GATEKEEPERS GONE WRONG: REFORMING THE CHAPTER 9 ELIGIBILITY RULES.

• Author: Coordes, Laura N.

ABSTRACT

In order to gain access to chapter 9 bankruptcy, municipalities must demonstrate that they meet several eligibility requirements. These requirements were put in place to prevent municipalities from making rash decisions about filing for bankruptcy. Too often, however, these requirements impede municipalities from attaining desperately needed relief. This Article demonstrates that as currently utilized, the chapter 9 eligibility rules overemphasize deterrence and are not rationally connected to the reasons the chapter 9 bankruptcy system was developed. This Article therefore posits that the chapter 9 eligibility requirements should be relaxed.

To support this claim, the Article conducts a detailed analysis of the history and theory of chapter 9 to determine the primary reasons for the eligibility rules and the core functions of a municipal bankruptcy solution. It then demonstrates how many of the concerns driving the eligibility rules' existence are addressed in other chapter 9 mechanisms and proposes sweeping revisions to the eligibility rules to facilitate appropriate access to chapter 9. Specifically, municipalities in fiscal distress should be able to access bankruptcy when they demonstrate a need for the primary types of assistance that bankruptcy can best provide: nonconsensual debt adjustment, elimination of the holdout creditor problem, and breathing space. Through its analysis, this Article brings needed attention to the broader questions of who should have access to bankruptcy and when that access should be granted.

TABLE OF CONTENTS INTRODUCTION I. CAUSES OF MUNICIPAL DISTRESS A. Overview: Cyclical v. Structural Distress B. Management Problems: Source or Scapegoat? C. Individual Poverty: Cause or Consequence? D. Federal and State Effects E. Failed Projects or Events II. BANKRUPTCY SOLUTIONS A. Bankruptcy Purposes and History B. Distinct Roles for State and Federal Law 1. State Roles 2. The Benefits of Federal Relief C. Other Considerations for Chapter 9 Relief III. LESSONS FROM ELIGIBILITY STRUGGLES A. Rules and Examples 1. Eligibility and Confirmation Rules 2. Eligibility and Confirmation Decisions 3. Unnecessary Deterrence B. Problems Stemming from Specific Eligibility Requirements C. State Hurdles D. Rhetoric IV. A NEW PERSPECTIVE ON ELIGIBILITY A. The Insolvency Requirement B. The Authorization Requirement C. The Creditor Negotiation Requirement D. The Plan Requirement E. Concerns and Criticisms CONCLUSION INTRODUCTION

In December 2013, U.S. Bankruptcy Judge Steven Rhodes issued his decision that Detroit was eligible for bankruptcy under chapter 9 of the Bankruptcy Code. (1) Judge Rhodes's ruling was significant for many reasons, not least because it allowed the largest municipal bankruptcy case in U.S. history to move forward. But Judge Rhodes also made a key observation when he issued his ruling: Detroit had waited too long to file for bankruptcy, filing long after it was in the city's best fiscal interest to do so. (2) As a consequence, Detroit residents and officials were suffering unnecessarily when they could have sought--and been granted--federal relief much earlier.

Another city that Judge Rhodes could have had in mind when he made this observation was Atlantic City, New Jersey, which is facing some truly desperate times. The city's $262 million budget has a $100 million deficit. (3) It owes about $400 million to its bondholders and casinos and has no concrete plan for making those payments. (4) Although New Jersey recently provided Atlantic City with a rescue loan package, city officials had already begun delaying paychecks to workers to save up money to make debt payments, and the state's repayment terms are particularly harsh. (5) For the past ten years, Atlantic City has struggled with a rapidly shrinking property tax base, the closure of one third of its casinos, a sharp decline in gambling revenue, and fierce competition from new casinos in neighboring states. (6) Some city officials suggested that the city ought to file for bankruptcy; (7) yet, the years of decline Atlantic City has faced may mean that bankruptcy is no longer a viable option. Specifically, Atlantic City's shrinking revenues and casino closures indicate that the city may not have adequate resources to fund a bankruptcy and plan of adjustment. Atlantic City now finds itself between a rock and a hard place: unable to liquidate as a business could, but beyond the point where federal bankruptcy would be sensible, it has become dependent on reluctantly-given state aid and continues to struggle.

The stories of Detroit and Atlantic City illustrate how difficult it can be to figure out when or whether (8) to file for municipal bankruptcy. Indeed, these cities are just two of many municipalities that cannot easily determine whether a federal bankruptcy solution makes economic and political sense. (9) As David Skeel and Clayton Gillette have observed, politics and concerns about stigma play a role in determining whether a municipality will file for bankruptcy or not. (10) But on the legal front, a municipality's entry into the federal bankruptcy system is further complicated by chapter 9's eligibility requirements, which incorporate a dizzying array of hurdles a municipality must clear before obtaining federal relief. The expense, time, and legal effort necessary for an eligibility determination may ultimately discourage cities from taking advantage of the bankruptcy process. This Article argues that the chapter 9 eligibility rules unnecessarily impede access to municipal bankruptcy, a process that already has sufficient safeguards against opportunistic or careless filings. The front-end gatekeeping provided by the eligibility requirements is also aberrational within the bankruptcy system: no other type of debtor is subjected to such a rigorous, litigious screening process (11) before bankruptcy relief is granted. (12)

Although municipal bankruptcy is rare, municipal distress is not. (13) As increasing numbers of cities and towns face fiscal distress, many will consider chapter 9 as an option for resolving their problems. (14) It is therefore crucial to determine with precision what cities stand to gain from a municipal bankruptcy filing. This Article will illustrate that the current eligibility rules stand in the way of this determination and discourage municipalities from seeking relief until long after a municipality has begun to experience severe distress. By the time a municipality files for chapter 9, therefore, it may not be in the best position to take full advantage of all that bankruptcy has to offer. (15)

Although the chapter 9 bankruptcies filed over the past few years have renewed scholarly interest in municipal bankruptcy, (16) the academic literature to date has only briefly and sporadically touched on chapter 9 eligibility. (17) A holistic reform of the eligibility requirements is needed because a municipality will not be able to reap the benefits of chapter 9 without first being deemed eligible for relief. As this Article will illustrate, the eligibility requirements are largely unnecessary, as chapter 9 has so many negative consequences and built-in costs that only cities in desperate financial shape will use it. Furthermore, the standards for confirming a plan of adjustment in chapter 9 provide substantial safeguards that are often replicated by the eligibility rules, forcing municipalities that engage in the chapter 9 process to fight duplicative battles at the eligibility and confirmation stages and further increasing the costs of an already expensive process.

Critics argue that, since chapter 9 is not used very often compared to the other bankruptcy chapters, it is not very useful. (18) Yet, this Article will show that chapter 9 is not being used because it is so difficult to access in its current formulation. Changing the eligibility rules may help a municipality prevent a truly dire situation, transforming chapter 9 from a last resort into a valuable tool in a municipality's arsenal. By focusing on increasing chapter 9's utility, this Article's proposals also provide guidance to courts and legislatures considering the question of which municipalities should have access to chapter 9 bankruptcy tools.

This Article thus makes two distinct contributions to the existing literature. First, the Article ties bankruptcy theory together with municipal finance research that pinpoints common sources of municipal fiscal distress in order to identify when and why a municipality might choose to file for chapter 9. Second, the Article proposes a set of revisions to the eligibility rules designed to facilitate, rather than impede, access to chapter 9. In doing so, this Article demonstrates the shortcomings of the eligibility rules as currently constituted.

Importantly, this Article focuses only on general-purpose municipalities: cities, towns, and counties. Special-purpose entities, which may also be eligible to file for chapter 9 bankruptcy, face eligibility hurdles as well, but these hurdles are of a different nature. Although many of the proposed changes to the eligibility rules may be applied to special-purpose entities, these entities merit their own consideration and, possibly, their own entry rules. (19)

This Article proceeds in five parts. Part I serves as the foundation for the rest of the Article, introducing the literature on municipal fiscal distress and pinpointing common triggers. Part II connects this foundation with bankruptcy history and theory to determine why a federal bankruptcy solution exists for municipalities. Part III explains how the current eligibility rules discourage many municipalities from seeking federal relief. Part IV then proposes specific reforms for the chapter 9 eligibility process. Using the groundwork laid in the previous parts, Part IV suggests sweeping changes to the eligibility rules to facilitate access to chapter 9. Part IV also addresses concerns...