Eligibility Issues in Chapter 9 Municipal Filings

09.11.2013

Although bankruptcy filings may be down as a whole, Chapter 9, which provides for the reorganization of a municipality’s debt, is seeing an increase in filings.  Since January 2010, 37 municipalities have filed for Chapter 9 bankruptcy protection, including the City of Detroit, the largest municipality to file for bankruptcy in United States history.  In comparison, from 2006 until the end of 2009, there were only 27 filings under Chapter 9 of the Bankruptcy Code.

One of the most hotly litigated aspects of a Chapter 9 filing is whether the debtor is eligible to file bankruptcy under Chapter 9.  If the debtor is found to be ineligible for Chapter 9, the case may be dismissed.  There are five requirements that an entity must meet in order to be eligible to file for protection under Chapter 9:

(1) the entity must be a municipality, as defined in 11 U.S.C. § 101(40);

(2) the entity must be specifically authorized to be a debtor under Chapter 9.  Authorization may be given by state law or by a governmental officer/organization empowered by state law to give such authorization;

(3) the municipality must be insolvent, as defined in 11 U.S.C. § 101(32)(C);

(4) the entity must desire to effect a plan to adjust its debts;

(5) the entity must either:

(A) obtain the agreement of a majority (in amount) of creditors in each class that the municipality intends to impair under its plan;

(B) negotiate in good faith with creditors, but fail to obtain the requisite agreement referenced in subsection (A);

(C) be unable to negotiate with creditors because negotiation is impracticable; or

(D) reasonably believe that a creditor may attempt to obtain a preferential transfer.

See 11 U.S.C. § 109(c).

In the Detroit bankruptcy case, approximately 109 objections to the city’s eligibility were filed.  Although it initially appeared that the majority of the eligibility litigation would be based on Detroit’s plan to modify pension obligations, Judge Rhodes, who is overseeing the Detroit bankruptcy case, ruled in August that he will not consider any objections that allege that Detroit is ineligible merely because there is a possibility that pensions will be impaired.

Although in some cases, like the Stockton California bankruptcy case, trials on eligibility issues are set for several months out, in the hope that it will allow the parties sufficient time to negotiate a satisfactory resolution, Judge Rhodes set the hearings on Detroit’s eligibility on an aggressive timetable, much like that in the Central Falls, Rhode Island bankruptcy case.  The hearing on Detroit’s eligibility is split into two phases.  On September 18, 2013, a mere two months after the petition date, Judge Rhodes will hear arguments on the constitutionality of the Detroit bankruptcy.  On October 23, 2013, Judge Rhodes will hear the factual objections to eligibility, i.e., whether the city meets the requirements of section 109(c).  Only if Judge Rhodes rules that Detroit is eligible to be a debtor in Chapter 9, will Detroit be able to attempt to restructure its crushing debt.  While many Chapter 9 filings involve litigation over eligibility questions, the stakes are quite high in the Detroit case.  The repercussions of the decision will be significant as many financially strapped municipalities could find themselves seeking Chapter 9 protection in the months and years to come.