The rarely-used Chapter 9 bankruptcy provision was created during the Depression in 1934 to allow municipalities (cities and towns) to continue functioning despite overwhelming debt. Unlike other forms of bankruptcy, Chapter 9 does not require liquidation of assets, due in part to limitations on the government's oversight of issues that fall under states' jurisdictions.
Prior to filing for bankruptcy, municipalities must take the following steps: it must meet the standard of debtor and authorized to file; it must meet a certain standard of insolvency; the entity must seek to resolve its financial issues; and it must have attempted to negotiate with creditors.
Following a voluntary filing under this chapter, a judge is assigned and an automatic stay is enacted, stopping any collection efforts including mandamus, the provision that allows creditors to sue in order to raise taxes or fees.
Chapter 9 bankruptcy applies not only to entities traditionally known as municipalities (cities and towns) but also many forms of districts including school districts and public improvement districts as well as utilities and authorities (bridge authority, highway authority).
After filing Chapter 9 bankruptcy a municipality attempts to reduce its debt through negotiations with creditors, including refinancing, reducing the interest rate, or extending the term of a loan. Because state jurisdiction prevails over federal bankruptcy laws, municipalities cannot be forced to liquidate assets in bankruptcy.
Notable Chapter 9 Bankruptcy Filing Cases
In each of the past 10 years, there were 14 or fewer municipalities in the United States that filed for Chapter 9. Some of the most famous Chapter 9 cases have included Orange County, California in 1994 for interest losses totaling $1.7 billion; Jefferson County, Alabama in 2011 for a $4 billion sewer revenue bonds scam; and Detroit, Michigan in 2013 for as much as $20 billion due to declining income and population as well as antiquated record keeping systems, large pension obligations, and mismanagement or abuse of the system.
The law also allows municipalities to renegotiate labor contracts as part of bankruptcy proceedings. However in the case of Detroit there was a provision in the state Constitution protecting employee pensions, which became a central point of contention when dozens of labor unions and individuals protested the bankruptcy. A controversial aspect of the bankruptcy was the determination of the city's salable assets, including much artwork held at the Detroit Institute of Arts. The city's emergency manager for the bankruptcy managed to negotiate $100 million in contributions from the arts organization as well as local foundations to affect his restricting plan. Retirees approved a 4.5 percent cut in benefits along with no cost of living adjustments. A Financial Review Commission was created to scrutinize the city's accounts for a period of three years after the bankruptcy was discharged.