Q&A on Municipalities and Chapter 9 Bankruptcy Introduction There has been much concern of late regarding the performance of municipal bonds and pending defaults. Some in the industry have gone as far as predicting the extent of the defaults and when they will likely occur. With the size of the U.S. municipal bond market nearing $3 trillion, and in light of the recent financial crisis and the debt ceiling debates, there is cause for concern. To better serve our clients with respect to the analysis and valuation of municipal bonds, Black Swan Consulting researched the Chapter 9 bankruptcy process as outlined in the federal Bankruptcy Code and arranged its findings in a question and answer format. This Q&A seeks to address the most frequently asked questions and least understood aspects bondholders might have regarding Chapter 9 bankruptcies. What is Chapter 9 bankruptcy? In a Chapter 9 bankruptcy, a municipality s assets are not liquidated to pay creditors. Rather, the assets are reorganized through an adjustment of debts to allow for future performance. 1 Chapter 9 bankruptcy should not be confused with Chapter 11 bankruptcy, also known as corporate bankruptcy, which is mainly utilized by businesses seeking to reorganize their financial affairs through a repayment plan. Under Chapter 9, reorganization is accomplished through a plan of adjustment which typically involves extending debt maturities, reducing the amount of principal or interest, and/or refinancing the debt by obtaining a new loan. What does it mean for a municipality to default? The term default has been used somewhat broadly in the news with respect to municipal bonds. A careful distinction should be made between two kinds of default: monetary and technical. A monetary default occurs when the issuing municipality fails to pay principal, interest, or both, when due. 2 A technical default occurs when the issuing municipality fails to meet its legal obligations according to the bond contract (indenture). Examples of technical defaults can include failing to charge rates sufficient to meet rate covenants, failing to maintain insurance on the project and/or failing to maintain a certain level of capital (reserves). 3 Does a municipality that defaults automatically go into Chapter 9? A municipality that defaults on its bonds, whether due to monetary or technical reasons, may not necessarily go into Chapter 9 bankruptcy. There are economic and political reasons why a municipality may want to avoid Chapter 9 bankruptcy altogether and if available, seek state alternatives. Many states have set up mechanisms to help a municipality avoid Chapter 9 bankruptcy which is a federal proceeding. Chapter 9 does not lift from the municipality the 1 11 U.S.C. 941 2 http://www.msrb.org/msrb1/glossary/glossary_db.asp?sel=d 3 Id.
burdens imposed upon it by state laws. 4 To the extent that Chapter 9 impairs or limits state control of the municipal debtor, the state will have standing to challenge this under 903 of the Bankruptcy Code. Who is eligible to file for Chapter 9? Chapter 9 bankruptcy is available only to a municipality. 5 Municipality is defined under the federal Bankruptcy Code as a political subdivision or public agency or instrumentality of a State. 6 Municipalities include counties, cities, towns, villages, municipal utilities, school districts, and other taxing districts. The Bankruptcy Code s definition of municipality does not include states. In addition, municipality filings must be voluntary; this means that creditors cannot file an involuntary bankruptcy case against a municipality. What are the prerequisites for filing a petition for bankruptcy? Section 109(c) of the Bankruptcy Code lists four additional eligibility requirements. The debtor municipality: (1) must be specifically authorized to file under state law in its capacity as a municipality, or by name 7 ; (2) is insolvent 8 ; (3) desires to effect a plan to adjust such debts 9 ; and (4) must satisfy one of the four creditor negotiation requirements for Chapter 9 bankruptcy. It must either (i) have obtained agreement to a reorganization plan by a majority of creditors whose claims it intends to impair; or (ii) have negotiated in good faith with creditors and failed to obtain agreement; or (iii) be unable to negotiate with creditors because negotiations are impracticable; or (iv) reasonably believes that a creditor may attempt to obtain an avoidable preference. 10 4 11 U.S.C. 903 5 11 U.S.C. 109(c) 6 11 U.S.C. 101(40) 7 11 U.S.C. 109(c)(2) 8 11 U.S.C. 109(c)(3); The term insolvent, as defined under 11 U.S.C. 32(C), with reference to a municipality is a financial condition such that the municipality is (i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or (ii) unable to pay its debts as they become due. 9 11 U.S.C. 109(c)(4) In a case under Chapter 9, only a debtor may file a plan for adjustment of debts creditors may not propose and file competing plans. 10 11 U.S.C. 109(c)(5) 2
How is a Chapter 9 case commenced? A municipal debtor commences a Chapter 9 bankruptcy by filing the bankruptcy petition. In addition, a Notice of Commencement must be published in a local newspaper for three consecutive weeks and be published in a newspaper which has a general circulation among bond dealers and bond holders. 11 The municipal debtor must also file a list of creditors, usually filed along with the petition. 12 However, the bankruptcy court has discretion to fix a different time for filing the list of creditors if the debtor is unable to prepare the list of creditors in the form and with the detail required by the Bankruptcy Rules at the time of filing. 13 What is the role of the court in a Chapter 9 proceeding? A bankruptcy court s powers are limited in a Chapter 9 proceeding. Absent consent by the municipal debtor, the court may not interfere with the municipal debtor s: (i) political or governmental powers; (ii) property or revenues; or (iii) use or enjoyment of income producing property. 14 As a result, the power of a bankruptcy court in a Chapter 9 case is effectively limited to: (i) (ii) (iii) (iv) determining whether the municipality is eligible to file for Chapter 9 protection; confirming or denying confirmation of a plan of adjustment; approving the assumption or rejection of executory contracts and unexpired leases; and dismissing the Chapter 9 case when appropriate. Is there a deadline for filing the plan of adjustment? The Bankruptcy Code does not fix a specific deadline by which the municipal debtor must file a plan. If the plan is not filed with the petition, the debtor will be required to file a plan at a later date determined by the bankruptcy court. 15 Are there any minimum requirements for the plan of adjustment? The Bankruptcy Code requires that all classes either be unimpaired or have accepted the plan. 16 If the plan proposes treatment for a class of creditors such that the class is impaired, then acceptance by that class is required. Should any class of claims be impaired under the plan, the court may confirm the plan only if at least one impaired class has accepted the plan. 17 As long as one impaired class of creditors consents to the plan, plan confirmation is still possible under the ʺcram downʺ provisions of 11 U.S.C. 1129(b). Under ʺcram down,ʺ if all other requirements are met except the Bankruptcy Code requirement that all classes either be unimpaired or have accepted the plan, then the plan is confirmable if it does not discriminate unfairly and is fair and 11 11 U.S.C. 923 12 11 U.S.C. 924 13 Fed. R. Bankr. P. 1007 14 11 U.S.C. 904 15 11 U.S.C. 941 16 11 U.S.C. 1129(a)(8) 17 11 U.S.C. 1129(a)(10) 3
equitable. 18 What this means is that if a bankruptcy court judge finds that the plan does not discriminate unfairly and is fair and equitable, the municipality can proceed to Chapter 9 bankruptcy, hence cram down over the objection of creditors. Who may object to the plan? Creditors whose claims are affected by the plan, an organization of employees of the debtor, special taxpayers, as well as the Securities and Exchange Commission (SEC) may object to the plan. 19 What happens once a Chapter 9 plan is confirmed? Once a Chapter 9 plan is confirmed by the bankruptcy court, the municipal debtor s former obligations are replaced by the new obligations outlined under the confirmed plan. As mentioned above, the plan of adjustment typically involves extending debt maturities, reducing the amount of principal or interest, and/or refinancing the debt by obtaining a new loan. What can a creditor do when a municipality files for Chapter 9? The Bankruptcy Code permits objections to the petition. 20 The court may dismiss a petition if it determines that the debtor did not file the petition in good faith or that the petition does not meet the requirements of title 11, the chapter of the Bankruptcy Code that deals with reorganization. 21 A court may also dismiss a petition for: (i) (ii) (iii) (iv) (v) lack of prosecution; unreasonable delay; failure to propose a plan within the time the court has stipulated; material default under a plan; and other causes. If the court dismisses a petition, creditors are returned to their pre petition state, with their nonbankruptcy procedural and substantive rights under state law. If the petition is not dismissed upon an objection, the Bankruptcy Code requires the court to order relief, allowing the case to proceed under Chapter 9. 22 How much will a Chapter 9 bankruptcy cost and how long will a take? The Code does not have a provision regarding cost. And outside of 11 U.S.C. 921(c), which says a court may dismiss a petition for unreasonable delay, or failure to propose a plan within the time the court has stipulated, the Bankruptcy Code does not have a rule regarding the duration of a Chapter 9 bankruptcy. However, if prior cases are any indication, bondholders can expect the process to be long and expensive. Orange County, California filed for Chapter 9 bankruptcy in December 1994 and emerged eighteen months later, in 1996. Vallejo, California filed for 18 11 U.S.C. 1129(a)(8) 19 11 U.S.C. 901(a), 943, 1109, 1128(b). 20 11 U.S.C. 921(c) 21 Id. 22 11 U.S.C. 921(d) 4
bankruptcy in April of 2008. The city won approval for its financial plan to exit bankruptcy protection in July 2011. 23 As of this writing, a Bank of America report estimates that Vallejo has already spent about $10 million in legal fees. 24 What is the role of creditors in Chapter 9? The role of creditors is more limited in a Chapter 9 case than in other bankruptcy cases. There is no first meeting of creditors, and creditors may not propose competing plans. If certain requirements are met, the municipal debtorʹs plan is binding on dissenting creditors. In each Chapter 9 case, however, there is a creditorsʹ committee that has powers and duties that include: (i) (ii) (iii) selecting and authorizing the employment of one or more attorneys, accountants, or other agents to represent the committee; consulting with the debtor concerning administration of the case; investigating the acts, conduct, assets, liabilities, and financial condition of the debtor; participating in the formulation of a plan; and (iv) performing such other services as are in the interest of those represented. 25 Is there a priority among different types of bondholders? Chapter 9 bankruptcy draws a distinction between general obligation bondholders and special revenue bondholders. By definition, general obligation bonds are backed by the full faith and credit of the issuing municipality. This means the bonds are backed by the taxing power of the municipality. However, in Chapter 9, a court may treat general obligation bonds not secured by a pledge of any specific revenue or assets as general unsecured debt. As such, the municipality is not required to make payments of either principal or interest on such bonds during the Chapter 9 bankruptcy. In addition, general obligation bonds are subject to negotiation and possible restructuring under the plan of adjustment. Special revenue bonds differ in that they are secured by a pledge of a specific stream of income often a particular tax or revenues generated by a utility or other project. Special revenue bondholders, by contrast, maintain their collateral security and can expect to receive payment on such bonds during the Chapter 9 case, if revenues are available. 26 In addition, the automatic stay (which goes into effect when a Chapter 9 petition 23 http://newsandinsight.thomsonreuters.com/bankruptcy/news/2011/07_ _July/Judge_approves_Vallejo,_Calif bankruptcy_exit_plan/ 24 http://www.cnbc.com/id/43932782 25 11 U.S.C. 901(a), 1103. 26 11 U.S.C 922(d). Special revenues is defined under 11 U.S.C. 902(2) as (A) receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems; (B) special excise taxes imposed on particular activities or transactions; (C) incremental tax receipts from the benefited area in the case of tax increment financing; (D) other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or (E) taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax increment financing) levied to finance the general purposes of the debtor; 5
is filed and prohibits creditors from attempting to collect a debt from the municipality, its elected officials or officials and the municipality s taxpayers 27 ) does not apply to pledged special revenues as long as the pledge is consistent with 11 U.S.C. 928, which ensures that a lien of special revenues is subordinate to the operating expenses of the project or system from which the revenues are derived. 28. Bondholders should refer to the bond agreement and be aware of this distinction between the general obligation bondholders and special revenue bondholders. Conclusion The Bankruptcy Code provides a general framework as to how a Chapter 9 bankruptcy shall proceed. In a Chapter 9 proceeding, the bankruptcy court s powers are limited.to ensuring that the municipal debtor acts in accordance with the general framework. It is then left to the municipal debtor and its creditors to reach some agreement on an acceptable reorganization plan. Therefore, how much bondholders will recover will inevitably vary from case to case based on their reorganization plan. (3) ʺspecial tax payerʺ means record owner or holder of legal or equitable title to real property against which a special assessment or special tax has been levied the proceeds of which are the sole source of payment of an obligation issued by the debtor to defray the cost of an improvement relating to such real property; (4) ʺspecial tax payer affected by the planʺ means special tax payer with respect to whose real property the plan proposes to increase the proportion of special assessments or special taxes referred to in paragraph (2) of this section assessed against such real property; and (5) ʺtrusteeʺ, when used in a section that is made applicable in a case under this chapter by section 103(e) or 901 of this title [11 USCS 103(e) or 901], means debtor, except as provided in section 926 of this title [11 USCS 926] 27 11 U.S.C. 922(a)(1) 28 11 U.S.C. 922(d); 11 USC 928(b); The automatic stay is an injunction that prevents creditors from filing or continuing lawsuits or other collection activities against the debtor 11 U.S.C. 362 6