San Bernardino, California is in the news and may become the third California city in recent weeks to seek bankruptcy protection under Chapter 9 of the Bankruptcy Code.According to the LA Times, San Bernardino will be unable to meet its payroll and may have no option except to file for bankruptcy protection. So, what does a Chapter 9 do and how is it different from other Chapters of bankruptcy?
First, the Chapter 9 is only available for municipalities, defined in 11 USC § 101(40) as “political subdivision or public agency or instrumentality of a State.” Because of the states’ rights provisions of the 10th amendment to the U.S. Constitution, the bankruptcy code expressly restricts Chapter 9 filings such that “the municipality must be specifically authorized to be a debtor by state law or by a governmental officer or organization empowered by State law to authorize the municipality to be a debtor”. In approximately half of U.S. states, a municipality would have to apply to the legislature for the right to file a Chapter 9. Obviously, in California, which has had several high profile filings, there is no such restriction.
In a Chapter 7 or Chapter 11, there is the option to liquidate assets to pay bills, but no such option exists in a Chapter 9. A city can’t simply sell off its assets and close up shop, so what options are available? In practice, Chapter 9 is used to shield municipalities from damages in lawsuits, as in the Mammoth Lakes, California bankruptcy. It can be used to shield the municipality from its own bad investments, as in the recent Stockton, California filing. Most often, though, the chief targets of the filing are the benefits packages negotiated with public employees. Where there is pressure to lower taxes and declining property values coupled with high foreclosure rates lower the tax base, many cities are struggling to pay employees their salaries, much less pensions and ever rising health care costs. Chapter 9 permits renegotiation of those contracts.
Chapter 9 originated during the Great Depression, so it should be no surprise that it is gaining momentum in this recession. While rates of filings have only increased slightly in the past four years, larger municipalities are being affected and there is every likelihood that the trend will continue. So long as municipalities feel the pressure to balance their budgets from shrinking revenues, the temptation will exist to use the power of the courts to help cities renegotiate. From their perspective, their choices are to rewrite contracts that they can no longer afford or to cut services to their citizens.
The risks of Chapter 9 filing are that there is no guarantee that the Bankruptcy Court will approve the proposed plan and, perhaps more worryingly, that the filing can have long term implications for the municipality’s credit rating. Jobs in city government and repayment of municipal bonds have always been perceived as secure. The recent spate of Chapter 9 filings reminds us that in the current economy, those perceptions may no longer be valid.