Filing for a Chapter 9 Municipal Bankruptcy does not automatically mean the court will grant it to a municipality.
Passed by Congress in 1937, Chapter 9 of the federal bankruptcy code allows a municipality to negotiate repayment with creditors while still providing necessary services to its residents. It stops all debt collection until a plan is proposed and voted on by creditors.
Before petitioning the court, a municipality must be authorized by state law to be able to file for bankruptcy relief under Chapter 9. There are 22 states that are not authorized through state statute to allow municipalities to file for bankruptcy.
A municipality must meet all the requirements in state law before it can petition for relief in federal bankruptcy court. Upon filing the petition, an automatic stay which halts all collection actions against the municipality is granted. During this stay, the municipality determines which creditors it can continue to pay. No claims or suits can be filed by creditors during the stay.
Filing the petition with the court does not automatically grant the municipality protection under Chapter 9. The municipality must prove that it meets all four of the court’s eligibility requirements and at least one of the creditor test requirements.
The four court eligibility requirements are:
- Must be a municipality
Does the municipality have traditional government attributes and operate under state controls?
Does the state identify it as a municipality (city, town, village, township, county, taxing district, municipality utility, municipal authority)
- Must be authorized to file for Chapter 9 Bankruptcy
The state statute must be explicit and “direct with well defined limits, so that nothing is left to inference or implication” (Chapter 9: Municipal Bankruptcy White Paper, MSU, December, 2012)
- Must be insolvent
Municipality must demonstrate that it will run out of money in the near future and be unable to pay debts as they come due.
- Must want to achieve a plan of adjustment
There is no specific test or rule so the court will accept a sworn statement from municipality indicating its intent along with evidence of efforts made to negotiate and draft a plan.
The four creditor test requirements are:
- Municipality has reached agreements with a majority of its creditors to file bankruptcy. This can be difficult if there are many creditors and most want to keep the municipality out of bankruptcy court to protect their claim.
- Municipality negotiated in good faith but failed to reach an agreement. Good faith negotiations must include negotiating terms similar to those that would be achieved under Chapter 9. This shows the court that bankruptcy is a last resort.
- Negotiations are impractical. The court defines this as causing extreme or unreasonable difficulty, such as when taking time to negotiate would result in reduced services or risk to municipal assets.
- Municipality believes that a creditor may try to obtain a preference which would result in that creditor receiving more than its fair share of the municipality’s available assets as repayment.
When a municipality has proven its eligibility, it gains access to the bankruptcy court. The court grants an order of relief and the automatic stay continues. The municipality would then develop a plan of adjustment. This is basically a revised contract between the municipality and the creditors on how the debt will be adjusted and how the municipality will be structured after bankruptcy.
The municipality’s petition could still be dismissed for cause. One reason for dismissal is the municipality did not submit its plan under the court ordered timeline.
For more detailed information on the entire Municipal Bankruptcy process, read more from Michigan State University Extension: