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When Your Town Goes Bust

February 17, 2010


Lately municipal bankruptcy has been the subject of many news features as economic troubles press cities to consider their legal options. San Diego and Los Angeles are two major cities that are reportedly considering federal bankruptcy protection. 

While federal bankruptcy protection has been available to U.S. cities since the 1930’s, only a few hundred have actually filed. Chapter 9 of the Bankruptcy Code provides a financially distressed municipality the opportunity to reorganize its debts under federal protection. A “municipality” as defined in the Bankruptcy Code includes cities, counties, and special districts. This definition does not include states.

A Chapter 9 bankruptcy can only be commenced after the governing body specifically authorizes the filing. Twenty-six U.S. states have prohibited their municipalities from filing bankruptcy: Alaska, Delaware, Georgia, Hawaii, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Massachusetts, Mississippi, Nevada, New Hampshire, New Mexico, North Dakota, Oregon, Rhode Island, South Dakota, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin, and Wyoming. 

Once filed the federal bankruptcy law’s automatic stay provision enjoins creditors from taking any collection action against the municipality. The automatic stay provides an opportunity for the municipality to raise new revenues, renegotiate contracts, or restructure its debt without pressure from creditors. Chapter 9 is tricky business for the bankruptcy court because the Tenth Amendment to the U.S. Constitution and section 904 of the Bankruptcy Code prevents a federal bankruptcy court from interfering with the city’s political or governmental powers. The bankruptcy judge is largely a facilitator of the restructuring process.

The essence of a Chapter 9 bankruptcy is that it gives the municipality an opportunity to reorganize and restructure its debts through an agreement with its creditors called a “Plan of Adjustment.” If a creditor cannot agree with the municipality, Chapter 9 allows the bankruptcy court to force the municipality’s Plan of Adjustment on the non-consenting creditor. The bankrupt municipality is also empowered to accept or reject contracts and leases through the Plan of Adjustment.

Chapter 9 municipal bankruptcy is a very rare and special bankruptcy case. The stigma and complexity of Chapter 9 makes it a last option for U.S. municipalities. However, if the debt problem is serious and substantial enough, the federal bankruptcy laws can protect a city of millions and give it a chance for a fresh start, just like it can protect an individual or family in financial distress.


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