Legal Alert Adjustment of Debts of a Municipality: Chapter 9 Summary

Authored By SUSAN E. TRENT

As most of the country knows, Detroit filed for chapter 9 bankruptcy protection on July 18, 2013.  With Detroit’s proximity to Northeast Indiana, many clients have contacted this firm expressing an interest in just what happens in a chapter 9 bankruptcy.  Given the magnitude of the Detroit bankruptcy filing, there is no doubt that new substantive and procedural ground will be broken; however, this Legal Alert provides an outline of what generally happens in a chapter 9 case.

Chapter 9 of the Bankruptcy Code provides for adjustment of debt of municipalities (which includes cities and towns, villages, counties, taxing districts, municipal utilities, and school districts).  The first municipal bankruptcy legislation was enacted in 1934 – during the Great Depression.  Municipal bankruptcies are very rare.  Since 1934, there have been approximately 500 cases filed.  The purpose of a municipal bankruptcy is to provide the municipality protection from creditors while it adjusts its debt obligations.

News outlets have reported that Detroit may seek to sell assets – including fine works of art, parks, stadiums, etc.  However, unlike other chapters of the Bankruptcy Code, Chapter 9 does not clearly provide for distribution of the proceeds of any such sale to creditors.   When a chapter 9 petition is filed the bankruptcy judge is not automatically assigned by the clerk of courts; instead, the chief judge for the Federal Court of Appeals for the local Circuit designates the bankruptcy judge.  In this case, the Detroit case has been assigned to a 28-year veteran of the bench, Judge Steven W. Rhodes, from the Eastern District of Michigan.

The court’s power is limited by §§ 903 and 904 of the Bankruptcy Code.  The point of these provisions is to ensure that the Court does not substitute its control over the political or governmental affairs or property of the municipality for that of state and the elected officials.

Creditors have less ability to participate in the chapter 9 bankruptcy process.  For example, unlike in a chapter 11 where a creditor can propose a competing plan of reorganization following expiration of the exclusivity period, creditors cannot propose competing plans in a chapter 9.

In order to confirm a plan under chapter 9 of the Code, a sufficient number of claimants must accept the plan (Detroit creditors are estimated to number 100,000), and the municipality must demonstrate the following:

  • The plan complies with the Bankruptcy Code;
  • The plan complies with the provisions of chapter 9;
  • All amounts paid by the Debtor for services and expenses are fully disclosed and reasonable (Judge Rhodes has already sought to appoint an examiner in the Detroit case to look at these issues);
  • The Debtor is not prohibited by law from taking any action necessary to carry out the plan;
  • Any regulatory or electoral approval necessary under non-bankruptcy law has been obtained; and
  • The plan is in the best interest of creditors and is feasible.

The best interest test under chapter 9 is different than the test under chapter 11.  Under chapter 11 (business reorganization), a plan is in the best interest of creditors if creditors receive as much as they would have if the debtor was liquidated.  In a chapter 9 bankruptcy, the test generally measures whether the plan presents a better alternative than is otherwise available given a reasonable effort to reorganize.  A municipal debtor ultimately receives a discharge after confirmation of the plan and deposit by the municipality of any consideration to be distributed under the plan and a court determination of the validity of any securities to be issued.

A discharge can be revoked if fraud in the procurement of the discharge can be demonstrated.  According to current news reports, a plan for Detroit is anticipated to be filed by year end 2013.

As with any other bankruptcy, creditors will be precluded from collecting pre-petition debts and will have the opportunity to file proofs of claim.  Detroit will be able to assume favorable contracts and reject unfavorable contracts.  Similarly, collective bargaining agreements may also be assumed or rejected.  Trade vendors will be able to continue to do business with Detroit – but should be careful in doing so.  If you are a Detroit creditor, trade vendor, etc., legal counsel can help you assess your options.  Rothberg Logan & Warsco can also assist you in locating experienced, local Michigan bankruptcy counsel.

The Detroit bankruptcy case is already historic in terms of size and scope.  New precedent concerning substantive and procedural bankruptcy issues will certainly result – impacting many future chapter 9 filings in the United States.

Dated:  August 2, 2013

RLW Bankruptcy Section

Update:  Republican Senator Ed Charbonneau of Valparaiso is pushing a measure next year that will allow Indiana local governments to file for chapter 9 bankruptcy relief.  Currently, only 28 states allow chapter 9 filings under various conditions.  Dated: August 3, 2013. (as reported in the Indianapolis Business Journal).

The Legal Alert is for general information purposes only, and is not intended as legal, tax or accounting advice or as recommendations to engage in any specific transaction and does not purport to be comprehensive.  Under no circumstances should any information contained in this Legal Alert be used or considered as an offer or commitment, or a solicitation of an offer or commitment, to participate in any particular transaction or strategy.  Any reliance upon any such information is solely and exclusively at your own risk.  Please consult your own counsel, accountant or other advisor regarding your specific situation.   Rothberg Logan & Warsco LLP will not be responsible for any consequences of reliance upon any opinion or statement contained here, or any omission.