This installment of “Breaking the Code” will dissect section 109(c) of the Bankruptcy Code, which establishes who may commence a proceeding under chapter 9.  As countless public entities edge closer to federal bankruptcy protection amid the recent wave of municipal distress, the once-inconspicuous section 109(c) merits our attention.
Section 109(c)(1) provides that an entity may seek relief under chapter 9 if and only if it is a “municipality.”  The term municipality is defined in section 101(40) as a “political subdivision or public agency or instrumentality of a State.”
The proliferation of public-private partnership financing structures in the past 20 years has blurred the line between public and private enterprises, making it difficult in some cases to determine whether an entity constitutes a municipality.  The Bankruptcy Court for the District of Nevada recently surveyed the law on this point and articulated three “basic sets of characteristics” for courts to consider when determining whether an entity constitutes a municipality under section 101(40) of the Bankruptcy Code.
First, courts should consider the extent to which an entity has traditional governmental attributes or engages in traditional governmental functions.  If, for example, an entity has powers associated with sovereignty, such as eminent domain, sovereign immunity, or the power to tax, then it is likely that the entity would be deemed a municipality.
Second, courts should consider the extent to which the state controls an entity’s operations. If an entity has a public purpose, the consideration should turn on the level of control exerted by the state to further that purpose.  More state control over day-to-day decisions and operations makes it more likely an entity is an instrumentality of the state.  The type of control should also be considered:  If state control is necessary or intended to allow an entity to manage its finances, then the entity likely is a municipality for bankruptcy purposes.  If, however, the state’s control is general oversight or regulation, then the entity is less likely to be a municipality.
Finally, courts should consider the extent to which the state itself categorizes the entity as a municipality or instrumentality.  The court may look beyond the state-given label and consider whether state law gives the entity the powers and functions essential to a municipality, but if the state treats the entity as a municipality, courts should as well.
Legislative Authority 
Section 109(c)(2) requires a municipality to be specifically authorized by state law to commence a bankruptcy case under chapter 9.  Approximately half of the states in the United States currently have legislation providing some form of authorization.  Certain of these statutes contain limitations as to the type of entity that may file and some require further approval from the state or a state official prior to any filing.  In previous blog entries, we discussed the unsuccessful efforts of creditors of two counties in Alabama to dismiss the chapter 9 cases of such entities on the ground that such counties were not authorized under Alabama law to commence such cases and the steps taken by the Pennsylvania and California legislatures to limit municipalities’ access to federal bankruptcy protections
Proof of Insolvency
Section 109(c)(3) requires that a municipality must be insolvent as of the date it petitions for relief under chapter 9.  Section 101(32)(C) of the Bankruptcy Code provides that a municipality is insolvent if it is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute, or is unable to pay its debts as they become due.  The determination that a municipality generally is not paying its debts as they become due requires a factual analysis of what payments have been missed and their relation to the municipality’s overall financial position.  In determining whether the municipality is unable to pay its debts as they become due, courts look at the cash flow of the municipality in the near future, rather than using a balance sheet test.  (See our previous blog posts discussing the insolvency issues here, here and here.)
Desire to Restructure 
Section 109(c)(4) requires that a municipality “desires to effect a plan to adjust [its] debts.”
Good Faith
Section 109(c)(5) requires a municipality to demonstrate that it meets one of the following requirements:

(i)         has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that the municipality intends to impair under a plan;

(ii)       has negotiated in good faith with creditors but failed to reach an agreement with creditors holding at least a majority in amount of the claims of each class that the municipality intends to impair under a plan;

(iii)     is unable to negotiate with creditors because negotiations are impracticable; or

(iv)     reasonably believes that a creditor may attempt to obtain a preference avoidable under section 547.

“Chapter 0” 
Section 109(d) provides that persons eligible to be a debtor under chapter 7 of the Bankruptcy Code may also be a debtor under chapter 11.  To be eligible for chapter 7, an entity must fall within the definition of “person” in section 101(41), which excludes, with certain limited exceptions, “governmental units.”  Section 101(27), in turn, defines governmental units to include municipalities.   Because a municipality generally will not be deemed a “person,” it generally will not be eligible for relief under chapter 11.  If an entity is a municipality ineligible for chapter 7 and chapter 11 and fails to meet the criteria for relief under chapter 9, it will have no restructuring options under federal law.  If this is the case, the entity would be subject to state law, and its bankruptcy process will depend on the state in which it is located.