Municipal bankruptcy, or Chapter 9 of the Federal Bankruptcy Code as it is known to lawyers and other players in this space, can be an incredibly effective tool to restructure a financially troubled municipality’s unaffordable legacy obligations. Breach of contract, constitutional impairment, and takings arguments that would restrict governmental attempts to unilaterally alter arrangements with active employees, retirees, and creditors cut no ice in a Chapter 9 bankruptcy. And the federal bankruptcy judge is powerless to interfere with governmental decisions that a petitioning municipality makes about how it will govern itself and how it intends to dispose of its property and assets as part of the bankruptcy process.

So why aren’t more municipal debtors rushing to invoke Chapter 9 when their good-faith efforts to reduce legacy debt obligations are insufficient to balance budgets and eliminate structural operating deficits? And what can asset-based lenders do to mitigate the risks that they will be treated as unsecured creditors in a municipal bankruptcy?

The principal answer to the first question lies in the fact that most politicians view bankruptcy as an anathema. Instead of embracing the option to restructure an insolvent city or town’s finances, reduce structural deficits, and impose new pension and retiree health care terms and employment arrangements that are affordable, politicians typically forswear invoking Chapter 9 and attempt to incrementally fudge their way to a better situation than the one currently facing the financially troubled city or town. Unfortunately, this too-little, too-late policy and practice leads to band aid fixes for mortal wounds. The all-too-familiar result: the politicians end up kicking the municipality’s core problems down the road instead of addressing the causes that have led to the financial crisis in the first place.

There are some important dynamics and factors to bear in mind in assessing the utility of a Chapter 9 bankruptcy.

First, no matter how insolvent a city or town may be, it cannot file for federal bankruptcy relief unless the State or State-designated official (e.g. a receiver) acting on its behalf authorizes it to do so. Thus the State, usually the Governor, is in the driver’s seat when it comes to determining whether to allow a financially troubled city or town to seek debt relief through the invocation of Chapter 9 in federal court.

In a Chapter 9 bankruptcy, the federal circuit’s chief judge for that district appoints the bankruptcy judge who will preside over the Chapter 9 proceedings, and the chief judge can appoint any judge he or she wishes, even one from outside the district.

A great advantage to a financially troubled city or town invoking Chapter 9 is its power to unilaterally implement savings on the first day it files for relief –- for example, by cutting pensions, restructuring retiree and employee health benefits, rejecting existing collective bargaining and other burdensome contracts, and committing itself to an interim pendency plan whereby the municipality can begin to operate the city in a restructured fashion from the day of its first filing with the bankruptcy court.

Thereafter during the pendency of the bankruptcy, the municipality can decide who it wants to pay, when it wishes to do so, and how much –- and the court cannot order the city to raise taxes or to liquidate any of its assets to meet the debts of the city.

Indeed, insolvency–- which is one of the Chapter 9 eligibility hurdles that the municipality must clear –- is an operating-cash test under Chapter 9, but not a balance-sheet test. Thus, no matter what other assets and property a municipality may own, the judge cannot take these into account in determining whether the municipality is insolvent, much less order their liquidation to alleviate its financial problems.

From the day the municipality files its Chapter 9 petition, an automatic stay descends on all claims and claimants against the municipality and its officers, freezing them and preventing any forward movement on any existing or to-be-filed cases. This stay extends not only to suits and administrative claims against the municipality, but also to claims against its officers and other officials, including any emergency manager or receiver appointed before or during the bankruptcy.

Typically, the receiver or emergency manager will succeed to all the powers of the municipality’s elected and appointed officials, thereby centralizing in one person all the city or town’s governmental decision making. And if, as in Rhode Island and in a growing list of states, a statutory lien exists for general obligation bondholders, then these creditors will be protected from any losses or debt reduction as a result of the bankruptcy.

One of the most interesting features of a municipal bankruptcy –- one that differs dramatically from a commercial or private bankruptcy –- is that only the municipality can propose a plan of debt adjustment. Neither the bankruptcy judge nor any of the municipality’s creditors can do so, and there is no liquidation option for the court or creditors to pursue. Thus, Chapter 9 is all about formulating a debt-adjustment plan that the debtor city or town can afford going forward.

The overriding purpose of the Chapter 9 proceeding is to restructure the municipality’s finances in such a way as to leave it with a balanced budget, to eliminate or reduce unsustainable legacy obligations, and to allow it to avoid creditor litigation and live in a financially stable situation for at least the next five foreseeable years pursuant to a court-approved and supervised plan of reorganization and debt adjustment.

One of the great knocks against a municipal bankruptcy is that it is typically deemed to be too expensive –- primarily because of the legal and other professional costs associated with its prosecution, not to mention its potentially time consuming nature. But both Detroit and Central Falls exited bankruptcy in little over a year from the dates of their respective filings to approval of their plans of debt adjustment. Thus, depending on the size, complexity, and litigiousness of the various creditors and their claims, a municipal bankruptcy can be initiated and concluded in a year or so. And the expense is relatively insignificant when compared to the actual and potential savings to the municipality and its taxpayers.

The biggest mistake that states are making is their failure to enact statutes that authorize an emergency manager or receiver to take an insolvent city or town into a Chapter 9 proceeding. States should authorize a Chapter 9 filing because, by failing to do so and thereby taking it off the table during negotiations with creditors and other stakeholders, the state only emboldens these claimants to harden their positions and not to make the kind of substantial concessions that are needed to restore the municipality to fiscal solvency. In other words, even if Chapter 9 should be invoked only as a last resort, it needs to be a viable option when cities or towns are unable to restructure their obligations in a way that leads to the elimination of unsustainable legacy costs and a balanced budget for the foreseeable future.

So what can asset-based lenders do to mitigate the risks that they will be treated as unsecured creditors in a municipal bankruptcy? First and foremost, they should obtain security from a reliable special source of revenue other than the general tax collections; e.g., sewer usage or connection fees. A municipal bankruptcy should not interrupt such payments, and a favorable lien, one that a Chapter 9 bankruptcy judge will respect, should attach in favor of such a creditor. Second, know whether you are lending into a jurisdiction that creates statutory liens for the type of debt obligations at issue. If you are, then there is a greater likelihood that you will receive favorable treatment in a municipal bankruptcy. If not, then you may find yourself in the position of an unsecured creditor, notwithstanding a pledge of the municipality’s “full faith and credit” to pay off the debt.

Given the utility and effectiveness of a Chapter 9 proceeding to restructure unsustainable obligations owed to municipal retirees, active employees, and creditors, it is likely that more municipalities will be invoking this option in the future. Confronting that possibility and its implications – and protecting against its potential adverse consequences – is a new frontier for asset-based lenders to explore and settle.