The Basics of Chapter 9 Bankruptcy

The U.S. Bankruptcy Code is the collection of federal laws that govern American bankruptcy. Many people and businesses use these laws each year to get debt relief. Chapter 9 of the Bankruptcy Code outlines the bankruptcy laws and procedures for municipalities, such as cities, townships, and school districts. 

This article covers what Chapter 9 bankruptcy entails and how it compares to other kinds of bankruptcies. We’ll also look at the widespread effects of municipal bankruptcy and review some of the most well-known recent Chapter 9 filings.

Understanding Chapter 9 Bankruptcy 

Chapter 9 of the Bankruptcy Code extends federal bankruptcy rights and protections to municipalities. The code’s definition of municipality includes: 

• Towns

• Cities

• Villages

• Counties

• Political subdivisions

• Taxing districts

• School districts

• Municipal utilities 

In some ways, Chapter 9 relief resembles Chapter 13 personal bankruptcy. Like Chapter 13, Chapter 9 protects municipalities from their creditors and allows them to create plans to reorganize their debts. Just as someone who files bankruptcy can continue to work while their bankruptcy is pending, municipalities that file Chapter 9 cases continue to carry out basic government functions during this period of debt restructuring.

Congress enacted the first municipal bankruptcy laws in 1934 during the Great Depression. The Supreme Court struck that version down, though, because it violated the 10th Amendment to the Constitution, which says that powers not given to the federal government belong to the states. 

In 1937, Congress passed a revised version of the Municipal Bankruptcy Act. This time, they were careful not to overstep federal boundaries or interfere with the 10th Amendment’s state sovereignty rights. The Supreme Court upheld the new law, and it remains in effect today. Still, Chapter 9 filings are rare. Since the law was passed in 1937, fewer than 700 Chapter 9 cases have been filed. By contrast, around 290,000 Chapter 13 cases and 480,000 Chapter 7 cases are filed each year, based on statistics from recent years. 

States have the ultimate authority over their municipalities’ Chapter 9 rights. In addition to the federal eligibility rules, a municipality must have permission from its state government to file a Chapter 9 bankruptcy. Each state has its own rules for when a municipality may file. In some states, municipalities are free to file bankruptcy at any time. In other states, municipalities get the state’s permission to file bankruptcy first. Some states don’t allow municipalities to file Chapter 9 bankruptcy at all.

Chapter 9 vs. Other Chapters of the Bankruptcy Code 

Under the Bankruptcy Code, both Chapter 9 and Chapter 11 give debtors the chance to negotiate with their creditors to change the terms of their debts. Both chapters also require debtors to create a reorganization plan for their debts going forward. 

The most important difference between Chapter 9 and Chapter 11 is that Chapter 9 is only available to municipalities. Chapter 11 bankruptcy is primarily used by businesses, although individuals can file Chapter 11 cases under rare circumstances. The other key differences between Chapter 9 and Chapter 11 are mostly related to the state sovereignty rights involved in Chapter 9 cases. 

While a bankruptcy court has broad powers to oversee cases filed under Chapter 11 and other chapters, the court’s powers are much more limited in Chapter 9 cases. Because of the 10th Amendment, a bankruptcy court can’t make spending or policy decisions on behalf of a municipality or order the liquidation (sale) of assets like in other types of bankruptcies. In a Chapter 9 case, the bankruptcy court can only:

• Approve or deny the municipality’s bankruptcy petition,

• Confirm the municipality’s plan for reorganizing its debts, and

• Ensure that the repayment plan is carried out correctly.

As a result, municipal debtors in ongoing Chapter 9 bankruptcies have much more authority over their finances and functions than a debtor in any other chapter of bankruptcy. For example, a municipal debtor doesn’t need to get court approval to lease or sell its property while the bankruptcy case is ongoing. 

Also, a municipal debtor can rewrite or reject collective bargaining agreements (union contracts) without seeking approval from the union or the bankruptcy court, even though doing so could have a big impact on public employees’ pensions and other benefits. For municipalities, this is one of Chapter 9’s most important benefits. Unsustainable retiree plans and union agreements are among the top reasons that municipalities file for Chapter 9 bankruptcy relief.

Chapter 9 Eligibility

To be eligible to file a Chapter 9 bankruptcy, a debtor must be a municipality or instrumentality of a state, as defined by the Bankruptcy Code. States aren’t considered municipalities, and state governments can’t file Chapter 9. In addition, to have its bankruptcy petition approved, a municipality must:

• Have permission from its state government to file Chapter 9,

• Have debts that it can’t reasonably afford to pay (in other words, be insolvent),

• Have a workable plan to adjust those debts, or at least be willing to create a reorganization plan, and

• Have made, or be willing to make, a good-faith effort to work with its creditors to reach an agreement about how to reorganize its debts.

How Chapter 9 Bankruptcy Protection Works

Depending on a municipality’s state laws, it might have to take certain steps to get state permission to file bankruptcy. When a municipality has permission from its state government, it can file a petition for relief under Chapter 9 of the Bankruptcy Code. To file a petition, the municipality must file all necessary paperwork with the clerk of the bankruptcy court for the district where the municipality is located.

Automatic Stay

Like all other chapters of bankruptcy, filing a Chapter 9 petition triggers an automatic stay. This stops all collection actions against the municipality. In some cases, the automatic stay also stops collection actions against municipal officials and officers. Stopping these collection efforts gives the municipality a little breathing room to evaluate its finances and figure out the best plan for reorganizing its debts and moving forward. 

Petition Review

When a municipality files a Chapter 9 petition, the bankruptcy judge assigned to the case reviews the petition. If all the eligibility requirements have been met, the judge will likely approve the petition, and the case can move forward. If the municipality hasn’t met all the requirements under Chapter 9 and state law, the judge may deny the petition. The judge can also deny the petition if the judge determines that the municipality has better options available to resolve its debt situation.

Reorganization Plan

If the judge allows the case to proceed, the municipality creates a plan to reorganize its debts and repay its creditors. The municipality has lots of freedom to negotiate with its creditors in this regard. Distressed municipalities often reorganize their debts by taking one or more of these actions:

• Extending the length of the loan term so that the regular payment amount is less.

• Reducing the principal amount owed on the debt.

• Lowering the interest rate on the debt.

• Refinancing the debt — in other words, taking out a new loan with better terms to pay off the old loan.

The municipality submits its reorganization plan to the court. The bankruptcy judge reviews the plan to confirm that the plan meets all the requirements of Chapter 9, is feasible, and isn’t violating any laws. From a bankruptcy court standpoint, the case is generally complete when the judge confirms the reorganization plan. 

Depending on the amount of debt, the number of creditors, and the complexity of the issues, a Chapter 9 bankruptcy could be completed within a few months, or it could take several years. This doesn’t include the time it takes to carry out the confirmed plan and repay all the debt.

Statewide Effects of Municipal Bankruptcies

For people who live in a city or town that files for Chapter 9 relief, the bankruptcy may not seem to cause any noticeable effects. Schools stay open, and the fire department and police still respond to emergency calls. It can often take years to see the reorganization’s effects.

Even though things may initially appear the same, a municipal bankruptcy often has big consequences. A municipal bankruptcy can improve a municipality’s financial situation. In many cases, it’s what allows local services to keep operating. But bankruptcy can also damage a municipality’s credit rating and reputation and make it hard to recruit new businesses. These municipal consequences often ripple through the surrounding communities and across the entire state.

The state’s credit rating, for instance, can be downgraded because of a municipal bankruptcy filing. Municipalities often rely on municipal bond investors to help finance public works projects, and Chapter 9 filings may seriously hurt a region’s municipal bond market. In 2011, to prevent this effect, the Rhode Island legislature passed special revenue laws just before the city of Central Falls, Rhode Island, filed a Chapter 9 bankruptcy. These laws gave bondholders liens on the city’s incoming tax money. The special laws helped Rhode Island avoid the collapse of its municipal bonds market and maintain a good credit rating.

A municipal bankruptcy can also result in the need for other state action. In the case of Central Falls, the state of Rhode Island had to take on the responsibility of naming a state receiver. The receiver took over for the local government to oversee the city’s finances until the bankruptcy was complete.

Some Notable Chapter 9 Bankruptcies...

The Central Falls, Rhode Island, bankruptcy is memorable for the state’s actions, but Central Falls is far from being the most noteworthy Chapter 9 bankruptcy case in past decades. Other significant Chapter 9 cases include:

• Detroit, Michigan: In 2013, Detroit filed what remains the biggest municipal bankruptcy in U.S. history, in terms of debt. The city had been declining for years and didn’t have enough cash flow to pay its ongoing expenses or fund its pension obligations. Experts estimate that Detroit filed for Chapter 9 with around $18-$20 billion in municipal debt.

• Jefferson County, Alabama: A massive sewer system makeover put the county deeply in debt. After panicked officials became involved in a major bribery scandal with JPMorgan, the county filed bankruptcy in 2011 with over $4 billion in debt.

• Vallejo, California: Vallejo was facing a budget deficit caused by pension obligations and expensive labor contracts. Labor leaders refused to negotiate, so the city filed for bankruptcy in 2008.

• Prichard, Alabama: Prichard experienced a sharp decline in the city’s population and tax revenues and stopped paying into the public pension fund. Funds ran out, and the city filed for bankruptcy in 1999 and again in 2009.

• Orange County, California: Facing budget deficits, the county tried to solve its financial problems by making risky investments with county funds. The market fell, leaving the county with $1.7 billion in investment losses. Orange County filed for bankruptcy in 1994.

Let’s Summarize...

Chapter 9 bankruptcy offers relief for struggling municipalities. Chapter 9 shields them from their creditors while allowing them the chance to create plans for reorganizing their debts. Relief under Chapter 9 is only available to municipalities. State governments can’t file for Chapter 9 protection.

Bankruptcy courts have a much smaller role in Chapter 9 cases than in other kinds of bankruptcies. This is because of the states’ sovereign immunity rights guaranteed by the 10th Amendment. In a Chapter 9 case, a bankruptcy judge can’t make spending decisions or force the sale of assets. Under Chapter 9, municipalities have broad authority to reorganize their debts, especially debts related to pensions and labor unions. Chapter 9 filings are rare but often have lasting effects on communities and states.