A request for unanimous consent made on Wednesday, December 9th in the Senate to a bill that would allow Puerto Rico to declare bankruptcy was unsuccessful.  This prevents prompt passage of the proposed bill by the Senate to extend Chapter 9 of the Bankruptcy Code, which allows municipalities to declare  bankruptcy but is not available to Puerto Rico due to its status as a US Commonwealth.  The move does not prevent the bill from being considered and voted on through the normal Senate legislative process.  Legislation to extend Chapter 9 to Puerto Rico remains pending in both the House and the Senate, but its prospects remain ambiguous adding further uncertainty to the ongoing Puerto Rico financial crisis.

This bill comes on the heels of the Supreme Court’s recent decision to grant certiorari to Puerto Rico’s appeal of the First Circuit’s decision upholding the lower court’s decision[/link] striking down the Recovery Act, a law passed by Puerto Rico to provide a bankruptcy process for some local public corporations.  While the First Circuit upheld the decision striking down the Recovery Act as pre-empted by the Bankruptcy Code, its ruling has been used to support the legislative push to extend Chapter 9 to Puerto Rico.

The situation with Puerto Rico remains fluid and the HHR Bankruptcy Report will continue to monitor the situation and provide updates.

In the early 1970’s, New York City faced imminent bankruptcy.  Former Hughes Hubbard & Reed LLP Chairman Orville H. Schell, Jr. was a member of a task force that advised New York City Mayor John Lindsay on a possible Chapter 9 filing.  Schell, with the assistance of James W. Giddens and other Hughes Hubbard attorneys, advised Mayor Lindsay on this then-novel approach to municipal financial reorganization.  Although the filing was ultimately avoided through a federal loan and financial restructuring, the challenges that New York City faced echo in the struggles that several major cities are currently experiencing.  In March, Michigan responded to Detroit’s financial distress by appointing former Jones Day bankruptcy partner, Kevyn Orr, as emergency manager of the city’s operations and finances. The state made the appointment pursuant to a recently enacted law allowing the state to intervene when local governments face financial emergencies.

Many communities in the United States are suffering from problems similar to those faced by Detroit: unreliable revenues, all-too-reliable fixed costs and past deficits too steep to overcome through the budget process.  Lagging property values, the departure of taxpayers, and other unfavorable economic conditions are leaving municipalities unable to meet obligations that are often dictated by existing contracts or statutes.  Political and economic realities make it unlikely that these distressed municipalities will be able to raise sufficient tax revenue or obtain sufficient financing.  Meanwhile, the creditors of these municipalities, most notably bondholders (and their insurers) and public employees, are often reluctant to make the necessary concessions, particularly if the pain of such concessions is not shared equitably by other creditors.

Municipal bankruptcy under Chapter 9 of the Bankruptcy Code provides a framework to address these challenges.  Chapter 9 confers on municipalities many of the same restructuring tools as the Bankruptcy Code’s other chapters, including the protection of the automatic stay.  Moreover, because of the Tenth Amendment’s limitation on the federal government’s power to interfere in the affairs of the states, the municipal debtor retains much greater power over its own operations and finances than debtors under other chapters.  In the case of Detroit, Mr. Orr has used the mere threat of Chapter 9 to bring the city’s creditors to the table.  While Mr. Orr has suggested that a Chapter 9 bankruptcy filing would only be a last resort, if Detroit were to file, it would be the largest municipal bankruptcy in history and may provide a roadmap for addressing the fiscal problems of municipalities throughout the country.

Unlike most debtors, municipalities do not automatically earn permission to proceed in bankruptcy merely by filing a petition.  In order to be eligible for relief under Chapter 9, a city or organization must demonstrate that it meets all of the requirements of section 109(c) of the Bankruptcy Code.  First, it must, of course, be a “municipality,” which the Code defines as a “political subdivision or public agency or instrumentality of a State.” Second, the city must be authorized by state law to file a petition under the Bankruptcy Code.  Some states require the enactment of special statutes that confer such authority on a case-by-case basis.  Third, the city must have been “insolvent” as of the date of its petition.  Municipal insolvency is usually determined on a cash flow basis.

A municipality that can demonstrate that it will be unable to pay its bona fide debts in the next fiscal year has been held to be insolvent.  It is not necessary for the municipality to first cut every service or expense.  Next, the city must demonstrate that it filed its Chapter 9 petition with the honest desire to effect a restructuring of its debts, and “not simply be to buy time or to evade creditors.”  Finally, the municipality must be able to show (a) that it has reached agreement with at least a majority of each class of creditors that it intends to impair under its restructuring plan, (b) that it has negotiated in good faith with creditors to achieve such a result but that such negotiations have failed or would be impracticable, or (c) that the debtor has reason to believe its creditor(s) is/are attempting to obtain a voidable preference.

As Detroit’s emergency manager, Mr. Orr faces daunting fiscal challenges.  His ability to analyze the city’s finances and negotiate with its creditors in light of the benefits and requirements of Chapter 9, however, may just give Detroit a head start on its road to recovery.