Bridgeport – Distressed but not Insolvent

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Contributed by Marvin Mills

On November 9, 2011, facing an ongoing sewage debacle and claimed liabilities in excess of $4 billion, Jefferson County, Alabama, filed for bankruptcy protection under chapter 9 of the Bankruptcy Code.  Jefferson County’s chapter 9 filing is reported to be the largest municipality bankruptcy filing in U.S. history.  The county claims that it is eligible to be a chapter 9 debtor based, in part, upon its inability to pay certain accelerated warrant indebtedness that is currently due, as well as certain general obligations that – absent the filing – would become due during the 2012 fiscal year.

As seen in the recent cases of Boise County and City of Vallejo, a municipality must demonstrate its insolvency if a party challenges its eligibility to be a chapter 9 debtor.  To qualify as insolvent, a municipality must prove under section 101(32)(C) of the Bankruptcy Code that it is “generally not paying its debts as they become due” or is “unable to pay its debts as they become due.”  Chronic economic distress or a budget shortfall seemingly would suggest that a municipality is insolvent.  Twenty years ago, however, In re City of Bridgeport, made it clear that an economically distressed city can fail to qualify as insolvent.

On June 6, 1991, Bridgeport filed for protection under chapter 9 of the Bankruptcy Code.  At the time of filing, and for several years prior, Bridgeport was experiencing financial distress.  As a result, the city was providing suboptimal public safety, sanitation, health, and general welfare services.  Shortly after Bridgeport filed for bankruptcy protection, the State of Connecticut (and a related, state-created agency) objected to the petition and argued, among other things, that Bridgeport was not insolvent at the time of filing.

In its decision, the United States Bankruptcy Court for the District of Connecticut began its analysis of whether Bridgeport was insolvent with a determination that on the petition date, Bridgeport was paying its debts as they became due.  Consequently, the bankruptcy court focused on whether, as of the petition date, Bridgeport satisfied the other prong for insolvency under section 101(32)(C).

The first issue the bankruptcy court considered was whether section 101(32)(C)(ii) requires a retrospective or prospective analysis.  Connecticut argued that sections 101(32)(C)(i) and  101(32)(C)(ii) each refer to a municipality’s current unwillingness or inability to pay its debtors.  The bankruptcy court disagreed.  According to the bankruptcy court, Connecticut’s position was untenable because its reading would make section 101(32)(C)(ii) extraneous and a subcategory of section 101(32)(C)(i).  The bankruptcy court also considered a prospective analysis to be consistent with the purpose of chapter 9, which is to enable an economically distressed city to continue to provide necessary services while it develops a plan to adjust its liabilities.  Thus, the bankruptcy court established that section 101(32)(C)(ii) hinges on a prospective analysis.

The bankruptcy court next addressed whether such a prospective analysis required a cash flow or budget analysis.  On this issue, the bankruptcy court agreed with Connecticut, concluding that an insolvency determination under section 101(32)(C)(ii) requires a cash flow analysis and does not turn on whether a municipality will have a budget gap in the current year.  Based on Bridgeport’s own evidence, the bankruptcy court determined that Bridgeport would have sufficient cash (approximately $12.5 million) to meet its obligations during the current fiscal year.

The court declined to consider Bridgeport’s argument that the city would run out of cash the following fiscal year (1992-1993) as too speculative.  Because neither the Bankruptcy Code nor its legislative history indicate how far into the future a court must look to determine insolvency under section 101(32)(C)(ii),  the bankruptcy court looked to the former Bankruptcy Act for guidance.  Section 130 of the Bankruptcy Act required a Chapter X debtor to demonstrate that its inability to pay debts in the future was not speculative, but rather, was imminent and certain.  The bankruptcy court also observed that the interpretation of section 101(32)(C)(ii) should account for the practical effects of such interpretation.  Extending cash flow projections, explained the bankruptcy court, yields “less informed” conclusions.  The bankruptcy court expressly determined that any assertion at the outset of Bridgeport’s case that the city would be unable to pay its debts in the following fiscal year would be unreliable.  Accordingly, the bankruptcy court concluded that, to be 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.”  Despite Bridgeport’s “deep financial trouble,” the bankruptcy court ruled that the city was not insolvent and dismissed Bridgeport’s chapter 9 petition.

Although Jefferson County – like many other municipalities across the country – is experiencing financial distress, whether such distress rises to the level of insolvency remains an open question 20 years after the City of Bridgeport first faced the issue.