Cities Face a Cash-Flow Problem in Chapter 9

It has now been almost two years since Bankruptcy Judge Steven W. Rhodes (ret.) confirmed an adjustment plan for the city of Detroit, the largest chapter 9 case ever filed. According to ABI’s statistics, 11 “municipalities” have filed for chapter 9 protection since Jan. 1, 2015.[1] Since the beginning of the financial crisis of 2008, 91 have filed under chapter 9.[2] While there are other factors and events that have caused these municipalities to seek bankruptcy court protection, unsustainable budget deficits, increased labor costs and expenses, and looming pension crises are at the top of the list for municipalities across the U.S. to begin uttering the word “bankruptcy.”

A prime example of such a city is Chicago. Largely thought to potentially be the next big city to “fail,” Chicago currently has a $33 billion net pension liability, according to its 2016 annual financial analysis report (AFAR).[3] The Illinois Supreme Court, in a decision striking down attempted pension reform in Chicago as unconstitutional under the state’s constitution, affirmed that two of Chicago’s public pensions will be insolvent in “about 10 and 13 years, respectively.”[4] This begs the following question: Would it not be better to proceed with filing for chapter 9 protection now to work out an adjustment plan before the city defaults and can no longer pay for not only its pension liability but also essential services (transportation, law enforcement and emergency response)?

However, Chicago may have a cash flow problem. Under the Bankruptcy Code, in order to be eligible to file for chapter 9, a municipality must meet an enumerated list of criteria set forth in § 109(c).[5] In addition to requiring the debtor to be a “municipality,” being specifically authorized to be a bankruptcy debtor under state law (and several other requirements), § 109(c) requires the debtors to be “insolvent.”[6] Section 101(32)(C) of the Bankruptcy Code defines “insolvent” as “with reference to a municipality, [a] financial condition such that the municipality is — (i) generally not paying its debts as they become due unless such debts are the subject of a bona find dispute; or (ii) unable to pay its debts as they become due.”[7] Insolvency is determined as of the date that the petition is filed.[8]

Further, rather than a balance-sheet approach, which would take into consideration a municipality’s budget gap/pension deficit, the main analysis for chapter 9 eligibility is based on a cash-flow analysis.[9] While the duration of that analysis has been debated among courts, the U.S. Bankruptcy Court for the District of Connecticut in In re Bridgeport concluded that “to be found insolvent, 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.”[10] The U.S. Bankruptcy Appellate Panel of the Ninth Circuit similarly affirmed the lower bankruptcy court’s insolvency determination that a city must demonstrate its inability to pay its debts due within the next year.[11]

Thus, even if Chicago wanted to file for chapter 9 protection, it would be faced with a heavy burden of proof to prove that it is truly “insolvent,” as that term has been defined and interpreted under the Bankruptcy Code. Chicago’s 2016 AFAR projects a budget deficit of $137.6 million.[12] However, Mayor Rahm Emanuel’s press release associated with the city’s proposed 2017 budget optimistically proclaims that this is the lowest the deficit has been in “nearly a decade and 80 percent smaller than it was in 2012.”[13] Only time will tell the state of Chicago and other large and small cities’ financial future, and whether chapter 9 will again be utilized on such a large scale as it was in Detroit. One hurdle that these cities may face is showing that they are truly “insolvent” under chapter 9. As the bankruptcy court opined in In re Bridgeport, a “city should not have to wait until it runs out of money in order to qualify for bankruptcy protection. It must, however, demonstrate, as a condition precedent to filing, that in the near future it will run out of money and be unable to pay its debts as they become due.”[14] The court concluded that “[i]n the absence of that proof, it would be an unwarranted intrusion into the political and collective-bargaining processes for a bankruptcy court to become involved in the resolution of that city’s economic problems.”[15] At this point, we will have to wait and see.