Chapter 9 Update: Limiting Jurisdiction In Municipal Bankruptcies

Since the publication of our two-part municipal bankruptcy series (see NYLJ, March 4, 2010, and May 6, 2010), the strain of rising pension costs, declining tax revenues, and onerous debt obligations has become more acute for many struggling municipalities. Recent decisions regarding Bankruptcy Code section 904, which constrains a bankruptcy court's oversight of a municipality's assets and spending power, have affirmed the proposition that a municipal debtor has full discretion to modify its obligations without court approval. Most recently, the courts presiding over the Stockton and Jefferson County cases have clarified the scope of section 904 to afford a municipal debtor the unfettered right to pay creditors on account of their prepetition claims during the pendency of its chapter 9 case.

Statutory Background

Chapter 9 has evolved over the years to keep up with the advances of municipal finance while also ensuring that the provisions of it do not encroach upon the municipal debtor's sovereignty. In drafting chapter 9 and its predecessor under the Bankruptcy Act of 1898, chapter IX, Congress had to take care not to violate the Tenth Amendment, which bars Congress from interfering with the sovereign affairs of the states. Indeed, in the 1930s, the Supreme Court struck down a jurisdictional provision of the statutory predecessor to chapter 9 as unconstitutional because it permitted bankruptcy courts to interfere with municipal property or revenues if such property was not necessary "in the opinion of the judge for essential governmental services."1

New York City's fiscal crisis in the 1970s served as the genesis for the liberalization of the municipal bankruptcy laws because, at the time, the existing municipal bankruptcy provisions were woefully inadequate to deal with the restructuring needs of a city as large and complex as New York. In 1976, Congress liberalized and broadened many of the provisions of chapter IX to their current form as set forth in chapter 9 of the Bankruptcy Code of 1978. In particular, Congress further broadened the jurisdictional limitations by enacting section 904 of the Bankruptcy Code, deleting the phrase "necessary for governmental services" from the jurisdictional provision. In its current form, section 904 provides that, absent a chapter 9 debtor's consent, a bankruptcy court "may not...interfere with...(1) any political or governmental powers of the debtor; (2) any property or revenues of the debtor; or (3) the debtor's use or enjoyment of any income producing property."2 Section 904 is a keystone in the interplay between federal bankruptcy powers and municipal sovereignty, and imposes significant limitations on the court's ability to issue orders that would "interfere" with the debtor's use of its property or revenues.

Recent Decisions

Over the past year, multiple bankruptcy courts have addressed the interplay of section 904 with other provisions in the Bankruptcy Code and the Judicial Code, and all have broadly interpreted section 904 to prohibit any court interference with the debtor's use of its property during the pendency of its case.3

Jefferson County I. The chapter 9 filing by Jefferson County, Ala., in November 2011 - the largest such filing as measured by total liabilities (over $3 billion) - was precipitated by a default on its sewer warrant obligations and declining revenue. The warrants were secured by the net revenues of the sewer system, which the county was obligated to transfer to a revenue fund...