What is Chapter 9 bankruptcy?

Chapter 9 filings are set aside for municipalities to file for bankruptcy protection if faced with crippling financial problems such as high bond debt, increasing foreclosure rates and unpaid pensions.

The U.S. Bankruptcy Code defines a municipality as a “political subdivision or public agency or instrumentality of a state.” This could be a township, city, county, school district, public improvement district, or an entity such as a bridge, highway or gas authority. Chapter 9 allows a city or other municipality to restructure debts and create a feasible plan to pay their creditors through bankruptcy.

Reorganization of the debts of a municipality is typically accomplished through extending debt maturities, reducing the amount of principal or interest on bonds, or refinancing the debt by obtaining a new loan.

Purpose

Chapter 9 is an option for a city to protect itself from creditors while negotiating a plan for debt repayment.

The municipal bankruptcy contains similar elements to Chapter 11 and Chapter 13 filings. However, unlike other forms of bankruptcy, Chapter 9 is exclusively based on repayment, and there is no option for liquidation. In addition, the Bankruptcy Court does not play an important role in a Chapter 9, as it might in a business or individual bankruptcy filing.

The overall function of Chapter 9 includes stabilizing local economies through agreements with creditors and bondholders. But one of the most common reasons a town will resort to bankruptcy is to continue to pay pensions of government workers, while working out feasible plans to pay bondholders (this usually involves reducing or eliminating interests and principals on bonds during the filing period).

While a business or consumer bankruptcy may be a financial tool to protect assets, because a municipality affects a great number of people, Chapter 9 is strictly intended to provide the municipality with room to actually pay back creditors. It is the goal of this filing to ensure not only that creditors are paid, but that the municipality emerges from the filing on a path to solvency.

History

This type of bankruptcy filing is not common. There have only been around 600 filings in the past 60 years. Prior to the 1930s, towns in serious financial trouble had virtually no options to escape creditors, aside from raising taxes. Then, in 1934 during the Great Depression, the U.S. Bankruptcy Code was amended to include municipal filings. It was a few more years before the kinks of Chapter 9 were worked out, but as it stands today, eligible entities can create a creditor repayment plan that helps alleviate the burden from taxpayers.

Eligibility

While businesses and consumers have several filing options including the most common types, Chapters 7,11 and 13, municipalities only have the one option. In addition, it is far more difficult for a town or other municipality to prove to the Bankruptcy Court that they are an eligible debtor under Chapter 9.

In general, an eligible entity is a state-controlled one that uses taxes or other revenue to employ public initiatives. Often times, this includes entities such hospitals, public improvement entities, irrigation or sanitary districts, utility boards, or highway authorities, not just towns or cities.

There are four requirements for an entity to qualify for Chapter 9:

  1. The debtor - be it a city or otherwise - must show it is unable to pay its debts and is in insolvency. The Bankruptcy Court will analyze a very specific set of factors to determine whether a municipality is insolvent. In addition to debts, the court will look at whether the municipality has exhausted all measures to raise funds, cut spending, and has considered all of its obligations, before turning to Chapter 9 bankruptcy. If it can not prove insolvency, it will not be eligible for filing.
  2. State law must specifically provide the authority for Chapter 9 bankruptcy filings. Some states allow municipalities control over bankruptcy, while others have conditions on when and how cities can file. Some states do not allow municipalities to file at all, but instead stipulate that municipalities seeking bankruptcy protection must petition the state to pass a law authorizing a Chapter 9 filing in order to proceed with their case.
  3. The municipality must satisfy at least one of these elements:
    • It must have consent from majority creditors;
    • At least attempted in good faith to obtain consent from creditors;
    • Could not negotiate with creditors as it was determined that to do so is "impracticable";
    • Show that a creditor will likely try to make a transfer that would preferably be avoided.
  4. The municipality must show they are committed to designing a debt repayment plan that will not just buy time, but provide the framework for future and continued solvency.

The entity may also be required to prove to the Bankruptcy Court that it is filing in good faith and not for the benefit of any one person or group of people, but for the greater good; and that all other alternatives were considered or exhausted.

Examples

In recent years, Chapter 9 cases have been more common in the United States. Some cities and towns to file include:

Orange County, California - In 1994, Orange County became the largest town to file bankruptcy to date. Many blamed the town's treasurer for poor investments leading to financial problems, and after taxpayers voted not to raise taxes, the town filed Chapter 9.

Vallejo, California - In 2008, Vallejo filed bankruptcy reportedly due to overpaid city workers such as firefighters and police officers, and excessive pensions and retiree benefits.

Jefferson County, Alabama - Jefferson County's 2011 filing became the most expensive to date, with over $3 billion in debts.

Central Falls, Rhode Island - The tiny town of Central Falls filed Chapter 9 in 2011 after declaring insolvency the previous year, largely due to excessive bond debts and unpaid pensions.

Stockton, California - In 2012, Stockton had no choice but to file bankruptcy. The real estate bust and collapse of the sub-prime lending market led to many foreclosures and plummeting property values. The city's primary revenue industry, real estate, took a hit and Chapter 9 was the only option.

San Bernardino, California - San Bernardino surpassed previous cities to become the largest to ever file. Declaring a fiscal emergency, the city was unable to negotiate with creditors and became the third municipal bankruptcy case in California in the span of weeks.

To learn about the other types of bankruptcies that exist under the U.S. Bankruptcy Code, start with the following articles:

What is Chapter 11 business bankruptcy?

When, why and why not, should I consider bankruptcy?

What is Chapter 7 bankruptcy?