By Scott Blakeley, Esq. & David M. Mannion, Esq.

Scott Blakeley, Esq.

Trade creditors can no longer assume that trade credit extended to a municipality is risk free. Bankruptcies filed under Chapter 9 of the Bankruptcy Code, which allows municipalities to discharge debts and reorganize, are becoming more common as the financial crisis continues to affect counties, cities, and agencies. Even the propriety of a State being eligible to file Chapter 9 is being debated. This article considers the recent headlines of the debate of a municipality evaluating a Chapter 9 filing, a Chapter 9 in action, and the impact of trade creditors extending credit. The article also considers the federal debate of States being eligible to file Chapter 9. The article also considers whether the trade creditor should reevaluate the amount of their credit lines to municipalities and public agencies, as well as the percentage of their accounts they have with these agencies.

A State in Bankruptcy?
Rarely has the topic of bankruptcy captured the attention of the public in the same way as the debate concerning a possible State bankruptcy scheme. With States laboring under the weight of bloated deficits and unsustainable public compensation schemes, coupled with a growing sense of frustration among private sector constituents who have been hit hard by the recession, a perfect storm has been brewing.

Hamstrung by the uncompromising demands of public sector unions, several State Governors have mentioned the unmentionable as a possible way of resolving their fiscal woes. Whether such statements are made in earnest or for the purpose of political posturing is difficult to tell.

There is a valid concern in some quarters that the mere talk of enacting State bankruptcy legislation could, in and of itself, create a real need for such a scheme by precipitating volatility in the muni-bond market and jeopardizing indispensable relationships between States and their contractors and creditors. This understandable reluctance to discuss the topic should cause creditors to at least consider the possibility that State bankruptcy legislation will be passed with little public forewarning.

If a state bankruptcy scheme were enacted tomorrow, it could be at least two years before it had any effect.

Unfortunately, from a legal perspective, the road to State bankruptcy is paved with nothing but uncertainty. For a start, it is questionable whether the federal government possesses the power to enact a State bankruptcy scheme. At a minimum, if such legislation is enacted, an avalanche of constitutional challenges will be inevitable. At this point it is worth noting that the pending lawsuits challenging the constitutionality of President Obama's healthcare reform were filed in March 2010. Now, almost a year later, the issue has yet to reach a federal court of appeals and, in the final analysis, will almost certainly be resolved by the Supreme Court. When that will happen is anybody's guess. The question also arises whether, if Congress did enact a State bankruptcy scheme, the courts would stay the implementation of the legislation pending a determination of its constitutionality. In other words, if a State bankruptcy scheme were enacted tomorrow, it could be at least two years before it had any effect (or, at least, any of the effects intended by its enactment).

Key Points in this Article It is questionable whether the federal government possesses the power to enact a State bankruptcy scheme. At a minimum, if such legislation is enacted, an avalanche of constitutional challenges will be inevitable. Nationwide, public pension fund deficits are estimated to be between $1 trillion to nearly $4 trillion, with California alone accounting for an estimated $500 billion. In 45 states, taxes and fees are bringing in less than they did a year ago, and 24 states made budget cuts greater than 5%. There is additionally a cumulative state $108.7 billion budget gap projected for 2010. These unsettling statistics raise concerns for the credit professional about risk free credit extensions. Another factor contributing to many municipal budget gaps is the disparity between state government and private wages and pensions. The state and local government average wage is almost $6 per hour higher than the private sector. The disparity is largely due to the $3.23 state and local governments award their workers in pension and saving plans, compared to 94 cents in the private sector. Chapter 9 includes cities, counties, school districts, hospitals, sanitary districts, and port or highway authorities. A municipality may not be a Chapter 7 or Chapter 11 debtor, nor may an involuntary bankruptcy be commenced against a municipality. County and city budget shortfalls raise issues that should cause credit executives throughout the country to re-evaluate the amount of their credit lines to these public agencies, as well as the percentage of their accounts they have with these agencies. Scott Blakeley, Esq.

The position of State contractors, bond-holders, employees, and others is unenviable. Right now, there are probably more questions than answers surrounding the topic. However, it is important to try and maintain a sense of perspective. Many have noted that the problems facing the States -- and, indeed, the wider economy -- are cyclical rather than cataclysmic. Last Wednesday, February 9, at the first of a series of hearings convened by a House Oversight and Government Reform sub-committee to address the problems presented by State and local debt, Iris Lav of the Center on Budget and Policy Priorities noted that historical default rates have been at one-third of one percent since the 1970s and only one State defaulted during the Great Depression (Arkansas). Doomsday predictions are understandable in times like these.

Certainly, at least for now, interested parties would do well to view the state bankruptcy specter from a political rather than legal perspective. Representative Lamar Smith (R-Texas), chairman of the House Judiciary Committee, expressed his concerns that "a state bankruptcy option may actually encourage states to borrow more money, knowing that they could later restructure their debt in bankruptcy" and "borrowing would be at higher interest rates for all states because lenders would justifiably charge a price for the risk of state bankruptcy." Such statements, particularly by senior members of the Republican administration which appears to be in the ascendancy on the tedious political pendulum that swings between Democrats and Republicans, should be closely watched as signs of what may be coming.

However, at least for now, common-sense business judgment and risk management are more appropriate than panic, and conducting business with the states probably remains a challenge more suitably addressed by business-people than lawyers. That being said, Chapter 9 of the Bankruptcy Code filings by certain municipalities provides some insight into the possible contours of a similar scheme for the States, and how it may impact the trade creditor.

The State of Municipal Debts
The City of Vallejo, California, is one of the few municipalities to actually file Chapter 9 bankruptcy since the financial crisis began. Although Vallejo cut its police force, youth programs, and development plans, it is still struggling to break even. As it prepares to emerge from its two year long bankruptcy, the city must deal with a problem facing many municipalities across the nation: pensions.

Currently, both present and future pension liabilities amount to one of the largest problems for municipalities. Nationwide, public pension fund deficits are estimated to be between $1 trillion to nearly $4 trillion, with California alone accounting for an estimated $500 billion. Many states treat pensions as vested rights, and therefore are not subject to unilateral termination or modification. As such, most efforts to decrease or adjust pension obligations outside of Chapter 9 are unsuccessful. The question of how to treat pension liabilities under Chapter 9 has yet to be answered, as municipalities filing for bankruptcy have avoided addressing such politically-charged issues.

Many states treat pensions as vested rights, and therefore are not subject to unilateral termination or modification.

Although the pension agreements are valid contracts, the Vallejo bankruptcy judge stated that Vallejo had the authority to void its existing union contracts, in an effort to create a feasible post-bankruptcy work out plan. What are some of the factors that are contributing to the budget shortfalls? Can these factors be considered by the credit professional as factors in measuring credit risk of a municipality and public agency?

In 45 states, taxes and fees are bringing in less than they did a year ago, and 24 states made budget cuts greater than 5%. There is additionally a cumulative state $108.7 billion budget gap projected for 2010. These unsettling statistics raise concerns for the credit professional about risk free credit extensions.

Key Definitions Automatic stay - An automatic stay is an injunction filed immediately after a bankruptcy petition is filed which prohibits lawsuits, foreclosures, and all other collection activities against the debtor/filer. Upon the filing of a Chapter 9, an injunction, or automatic stay, goes into effect prohibiting creditors from taking any action against a municipality's property without first obtaining relief from stay. For trade creditors, the automatic stay enjoins lawsuits to collect on pre-petition obligations. Bar date - Is the date by which a bankruptcy claim must be filed with the bankruptcy clerk. In Chapter 11 cases, the court sets the bar date for filing proofs of claim and notice of such deadline must be given to all creditors and interested parties. Chapter 9 - Chapter 9 of the Bankruptcy Code provides for municipalities to obtain bankruptcy protection, with the primary purpose to permit debt adjustment. Debtor eligible for Chapter 9 include any state-sponsored or state-controlled entity that raises revenues through taxes or user fees to fund public projects, including cities, counties, school districts, hospitals, sanitary districts, and port or highway authorities. It is the public sector's equivalent to Chapter 11. A municipality may not be a Chapter 7 or Chapter 11 debtor, nor may an involuntary bankruptcy be commenced against a municipality. Cram-down - A cram-down plan provides for the confirmation of a plan of adjustment (a chapter 9's version of a plan of the chapter 11 plan of arrangement) over the objections of one or more creditor classes. Plan of Adjustment - A plan of adjustment is the method under Chapter 9 of the Bankruptcy code by which a municipality or other state entity discharges its pre-petition obligations and provides the method for repayment of its obligations. Chapter 9 imposes several conditions on a municipality for its plan to be confirmed, including that the amounts paid by the municipality under the plan are reasonable; that all post-petition administrative claims be paid in full; and, perhaps most importantly, that the plan is in the best interest of creditors.

Another factor contributing to many municipal budget gaps is the disparity between state government and private wages and pensions. The state and local government average wage is almost $6 per hour higher than the private sector. The disparity is largely due to the $3.23 state and local governments award their workers in pension and saving plans, compared to 94 cents in the private sector. The government also spends $2 more on health benefits than the private sector.

In addition to the wage disparity, "swap" debts are also contributing to budget crises. Many municipalities took out relatively long term loans with variable interest rates that were expected to stay stable, rather than drastically increase. The creditors and municipalities did not foresee a tumbling economy, and when the market fell, interest rates rose. One of the more dire examples of this type of loan is occurring in Jefferson County, Alabama. The swaps were supposed to make the county's debt more manageable, but instead are forcing it to the brink of bankruptcy -- over $4 billion in debt.

Many states, counties, and cities are constructing new ways to raise revenue, without taxing. Multiple cities have started charging large fees for fire and ambulance services rendered at the scene of accidents, though some exempt residents from payment. Multiple localities have also started citing motorists under local ordinances, rather than state vehicle codes, which directs any fine paid to the local government rather than the state. Some states are starting to look into collecting online shopping taxes, a lucrative area that has managed to fly under the radar since its advent. About a dozen states have considered legislation that would require online retailers to collect taxes based on their online sales; however, only a few of these bills have passed.

Although many municipalities are creating clever ways to avoid bankruptcy, a Chapter 9 filing is not a risk vendors can ignore. After a Chapter 9 filing, the debtor commonly reviews its vendor lists to determine which vendors are critical to keep those vendors that provided goods and services necessary to maintain the health and safety of its inhabitants. Those vendors not found to furnish such critical goods and services may have their agreements terminated or postponed indefinitely.

The Chapter 9 Debtor
Chapter 9 of the Bankruptcy Code provides for municipalities to obtain bankruptcy protection, with the primary purpose to permit debt adjustment. The definition of an eligible Chapter 9 debtor encompasses any state-sponsored or state-controlled entity that raises revenues through taxes or user fees to fund public projects. As such, Chapter 9 includes cities, counties, school districts, hospitals, sanitary districts, and port or highway authorities. Chapter 9 is the public sector's equivalent to Chapter 11. A municipality may not be a Chapter 7 or Chapter 11 debtor, nor may an involuntary bankruptcy be commenced against a municipality.

Chapter 9 is the public sector's equivalent to Chapter 11.

A condition for Chapter 9 eligibility is that the municipality be insolvent, based on whether the municipality is generally able to pay its debts as they become due. A basic principle of Chapter 9 is that the municipality continues operations while it reorganizes its affairs and adjusts its debts through a "plan of adjustment." From the viewpoint of a creditor or the bankruptcy court, Chapter 9 is a "hands-off" reorganization, as neither the bankruptcy court nor creditors may interfere with expenditures or revenues generated by the municipality.

Trade Creditors' Rights Under Chapter 9
In some regards, municipalities enjoy a greater level of protection over their operations and property that non-municipal debtors do not. Chapter 9 recognizes the sovereign power of the states derived from the Tenth Amendment of the Constitution in regards to the management and regulation of daily activities and operations of a municipal debtor. As a result, the bankruptcy court has less power over a municipal debtor than a Chapter 7, 11, or 13 debtor. For example, unlike a non-municipal debtor, a bankruptcy court cannot allow a secured creditor to force a sale of assets to satisfy a lien from a Chapter 9 debtor. Additionally, a municipal debtor does not need bankruptcy court approval to use, sell, or lease its property during the bankruptcy case.

Upon the filing of a Chapter 9, an injunction, or automatic stay, goes into effect enjoining any creditor from taking any action against a municipality's property without first obtaining relief from stay. For trade creditors, the automatic stay enjoins lawsuits to collect on pre-petition obligations.

Creditors and creditors' committees' leverage in Chapter 9 is found to be more restricted when compared to Chapters 7, 11 or 13 of the Bankruptcy Code. Chapter 9 provides for the appointment of an official creditors' committee. As with Chapter 11, those creditors holding the seven largest unsecured claims will likely qualify to serve on the committee. However, the powers and duties of a creditors' committee under Chapter 9 are more limited than under Chapter 11.

Under Chapter 11, a creditors' committee has a fiduciary duty to investigate the debtor's financial condition, which requires the committee to consult with the debtor and dig into its business affairs. Moreover, a creditors' committee under Chapter 11 has a duty to assist in the formulation of a plan of reorganization and has standing to request the appointment of a trustee or examiner. On the other hand, under Chapter 9, the municipality has complete control over its operations and a creditors' committee is greatly restricted in its involvement in the administration of the case.

In Chapter 11, the ability of a creditors' committee to seek appointment of a trustee or examiner is one of the most important weapons it holds against untrustworthy or highly incompetent management. However, under Chapter 9, a trustee or examiner may not be appointed as the appointment would interfere with the municipality's political or governmental affairs.

Beyond the restrictions Chapter 9 imposes on the powers and duties of creditors' committees, there may be certain advantages for individual trade creditors under Chapter 9. Many of the risks associated with selling on credit to an account in Chapter 11 may not exist in Chapter 9. For example, in Chapter 11, a debtor that ultimately cannot reorganize may not be able to pay trade creditors in full for goods sold post-petition should the case convert to Chapter 7 liquidation. Likewise, a super-priority creditor, one who lends to the debtor on a secured priority basis, may prevent trade creditors who provide goods or services post-petition from being paid in full.

In contrast, Chapter 9 does not provide for the liquidation of a municipality. Moreover, as the bankruptcy court has no authority over expenditures by the municipality, post-petition operating expenses incurred in favor of trade creditors may not even qualify as an administrative expense. As the court does not supervise what debts the municipality may incur during the case, such claims should not be discharged and should remain liabilities of the municipality after confirmation of a plan.

Many of the risks associated with selling on credit to an account in Chapter 11 maynot exist in Chapter 9.

As with Chapters 7, 11 and 13, those creditors holding unsecured, non-priority claims in a Chapter 9 must file proofs of claims prior to the bar date. Should a trade creditor not timely file proof of its claim, the claim will be disallowed. Preference, fraudulent conveyance and other kinds of pre-bankruptcy transfers are avoidable in Chapter 9. The municipality holds these avoiding powers. Where a municipality refuses to pursue avoidance actions, however, a trustee may be appointed to do so.

The Plan of Adjustment
With Chapter 9, the municipality is the only party who may file a plan to restructure its obligations, referred to as a "plan of adjustment." To permit another entity, such as a creditors' committee, to file a plan of adjustment would interfere with the municipality's right to control its political and governmental affairs. Chapter 9 does not establish a deadline as to when a municipality must file its plan; rather, the bankruptcy court sets the deadline. The bankruptcy court should give a municipality sufficient time to restructure its obligations in setting a "drop-dead" date for the municipality to file its plan. Depending on the complexity of case, this time period could run from perhaps several months to over a year. Should the municipality fail to file its plan by the court-imposed deadline, the court may dismiss the case.

As with Chapter 11, a plan of adjustment is the method by which a municipality discharges its pre-petition obligations and provides the method for repayment of its obligations. Chapter 9 imposes several conditions on a municipality for its plan to be confirmed. Those conditions include the requirements that the amounts paid by the municipality under the plan are "reasonable"; that all post-petition administrative claims be paid in full; and, perhaps most importantly, that the plan is in the best interest of creditors. Prior to any vote on a plan, a municipality must first obtain bankruptcy court approval of its disclosure statement. The purpose of the disclosure statement is to provide creditors with adequate information as to their treatment under a plan. Creditors can agree to any treatment of their claims under a Chapter 9 plan. Trade creditors whose claims are affected by the plan of adjustment have standing to object.

The plan must segregate creditors' claims into classes and describe how such creditor classes are to be treated. The municipality, through the terms of the plan, may offer cash, securities or other property to trade creditors in satisfaction of their claims. A plan of adjustment may be confirmed by consent of the creditors or over the objection of one or more creditor classes. With objection by one or more creditor classes, the cram-down provisions of Chapter 11 apply. A cram-down plan provides for confirmation of a plan notwithstanding its rejection by one or more creditor classes. However, as the nature and purpose of Chapter 9 is to achieve consent between the municipality and its creditors, the likelihood of a cram-down plan is unlikely. As with Chapter 11, when the municipality's plan is confirmed, trade creditors are bound by the terms of the plan. With the confirmation order, the municipality's debts are re-structured and its pre-petition obligations discharged, pending bankruptcy court approval of the securities the municipality will offer pursuant to its plan.

Chapter 9 filings undermine the notion that public agencies always pay their obligations.

Learning From Chapter 9
For vendors that rely exclusively on a county or city for their business, a Chapter 9 filing can have a dramatic effect, throwing into question their very survival. Even vendors who do not rely directly on county contracts may feel a Chapter 9's rippling effect, as vendors relying on county dollars are unable to pay their suppliers. County and city budget shortfalls raise issues that should cause credit executives throughout the country to re-evaluate the amount of their credit lines to these public agencies, as well as the percentage of their accounts they have with these agencies.

Chapter 9 filings undermine the notion that public agencies always pay their obligations, which notion is often employed by public agencies to justify their demands that vendors accept lower profit margins on their contracts, when compared to contracts in private industry. For those vendors that rely exclusively on public agencies for their business, the threat of Chapter 9 bankruptcy filings may provide the impetus to alter their business mix and move to selling to both public agencies and private industry.

Contact info
Scott practices creditors' rights and bankruptcy law. His e-mail is seb@blakeleyllp.com. David is an associate of the New York office and also practices creditors' rights and bankruptcy law.