper or the cash outfow

decits to be covered rom pooled cash during the year so long as the general und

makes up the dierence rom cash infows by the end o the scal year.

3 The Government Finance Ocers Association (GFOA) recommends that agenciesmaintain general und unrestricted reserves o at least ve to teen percent o the annualgeneral und budget.


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The trouble arises when the budgeted revenues or a general und will not meet

budgeted expenditures, and there are insufcient reserves to cover the shortall.

Oten these imbalances are not apparent until the fscal year is well under way and

it becomes clear that projections o revenue and expense will not be met. In such acase, use o restricted unds in pooled cash could be a violation o the restrictions

imposed on the special unds and thereore illegal. It is important to note that while

municipal fnancial ofcers generally have immunity rom personal liability or

ofcial acts, that immunity does not necessarily extend to knowingviolations o the

law. Thus, a municipal fnance ofcer should be very careul not to permit advances

rom restricted unds intra-yeari he or she knows that the amounts cannot be

restored rom budgeted revenues or reserves by the end o the fscal year.It is very important or a municipality that appears to be headed or

insolvency to monitor its cash position, particularly in the unds that are

projected to go negative by the end o the

scal year, so that it can determine when it will

run out o unds to keep operations going. A

municipal ocial who requires or even permits

employees to come to work i the oicialknows that the municipality will not be able to

pay them may be violating state labor laws or

committing common law raud. In some states,

this may even constitute a criminal oense.

For example, i an employee is paid rom a

municipalitys general und (and cannot be

allocated to some other special restricted undbecause the employees duties do not support the

special unds activities), and the general und

budget position is such that, taking into account

any available reserves, it will be unable to

achieve at least a zero year-end balance without

using legally restricted unds in pooled cash, the

municipality could be aced with the choice oeither breaking the law by using restricted unds

or an impermissible purpose or by ailing to pay

... the

municipality

could be facedwith the choice of

either breaking

the law by

using restricted

funds for an

impermissible

purpose or by

failing to pay

contracted for

wages after

work has beenperformed.


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contracted or wages ater work has been perormed. I either o these occurs

with oreknowledge by the municipalitys managers or governing body, normal

governmental immunity or ocial acts may not protect such ocials rom

personal liability. This issue becomes important with respect to the timing o abankruptcy ling, as will be seen below.

Acknowledgement by Stakeholders

Once the municipalitys management has identied and quantied the underlying

scal problems, it must recognize that a key ingredient to solving them is to

clearly and transparently communicate the nature and scope o the challenges

to all potentially impacted stakeholders so that they are able to understand andacknowledge the problems. Managers and political leaders should insist on clear

and open disclosure o the nancial data and related acts, and they should

make sure that stakeholders both receive all relevant inormation and have an

opportunity to ask questions and oer solutions. All reasonable suggestions to solve

the problems should be investigated and taken seriously.

The ins and outs o labor negotiations are ar beyond the scope o

this pamphlet, but i payroll costs or benets are a key component o themunicipalitys scal stress, it will be necessary to engage labor law advisors

and to assist resolving these problems. Outside a bankruptcy case, in most

states labor laws applicable to public employee contracts place numerous

restrictions on revising labor agreements, even i the agreements are pushing

the municipality toward bankruptcy. However, i all parties realize that ailure

to modiy extant agreements would likely land the municipality in bankruptcy

court, all parties should be willing to work very hard to achieve consensualmodication o burdensome agreements. Although bankruptcy may provide

more fexibility in dealing with labor agreements, bankruptcy is not necessarily

a silver bullet with respect to such matters, so every eort should be made to

reach an agreement that provides a workable arrangement or the municipality

prior to the decision to le.

Similarly, creditors such as banks, bondholders and credit enhancers may

be willing to restructure long term debt in order to avoid orcing a municipalityinto bankruptcy. Attempts should be made to approach these stakeholders with

clear and transparent inormation in order to reach some accommodation.


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Oten an intermediate step in such a restructuring is a orebearance agreement

under which the creditors agree not to declare a deault and/or take remedial action

against the municipality or a specied period o time while the parties attempt to

reach a negotiated settlement.Finally, the ocers and governing body o the ailing municipality must

make the hard decisions about ongoing projects and programs that may have to

be postponed, scaled back or cancelled in order to ree up cash. These are oten

painul political choices, but the looming possibility o a bankruptcy ling can

serve as a catalyst to reach consensus on these dicult issues.


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chapter two

Advantages and Disadvantages of aChapter 9 Filing

There are many misconceptions about the utility o a bankruptcy ling in

addressing extreme nancial problems or municipalities. While bankruptcyclearly provides certain benets or municipalities that cannot otherwise solve

their scal problems, it is no panacea and comes with some signicant downsides.

Advantages

Protection.One o the most important and immediate advantages o abankruptcy ling is the protection against actions that might be taken by

creditors or others against the municipality, its ocers, elected ocials,employees and even its inhabitants. Filing a bankruptcy petition invokes an

automatic staybasically a ederal court injunctionagainst any action that

could otherwise be taken against the municipality (which becomes the debtor

upon the ling o the bankruptcy case) or its ocers or employees. Unlike a

bankruptcy involving a private entity, in chapter 9, the automatic stay extends

to elected ocials and to all inhabitants o

the jurisdiction o the debtor municipality.This means that even i the municipality

or other protected persons take or omit to

take actions related to claims against the

municipality that would otherwise subject

them to sanctions or liability in state or

ederal court, or to actions by regulatory

bodies, those actions may not proceedwithout the claimants rst obtaining the

permission o the bankruptcy court. The

... the automaticstay extends to

elected ofcials and

to all inhabitants

of the jurisdiction

of the debtormunicipality.


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stay lasts during the pendency o the chapter 9 case, but the bankruptcy judge

retains the right to modiy or terminate the stay or cause shown.

Breathing Space.Bankruptcy gives the debtor breathing space in which tounction while it tries to work out its creditor and cash fow problems. Raising

new revenues, renegotiating contracts and restructuring debt obligations takes

time. I a municipality is orced to breach contracts or ace other legal claims

caused by scal stress outside o bankruptcy, it may have to spend time ghting

o creditors trying to seize assets or collateral, or be orced into regulatory or

other state ora to answer or such actions and redress grievances beore it is

able to ashion a workable solution or the benet o all creditors and residents.The bankruptcy case allows all o these disputes to be addressed in one orum,

and the automatic stay provides the municipality the opportunity to ocus on a

comprehensive solution rather than simultaneously ghting multiple brushres.

Access to an Expert Arbiter.An oten underestimated advantage o a bankruptcy

ling is ound behind the bench o the bankruptcy courts. Bankruptcy judges

are experts in nancial restructuring, negotiations and arbitrating complexdebtor/creditor and intercreditor disputes. While chapter 9 lings may be rare,

bankruptcy judges see similar issues in the private sector day in and day out, and

generally are very well equipped by dint o knowledge and temperament to help

the parties arrive at workable compromises. Furthermore, because o the unique

system o assigning bankruptcy judges to chapter 9 cases, it is very likely that

a chapter 9 case will be assigned to one o the most qualied and experienced

judges within the applicable ederal circuit. The value o a highly qualiedand experienced judge in helping the stakeholders get to a solution should not

be underestimated.

Ability to Adjust Obligations. Most people see the ability to adjust debts

and other obligations as the prime benet o a bankruptcy ling. I a plan o

adjustment can be conrmed in a chapter 9 case, it may provide that unpaid

claims o creditors be either reduced (paid in tiny bankruptcy dollars) and/or extended and restructured. There are limitations on how these adjustments

can be made, and it may be possible or creditors to block a debtor rom making


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the adjustments they would like (or eel that it needs) to make. Nevertheless, in

situations where it is not be possible to ully repay all creditors absent some sort

o debt relie, the plan o adjustment can provide a resh start and the ability to

achieve long-term nancial stability or the municipality by deerring and/orreducing past obligations.

Disadvantages

Credit Markets Reaction.Municipalities that seek bankruptcy relie (and

even those that seriously consider iling) should expect the immediate

suspension and/or downgrade o their credit ratings. Particularly i bondholders

are not ully repaid, this credit stigma may last or many years. However, it iscertainly possible, as was seen with Orange County, that the municipality may

emerge rom bankruptcy and have its credit standing restored to robust levels

within only a ew years.

Municipalities contemplating

bankruptcy should expect intense scrutiny

rom their capital markets creditors and

rating agencies. One o the best things amunicipality can do to position itsel to get

its credit ratings restored is to be able to

provide timely and transparent inormation

about its nancial condition to the capital

markets and rating agencies. Establishing

a track record o providing trustworthy

inormation, even i it is not avorableinormation, is an absolute necessity i

a municipality expects to emerge rom

bankruptcy and get back on its eet in the

credit markets. This eort takes time and

resources rom the municipalitys nance

sta at a time when the sta will be under

tremendous stress. Municipalities musttake this burden into account when they

contemplate a ling.

Establishing

a track record

of providing

trustworthy

information, even

if it is not favorable

information, is an

absolute necessity

if a municipality

expects to emerge

from bankruptcy

and get back on its

feet in the creditmarkets.


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chapter three

Preparing for Chapter 9

The Importance of Negotiations

It is crucial that, once the magnitude o a nancial crisis is established, thoroughnegotiations be undertaken with creditors and stakeholders to avoid insolvency.

In act, such negotiations, undertaken in good aith, are a legal prerequisite to

ling a chapter 9 case. Even i the municipality already has determined that it

likely will be orced to le or bankruptcy protection, it should continue to try to

negotiate with key creditors to avoid that result, and should careully document

what steps are taken to reach agreement. It is not necessary that a municipality

accept a short term x that only briefy deers an inevitable meltdown. But i sucha x is oered, the municipality must analyze it careully and make sure it can

prove that in act it will not solve the municipalitys problems suciently to avoid

both short-term and long-term insolvency. For example, it makes no sense to

renegotiate a long-term debt obligation by deerring interest or other payments or

a year i, on the rst anniversary o the deerral, the municipality will be unable

to satisy the revised obligation absent something akin to divine intervention.

Similarly, a municipality should not accept one-time concessions rom laborthat would avoid insolvency in the short term but extend unsustainable labor

agreements by one or more years such that insolvency is inevitable and the decit

acing the municipality will be even deeper as a result o the extension.

Authorization to File

A municipality may not validly le a chapter 9 petition unless the governing body

o the municipality specically authorizes the ling. Local law determines whatorm this authorization must take, but the typical approach would be by resolution

adopted by the governing board in an open meeting. In many states, while


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discussions with counsel leading up to and ater a ling usually are conducted in

closed or executive sessions under the litigation exception to most open meeting

laws, the actual vote on whether or not to le typically must take place in an open

meeting, or at least be reported out immediately ater the vote in an open meeting.Authorization could take the orm o an immediate direction to le, or a

delegation to the executive ocer o the municipality to le in the event that

certain conditions are not satised (such as approval by creditors or bargaining

units o oers made by the municipality pursuant to authorizations rom the

governing body).

Taking a vote to le a bankruptcy petition is obviously a momentous step;

the municipality should expect signicant public and media attention, andshould be prepared to respond ully and accurately to inquiries, providing

relevant details and inormation regarding the process. While media strategy is

beyond the scope o this pamphlet, municipalities should careully consider

how they will provide timely responses to media inquiries, and should have a

clear plan in place including identication o one or more spokespersons. Also,

legal counsel should be consulted about public statements and press releases

so as not to inadvertently waive important privileges concerning condentialnegotiations and strategy.

Federal Securities Law Considerations

I the municipality has any outstanding publicly-traded securities, counsel

should be consulted regarding its obligations under the ederal securities laws

with respect to the bankruptcy ling and other material events. Securities

issued ater July o 1995 are generally covered by Securities ExchangeCommission (SEC) Rule 15c2-12, which requires both annual and material

event disclosure to be made by the issuing municipality. Filing or bankruptcy

protection is a material event that triggers disclosure. It is possible (even likely)

that leading up to the bankruptcy ling, deteriorating nances and public

discussion o the potential or insolvency will trigger rating agency actions,

which may constitute material events as well.

Any statement to the market by an issuer, such as a material event notice, mustsatisy Rule 10b-5 promulgated by the SEC. Rule 10b-5 requires that inormation

provided to the public intended to be a statement to the securities market may


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not misstate a material act nor omit to

state a material act necessary, in light o the

circumstances, to make the statements made

not misleading. The omission portion o therule is most dicult with which to comply.

In general, saying that a credit rating has been

downgraded or that a bankruptcy petition

has been led by itsel will not be enough.

Experienced counsel should be consulted

to assist in crating a public statement that

provides the relevant acts and materials inorder to satisy the broader standard o Rule

10b-5. Establishing a pattern o complete and accurate inormation dissemination

to the market will be important in helping a municipality reestablish a good credit

rating ater it emerges rom bankruptcy. Bad news is made worse by late discovery,

much more so i it appears that suppression or obuscation was involved.

TimingAs noted earlier, it is important to monitor the municipalitys cash position in the

period leading up to a potential bankruptcy fling so as not to knowingly violate the

lawor example by permitting employees to work when the municipality lacks the

ability to pay them, disregarding legal restrictions on special unds, or entering into

essential contracts knowing that there will be a lack o sufcient unds to meet the

contract terms. Having an idea o when this crossover point may occur is crucial in

determining when a petition must be fled in order to protect the municipality andits ofcers. While there will be tremendous pressure rom many quarters to delay the

ultimate step o fling a chapter 9 petition until the last possible moment, it is prudent

to leave at least some room between the time management would be compelled to

shut the doors o the municipality and the date o fling the petition. The precise

amount o time will depend on the circumstances o that particular municipality, but

in general, 60 to 90 days would be a prudent period. The reason or this is to allow

the court time to conduct an orderly process o considering the petition and anyobjections to it beore drastic actions that potentially aect public health and saety

(such as orced urloughs o essential service personnel) must be taken.

Bad news is

made worse by

late discovery,

much more so

if it appears

that suppression

or obfuscation

was involved.


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Dealing With Vendors and Trade Creditors

Most local government agencies have signicant commercial relationships with

vendors and trade creditors o various types, such as specialized service providers

and suppliers. A municipality preparing to le a chapter 9 petition should expectthat these providers will stop extending credit to the municipality in the orm o

delayed billing arrangements once news o the ling becomes public. It is likely

that they will require COD or prepayment terms or uture transactions and the

municipality should be prepared to implement these arrangements or critical

services and supplies. Moreover, payments made within 90 days o the ling o

the bankruptcy case on account o prior unpaid invoices may be recoverable as

preerences, so in order to protect avored vendors that have not put it on CODterms, the municipality should pay them during the normal payment cycle rather

than to all behind and then make catch-up payments. Unlike in chapter 11,

though, payments on account o a note or bond are not avoidable as preerences.


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3. The municipality must be insolvent as dened in the Bankruptcy Code, which

means that the municipality either must not be paying its undisputed debts

as they come due at the time o ling, or be unable to pay such debts when

they become due in the near uture. The latter test is a prospective, but mustbe based on a projection o the current or immediately ensuing scal year.

A projection that the municipality will not be able to meet its obligations in

subsequent years is not sucient to establish insolvency.

4. The municipality must desire to eect a plan to adjust its debts. It is

important to note that the plan o adjustment does not have to be in existence

as a precondition to ling, but there must be evidence that the municipalitywants to eect a plan through the vehicle o the bankruptcy case.

5. The municipality must demonstrate that it has attempted to avoid the ling or

that the ling was necessary by proving one o the ollowing:

a. It has obtained the agreement o creditors holding at least a majority

in amount o the claims o each class that the municipality intends to

impair under a plan o adjustment o claims, orb. It has negotiated in good aith and is unable to reach such an

agreement, or

c. Negotiations are impracticable (or example, because there are a

multitude o claimants and no practical way to negotiate with all o them

individually or to identiy a representative with authority to negotiate), or

d. A creditor is attempting to gain a preerence (basically a payment that

would unairly disadvantage other creditors because it disproportionatelyavors the creditor that seeks to receive the payment).

Assignment of the Bankruptcy Judge

In all other types o bankruptcy cases (such as chapter 11 cases), the bankruptcy

judge is assigned by lot to each case as it is led. Due to the importance and rarity

o municipal bankruptcies, and due to the powers reserved to the states under

the Tenth Amendment to the United States Constitution, the Bankruptcy Codeprovides that the Chie Judge o the Circuit in which the case is led has the task

o assigning a judge to each chapter 9 case. While it is probably likely that a judge


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rom the District in which the case is led will be assigned, the Chie Judge could

assign any bankruptcy judge in the Circuit to hear the case. This is an important

eature because it means it is very likely that a chapter 9 case will be assigned to

a highly competent and very experienced judge, which is good or all parties.Moreover, the Chie Judge will consider whether a judge who resides in or near the

debtor municipality ought to play a role in the case led by that municipality.

Bankruptcy judges, unlike judges o the U.S. Supreme Court, the various

Circuit Courts o Appeal and the numerous U.S. District Courts, serve pursuant

to Article I o the United States Constitution, or terms o 14 years. Any party to

a chapter 9 case has the right to petition the ederal District Court to remove the

case to the District Court so that it can be heard by a District Court judge, whoserves under Article III o the United States Constitution and is appointed or a

lietime term. It is up to the District Court to decide whether or not to take the

case away rom the bankruptcy court or to leave it there. In either case, all rulings

by the bankruptcy court are appealable to the Article III court system.


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chapter ve

The Tenth Amendment and Limitationson the Role of the Court

Tenth Amendment Limitations

The Tenth Amendment to the United States Constitution reserves certain powersto the states regarding the management o their internal aairs. In chapter 11 cases

(which municipalities are ineligible to le), the bankruptcy judge wields signicant

power to control what the debtor may and may not do during the course o the case.

For example, without court approval, any proposed action by the debtor outside the

ordinary course o business must be approved by the court ater creditors and other

parties in interest have been provided with the time and the opportunity to object.

Nor may the debtor borrow unds outside o the ordinary course o business, grantcollateral or a new loan or settle a signicant claim against it absent court approval.

However, in light o the Tenth Amendment and provisions o the Bankruptcy Code

that implement it, the court plays a signicantly more limited role in a chapter 9

case, and state law restrictions on the activities o municipalities and their uses o

unds must continue to be observed.

Thus, or example, the court cannot take over the operation o the municipality,

remove governing board members, direct the actions o the governing board orappoint a receiver or trustee to run the aairs o the municipality. Similarly, the

court cannot permit the municipality to override state laws such as those requiring

voter approval or new taxes, or limiting the use o restricted unds or particular

purposes. Obviously, the court lacks the power to require the sale or lease o a park or

a sewage acility in order to satisy the municipalitys obligations to creditors.

One important eect o the Tenth Amendment on municipal bankruptcies,

distinguishing them rom nongovernmental entity bankruptcies, is that there canbe no orced liquidation o a municipality under the Bankruptcy Code. I a private

rm les or bankruptcy under chapter 11 seeking to reorganize and thus continue


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to operate, but it ails to achieve that objective,

the case likely will be converted to a liquidation

case under chapter 7 o the Bankruptcy Code. In

chapter 7, a trustee is appointed, and is chargedwith liquidating all assets or the benet o

creditors, who go away with whatever share they

can receive. Assets are sold or oreclosed upon, the

entity no longer operates, and it ceases to conduct business. For obvious practical

reasons, and due to the Tenth Amendments limitations on the powers o the ederal

courts, there is no chapter 7 analogue or municipalities other than those that may

be provided by applicable state law outside o the bankruptcy court system. Thus, ithe chapter 9 case ails to produce a plan o adjustment allowing the municipality to

exit bankruptcy, the case is dismissed and the municipality continues to exist with

all o its problems and claims as it did beore bankruptcy, with whatever remedies

are available to the municipality and its creditors under state law.4

Role of the Bankruptcy Judge

The primary responsibilities o the bankruptcy judge are to approve or disapprovethe bankruptcy petition by determining eligibility, to oversee the assumption or

rejection o executory contracts and unexpired leases, to decide avoidable transer

actions (i.e., preerences and raudulent transers) and to conrm or decline to

conrm a plan o adjustment. The municipality may consent to the judges exercise

o jurisdiction in many o the more traditional areas o bankruptcy court oversight

in bankruptcy in order to obtain the protection o court orders and eliminate the

need or multiple ora to decide issues. Indeed, these latter eatures refect some othe benets o ling or bankruptcy in the rst place.

Despite this limited role, the judge in a chapter 9 case does exert considerable

infuence over the parties and can be a very helpul neutral arbiter o dicult

disputes. While, as described below, the only real hammer the judge ultimately

has is to dismiss the case and throw the municipality out o court, the judge

nevertheless is likely to be very helpul in bringing the parties to the point where a

plan can be approved.

4 The rules governing the ability o municipalities to disincorporate or otherwise be dissolvedvary greatly by jurisdiction and type o entity and are beyond the scope o this pamphlet.

... the court cannot

take over the

operation of the

municipality ...


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chapter six

The Chapter 9 Case

The ollowing sections discuss specic aspects o ling and prosecuting the

chapter 9 case important to municipalities.

Initiating the Chapter 9 Case

In addition to ling the chapter 9 petition itsel, the municipality must le a

number o pleadings in order to initiate the bankruptcy case. These include

the ollowing:

Creditors ListThis is a list o all persons who may assert a claim against themunicipality. The Bankruptcy Code denes the term claim very broadly, and

the municipality should include each and every person that may assert a claim,

even i the municipality believes that a given claim is specious.

List of Creditors Holding the 20 Largest Unsecured ClaimsThis list contains

more detail than the general list o creditors, including the requirement that

contact persons and phone numbers be listed. The list is used by the UnitedStates Trustee to solicit creditors to join an ocial committee or committees.5

Pleadings Establishing EligibilityThe Bankruptcy Code contains a number

o eligibility requirements, and the municipality must prove that it satises each

one. It does so by submitting a pleading and declarations. I the municipality

5 The Oce o the United States Trustee is an arm o the United States Department o Justice,and the various regional oces assist the court system in administering bankruptcy cases.The U.S. Trustees role in a chapter 9 case is much more limited than it is in cases underchapters 7 or 11.


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anticipates that one or more creditors or parties in interest will object to the

claim o eligibility, the pleadings and declarations will need to be more extensive

than in a case where eligibility is unquestioned.

Notice by PublicationThe municipality must publish a notice once a week

or three weeks in a local newspaper and in a national publication read by

bondholders. The notice must provide details about the ling o the chapter 9 case

and provide the date by which objections to eligibility must be led. The orm

o notice and the eligibility objection date must be approved by the bankruptcy

judge in advance o publication.

Ofcial Committees

Following the entry o the order or reliein other words, ater the court

determines that the municipality is eligible to be a chapter 9 debtorthe United

States Trustee or the relevant district may appoint a committee or committees

to represent the interests o creditors holding similar classes o claims. In the

Vallejo case, or example, there is one committee, and it represents the interests o

retirees. Unlike in the case o a chapter 11 debtor, a municipality is not obligatedto und the costs o counsel to such a committee, but prudence may dictate that

the municipality should pay reasonable costs because an inormed and organized

creditor body will expedite the resolution o the case.

Effect on Litigation

The automatic stay that becomes eective the moment the chapter 9 petition

is iled serves to enjoin litigation against the debtor, its oicers and itsinhabitants. The stay also prevents all other orms o creditor enorcement

remedies such as seeking a judgment lien or oreclosing on an asset (other

than special revenues, as described below). The stay continues throughout

the chapter 9 case, although a claimant may seek permission to terminate or

modiy the stay by iling pleadings that attempt to convince the bankruptcy

judge that cause exists or the litigation to proceed in court or or an

enorcement action to resume.


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Assumption and Rejection of

Contracts and Leases

The Bankruptcy Code provides a chapter 9

debtor with the ability to assume its avorablecontracts and real and personal property leases

and to reject its burdensome ones. Neither is

automatic, though. To assume a contract or

lease, absent consent by the nondebtor party,

the municipality must cure all monetary

deaults and provide adequate assurance that

it will be able to perorm under the agreementin the uture. So-called ipso facto clauses in

contracts or leases (which provide that the

contract or lease terminates on account o a

bankruptcy ling by one o the parties) are

not enorceable in a chapter 9 case or any

other bankruptcy case. In the event a lease

or contract is rejected, the nondebtor partywill have a general unsecured claim against

the municipality or the damages it has suered on account o the rejection o the

agreement. The damage claim will have to be addressed in the plan o adjustment

along with the other general unsecured claims against the municipality.

Collective bargaining agreements are subject to assumption and rejection

as well. However, due to the importance and the widespread impact rejection

o a collective bargaining agreement could have, the U.S. Supreme Courthas placed extra burdens on debtors seeking to reject such agreements. These

include mandating that the bankruptcy court balance the hardships employees

would suer as a result o rejection o the agreements against the benets to the

municipality or rejecting those agreements. The court also must conclude that

the municipality employed reasonable eorts to resolve contract issues short o

rejection, and that a prompt resolution would not be orthcoming. A special

Bankruptcy Code provision makes it even more dicult to reject a collectivebargaining agreement in a chapter 11 case, but Congress has chosen not to

extend the sweep o that provision to chapter 9 cases.

...due to the

importance and

the widespread

impact rejection

of a collective

bargaining

agreement could

invariably have, the

U.S. Supreme Court

has placed extra

burdens on debtors

seeking to reject

such agreements.


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Special Revenues

Many agencies have separate governmental enterprises that are owned and

operated by the municipality but are not separate legal entities. For example a

city may own and operate a system that provides potable water to its inhabitantsand businesses. Typically, such systems are treated as separate accounting units

and are paid or rom revenues received rom the users o the system in the orm

o ees and charges or service. Oten, new users that desire to connect to the

system and receive service must pay a capital charge or assessment to contribute

their share o the capital cost o the system. These systems oten are nanced

through debt obligations secured by a pledge o a lien on the system revenues,

and the capital, operations and maintenance costs o the system are similarlysupported only by the system revenues. In most cases, this is the sole source o

security and payment or the obligations o the system, but in some cases, the

municipality also is obligated to pay such amounts rom the general und i

revenues are insucient.

The Bankruptcy Code treats the revenues o such a system that are pledged

to the payment o debt obligations as special revenues and provides that those

special revenues may not be diverted to pay the debts o the municipality thatare unrelated to the system or enterprise that generated them. As noted above,

in many jurisdictions, this also is the result under state law, which restricts the

use o such revenues to the enterprise itsel. Notwithstanding the automatic stay,

which prohibits certain post-bankruptcy actions by creditors, the automatic

stay in chapter 9 permits the holder o a lien on special revenues to apply such

revenues to the obligation secured by the lien. Obligations payable rom special

revenues are treated as secured obligations or bankruptcy purposes, and as suchthe plan o adjustment may not impair those obligations at least to the extent

they can be paid rom the special revenues (but, or example, i the special

revenues are insucient, the municipalitys obligation to pay rom general

revenues, i any, could be impaired by the plan).

Another class o special revenues obligations is special assessment or special

tax nancing, which is commonly used to construct inrastructure to serve

new development or to improve inrastructure o special benet to the assessedproperty. In these situations, the special assessments or taxes levied and pledged

to support the bonds issued to provide such nancing are treated as special


33/44


revenues and cannot be invaded to pay other obligations o the municipality in

bankruptcy. This is also generally consistent with most state laws restricting the

use o these types o revenues solely to the purposes or which the assessment

or tax was levied.

Financing Leases

In many states, municipal agencies use lease nancing or capital projects

and equipment. Although styled as leases (usually to avoid limitations on

debt under state statutory or constitutional provisions), these instruments

typically bear tax-exempt interest to the investors who und the projects

or equipment (which requires that they be treated as debt or ederal taxpurposes), and are also treated as debt or accounting purposes. Although

the matter is not entirely ree rom doubt and will depend on the acts and

circumstances o each case, these instruments should in general be treated

as debt obligations under the Bankruptcy Code and not as true leases. The

signicance o such characterization might be that the municipality would

not be required to assume or reject the lease within a relatively short period

o time ater the courts acceptance o the chapter 9 petition, and that thecreditor (lessor) might be unable to evict the municipality rom the leased

property (or to require return o the leased equipment) in the event o a

payment deault.


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chapter seven

Emerging From Bankruptcy

Dismissal of the Case

The bankruptcy court may dismiss the chapter 9 case or cause, includingunreasonable delay by the debtor or denial o conrmation o a plan o

adjustment. Conversely, the case may be voluntarily dismissed by the

municipality, as the bankruptcy judge cannot orce it to remain in bankruptcy

against its will due to Tenth Amendment considerations. Thus, i the municipality

and its key creditors (such as indenture trustees, major vendors and unions) reach

agreements during the case and such agreements are binding on the parties under

applicable nonbankruptcy law, the municipality can and should dismiss the casenot only because conrming a plan o adjustment is no longer necessary, and

also because there is no need to incur the signicant cost and delay o drating,

conrming and consummating a plan o adjustment.

The Plan of Adjustment

A Good Plan Is the Product of Negotiation Among All Constituencies.

A plan o adjustment, like a chapter 11 plan o reorganization, is little morethan a contract among various parties that provides or the treatment o the

various claims against the municipality. One o the benets o chapters 9

and 11, other than preserving assets by way o the automatic stay during the

negotiation period, is that the bankruptcy court has the power to approve a

plan over the objection o dissenting creditors so long as the requisite majorities

o creditors holding similar claims have approved the plan and so long as the

plan does not discriminate among holders o similar claims. As describedabove, the municipality is not eligible or chapter 9 unless it has, among other

things, negotiated with its creditors prior to ling the case in an attempt to


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avoid the need or a ling. Once the case is led,

the negotiations should resume as soon as possible

with the goal o either reaching agreement and

dismissing the case or reaching agreement withthe requisite majorities and conrming a plan

o adjustment. Unortunately, i a creditor (or

creditors) mount an eligibility challenge, there is

less room or negotiation during the several month

period that will be devoted to determining whether

the debtor is eligible or chapter 9 relie.

The Role of Committees in the Plan Process.

Committees serve and speak or all similarly situated

creditors, and the members o and proessionals

employed by a committee have a duciary duty to

the class they represent. An energetic and inormed

committee, particularly one that is both proactive

and constructive during the process o negotiating aplan o adjustment, will be benecial or all parties to

the bankruptcy case.

The Role of the Court in Approval of the Plan

of Adjustment. The bankruptcy court must

conirm the plan o adjustment i it inds that the

various chapter 9 conirmation requirementshave been satisied. These include, among others,

that at least one class o impaired creditors has voted to accept the plan;

that post-bankruptcy claims will be paid in ull on the plans eective date

(unless an impacted creditor agrees to dierent treatment); that any necessary

approval by regulators or voters (in the case o most tax increases) has been

obtained; and that creditors will receive as much under the plan as they

would were the case dismissed. Broadly stated, the court should ind thatthe debtor municipality has used all reasonable eorts to pay its creditors

One of the

benets of

chapters 9 and

11, other than

preserving

assets by

way of the

automatic stayduring the

negotiation

period, is that

the bankruptcy

court has

the power

to approve a

plan over the

objection of

dissenting

creditors ...


37/44


as much and as quickly as possible, recognizing that application o state law

(such as tax limitation initiatives or other restrictions) may dramatically limit

the ability o municipality to raise revenues. The court also must ind that

the plan is easible, which means that the municipality will not need urtherreorganization or another chapter 9 case in the near uture.

Failure to Approve a Plan of Adjustment. I the plan o adjustment is not

conrmed either by consent or by a court order binding non-consenting creditors

(oten reerred to in bankruptcy parlance as a cramdown), the bankruptcy judge

has the discretion to send the parties back to the drawing board to crat a better

plan, or to simply can dismiss the chapter 9 case. Due to the Tenth Amendmentand the applicable Bankruptcy Code provisions, the judge has no ability to crat

a plan o adjustment and compel the municipality to accept it. Dismissal o the

case, o course, is a nightmare scenario because the municipality, which the judge

earlier concluded (during the eligibility phase o the case) was unable to pay its

debts, is now out o court, without the protection o the automatic stay, and is

still unable to pay its debts. Such a result benets neither the municipality nor

its residents nor its creditors, and should provide a compelling incentive or theparties to the chapter 9 case to reach agreement on a plan o adjustment.


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chapter eight

Yes, There Is Life After Bankruptcy

Capital Markets Issues

As should be expected, the capital markets will punish a municipality or havingbecome insolvent. The degree and lengthy o that punishment will depend in

large part on several actors:

Thedegreetowhichcapitalmarketdebtholdersandguarantorsaremadewhole

Thestrengthandviabilityofthenegotiatedsettlementorplanofadjustment

Thedegreeofcooperationandbuyinamongstakeholders

Whethervotersand/orelectedofcialshavecontributedtothesettlementor

plan by approving new taxes, ees or other revenue sources Whetherthemunicipalitycandemonstratethatithasstableandeffective

management in place

Howwellthemunicipalitycommunicateswiththemarketandthetimeliness

and transparency o the nancial inormation presented

Howwellthesettlementorplanofadjustmentisimplementedandmonitored

While it is unavoidable that access to the capital markets ater a bankruptcy will bemore expensive and limited than it normally would be, it is not certain that the act

o a bankruptcy will be a permanent or even a very long term problem. Focus on the

actors listed above will help municipalities mitigate the adverse eects o a bankruptcy

and emerge stronger and in a better fnancial position than beore they fled the case.

Avoiding a chapter 18

When a private company successully navigates through a chapter 11 case with aconrmed plan o reorganization, but either cannot perorm its obligations under

the plan or the plan is fawed because it ailed to adequately resolve all o the


40/44


companys nancial problems, the company may be orced back into bankruptcy

court to seek yet another reorganization. This is euphemistically reerred to as

seeking chapter 22 relie; several commercial airlines have taken this route. I

this were to happen to a municipality ater a chapter 9 case, we assume that thesecond round would be deemed a chapter 18 case. However, given the cost,

disruption and pain o going through a bankruptcy case, chapter 18 is to be

avoided at all costs. Also, and particularly i the need or new bankruptcy relie

occurs soon ater the completion o the original case, the bankruptcy court may

be very skeptical o the municipalitys eligibility to le again (remember, that one

o the criteria is that the municipality desires to eect a plan o adjustment).

Avoidance o a chapter 18 scenario will be best achieved by driving the hard

bargains required to achieve a settlement or plan o adjustment that not only

works, but that can weather contingencies and uncertainties. The successul

arrangement must:

Provideforadequaterainydayreserves

Leavethemunicipalitywithexibilitytoadjustcostsandservicelevelsto

account or uture unoreseen downturns Limitexposuretounduerisksinthedebtmarkets(byforexample,relyingon

too much variable rate debt without appropriate hedges or cushions against

rising rates)

Avoidrelianceonuncertainfuturerevenuestreams,particularlyiftheyrequire

voter approval or are otherwise outside the control o the municipality

Besupportedbyaconsensusofatleastamajorityoftheaffectedstakeholders,

and backed by a meaningul commitment to implement the plan

Finally, the municipalitys management and governing board must have the

discipline to stick to any settlement or plan and make it work. Remember that

the bankruptcy court has limited oversight powers due to the Tenth Amendment.

It may be tempting in light o the heartelt and legitimate desires o the citizens

and the politicians who represent them to spend more or tax less than the

plan contemplates. Perhaps a review o the costs o going through the rstbankruptcyin money, time, energy and reputationwould be warranted i such

temptations arise.


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chapter nine

Conclusion

For the overwhelming majority o municipalities, even severe economic

downturns such as the one currently being experienced will not result in the lingo a petition under chapter 9 o the Bankruptcy Code. Municipalities eeling

nancial stress should work as hard as possible, accepting as much pain as they

and their constituents, creditors and employees can endure, to avoid that path.

However, or some municipalities, the challenges will be too great, the avenues

o solution too limited, and the window o opportunity or corrective action too

small, to avoid using chapter 9 as a tool to help right the ship. For those entrusted

to manage and govern municipalities, we hope this pamphlet provides some initialguidance and promotes a disciplined and thoughtul approach to avoiding or

using chapter 9 in times o scal stress.


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36 Municipal Bankruptcy

About the Authors

John H. Knox, a partner in the San Francisco ofce o Orrick, Herrington &

Sutclie LLP, is a member o the frms Public Finance Department. Mr. Knoxhas been involved in several municipal workout situations, representing the City

o Vallejo, Caliornia, in its chapter 9 bankruptcy case, the City o Richmond,

Caliornia, in a successul fnancial restructuring that allowed it to emerge rom a

near-bankruptcy situation to become a solid A rated credit, and the City o Hal

Moon Bay, Caliornia, in connection with a very large judgment that threatened

to bankrupt it. His bond practice ocuses on local governmental inrastructure

fnancing, primarily or cities and counties, including general und fnancings,

pension bonds, special assessment and other land-secured fnancings, redevelopment

tax increment fnancings, enterprise revenue bonds, municipal lease transactions and

general obligation bonds. He also has been involved in creating various statewide

fnancing programs, including fnancings or governmental receivables, inrastructure

and development impact ees. He also assists nonproft institutions, including

colleges, universities, and private K-12 schools with tax-exempt fnancings.

Marc A. Levinson, a partner in the Sacramento ofce o Orrick, Herrington& Sutclie LLP, is a member o the frms Restructuring Group. Mr. Levinson

is nationally recognized or his capabilities in complex reorganizations and

restructurings, out-o-court workouts and other insolvency matters. Mr. Levinson

is the lead insolvency lawyer on the Orrick team that fled a chapter 9 case or

the City o Vallejothe largest Caliornia city to seek bankruptcy relie. The

case has generated cutting edge legal issues, as well as litigation over a number o

hotly-contested actual issues, including those relating to the Citys insolvency and

its eligibility to be a chapter 9 debtor. Mr. Levinson is a coneree o the National

Bankruptcy Conerence and a member o the Board o Directors o the American

College o Bankruptcy, and he is a requent speaker on bankruptcy topics.


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Contacts

For further information about any of the topics discussed in this book, please

contact one of the Orrick lawyers listed below.

San Francisco

John Knox 415-773-5626 [email protected]

Sacramento

Marc Levinson 916-329-4910 [email protected]

Norm Hile 916-329-7900 [email protected]

New York

Lorraine McGowen 212-506-5114 [email protected]

Washington, D.C.

Pauline Schneider 202-339-8483 [email protected]

Darrin Glymph 202-339-8401 [email protected]


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orrick, herrington & sutcliffe llp [email protected]

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