Historically, bankruptcy of governmental units has been rare, but in recent years large municipal units such as Detroit, Mich., Jefferson County, Ala., San Bernardino, Calif., and Stockton, Calif., have all filed and successfully exited from Chapter 9 bankruptcy. As with private sector bankruptcies, municipal bankruptcies have important implications for creditors and constituents of financially distressed units. For instance, many Detroit union workers, retirees, suppliers, and employees faced consequences such as the cancellation of existing city contracts and reduction of benefits paid to employees.
CPAs can benefit from having a good understanding of the Chapter 9 process in order to help clients doing business with bankrupt municipal units. This article seeks to shed light on some of the basic peculiarities and challenges of the Chapter 9 process, with an emphasis on Detroit’s experience. The article also addresses auditors’ associations with municipal units and important timelines involving municipal bankruptcy.
Chapter 9 Filings
Chapter 9 of the United States Bankruptcy Code grants financially distressed municipal units a temporary stay against creditors while the unit develops and negotiates a plan for adjusting its debts to make a fresh start. Even though Chapter 9 is similar to other chapters of the Bankruptcy Code, there is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors, because doing so would violate the Tenth Amendment’s reservation to the states of sovereignty over their internal affairs (Thomas Moers Mayer, “State Sovereignty, State Bankruptcy, and a Reconsideration of Chapter 9,” American Bankruptcy Law Journal, vol. 85, no. 4, http://bit.ly/2mBhsOR). In view of this reservation, bankruptcy courts are generally not as active in managing a municipal bankruptcy as they are in corporate reorganizations under Chapter 11.
Unlike Chapters 7 and 11, Chapter 9 must be voluntarily initiated by the municipal unit, as is the case with Chapter 13 bankruptcy (11 USC 301 and 303). Chapter 9 also differs from Chapter 7 in that Chapter 9 filings, like Chapter 11 filings, involve reorganizations and not a liquidation of assets. Consistent with 11 USC 109(c), only municipalities or their political subdivisions or agencies may file for bankruptcy under Chapter 9; federal governmental units are not eligible.
Once the petition for bankruptcy is filed, creditors are enjoined from pursuing the municipal unit [11 USC 362(a) and 901(a)]. During the period of bankruptcy protection, municipalities are allowed to continue to borrow from creditors; release bonds; raise, collect, and levy taxes; and provide services to constituents. Trustees are rarely appointed in Chapter 9 situations because the municipal unit retains its assets, governance, and right to draft a plan of rehabilitation.
Unlike cases filed under the other chapters of the Bankruptcy Code, the clerk of the bankruptcy court does not automatically assign a case to a particular judge. Instead, the chief judge for the Circuit Court of Appeals for the federal district in which the case is commenced appoints a judge to review the bankrupt unit’s petition and plan of adjustment [11 USC 921(a)]. This provision is intended to remove politics from the issue of which judge presides over the Chapter 9 case while assuring the assigned judge has the time and capability to handle the matter.
The role of creditors is limited under Chapter 9. For example, unlike filings under Chapters 7, 11, and 13, there is no first meeting of creditors under Chapter 9 (11 USC 341). In addition, creditors are not allowed to propose competing plans of rehabilitation (11 USC 941). The role of courts is also limited, as the unit’s day-to-day activities are not subject to approval by the court, and the unit may continue to borrow money without the court’s approval (11 USC 904). The unit may also employ certain professionals to assist without the court’s approval, and the fees paid to these professionals are reviewed by the court only within the context of the plan’s confirmation [11 USC 901(a)]. Unlike Chapters 7, 11, and 13, Chapter 9 grants the bankrupt unit full responsibility for proposing a plan without regard to creditor sentiment or court oversight.
The plan submitted by the unit must be confirmed by the court if the plan meets the conditions outlined in 11 USC 943(b). These conditions include, but are not limited to: 1) whether the amounts paid by the unit for services or expenses related to the plan have been fully disclosed and are reasonable, 2) the unit is not prohibited by law from taking any action necessary to carry out the plan, 3) any regulatory or electoral approval necessary to carry out any provision of the plan has been obtained, and 4) the plan is in the best interests of creditors and is feasible. It should be noted that the test of whether a plan is in the best interests of creditors under Chapter 9 is different from that under Chapter 11. Under Chapter 11, a plan is considered in the best interests of creditors if creditors would receive as much as they would if the unit were liquidated. Under Chapter 9, the test is whether the plan is better than the other alternatives available to creditors. In cases involving Chapter 9, the alternative to the proposed plan would involve dismissing the bankruptcy case, thereby leaving creditors to pursue collection on their own.
Chapter 9 of the United States Bankruptcy Code grants financially distressed municipal units a temporary stay against creditors while the unit develops and negotiates a plan for adjusting its debts to make a fresh start.
In accordance with the more detailed Bankruptcy Rule 3017(a), 28 days after a disclosure statement is filed in accordance with Bankruptcy Rule 3016(b), the court will hold a hearing to consider the disclosure statement and any objections or modifications thereto in accordance with Bankruptcy Rule 2002. Debtors, creditors, equity security holders, and other parties in interest will be provided notice of this hearing. Objections to the disclosure statement must be filed and served on the debtor, the trustee, any committee appointed under the Bankruptcy Code, and any other entity designated by the court, at any time before the disclosure statement is approved or by an earlier date as set by the court. Following this hearing, the court, consistent with Bankruptcy Rule 3017(b), will decide whether the disclosure statement should be approved.
Steps in the Chapter 9 Process
Exhibit 1 depicts the Chapter 9 process in five simple steps, commencing with the filing of the petition for Chapter 9 protection. The filing of the petition does not technically signify bankruptcy, because the designated court can deny the petition within the aforementioned time frame. 11 USC 901(a) grants officers of a distressed unit the power to file for Chapter 9 protection. If the unit does not have officers, the governing authority has the power to file [11 USC 921(a)]. Creditors may object to the petition, in which case the court may dismiss the plan if the petition is believed to have been filed in bad faith or does not meet the provisions of Chapter 9; however, such an occurrence is rare.
In Step 1, the entity must be a municipality within the definition of the Bankruptcy Code. 11 USC 109(c) states that a municipality “is specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under such chapter.” To be an eligible filer, the unit must be insolvent.
In Step 2, the unit is required to serve notice regarding the petition. 11 USC 923 requires weekly publication for three successive weeks in a general circulation newspaper. The judge may also request that documents be mailed to certain creditors directly, as well as that additional media outlets be used for the announcement. The publications place concerned parties on notice regarding the petition for relief; affected parties are then able to object.
In Step 3, the list of creditors is filed. 11 USC 924 states that this list must comprise the 20 largest creditors. Typically this list is submitted with the petition under Chapter 9, but the bankruptcy court can set a different timetable. The list of creditors may change as the situation evolves. The bankrupt unit also may list claims that are in dispute or that are contingent. The unit must show that it is trying to negotiate with creditors. In the event there are no sustainable objections to the petition, the court may order relief and an automatic stay to stop all collection actions and prohibit creditors from bringing a mandamus action against the unit [11 USC 922(a)].
Step 4 is the filing of a plan of adjustment and a disclosure statement. This step may not be needed if the bankrupt unit filed the plan of adjustment with the petition in Step 1; otherwise, the filing of the plan of adjustment may occur at any time after the petition is filed or as specified by the court. The bankrupt unit may modify the plan at any time without confirmation but must be careful that the conditions of Chapter 9 are not violated. The disclosure statement sets forth the operation of the plan after its confirmation.
In Step 5, the planned adjustments are confirmed. 11 USC 943(b) lists seven discharge conditions, which include that the plan complies with Chapter 9, that the amounts paid under the plan are fully disclosed and reasonable, that any regulatory or electoral approval be obtained, and that the plan is feasible and in the best interests of the creditors. Because of the complicated nature of the issues at hand, the court will set up a strict timetable for scheduling and deadlines before and during the hearings. In the event of confirmation, the court enters an order setting the plan in action, and all affected parties are duly notified.
The criteria for confirmation provide protection for existing creditors. In particular, each creditor must receive more than it would have under a liquidation scenario. 11 USC 945 empowers the courts to retain jurisdiction until the plan of adjustment is successfully completed. Indeed, as mentioned earlier, creditors of affected units have little say in the Chapter 9 process. Creditors should, however, ascertain whether they are listed in Step 3 of the process.
The largest Chapter 9 municipal filing in U.S. history was successfully completed on December 10, 2014, by the city of Detroit. The city was able to reject and renegotiate its debt load of $18 billion with its creditors, labor unions, and stake-holders. Not all states, however, allow municipal units to file for bankruptcy protection. Of the 50 states, only 25 allow Chapter 9 petitioning, as shown in Exhibit 2 (James Spiotto, “Primer on Municipal Debt Adjustment, Chapter 9: The Last Resort for Financially Distressed Municipalities,” Chapman and Cutler LLP, 2012, http://bit.ly/2meUbiW). The three most recent municipal units to come out of Chapter 9—Detroit and the cities of San Bernardino and Stockton, Calif.—have successfully unloaded $19.5 billion dollars in bond, pension obligations, and loan debt to satisfy operating needs while trying to uphold some of their pension obligations. Due to U.S. Bankruptcy Court Judge Steve Rhodes’s decision in Detroit’s case not to hold pension obligations sacrosanct, these other cities have been able to renegotiate without fear of appeal or reprisal by the debt holder. Moody’s has also stated that the taboo surrounding Chapter 9 is diminishing, as cities that had been propped up by state and federal loans for the past 40 years are successfully coming out of bankruptcy stronger [Kyle Glazier, “Moody’s Notes Higher Acceptance of Muni Bankruptcy,” Bond Buyer, Aug. 5, 2015, http://bit.ly/2lTfaGo].
State Authorizations for Municipalities to File a Chapter 9 Bankruptcy Case
Judge Rhodes’s decision approving Detroit’s petition for bankruptcy was based in major part on the evidence of the city’s service delivery insolvency to its citizens, including what the court characterized as rampant crime, blight, poverty, and dys-function [Eligibility Opinion, 504 Bankruptcy Reporter 97 (Bankr. E.D. Mich. 2013)]. By emphasizing these deficiencies, Judge Rhodes signaled to all interested parties that the taxpayers’ interest in essential services must be a part of the debt adjustment process.
Governmental units are becoming more susceptible to the financial problems that have been more often suffered by private sector companies.
The plan that was finally confirmed involved transferring certain assets to creditors to satisfy debts owed by the city. For example, Detroit reached a deal to pay Syncora, one of its largest creditors, a fraction of what it was owed while providing rights to city property and an extension of the company’s lease to operate the Detroit-Windsor Tunnel (Alisa Priddle, Matt Helms, Nathan Bomey, and Brent Snavely, “Detroit Bankruptcy Breakthrough: Syncora Reaches Agreement with City on Debt,” Detroit Free Press, Sept. 9, 2014, http://on.freep.com/2lTbGDE). Financial Guaranty Insurance Company, another creditor that was owed more than $1 billion, settled for about 13 cents on the dollar plus rights to develop the Joe Louis Arena waterfront property into a massive hotel development (Mary Williams Walsh, “Detroit in Deal with Its Biggest Holdout Creditor in Bankruptcy Case,” New York Times, Oct. 16, 2014, http://nyti.ms/2lTrk25). While the goal of providing essential services to residents may have been preserved, some of the other benefits expected by residents of a major city will now be privatized, and the economic impact of this change will take time to assess (Christine Sharlata Chung, “Municipal Bankruptcy, Essential Municipal Services, and Taxpayers’ Voice,” Widener Law Journal, April 2015, http://bit.ly/2n1VLon).
Some of the more immediate short-term impacts of the Detroit’s bankruptcy filing were to neighboring cities like Kalamazoo and Saginaw; both cities decided to delay planned securities offerings in the wake of Detroit’s bankruptcy filing (Emily Freeman, “Kellogg Home Is Second Michigan Issuer to Delay Bond Sale,” Bloomberg, Aug. 6, 2013, http://bloom.bg/2mSY7cu; John Gallagher, “Saginaw Is Third Michigan Community in a Week to Withdraw Bond Sale,” Detroit Free Press, Aug. 8, 2013). City planners for places like Kalamazoo and Saginaw may have found the delays to be more than just a minor nuisance.
In a related matter, the territory of Puerto Rico has no laws with regard to municipal bankruptcy. The U.S. Congress has yet to come up with a debt restructuring option for the troubled island territory, which owes its creditors $72 billion (Jack Casey, “Lew’s Pitch for P.R. Bankruptcy Doesn’t Sway Hatch,” Bond Buyer, Jul. 29, 2015, http://bit.ly/2micZzm). In an apparent effort to provide some relief to its municipal units, on June 28, 2014, Puerto Rico enacted the Public Corporation Debt Enforcement and Recovery Act, which was loosely based on Chapter 9 of the Bankruptcy Code. The act permitted Puerto Rico’s power authority, highway authority, and water authority to adjust their debts without the consent of all creditors. On July 6, 2015, however, the federal Court of Appeals for the First Circuit held that section 903(1) of the Bankruptcy Code expressly prohibits all states, including Puerto Rico, from enacting laws that prescribe a method of composition that discharges debts (Lorraine McGowan and Douglas Mintz, “First Circuit Rules Bankruptcy Code Preempts Puerto Rico’s Recovery Act,” Distressed Download, Jul. 8, 2015, http://bit.ly/2lAJ473). As a result, Puerto Rico continues to look for another way to solve its financial crisis.
In June 2016, Congress passed and President Obama signed into law the Puerto Rico Oversight, Management, and Economic Stability Act (Promesa), which provides Puerto Rico with a legal framework for restructuring its massive debt (Patricia Guadalupe, “Here’s How Promesa Aims to Tackle Puerto Rico’s Debt,” NBC News Latino, June 30, 2016, http://nbcnews.to/2lTqCGJ). Promesa tackles Puerto Rico’s debt through the creation of a fiscal control board that is not accountable to the island’s government and would have control over Puerto Rico’s budget, laws, financial plans, and regulations. The board, a seven-member body, has the power to force the island government to balance its budget and can force a restructuring with bondholders and other creditors if an agreement is not reached. In addition, Promesa also allows for the federal minimum wage to be lowered to $4.25 an hour for island workers 24 years old and under. Similarly, the U.S. Labor Department’s new rule on overtime pay for salaried workers would also not apply to Puerto Rico. Despite lawmakers’ reservations, Promesa is the next best thing to bankruptcy for Puerto Rico.
Managing the Risk
A creditor relationship with a governmental unit does not insulate creditors from the risk of nonpayment. Indeed, governmental units are becoming more susceptible to the financial problems that have been more often suffered by private sector companies. When a business recession creates financial difficulties for municipalities, prudent investors and creditors can protect themselves from losses by analyzing the financial statements and related disclosures of municipal units. Auditors can do their part in alerting investors, creditors, and officers of the troubled unit of a going concern problem. In this respect, auditors are not required to forecast a going concern problem; instead, they should base their opinions on matters arising in the audit that raise substantial doubt about the entity’s going concern status. Such conclusions require auditors to provide an explanatory paragraph after the auditor’s opinion.
When financial problems abound, fiscally troubled units have various alternatives to deal with the problems, including a merger with an adjoining governmental unit or a Chapter 9 petition for bankruptcy protection. CPAs whose clients do business with municipal units should be familiar with the basic provisions of Chapter 9 and ready to advise their clients should those units experience insolvency.