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Avoiding and Using Chapter 9

(page 3 of 3)

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.
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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