The Statutory Definition of “Insolvent” – Part Two – Chapter 9 Debtors

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Co-Authored by Andrea Saavedra and Christopher Hopkins

As a follow up to our first post on the Bankruptcy Code’s definition of insolvency as applied to corporate debtors, we now turn our exploratory lens towards the definition of insolvency as it applies to chapter 9 municipal debtors.

What constitutes municipal insolvency under the Bankruptcy Code?

A municipality is “insolvent” under section 101(32)(C) of the Bankruptcy Code if it is either (i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute or (ii) unable to pay its debts as they come due.  These two statutory standards are commonly referred to as cash flow, or equitable, tests of insolvency, with the former focusing on a city’s present (as of the petition date) nonpayment of undisputed debts (a “current cash flow insolvency test”) and the latter focusing on a city’s prospective inability to pay its debts post-bankruptcy (or “prospective cash flow insolvency test”).

Unlike debtors in chapter 7 or 11 cases, section 109(c)(3) of the Bankruptcy Code requires a municipality to prove insolvency as a prerequisite to chapter 9.  Because section 921(c) of the Bankruptcy Code permits the court to dismiss the municipality’s bankruptcy case if the municipality does not meet the filing requirements, creditors will often challenge insolvency at the outset of a chapter 9 case.  Judge Klein, who is presiding over the City of Stockton’s chapter 9 case, has likened these solvency battles to “qualifying rounds in a competition” that a municipal debtor must win in order to reach the “main event” of chapter 9 relief.

How do these cash flow tests work?

The cash flow tests of municipal insolvency are best understood in their application.  Because the burden of proof lies with the municipality, it may try to establish by a preponderance of the evidence either current or prospective cash flow insolvency.  It is generally considered easier from an evidentiary perspective for a municipality to show that it is currently cash flow insolvent because the municipality simply would have to provide proof of general nonpayment of currently due and undisputed debts.  Municipalities, however, may be less likely to rely upon the current cash flow insolvency standard because they may wish to seek chapter 9 protection prior to depletion of their cash reserves.  This practice is consistent with one of the purposes of chapter 9 – enabling a financially distressed municipality to continue to provide its constituents with essential services while it works out a plan to adjust its debts and obligations.

The Significance of City of Bridgeport

In a previous posting, we examined the 1991 decision issued by the bankruptcy court overseeing the chapter 9 case of the City of Bridgeport, Connecticut.  The decision is among the first significant decisions to examine and define the standards of municipal cash flow solvency.

The background facts of Bridgeport’s chapter 9 case likely sound familiar to those observing the current trend of chapter 9 debtors.  Bridgeport, a coastal city in western Connecticut, was suffering from an economic downturn that affected many northeastern cities in the early nineties.  Faced with skyrocketing crime rates, a looming public health emergency, and a projected budget deficit of $16 million for the 1991-1992 fiscal year, Bridgeport filed for chapter 9 relief in June 1991.

The State of Connecticut and Bridgeport’s financial review commission (which was an entity that operated independently of the mayor, who authorized the chapter 9 petition) objected to Bridgeport’s eligibility, asserting, among other things, that Bridgeport was solvent under either a current or prospective cash flow insolvency test.  Although Bridgeport conceded that it was not, as of the petition date, cash flow insolvent, it submitted that it was prospectively cash flow insolvent, based in large measure on its projected budget deficit.  The State argued in opposition that (i) budget deficiencies were irrelevant to an inquiry of cash flow projections, and (ii) the city’s actual cash flow projections demonstrated an infusion of cash from collected property taxes at the time of its asserted insolvency.

Based on a strict reading of the statute, the bankruptcy court concluded that whether a municipality is prospectively cash flow insolvent turns on the municipality’s projected ability (or inability) to actually pay its debts when such debts become due from its available cash reserves.  Further, the court reasoned that because prospective cash flow analysis is based on projections, and the “longer the [projection], the less informed the conclusion,” Bridgeport had to prove that its insolvency would occur within the “current fiscal year or, [if] based on an adopted budget, in its next fiscal year.”  Accordingly, the court rejected the projected budget deficit as adequate evidence of future insolvency, reasoning that it only demonstrated that expenditures would exceed revenue, not that cash reserves would be depleted.  The court further observed that, to the extent a budget deficit is the result of an impasse in the political process, chapter 9 is likely not the appropriate manner in which to resolve such disputes.  Turning its attention to the city’s actual cash reserves, the court found that they were projected to be sufficiently adequate to cover the city’s operating deficits.  Further, because the cash reserve did not have to be replenished within that year, the bankruptcy court was not persuaded that Bridgeport was prospectively insolvent and dismissed Bridgeport’s chapter 9 case.

Current Trends in Municipal Insolvency

The Bridgeport decision narrowly construed the statutory phrase “unable to pay its debts as they come due” so as to require, in essence, that a city project depleting (or depleted) cash reserves within a year of its bankruptcy filing in order to establish prospective cash flow insolvency.  The strictness of its holding appeared to dismiss the relevancy of budget deficits in determining chapter 9 insolvency.  Recent decisions from two California bankruptcy courts make clear that Bridgeport’s narrow holding was a product of the facts presented in that case, as each decision demonstrates a court’s willingness to consider the economic and political realities facing distressed municipalities in a determination of solvency.

The first of these decisions comes from the Stockton chapter 9 case.  Stockton’s path to chapter 9 is reminiscent of Bridgeport’s, updated solely to reflect the latest market’s bubble burst.  Specifically, facing a trifecta of severe financial stressors — the housing crisis, overly ambitious building projects, and out-of-control employee benefits — Stockton filed for chapter 9 relief in June 2012.  Shortly thereafter, Stockton’s capital markets creditors objected to the city’s eligibility, with certain of them arguing, among other things, that it was solvent or had manipulated itself into a technical insolvency that should be disregarded.

In a clear expansion of the Bridgeport decision, the bankruptcy court held that it could consider three forms of insolvency in determining the issue presented: cash, budget, and service delivery.  It grounded its conclusion in the “theme underlying” municipal insolvency, which, in its assessment, requires the existence of “bona fide” and non-transitory financial distress that is “not likely to be resolved without use of the federal exclusive bankruptcy power to impair contracts.”

Turning first to prospective cash flow insolvency, the bankruptcy court observed that because it implicates “notions of time and projections about the future,” a municipality did not have to be “actually out of cash” before it can be found to be cash insolvent.  Further, distinguishing the temporal aspect of the Bridgeport decision, the bankruptcy court held that the relevant period of time to test cash flow solvency need not be limited to the year out from the petition date, but could be as short or as long as the facts of a particular case established to be reasonable.  As Stockton was estimated to run out of cash within weeks of its filing (and its minimal cash reserve as of the petition date was due solely to its prepetition default on certain contractual bond payments), the bankruptcy court found that prospective cash flow insolvency was easily established.

As to the objectors’ arguments of fabricated insolvency, the bankruptcy court held that budget and service delivery insolvency were of particular relevance.  In the Stockton court’s view, budget insolvency focuses on the ability (or inability) of a municipality to create a balanced budget to pay for its expenses, and service delivery insolvency occurs when a municipality is unable to pay for the costs of providing essential services to the community.  The Stockton court found that because (i) the city projected that it would have insufficient revenues to pay expenses within the budget period being examined (and couldn’t accurately predict an increase in those revenues until it had its “fiscal house in order” via a plan of adjustment), and (ii) it was under-delivering or already defaulting on many of its service obligations to its citizenry, Stockton was genuinely insolvent.  Indeed, the court observed that the mere fact that Stockton’s cash reserve was the direct result of its decision to impair its contractual obligations prepetition was adequate evidence alone of its cash flow insolvency and need for chapter 9 relief.

The second of these decisions comes from the chapter 9 case of the City of San Bernadino, California, currently pending in the United States Bankruptcy Court for the Central District of California.

As with Stockton, San Bernadino’s bankruptcy was preceded by economic recession, mismanagement, and a reduction in substantial public services due to deteriorating tax revenues. After initial litigation over eligibility by a number of creditors, only a single creditor, the California Public Employees’ Retirement System (CalPERS), challenged San Bernardino’s eligibility.   Although CalPERS argued, among other things, that the city’s chapter 9 petition was not filed in good faith, it did not contest the city’s insolvency.  At the time of its chapter 9 filing, San Bernardino was facing a cash deficit of $45.9 million for fiscal year 2012-2013, and the single alleged cash reserve was simply “out of reach.”  CalPERS argued, however, that the city’s failure to prevent the city’s deepening insolvency in the years preceding chapter 9 was evidence of its bad faith filing.  The court found, however, that such criticisms were based in inappropriate hindsight analyses that were of “no import” to its decision.  Moreover, to the extent that the objecting creditor was asserting that the city’s insolvency was fabricated, the court rejected such assertions, finding that, similar to the Stockton court, the city’s insolvency was genuine because it would never be able to achieve a balanced budget without impairing its contracts.

The eligibility disputes in Bridgeport, Stockton, and San Bernadino reveal the heavy burden municipal debtors bear on the solvency issue at the outset of a chapter 9 case.  Indeed, the current eligibility trial in Detroit’s chapter 9 case — where, it seems, opponents are throwing every punch available (including contesting insolvency) — demonstrates the accuracy of Judge Klein’s boxing analogy from the Stockton decision.

In Detroit, the American Federation of State, County and Municipal Employees, the AFL-CIO, and the City Of Detroit Retirees’ filed a joint pretrial brief objecting to Detroit’s chapter 9 eligibility, arguing, among other things, that Detroit failed to carry its burden on insolvency.  The objecting parties argue that Detroit deliberately budgeted and spent itself into current cash flow insolvency and, that even if the city was currently not paying its debts, the nonpayment was purposeful and insufficient to constitute general nonpayment.  Further, the objectors argue that Detroit also failed to show that it would be prospectively cash flow insolvent because the city failed to explore chapter 9 alternatives that would have enabled it to pay its debts as they come due, citing the city’s failure to monetize its assets as a prime example.  Detroit’s eligibility hearing is currently ongoing and, as of today, is in its seventh day.  Testimony on the issue of insolvency has already been taken, and it will be interesting to see what happens in Detroit and whether, consistent with the current trend in the case law, the bankruptcy court there will show a willingness to consider other indicia of deterioration, including service and budget deficiencies, in making its insolvency determination.

Disclosure:  Weil represents National Public Finance Guarantee Corporation in the Stockton and San Bernadino bankruptcy cases, although Weil was not involved in the Stockton eligibility dispute.  Further, Weil represents Financial Guaranty Insurance Company in the Detroit bankruptcy case, although Weil is not involved in the eligibility trial.