Municipal bankruptcies, while occurring with more frequency, are still rare.¹ Historically, slightly more than 600 municipalities out of approximately 90,000 have sought Chapter 9 bankruptcy protection since the Great Depression. Why such a low number of filings? There are multiple requirements before a municipality can actually file. Furthermore, filings for municipalities constituting issuers of rated debt are particularly rare. Because of the limited number of filings, the effects on secured and unsecured creditors are unclear under the law. Consequently, it is not clear whether recovery to investors would typically be higher or lower in bankruptcy reorganization than in state court proceedings or out-of-court restructurings.

Municipalities file for bankruptcy protection under Chapter 9 of the United States Bankruptcy Code, which provides statutory preconditions. The municipality must also satisfy the statutory mechanisms poised by its home state. But, in addition, a state can make bankruptcy too politically cumbersome for the municipality to file.

The hurdles under the Bankruptcy Code are more difficult than they appear. The federal statutory preconditions are as follows:

• Municipality must be deemed insolvent in that it is generally not paying its debts on time or is not able to pay its debts as they become due.
• Municipality must be willing to adjust its debts, and be unable to negotiate with its creditors to adjust its debts outside of bankruptcy.

Note that an involuntary bankruptcy filing is not available to the creditors of the municipality. There are also other significant differences from filings under Chapter 11 of the Bankruptcy Code, which are set forth on Annex A.

By way of state statutory mechanisms, each of New York, New Jersey and Connecticut allow their respective municipalities to file for bankruptcy protection. The requirements and limitations vary by state and are listed in Table 1.

Unlike with non-municipality debtors, bankruptcy and default are not synonymous for local governments. A bankruptcy filing does not always result in a default on indebtedness, and a payment default can occur outside of and without leading to bankruptcy. Municipalities tend to continue to make payments on bonds in order to have access to more inexpensive financing. But when those payments stop, a bondholder can compel payment through a mandamus action whereby a court can order a municipality to levy taxes or use other sources of available funds to pay debt service.

In evaluating restructuring options, the most important issue for investors to consider is whether debt service payments will continue to be made on time and in full in bankruptcy. Once a bankruptcy filing occurs, an order granting mandamus relief may not be available due to the applicability of the automatic stay (generally prohibiting use of assets for reorganization for debt service payments). Nevertheless, some courts do allow certain pre-petition claims to be made for payment despite the automatic stay.

As in any bankruptcy, secured creditors, whether by cash collateral, mortgages or other liens, may be able to be paid in full to the extent the collateral exceeds the value of the claim. Other liens may include municipality-specific statutory liens, since certain states have passed laws that grant bondholders of general obligation debt first priority on any property tax levy. As indicated above, Connecticut (but not New York or New Jersey) is one such state that provides statutory liens on general ad valorem tax revenue. By contrast, special revenue bonds are given preferential treatment under the Bankruptcy Code as a policy matter, so they have priority over general property, income or sales tax pledges. But, they do not have preferential treatment over the project’s necessary operating expenses, so those operating expenses would prime debt service payments on special revenue projects.³ A sketch of the priority of payments of various classes of claims under the Bankruptcy Code is listed in Table 2.

Below are examples from actual filings, including the pending proceeding for Stockton, CA:

• In August 1991 a federal bankruptcy court dismissed the bankruptcy petition of Bridgeport, CT. Having general obligation debt rated A1 with a negative outlook, the municipality was unable to prove its insolvency amidst a $16 million apparent budget deficit compared to a reserve fund $27.9 million in cash.
• The bankruptcy court for the proceeding involving Jefferson County, AL (general obligation debt rated Caa1, under review for possible downgrade), the latest and largest of a small group of municipal bankruptcy filings in 2011, issued a decision providing that debt service payments secured by special revenues are not subject to automatic stay, although certain exceptions would apply.
• Prior to the August 2011 bankruptcy filing of Central Falls, RI (Caa1 with a negative outlook), the state of Rhode Island passed a statutory lien giving bondholders of general obligation debt of any municipality first priority on any property tax levy. Accordingly, Central Falls’ reorganization plan treats all general obligation bonds as secured and leaves repayment terms unaffected.
• At the end of June of 2012, Stockton, CA filed for bankruptcy protection following the failure of closed-door negotiations with its creditors to fill a $26 million budget gap. Recently, the Bankruptcy Court for the Eastern District of California held that the city of Stockton was eligible to file for Chapter 9 bankruptcy despite the challenges of the bondholders.⁴ The bondholders had asserted that the City of Stockton had not met the eligibility requirements by proving insolvency, negotiating with creditors pre-bankruptcy and filing the bankruptcy case in good faith.⁵ The court, however, explained in its ruling that the objections of the bondholders or the “capital markets creditors” are in the plan confirmation process. The court explained: “If a plan is proposed that does not deal with CalPERS and if the Capital Markets Creditors reject their treatment under the proposed plan, then I will have to focus on the question of unfair discrimination… And the City is going to have a difficult time confirming a plan over an objection and claim of unfair discrimination without being able to explain that problem away.”⁶ Furthermore, the court explained that “… if the City makes inappropriate compromises, the day of reckoning will be the day of plan confirmation.”⁷ Although the City won the right to file for Chapter 9 bankruptcy protection, it may not succeed in confirming a plan.

Nevertheless, the subsequent order from the court in Stockton does not indicate a creditor-friendly posture.⁸ It found the City of Stockton evidenced its good faith presumption in light of their multi-year effort to ratchet down expenses including good faith negotiations or efforts to negotiate with creditors.⁹ By invoking the “neutral evaluation process” provided for under California state law, the court was persuaded that the neutral evaluator would have worked further with the capital market creditors if they had expressed interest — but none was expressed.¹⁰ After only two meetings with the neutral evaluator (a former bankruptcy court judge), the capital market creditors departed having taken the position that there was nothing to discuss.¹¹ This abrupt end occurred since the capital market creditors took the position that the City of Stockton would not also impair a different creditor (CalPERS), notwithstanding that the City of Stockton’s proposals were within the range of reasonable starting positions in a negotiation of plan treatment — and CalPERS obligations were proposed to be reduced indirectly.¹²

Creditors are accordingly forewarned that the hurdles are not only those of the municipality. Besides the usual homework to confirm their level in the capital structure, creditors are urged to come to the table ready to deal. Time will tell in the Stockton case and others to come down the pike.

Susan Aufiero-Peters is associate general counsel and vice president of Sterling National Bank in Montebello, NY and may be reached at [email protected]. The views expressed in this article do not reflect the views of Sterling National Bank or Lowenstein Sandler LLP or any of its clients.

Annex A

Differences under Chapter 9 of the Bankruptcy Code¹³

• A bankruptcy court is prohibited from interfering with various powers and enjoyments of a municipality debtor, in recognition of the sovereignty of the states and the limitations of the 10th amendment. (§904)
• An order of relief is not entered upon the filing of the petition, but only upon the court’s determination that the petition will not be dismissed. (§921(c), (d))
• Automatic stay is expanded to prohibit actions against any officer or inhabitant of the debtor, if the action seeks to enforce a claim against the debtor or is an action to enforce a lien arising from taxes or assessments owed to the debtor. (§922(a))
• A Chapter 9 debtor must file a plan of adjustment and not a plan of reorganization, meeting seven statutory standards. There is no statutory deadline for filing, and the court fixes a time for filing if not filed with the petition. Creditors cannot move to end the exclusivity period for filing a plan or propose a competing plan. (§941, § 943)
• Discharge is granted only after the plan has been confirmed, the consideration to be distributed under the plan has been deposited with a disbursing agent appointed by the court and the court has determined that, any securities intended for distribution constitute a valid legal obligation of the debtor and that the provisions made to pay such obligations are valid. (§944(b))

Footnotes:

<sup>1. Unless cited otherwise, all reference information is from “Special Comment – Key Credit Considerations for Municipal Governments in Bankruptcy,” Moody’s Investors Service, January 19, 2012.↩
2. N.J.S.A. 52:27-40↩
3. See §902, §928 of the Bankruptcy Code.↩
4. In re City of Stockton, California, Case No. 12-32118 (Bankr. E.D. Ca. April 1, 2013) (“Stockton Hearing Transcript”).↩
5. Stockton Hearing Transcript at 574-590.↩
6. Stockton Hearing Transcript at 590:11-15 and 20-23.↩
7. Stockton Hearing Transcript at 591:17-19.↩
8. Order regarding Chapter 9 Order for Relief, In re City of Stockton, Case No. 12-32118 (Bankr E.D. Ca. June 12, 2013) [Docket No. 950] (Stockton Order).↩
9. Stockton Order at page 42: 3-9.↩
10. Stockton Order at page 14: 19-24.↩
11. Stockton Order at page 17: 11-14.↩
12. Stockton Order at page 20: 6-12; page 21: 9-11; page 38: 8-10.↩
13. “Important Differences between Chapter 9 and Chapter 11 Proceedings”, M. Stringley and W. Maloney, Secured Credit Committee – ABI Committee News, Volume 8, Number 1 / February 2011.↩</sup>