What is Chapter 9 Bankruptcy?

For financially distressed municipalities, a Chapter 9 bankruptcy may be the answer to the reorganization of the debtor's debts and protection from creditors.

This is a rare type of bankruptcy — it has been used less than 500 times since its creation in 1934, and its use continues to decrease.

Only 171 municipal authorities have filed for Chapter 9 bankruptcy protection since 2020. The practice reached its peak in 2012, when 20 municipal bankruptcies were recorded, but in 2020, only four municipalities filed Chapter 9 cases.

Chapter 9 bankruptcy gives a financially distressed municipality creditor protection.

This allows it to develop and negotiate a plan for debt adjustment. Debt reorganization of a municipality is usually accomplished by:

• Extending debt maturities.
• Reducing interest or principal amount.
• Refinancing municipal debt by getting new loans.

Unlike other types of bankruptcy, Chapter 9 has no provision for a municipality’s asset liquidation and distribution of its assets to creditors because this would violate the Tenth Amendment to the U.S. Constitution.

The bankruptcy court is severely limited in a Chapter 9 case per the Tenth Amendment and the decisions of the U.S. Supreme Court, both of which uphold municipal bankruptcy legislation.

In Chapter 9 bankruptcy cases, the bankruptcy court approves the petition if the municipality shows eligibility. It will confirm a plan to adjust the debt and ensure that the plan is implemented. The municipality may allow the court to have jurisdiction in many areas of oversight, to obtain court-ordered protection, and remove the requirement for numerous forums when making decisions on issues.

Bankruptcy legislation toward municipalities was first enacted at the time of the Great Depression in 1934. Congress attempted to draft this legislation in a way that did not impede a state’s sovereign powers, which are guaranteed through the U.S. Constitution’s Tenth Amendment.

However, the U.S. Supreme Court deemed it unconstitutional the same year, stating that it did, in fact, interfere with state sovereignty. In 1937, Congress enacted the Municipal Bankruptcy Act, which the Supreme Court upheld.

Since then, several amendments to the law have been made.

Since establishing this federal mechanism for municipal debt resolution, less than 500 municipal bankruptcy petitions have been filed. When they are, they often involve millions in municipal debt.

Some notable and recent municipalities that have filed for Chapter 9 bankruptcy include:

• Orange County, California (1994)
• Prichard, Alabama (1999)
• Vallejo, California (2008)
• Jefferson County, Alabama (2011)
• Detroit, Michigan (2013) — This was the largest municipal bankruptcy in the country’s history.

Chapter 9 and Chapter 11 bankruptcies are alike in that the debtor and their creditors negotiate to change the debt terms. Chapter 9 bankruptcy is based on Chapter 11. Much like a commercial debtor has protection in a Chapter 11 bankruptcy case, a municipality has protection in a Chapter 9 case.

Both chapters have an automatic stay provision and both give the option to negotiate an agreement with creditors or force creditors to accept new loan terms in bankruptcy proceedings, or cram-down, through a readjustment plan despite creditor objections.

In addition, in both cases, the readjustment plan must meet the bankruptcy court’s approval. If it does, the discharge of pre-petition debts occurs, with the exception of the assumed debts (i.e., those the debtor remains liable for) of the plan.

The main difference between Chapter 9 and Chapter 11 is who can use them.

Chapter 9 bankruptcy applies to specific government entities, while Chapter 11 bankruptcy allows businesses and individuals to reorganize their debts and obligations. Many corporations in the U.S. have filed for Chapter 11 protection, such as American Airlines and General Motors.

Bankruptcy court is typically not as active with municipality bankruptcy cases as it is with Chapter 11 corporate reorganizations, and it is more limited in its powers. In Chapter 9 cases, bankruptcy courts can’t make policy for spending on a locality’s behalf.

Chapter 9 bankruptcies also differ from Chapter 11 bankruptcies in many notable ways:

• Under Chapter 9, a municipality must qualify for its protections through eligibility requirements that go beyond those of Chapter 11. A Chapter 11 commercial debtor must have only some U.S. connection to file for bankruptcy. A Chapter 9 municipality debtor under must meet five requirements for eligibility.

• Under Chapter 9 bankruptcy, a municipality can submit a debt readjustment plan for confirmation, but does not have the time limits a Chapter 11 debtor does. Creditors cannot submit their own plans, even if there is a prolonged delay created by the municipality.

• The court does not appoint a trustee to the municipality's case. The municipality continues its operations with the same leadership throughout the case, even if that may impair the creditors' interests. These operations are left to municipal leaders' discretion.The bankruptcy court cannot interfere with the municipality’s government, political influence or powers, its property or revenues, or use or enjoyment of its income-producing properties.

According to U.S.C. § 109(c), only municipalities may file for Chapter 9 relief.

U.S.C. § 101(40) defines a municipality as the "political subdivision or public agency or instrumentality of a state,” and includes school districts, townships, cities, counties, public improvement districts, and revenue-producing bodies that provide services that users pay for, such as bridges, highways and gas distribution utilities.

Under the Bankruptcy Code, eligibility requirements for a municipality to file Chapter 9 bankruptcy are:

• The municipality must have approval via state law or a government organization or officer authorized by state law approving it be a debtor.
• The municipality must be insolvent.
  
• It must put a plan into affect to adjust its debts.
• It must obtain the agreement of creditors holding a majority in amount of the claims of each class that the debtor intends to impair under a plan in a case under chapter 9

The municipality must also:

• Obtain the agreement of creditors holding most of the claims of each class that the debtor will weaken under the bankruptcy plan;
• Conduct a good faith negotiation with creditors and fail to obtain an agreement of creditors holding most of the claims of each class that the debtor will weaken under the bankruptcy plan;
• Be unable to negotiate with creditors, as it is impracticable ; or,
  
• Hold a reasonable belief that creditors may attempt to obtain a preference.

A big difference between Chapter 9 bankruptcy cases and other types of bankruptcy cases is that the court clerk does not automatically assign a Chapter 9 case to a specific judge.

According to federal bankruptcy law 11 U.S.C. § 921(b), the chief judge of the court of appeals for the circuit embracing the district in which the case is commenced designates the bankruptcy judge to conduct the case.

This particular provision was created with politics in mind, as it attempts to remove politics when picking a bankruptcy judge who will preside over a major municipality’s chapter 9 case. It also ensures that the judge picked to handle the case has the time and capacity for it.

An automatic stay applies in Chapter 9 cases, according to 11 U.S. Code § 362, and stops all collection attempts against a municipality's debts and its property upon the filing of the bankruptcy case.

Other provisions for an automatic stay include prohibiting actions against officers of a municipality and its inhabitants, according to 11 U.S.C. § 922(a).

The stay also stops creditors from bringing a lawsuit, known as a mandamus action, against a municipality’s officers because of pre-petition debt. It also stops them from bringing an action against an inhabitant of the municipality by enforcing a lien on them or through assessments or taxes owed to the municipality.

The law also limits the stay’s applicability.

According to the Code, a Chapter 9 bankruptcy filing doesn’t operate to stop the application of pledged "special revenues" to pay the debt secured by those revenues. Therefore, an indenture trustee (or another paying agent), may apply special revenues to payments that are due or distribute them to bondholders without an automatic stay violation.

Once a municipality files for Chapter 9 bankruptcy, the case is assigned to a bankruptcy judge through the chief judge of the court of appeals for the circuit where the filing takes place, and creditors will be given notice when the case begins.

Creditors can object to the bankruptcy filing for several reasons, including whether the state gave the municipality authorization or whether the bankruptcy petition was filed in good faith.

The bankruptcy court has only limited power over a municipality's operations. It can:

• Review the municipality’s eligibility to file for bankruptcy.
• Approve its bankruptcy petition.
• Review and confirm its repayment plan and oversee its implementation.

The municipality provides a document, known as a plan of adjustment, that offers treatment of the various creditor claims against it.

The municipality must also prepare a disclosure statement describing the plan. These documents and a ballot are sent to creditors to vote on the plan. Conformation for the plan occurs when one and 1/2 of the creditors with two-thirds in each claim class vote to approve the plan.

A municipality must meet additional requirements for a Chapter 9 plan of adjustment:

• The municipality cannot be lawfully prohibited from carrying out the plan.
• Post-petition administrative claims must be fully paid in full.
• Regulatory and electoral approvals for the plan must have been obtained.
  
• The plan must be feasible and be in the creditor’s best interest.

A municipality's bankruptcy case can be discharged only after it meets these requirements:

• Its plan of adjustment has been confirmed.
• It deposits the required funds or property with a disbursing agent appointed by the court.
• The court determines that payment deposited with the disbursing agent will constitute the debtor’s valid legal obligations and any provision made by the debtor to secure or make payments is valid.

There are two exceptions to a municipality’s discharge in Chapter 9 cases — debts the plan says will not be discharged and debts owed to creditors that had no notice or knowledge of the bankruptcy case. The court may, within 180 days of a plan’s conformation, revoke the confirmation order if it was procured through fraud.