Since June 6, when Bridgeport, Conn., became the largest city ever to file a bankruptcy petition Chapter 9 has received nationwide publicity. For the municipal bond market, bankruptcy has become a household word. Still, few understand Chapter 9's history and functioning, or what the Bridgeport case will mean for future filings. Here is an effort to shed some light on the subject. Most of the information is based on conversations with James E. Spiotto, a partner in the Chicago law firm of Chapman & Cutler; Jeffrey Cohen, a lawyer with the Denver-basedfirm Cohen & Associates; and other attorneys.
* What is Chapter 9?
Chapter 9 is the section of the federal Bankruptcy Code that allows for the reorganization of a municipality, which the code defines as a "political subdivision or public agency or instrumentality of a state."
A state could not use Chapter 9. But a city, bond-issuing authority, or other governmental entity can, so long as it is "generally authorized" by the state to do so and can prove that it is insolvent.
Under the terms of the Bankruptcy Code, that means the city has already missed payments to creditors or that it faces the prospect of doing so in the near future.
* When was Chapter 9 writte?
Chapter 9 has its origins in the Great Depression of the 1930s. It was written in 1934, when cities across the country were suffering financially. At the time it was called Chapter IX.
Chapter IX was declared unconstitutional in 1936, because it interfered with states' rights. "The question," Mr. Cohen said, "was, to what extent did it interfere with the ability of a state to control and regulate its political subdivisions?"
In 1973, Congress passed a new municipal bankruptcy law, which the Supreme Court in 1938 deemed constitutional.
* When did it become Chapter 9
rather than Chapter IX?
Along with the rest of the code's chapters, Chapter IX made the jump from Roman to Arabic numerals under the Bankruptcy Reform Act of 1978.
* How else has it been amended
over the years?
Chapter 9 has been amended several times, notably in the mid-1970s in the wake of the New York City fiscal debacle. It was under a 1976 law that the current language governing state authorization was adopted. Congress said municipalities must be "generally authorized" to file for bankruptcy. Also, Congress rejected an earlier provision that required a bankrupt municipality to obtain the approval of a majority of its bondholders.
"This condition proved to be very onerous to major municipalities," says a report from the New York law firms Davis Polk & Wardwell. In fact, the report goes on to say, New York City reportedly has considered filing a Chapter 9 petition in the mid-1970s, but concluded that the 51% provision "prevented a bankruptcy filing from being a viable alternative."
The mid-1970s also brought municipal debtors the power to reject collective bargaining agreements.
And, in 1988, Chapter 9 was amended to protect holders of revenue bonds, so that the dedicated revenues cannot be used to pay other debts. But, according to Mr. Cohen, that does not guarantee that holders of revenue bonds would escape a Chapter 9 proceeding without losing money through a debt restructuring.
In addition, municipal lease-backed securities were strengthened by a provision saying that the leases involved could not, unlike other leases, be broken in bankruptcy court.
* Has the Bridgeport bankruptcy
filing added anything new to the
law?
Bridgeport was the largest city ever to file a bankruptcy petition. In that sense alone, Bridgeport broke new ground.
Between 1980 and 1989, 69 municipalities sought federal court protection. Most of the filers were special tax districts, public utilities, or small towns. Any cities that filed were cities only in name.
Bridgeport set a precedent for a large city, one with an array of complex urban proglems and corresponding services, in filing a bankruptcy petition. As Mr. Spiotto put it in a recent telephone interview, "We have not had a history of large municipal bodies filing for protection."
The rejection of Bridgeport's petition early this month has raised questions and provided few answers. How a large, complex urban center would function in bankruptcy court still has not been tested, Mr. Spiotto said.
But the case, with its two rulings by U.S. Bankruptcy Judge Alan H.W. Shiff, has added more weight to the notion that a state's broad municipal powers law can, without specifically mentioning bankruptcy, authorize cities to file.
In addition, Mr. Spiotto, said, Judge Shift may have shed light on just how poor a city must be to use Chapter 9.
The judge determined that for a city to be "insolvent," a Chapter 9 requirement, it must show a legitimate inability to pay creditors in its current fiscal year, or in the coming fiscal year if a budget for that period has been adopted.
By establishing a litmus test for municipal insolvency, the judge has "put more flesh on the skeleton which the code has set forth," Mr. Spiotto said.
* Why did Bridgeport's bankruptcy
attempt fail?
On Aug. 1, Judge Shiff rejected Bridgeport's petition for court protection from creditors because he was unconvinced that the city was so poor it would soon default on payments to creditors.
In his opinion, the judge said that "Chapter 9 offers a solution to chronic economic distress caused by costs and revenues spiraling in different directions." But, he continued, "Chapter 9 is not available to a city simply because it is financially distressed."
The federal Bankruptcy Code requires cities and towns seeking court protection to show that they are either "generally not paying" their debts as they become due, or that they are "unable" to pay debts as they become due.
The second provision, with its use of "unable," has been interpreted as having a forward-looking meaning. As city lawyer James Berman said last month during courtroom hearings before Judge Shiff, the wording would be superfluous otherwise.
While Judge Shiff concurred with the notion that a city's insolvency can be the result of an impending inability to pay creditors, he said Bridgeport had not shown that, for all its fiscal problems, it would actually run out of cash in the near future.
The city contended that its cash cushion of roughly $25 million, which it has maintained since a 1989 deficit bonding backed partially by the state, is not available to help it bridge a budget gap of $16 million in the current fiscal year. And even if it still has $12.54 million left over at the end of the next fiscal year, the city argued, it will run out of cash soon thereafter.
The judge seemed to consider that projection closer to augury than accounting. "To be found insolvent," Judge Shiff reasoned, "a city must prove that it will be unable to pay its debts as they become due in its current fiscal year or, based on an adopted budget, in its next fiscal year." He said that Bridgeport had not done that.
As Mr. Spiotto put it in an interview the day Judge Shiff rejected Bridgeport's petition, "You should be able to look into the future, but when you try to look beyond the current fiscal year, it becomes a question of speculation."
* Is the judge's opinion correct?
Attorneys who understand Chapter 9 have praised Judge Shiff's two rulings as extremely well-reasoned. They therefore seem likely to set strong precedents on the two issues with which they are mainly concerned -- authorization under state law and the nature of insolvency.
Mr. Spiotto praised Judge Shiff's ruling of Aug. 1, on the issue of insolvency, as "one that will help future courts in trying to apply the standard of insolvency." He said the judge "showed due care and consideration."
Jeffrey Cohen, of the Colorado law firm Cohen & Associates, said Judge Shiff's rulings will "reinforce Chapter 9 as a viable and important outlet for a financially distressed municipality."
* Are the rulings good news for
the municipal bond market?
As the dust settles on what would have been the largest municipal bankruptcy proceeding in history, legal observers say that even though the bankruptcy petition was thrown out of court, municipal bond investors have more reason to worry than to rejoice.
While Judge Shiff's ruling that the city could not use Chapter 9 because it is not insolvent may be good news for the owners of the city's $77.7 million of outstanding uninsured general obligation bonds, it is bad news for just about everyone else, according to Jeffrey D. Sternklar, a lawyer with the Boston-based firm of Burns & Levinson.
"This is not the reason why bondholders wanted to see this kicked out of bankcuptcy court," Mr. Sternklar said. "They wanted to win on the first issue," he added, referring to the question of whether Connecticut's municipal powers law gives implicit authorization for bankruptcy filings.
"The next one that comes down may really be insolvent," Mr. Sternklar said. "Bondholders can take very little comfort insofar as what it means for other municipalities in the future."
John E. Petersen, senior director of the Government Finance Officers Association, called Judge Shiff's ruling on authorization to file "worrisome. It has raised issues that need to be resolved."
While Bridgeport may have flunked the insolvency test, plenty of other municipalities might pass. "You have a lot of jurisdictions out there that are running operating deficits and that don't have the liquidity that Bridgeport does," Mr. Petersen said.
Already, other cities suffering from the same economic downturn as Bridgeport have begun to hear talk of bankruptcy. In Chelsea, Mass., Mayor John J. Brennan recently spoke of receivership and bankruptcy, or even the possibility of being annexed by neighboring Boston -- anything to ease the burdens of its labor contracts and shrunken tax base.
* How many states allow municipalities
to file for bankruptcy?
Seventeen states have specific laws pertaining to municipal bankruptcy, one being Georgia, which prohbits municipal bankruptcies altogether. The rest of the 50 states have laws that, similar to Connecticut's, do not mention municipal bankruptcy at all.
For municipalities in those states, the Bridgeport ruling represents one more decision affirming the right to use Chapter 9, as long as they can demonstrate insolvency.
* How will those states that allow
municipal bankruptcy react to
the Bridgeport rulings?
It is conceivable that lawmakers in Washington might come under pressure from state officials to change the language of Chapter 9, so that instead of requiring "general" authorization under state law, the code would require "specific" authorization -- language that would demand a state's clear acquiescence in a municipal bankruptcy filing.
Or, states that now allow municipal bankruptcy could pass laws governing or prohibiting Chapter 9 filings. Conencticut was considering just such a law -- called the Distressed Municipalities Act -- when Bridgeport filed its petition.
