John H. Knox is a partner in the San Francisco office of Orrick, Herrington & Sutcliffe, LLP, and a member of the firm’s Public Finance Department. He can be reached at jknox@ orrick.com. Marc A. Levinson is a partner in the Sacramento office of Orrick, Herrington & Sutcliffe, LLP, and a member of the firm’s Restructuring Group. He can be reached at malevinson@ orrick.com.

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Municipalities, a term defined in the U.S. Bankruptcy Code to include cities, counties and special districts — but not states — are being squeezed between the increasing cost of providing basic services and flat or declining revenues. Some may need to seek protection under Chapter 9 of the U.S. Bankruptcy Code. In May 2008, the City of Vallejo filed a Chapter 9 petition, and the media have reported that several other California municipalities are considering filing. Whether this is the start of a trend remains to be seen, but it’s clear that the stresses that can result in the drastic step of filing for bankruptcy protection are currently affecting many municipalities.

Filing for Chapter 9 protection should be considered a last resort. However, when all attempts to avoid a filing have failed to solve the underlying financial problem, bankruptcy is the appropriate solution — albeit an imperfect one. There are several significant downsides to such a filing, and ultimately the problems that brought the municipality to the point of filing will have to be solved anyway, so it is far better to resolve them, if possible, outside of bankruptcy.

Assessing the Problem(s)

The initial step, as in any crisis, is to clearly and dispassionately assess the underlying problem(s). Municipalities forced to the brink of or into bankruptcy generally experience one or both of two types of fiscal problems. The first is a large and extraordinary financial hit that cannot be absorbed by the budget or covered out of reserves. This could be a sudden and catastrophic investment loss, such as that experienced by Orange County in 1994, or a large judgment rendered against the municipality, such as those experienced by Desert Hot Springs, Calif., in 2001, and by Westfall Township, Pa., and Washington Park, Mo., in 2009.

The second kind of problem is a structural operating deficit that continues long enough to burn through reserves and is not resolved by revenue increases or spending cuts quickly enough for the municipality to avoid running out of cash while continuing to meet necessary and fixed expenses such as debt service and payroll. Vallejo, which had spent down its reserves over a period of several years in order to meet its obligations, became insolvent as a result of California’s economic slowdown and the concomitant drop in real estate and sales tax revenues, combined with significant employee salary and benefit cost increases dictated by collective bargaining agreements.

In general, fiscal stress related to one-time problems can be resolved by financing the “cure” costs over time. And while bankruptcy protection may be necessary to buy time to accomplish such a financing, all efforts should be made to convince creditors to be patient and not cause the municipality to incur the significant costs associated with Chapter 9. The creditor(s) should understand, too, that the money spent on the bankruptcy case is that much less available to pay the obligation.

Fiscal stress related to ongoing structural deficits and lack of reserves is much more difficult to tackle, because new financing will have little impact on solving the underlying structural problem. In fact, this tactic likely will make matters worse by “kicking the can down the road” and increasing the overall costs to the municipality. Bankruptcy protection may be needed to avoid immediate sanctions for breaching contracts, including labor agreements, missing debt service payments or failing to provide required levels of service.

Cash Position and Special Funds

Most municipalities maintain numerous separate funds within their treasuries, each having a particular function and source of revenues, and each burdened by legal or grantor restrictions on the use of the funds. Careful analysis must be made of the various funds held by the municipality to determine what diversions can legally be made and how limitations on the uses of funds will affect the municipality’s true available cash position. While it’s common for all of these funds to be commingled for investment purposes into a pooled cash account, a significant positive balance in pooled cash can mask a serious problem in the municipality’s underlying financial condition. For example, in the City of Vallejo case, certain creditors contended that the restricted funds could be raided in order to pay General Fund expenses. The bankruptcy court disagreed, and its ruling was affirmed on appeal.

Typically, a municipality’s only completely unrestricted fund is its General Fund. It is common and accepted practice for municipalities to use their pooled cash accounts as a source of cash flow within a fiscal year to carry funds that have intra-year cash inflows that do not match their cash outflows. This practice is permissible as long as the budget and reserves are sufficient to ensure that, at the end of the fiscal year, restricted funds are not in a position of having funded items not permitted within their restrictions. Use of restricted funds in pooled cash could be a violation of the restrictions imposed on the special funds and, therefore, illegal. It is important to note that while municipal officers generally have immunity from personal liability for official acts, such immunity does not necessarily extend to knowing violations of the law. In addition, a municipal official who requires or even permits employees to come to work knowing that the municipality will not be able to pay them may be violating state labor laws or committing common law fraud.

Advantages and Disadvantages of A Chapter 9 Filing

While bankruptcy clearly provides certain benefits for municipalities that cannot otherwise solve their fiscal problems, it is no panacea.

Advantages

Protection. Filing a bankruptcy petition invokes an automatic stay — a federal court injunction — against virtually any action that could otherwise be taken against the municipality. Unlike a bankruptcy involving a private entity, in Chapter 9 the automatic stay extends to elected officials and all inhabitants of the municipality. The stay lasts during the pendency of the Chapter 9 case, but the bankruptcy judge retains the right to modify or terminate it for cause shown.

Breathing Space. Raising new revenues, renegotiating contracts and restructuring debt obligations takes time. The bankruptcy case allows creditor, labor and most other disputes to be addressed in one forum, and the automatic stay provides the municipality the opportunity to focus on a comprehensive solution.

Access to an Expert Arbiter. Bankruptcy judges are experts in deciding complex financial disputes. While Chapter 9 filings 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 of knowledge and temperament to help the parties arrive at workable compromises. The value of a highly qualified and experienced judge in helping the stakeholders reach a solution should not be underestimated.

Ability to Adjust Obligations. A Chapter 9 plan of adjustment may provide that creditor claims 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 for creditors to block a municipality from making the adjustments it would like (or believes that it needs) to make. Nevertheless, in situations where it is impossible to fully repay all creditors absent some sort of debt relief, the plan of adjustment can provide the municipality a fresh start and the ability to achieve long-term financial stability by deferring and/or reducing past obligations.

Disadvantages

Credit Markets’ Reaction. Municipalities that seek bankruptcy relief, and even those that seriously consider filing, should expect the immediate suspension and/or downgrade of their credit ratings, particularly if bondholders are not fully repaid. This credit stigma may last for many years. One of the best ways for a municipality to position itself to restore its credit ratings is by providing timely and transparent information about its financial condition to the capital markets and rating agencies even if the data is not favorable, but this effort will take time and resources from the municipality’s finance staff at a time when the staff will be under tremendous stress.

Cost and Distraction. Filing and pursuing a Chapter 9 case is very expensive. Legal and financial consulting fees can easily range into seven figures, particularly when adversaries are well funded and litigious. Every dollar spent on professionals is a dollar that cannot go toward solving the underlying financial problem. Moreover, preparing for and attending hearings and depositions and responding to requests for information and documents from creditors, rating agencies, labor organizations, elected officials and the public can be a major impediment to the work necessary to solve core problems and keep the municipality functioning.

Stigma. Bankruptcy likely will be viewed by residents, workers and businesses as a stigma, and that perception can affect the self-esteem of residents and have an adverse impact on the overall business climate. This stigma could linger after the municipality emerges from bankruptcy.

Preparing for Chapter 9

The Importance of Negotiations

Once the magnitude of a financial crisis is established, well-documented negotiations with creditors and stakeholders should begin. It is not necessary that a municipality accept a short-term fix that defers an inevitable meltdown. But if such a fix is offered, the municipality must analyze it carefully to make sure that in fact it will not solve the municipality’s problems sufficiently to avoid both short-term and long-term insolvency. For example, in the Vallejo case, both the bankruptcy court and the appeals court ruled that the city was not obligated to accept one-time concessions from labor that might have avoided insolvency in the short term but would have extended unsustainable labor agreements by one or more years so that the deficit would have been even deeper as a result of the extension.

Authorization to File

A municipality is not eligible for Chapter 9 relief unless its governing body specifically authorizes the filing. Authorization can take the form of an immediate direction to file or delegated to the executive officer of the municipality to file in the event that certain conditions are not satisfied (such as approval by creditors or bargaining units of offers made by the municipality pursuant to authorizations from the governing body). Taking a vote to file a bankruptcy petition is a momentous step, and the municipality should expect significant public and media attention.

Timing

As noted earlier, monitoring the municipality’s cash position helps officials avoid violating the law — for example, by permitting employees to work when the municipality lacks the ability to pay them, disregarding legal restrictions on special funds or entering into essential contracts knowing that there will not be sufficient funds to meet the contract terms. While there will be tremendous pressure from many quarters to delay the actual filing until the last possible moment, it is prudent to leave at least some room between the time the municipality would be compelled to shut its doors and the date of filing the petition. This buffer period will give the bankruptcy court time to conduct an orderly process of considering the petition and any objections to it before drastic actions that potentially affect public health and safety (such as forced furloughs of essential service personnel) must be taken.

Dealing With Vendors and Trade Creditors

Most local governments have significant commercial relationships with vendors and trade creditors of various types. These providers likely will stop extending credit once news of the bankruptcy filing becomes public. It is also likely that they will require COD or prepayment terms for future transactions, and the municipality should be prepared to implement such arrangements for critical services and supplies. Such arrangements are often modified and credit re-extended after the municipality has demonstrated its ability and willingness to pay.

The Tenth Amendment and Limitations on the Role of the Court

The Tenth Amendment to the U.S. Constitution reserves certain powers to the states regarding the management of their internal affairs. In private-sector Chapter 11 cases, the bankruptcy judge wields significant power to control what the debtor may and may not do during the course of the case. However, in light of the Tenth Amendment and provisions of the Bankruptcy Code that implement it, the court plays a significantly more limited role in a Chapter 9 case, and state law restrictions on the activities of municipalities and their uses of funds must be observed.

Thus, the court cannot take over the operation of the municipality (such as requiring the sale or lease of a park in order to satisfy obligations to creditors), remove governing board members, direct the actions of the governing board or appoint a receiver or trustee to run the municipality’s affairs. Similarly, the court cannot permit the municipality to override certain state laws, such as those requiring voter approval for new taxes or limiting the use of restricted funds for particular purposes. Nor can the court force the liquidation of a municipality. A private firm in a Chapter 11 case that fails to achieve reorganization may be liquidated under Chapter 7 of the Bankruptcy Code, resulting in the sale of assets to pay creditors and the winding down of the firm. There is no Chapter 7 analog for municipalities.

The primary responsibilities of the bankruptcy judge in a Chapter 9 case are to:

• Determine eligibility for bankruptcy;
• Oversee the assumption or rejection of executory contracts and unexpired leases;
• Decide preference and similar litigation; and
• Confirm or decline to confirm a plan of adjustment.

Despite this limited role, the judge in a Chapter 9 case exerts considerable influence over the parties and can be a very helpful neutral arbiter of difficult disputes.

Official Committees

Once the court determines that the municipality is eligible to be a Chapter 9 debtor, the U.S. trustee may appoint a committee or committees to represent the interests of creditors holding similar classes of claims. In the Vallejo case there is one committee, and it represents the interests of retirees.

Assumption and Rejection of Contracts, Collective Bargaining Agreements and Leases

The Bankruptcy Code enables a Chapter 9 debtor to assume favorable contracts and real and personal property leases and reject burdensome ones. To assume a contract or lease, absent consent by the nondebtor party, the municipality must cure all monetary defaults and provide adequate assurance that it will be able to perform under the agreement in the future. Clauses in contracts/leases that provide that the agreement terminates on account of a bankruptcy filing by one of the parties are not enforceable in a Chapter 9 case (or in any other bankruptcy case). In the event a lease or contract is rejected, the nondebtor party will have a general unsecured claim against the municipality for the damages it has suffered on account of the rejection. Such a claim must be addressed in the plan of adjustment.

Collective bargaining agreements are subject to assumption and rejection as well, although the U.S. Supreme Court has placed extra burdens on debtors seeking to reject such agreements. In Chapter 9 cases, these include mandating that the bankruptcy court balance the hardships employees would suffer as a result of rejecting the agreements against the benefits to the municipality for rejecting those agreements. The court also must conclude that the agreement is burdensome on the municipality and that the municipality employed reasonable efforts to resolve contract issues short of rejection and that a prompt resolution would not be forthcoming. The Vallejo case includes two landmark rulings: first, that the Bankruptcy Code allows rejection of collective bargaining agreements even where such rejection would not be permitted under state labor laws applicable to public entities; and second, rejecting two such agreements, one by stipulation and the other over the strenuous objection of the affected union.

Special Revenues

Many agencies have separate governmental enterprises that are owned and operated by the municipality but are not separate legal entities. The Bankruptcy Code treats the revenues of such an enterprise that are pledged to the payment of debt obligations as “special revenues” and provides that those special revenues may not be diverted to pay the debts of the municipality that are unrelated to the enterprise that generated them. If the special revenues are insufficient to pay the debt, however, the municipality’s obligation to pay from general revenues, if any, could be impaired by the plan. Special assessments or taxes levied and pledged to support the bonds issued to provide such financing used to construct infrastructure also cannot be invaded to pay other obligations of the municipality.

Financing Leases

In many states, municipalities use lease financing for capital projects and equipment. Although styled as leases, these instruments typically bear tax-exempt interest to the investors, and are treated as debt for accounting and tax purposes. Although the matter is not entirely free from doubt and will depend on the facts and circumstances of each case, these instruments should in general be treated as debt obligations under the Bankruptcy Code and not as true leases. The significance of such characterization might be that the municipality would not be required to assume or reject the lease within a relatively short period of time after the order for relief, and that the creditor (lessor) might be unable to evict the municipality from the “leased” property (or to require return of the “leased” equipment) in the event of a payment default.

The Plan of Adjustment

A plan of adjustment is little more than a contract among various parties that provides for the treatment of the various claims against the municipality. The bankruptcy court has the power to approve a plan over the objection of dissenting creditors as long as the requisite majorities of creditors holding similar claims have approved the plan and as long as the plan does not discriminate among holders of similar claims.

The municipality and its creditors should avoid a quick fix that all but guarantees a prompt return to insolvency. Thus, a successful plan must:

1. Provide for adequate rainy‑day reserves;
2. Leave the municipality with flexibility to adjust costs and service levels to account for future unforeseen downturns;
3. Limit exposure to undue risks in the debt markets (that is to say, by relying on variable rate debt without appropriate hedges against rising rates);
4. Avoid reliance on uncertain future revenue streams, particularly if they require voter approval or are otherwise outside the control of the municipality; and
5. Be supported by a majority of the affected stakeholders and backed by a meaningful commitment to implement the plan.

The bankruptcy court must confirm the plan of adjustment if it finds that the various Chapter 9 confirmation requirements have been satisfied. These requirements include, among others, that:

• At least one class of impaired creditors has voted to accept the plan;
• Post-bankruptcy claims will be paid in full on the plan’s effective date (unless an impacted creditor agrees to different treatment);
• Any necessary approval by regulators or voters (in the case of most tax increases) has been obtained; and
• Creditors will receive as much under the plan as they would were the case dismissed.

Broadly stated, the court should find that the debtor municipality has used all reasonable efforts to pay its creditors as much and as quickly as possible, recognizing that application of state law (such as tax limitation initiatives or other restrictions) may dramatically limit the municipality’s ability to raise revenues. The court also must find that the plan is feasible, which means that the municipality will not need further reorganization or another Chapter 9 case in the near future.

If the plan of adjustment is not confirmed either by consent or by a court order binding a nonconsenting class of creditors (referred to in bankruptcy parlance as a “cramdown”), the bankruptcy judge has the discretion to send the parties back to the drawing board to craft a better plan or to simply dismiss the Chapter 9 case. The judge has no ability to craft a plan of adjustment and compel the municipality to accept it. Dismissal of the case is a nightmare scenario because the municipality, which the judge earlier concluded (during the eligibility phase of the case) was unable to pay its debts, is now out of court without the protection of the automatic stay and is still unable to pay its debts.

Life After Bankruptcy

It should be expected that the capital markets will punish a municipality for having become insolvent. The degree and lengthy of that punishment will depend in large part on several factors:

• The degree to which debt holders and guarantors are made whole;
• The strength and viability of the negotiated settlement or plan of adjustment;
• The degree of cooperation and buy-in among stakeholders;
• Whether voters and/or elected officials have contributed to the settlement or plan by approving new taxes, fees or other revenue sources;
• Whether the municipality can demonstrate that it has stable and effective management;
• How well the municipality communicates with the market and the timeliness and transparency of the financial information presented; and
• How well the settlement or plan of adjustment is implemented and monitored.

Conclusion

For the overwhelming majority of municipalities, even severe economic downturns such as the one currently affecting California and the nation will not result in the filing of a petition under Chapter 9 of the Bankruptcy Code. Municipalities under financial 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, for some municipalities, the challenges will be too great, the avenues of solution too limited and the window of opportunity for corrective action too small to avoid using Chapter 9 as a tool to help right the ship.

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About Legal Notes

This column is provided as general information and not as legal advice. The law is constantly evolving, and attorneys can and do disagree about what the law requires. Local agencies interested in determining how the law applies in a particular situation should consult their local agency attorneys.

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This article appears in the November 2009 issue of Western City
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