The following article was written by Kenneth R. Epstein and Nelly Almeida and originally published in the December 8, 2014 edition of the New York Law Journal. Kenneth Epstein is the Managing Director of the Insured Portfolio Management Special Situations Group at MBIA Insurance Corporation. A link to the journal can be found here.”
A successful restructuring depends, in part, on disclosure by a debtor of information pertaining to its finances and operations. This feature, however, is notably absent in most municipal bankruptcies. Chapter 9 of the Bankruptcy Code, available to municipalities seeking to reorganize their debts, imposes few statutory requirements on municipal debtors. Additionally, federal courts have been careful not to interfere with the affairs of a municipality due to the inherent constitutional limitations on courts’ powers. The absence of mandatory disclosures by municipal debtors often creates inefficiencies and increased costs during a bankruptcy process and should, therefore, be addressed. This article compares and contrasts Chapter 11 and Chapter 9 disclosure requirements and discusses a bankruptcy court’s ability to compel greater disclosure from municipal debtors under the current Chapter 9 framework.
A Comparison of Disclosure Requirements
Though only a few pages long, Chapter 9 of the Bankruptcy Code contains a handful of statutory provisions requiring municipal debtors to provide information to creditors and other stakeholders. These requirements, however, may not afford interested parties, including the court, with the information necessary to efficiently and fairly utilize the bankruptcy process.
At the outset of a case, both Chapter 11 and Chapter 9 debtors are required to file with the court a petition for relief and a list of creditors. Unlike in Chapter 11, however, Chapter 9 debtors are not required to provide basic financial information such as a schedule of assets and liabilities or an income statement—creating an information gap in the early stages of a case. Once a bankruptcy judge has been assigned, municipal debtors must prove they are eligible to be a debtor under the Bankruptcy Code. Eligibility requires, among other things, a showing of “insolvency.” Accordingly, a Chapter 9 petition is often followed by information pertaining to a debtor’s historical and projected revenues (e.g., income, sales and property tax receipts) and expenses (e.g., active workers’ and retirees’ obligations, capital expenditure needs and debt service requirements), the current level of municipal services being provided, and measures taken by the debtor to avoid bankruptcy.
While the information disclosed during the eligibility stage of the case may make a compelling argument for insolvency, it is often too “high-level,” incomplete, and/or unreliable to be of significant use to interested parties. Moreover, the financial data produced at this point is based on information as of, and leading up to, the petition date. While a creditor may seek discovery to obtain more information, it is costly to do so and the scope may be limited by a court suspicious of a creditor’s motives. In response to discovery requests made in In re City of Detroit, for example, Judge Steven W. Rhodes initially permitted only narrow discovery on objections raising certain identified issues of fact. He later reversed himself on this point after receiving comments from objectors. In short, the information obtained during the eligibility stage is unlikely to put stakeholders on equal footing with the debtor in deciding whether to challenge treatment of a claim or negotiate a potential settlement.
After a municipal debtor satisfies its initial disclosure requirements and substantiates eligibility, it is not statutorily mandated to provide information until the plan confirmation process begins. As in Chapter 11, considerable time may pass between the filing of the petition and the filing of plan documents (which includes a plan of adjustment of debts and related disclosure statement containing “adequate information”). During such time, municipal debtors are not required to seek court approval to pay prepetition debts, sell and use assets, or retain professionals. In a recent decision, in In re City of Stockton, Judge Christopher Klein held that municipal debtors are also not required to seek court approval to enter into settlements during the pendency of a case, including settlements that result in payment of disputed claims. This was shocking to many Chapter 11 practitioners who are accustomed to receiving notice of key settlements and sufficient opportunity to object. After all, there are often limited resources available to pay claims.
Accordingly, during the pendency of a Chapter 9 case, a municipal debtor has very little accountability to the court and other stakeholders. Indeed, many actions taken by municipal debtors during a case may only be disclosed to the extent state law or city governance (i.e., a city charter) requires it or through formal discovery at the confirmation stage. Municipalities do not, for example, file monthly operating reports or the related financial information Chapter 11 debtors must file. Moreover, the Federal Rules of Bankruptcy Procedure explicitly exempt municipal debtors from having to file a list of executory contracts and unexpired leases. This lack of mandatory disclosure is likely to result—and has resulted in recent cases—in burdensome discovery pertaining to a municipality’s actions and liabilities, which increases creditor and debtor litigation costs and diminishes the pool of assets available to pay claims.
Balancing Sovereignty with Transparency
Whether a bankruptcy court can lawfully compel a municipality to disclose information (or cause it to compile information and provide reports) remains an open question. Under section 904 of the Bankruptcy Code, a court cannot lawfully interfere with the political or governmental powers of a municipal debtor, its property or revenues, or the use or enjoyment of any income-producing property. To do so would be in violation of the Tenth Amendment to the U.S. Constitution—reserving certain powers to the states. However, the constitutional limitations on a court’s powers are intended only to ensure they do not substitute their judgment for that of state or elected officials. They are not intended to impinge on a court’s ability, or excuse its responsibility, to administer a Chapter 9 case in an efficient and fair manner.
The Bankruptcy Code would not, for example, prohibit a bankruptcy court from creating guidelines detailing what sort of financial information should be provided at the eligibility stage. The Bankruptcy Code would also not prevent a court from compelling a municipal debtor to disclose its major settlements before the plan confirmation stage so as to put other creditors on notice. Notably, although in In re City of Stockton Klein found that §904 of the Bankruptcy Code gives a municipal debtor freedom to decide whether to seek court approval when settling claims and disposing of its property, the decision did not address whether the court may compel a debtor to disclose any such settlement during the case.
Some bankruptcy courts have viewed their powers expansively, provided that in doing so they do not interfere with a debtor’s “property or revenues.” For example, in In re Orange County, the court determined that it had the power to order the county to provide adequate protection to certain creditors by setting aside certain revenues as a condition for the continuance of the automatic stay. Importantly, the court noted that, by doing so, it was not unduly encroaching “on the County’s ability to conduct its affairs free from court interference.” The court further explained that the County came “uninvited to obtain the benefit of the automatic stay … [and] the price for retaining this benefit is the County’s implied consent to [the] court’s power to apply all the provisions of §362.” Thus, it would not be a far stretch for a bankruptcy court to compel a debtor to turn over information prepared and produced in the ordinary course of a bankruptcy case.
In addition to the aforementioned example, there is also statutory support for the proposition that courts have the power to require greater disclosure. Under Federal Rule of Bankruptcy Procedure 2004, which is applicable in Chapter 9, on motion of a party in interest, the court may order the examination of debtor including the production of certain documents.
Authority From Non-Bankruptcy Laws
Bankruptcy courts may also look to applicable non-bankruptcy laws for judicial authority. Municipal debtors are generally not exempt from adhering to applicable state law and city governance. Most city charters impose reporting obligations on local governments and most states require municipalities to make financial information regularly available to the public. Under the state laws of New York and Michigan, for example, all cities and counties are required to file comprehensive annual financial reports within 120 days of their fiscal year end. In addition, many states have financial emergency laws applicable to municipalities in financial distress. There are also sunshine laws (open meeting laws) and freedom of information laws that may apply. Bankruptcy courts can and do interpret and apply state law regularly in Chapter 9 cases. Thus, state and local laws may provide a basis for asserting creditors’ information rights in municipal bankruptcies.
In addition, federal securities laws may provide leverage to stakeholders seeking better information, even if they don’t provide a right of private action. Disclosure of information to investors is at the heart of U.S. securities laws, which require full and fair disclosure be made to each investor and apply equally to municipal debt. While the U.S. Securities and Exchange Commission cannot impose detailed rules as to the format or content of disclosure for the sale of municipal securities, “the concepts of materiality, accuracy and completeness found in Rule 10b-5 still control.” Annual, periodic and event-driven disclosures are subject to these anti-fraud rules. In addition, the SEC has adopted a rule specifically dealing with secondary disclosure requirements in the municipal market. Rule 15c2-12, as amended, requires a broker, dealer or municipal securities dealer to make certain ongoing and operating financial information available to bondholders at least annually. Further, rules promulgated by the Municipal Securities Rulemaking Board (MSRB) and designed to prevent fraudulent manipulation have the force of law. Although SEC disclosure requirements may not be directly implicated in Chapter 9, failure to comply with accepted standards may violate anti-fraud rules, which would, among other things, affect whether or not a plan of adjustment may be confirmed.
The lingering effects of the recent financial crisis, significantly underfunded pension liabilities and decades of poor fiscal decision-making will keep municipal bankruptcies relevant for some time to come. Thus, it is important to ensure that an effective Chapter 9 process is in place—one that encourages transparency in an effort to facilitate consensual resolutions. While the unique aspects of Chapter 9 include limitations on a bankruptcy court’s power to interfere with local governmental functions, there are no express limitations on a court’s ability to order greater disclosure.
A bankruptcy court can and should require municipal debtors to produce detailed reports, including updated bank account statements, updated revenue forecasts, updated business plans and projections, reports on operational improvements and efficiencies, etc. Much of this information is already prepared by municipal debtors’ advisors in the ordinary course of a case and will not cause substantial additional expense. A court can and should also require that a debtor disclose key settlements as they occur (rather than at the confirmation stage), which would avoid the risk of interim settlements dictating the terms of a plan without notice to the court or creditors—possibly creating a sub rosa plan (i.e., a de facto plan that seeks to avoid the plan process and/or significantly impacts the terms of a debt adjustment). Establishing a robust process for disclosure would not only facilitate favorable settlements, but could help minimize the need for protracted litigation and assuage overall creditor distrust of municipal debtors.