Central to any understanding of the bankruptcy filing by Orange County, Calif., and the Orange County Investment Pool are the little known workings of Chapter 9 of the U.S. Bankruptcy Code, which governs municipal bankruptcies. Chapter 9 is significantly different from Chapter 11, which governs corporate bankruptcies. The five differences discussed here will have a critical impact on the Orange County cases.
First, Chapter 9, unlike Chapter 11, requires that an entity seeking relief meet these requirements:
* It must be a "municipality," which is defined as a political subdivision or public agency or instrumentality of a state.
* It must be specifically authorized under state law to file under Chapter 9.
* It must be "insolvent" - that is, generally not paying its debts or unable to pay its debts as they become due.
* It must desire to effect a plan to adjust its debts.
* It must either negotiate with creditors in good faith before a filing or such negotiation must be impracticable.
The requirements that the filing entity be a "municipality" and that it be "insolvent" are particularly important here.
In earlier municipal cases, such as Bridgeport in 1991, central issues were whether the municipality was authorized by state law to file and whether it was insolvent. Bridgeport's filing was dismissed because Bridgeport failed to meet the insolvency requirement, despite its serious financial difficulties. Regarding the filing by Orange County, itself, California law specifically authorizes municipal entities to file under federal bankruptcy law. The county's default on a $110 million bond issue on Friday suggests that the county will meet the insolvency test.
Significantly, however, the pool itself may not meet the initial requirement of being a "municipality." Because the statute creating the pool does not create a distinct municipal entity, the outcome of this issue is particularly uncertain. If the court determines that the pool is not a municipality, its case would be dismissed.
At this point, the county may claim that the pool is part of its "property" and, therefore, subject to the county's bankruptcy case. The court, however, may decide that those investments in the pool made by other municipal entities are not the county's property. If this occurs, die pool, as opposed to the county, will not be within die jurisdiction of die bankruptcy court and would have to resolve its crisis outside the bankruptcy proceedings - probably through state or county action.
A second unique feature of Chapter 9 is that it does not incorporate Section 559 of the code, which allows a repo participant to exercise a contractual right to liquidate a repurchase agreement when a counterparty files for bankruptcy. Because Chapter 9 does not incorporate Section 559, repo participants may not be able to exercise contractual liquidation rights that would otherwise be triggered by a bankruptcy. Another critical issue here, however, is whether die automatic stay applies to die liquidation of collateral at the time that a repurchase agreement matures. If the automatic stay does not apply, repo participants can liquidate their collateral and the pool will suffer immediate losses. These issues are the subject of litigation and their outcome will determine the extent of actual short-term losses suffered by the pool. If liquidation is permitted, it will increase the likelihood of a wave of bankruptcy filings by other municipal entities with investments in the pool.
A third unique feature is that Section 903 of Chapter 9 specifically protects a state's right to control municipal actions, regardless of a bankruptcy filing. These state sovereignty provisions are untested in a major municipal bankruptcy case, but in the Orange County cases, may take center stage. For example, under state law investors in the pool have the right to withdraw funds at any time upon 30 days' written notice. Does the automatic stay prohibit investors from sending notices and withdrawing funds, or does Section 903 allow investors to exercise their rights under state law? The resolution of this issue will obviously be critical to these cases.
A fourth unique feature of Chapter 9 is its treatment of municipal debt secured by "special revenues," which generally includes revenues derived from a project or from certain special tax levies pledged to serve as security for bondholders.
Creditors secured by "special revenues" maintain their lien on those revenues, and the automatic stay does not apply. Bondholders secured by "special revenues" should continue to be paid from the revenue source securing their bonds during the bankruptcy case. The issue here is how to characterize the debt instruments; that is, are they secured by "special revenues"? This will determine the fate of creditors.
A fifth unique feature of Chapter 9 is that creditors have fewer tools than in corporate bankruptcies to influence the outcome of the case. Creditors may not submit their own plan of reorganization to the court or move for the appointment of a trustee to manage the affairs of the debtor. In addition, creditors may not contest decisions of the municipality regarding its properties or revenues. Section 904 prohibits the court from interfering with:
* Any of the political or governmental powers of the debtor.
* Any of the property or revenues of die debtor.
* The debtor's use or enjoyment of an income producing property.
If the county and pool are deemed to meet the filing requirements, during the bankruptcy case they will have considerable flexibility and control over running their own affairs.
If, within a few months, the pool filing is dismissed for failing to meet the filing qualifications, the county may nevertheless have met one of its primary goals in filing - stopping an immediate run on the pool.
The statute creating the pool does not specify how losses should be distributed, and it seems that all investors would be harmed by a race to collect remaining pool funds. The filings have created breathing space to allow the county and the investors to agree on an equitable, fair, and orderly way to address the serious problems facing the pool.
David L Dubrow is a lawyer with Mudge Rose Guthrie Alexander & Ferdon. He is the author of "Chapter 9 of the Bankruptcy Code: A Viable Option for Municipalities in Fiscal Crisis?," which appeared in The Urban Lawyer in the summer of 1992.