Overview of Chapter 9 Bankruptcy

The types of bankruptcy that people are most familiar with are those used by individuals.  These typically include Chapter 7 to discharge many debts entirely and Chapter 13 to reorganize debts into an affordable payment plan.  But the type of bankruptcy getting the most attention in the media in recent months is a Chapter 9 bankruptcy.

This article provides an overview of what a Chapter 9 bankruptcy is, who uses it, and how it affects individuals.

Chapter 9: Municipality Bankruptcy

A Chapter 9 bankruptcy is known as a municipality bankruptcy.  Municipalities include towns, cities, counties, tax districts, school districts, and other service-providing bodies paid for by users of those services rather than taxes.

Chapter 9 allows a municipality to reorganize its debts, much as a Chapter 13 bankruptcy allows individuals to reorganize their debts.  Chapter 9 bankruptcy provides the municipality a stay against actions to collect debts owed, allowing the municipality time to create a reorganization plan so that it can continue to operate.

As with a Chapter 13 bankruptcy, reorganization of a municipality’s debts under a Chapter 9 bankruptcy is typically a combination of extending the date by when debts must be paid; refinancing a debt with more favorable terms; and reducing the amount of principle, interest, or both owed on a particular debt.

Bankruptcy Court Powers

In general, the powers of the bankruptcy court are much more limited in a Chapter 9 bankruptcy than they are when dealing with the bankruptcy of an individual.  The main purpose of the bankruptcy court in a municipality bankruptcy is to ensure the reorganization plan is reasonable given the financial position of the municipality.

A municipality may choose to liquidate certain assets as part of a Chapter 9 bankruptcy in order to help pay debts owed.  However, a bankruptcy court does not have the power to force a municipality to liquidate assets as does the court or trustee in an individual bankruptcy.  The Tenth Amendment to the United States Constitution enforces this limitation of a bankruptcy court’s power concerning municipalities.  The Tenth Amendment gives states the power to make decisions not explicitly granted to the federal government.  The choice to sell a municipality’s assets is one such decision reserved for states even in the midst of a bankruptcy.

In addition, the bankruptcy court cannot interfere with actions made by the municipality to continue to operate, even when such decisions might be ones a bankruptcy court or trustee would not permit an individual to make.  For example, if a municipality needs additional funds to continue to operate, the municipality may borrow money to obtain those funds even though it is in a Chapter 9 bankruptcy.  The bankruptcy court does not have the power to prevent this action, only to review the terms of a new loan and any other loans as a part of the reorganization plan as a whole to ensure those terms are reasonable.

Chapter 9 Qualifications

For a municipality to use Chapter 9 bankruptcy, the municipality must not have the financial capability to pay the debts it owes and must have the willingness to reorganize its debts.  In addition, the municipality must obtain approval of the reorganization plan by the creditors owed at least half of each type of debt being reorganized.

Impact of Chapter 9 Bankruptcy

Typically creditors and bankruptcy courts have proven to have little power when it comes to municipality bankruptcy.  While there may not be clear-cut examples where a municipality has abused this fact, creditors in the end may not have much choice but to accept the reorganization plan proposed by the municipality as reviewed by the bankruptcy court.

In the event creditors do not accept a reorganization plan, the only alternative may be for the municipality to dissolve.  Given the importance of services that municipalities provide to individuals, this is typically not a viable option.

Unfortunately, one of the main drivers of recent municipality bankruptcies is the funding of pensions.  This is where individuals feel the main impact of Chapter 9 bankruptcies, as the reorganization may completely defund pensions and leave those counting on those monies for retirement with a greatly lessened benefit.

The question of how municipalities can treat pensions in Chapter 9 bankruptcies is likely a matter that will be reviewed in the United States Supreme Court at some point in the future.

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Mark has been a contributor to legal web sites related to bankruptcy, tax, and criminal law since 2011. He has an Accounting degree from Texas A&M University.