Can a City or School District File for Bankruptcy?

The staggering number of layoffs and furloughs caused by coronavirus pandemic prompt many to wonder how government entities—like cities and school districts—will address budgetary shortfalls that are sure to follow. While impossible to predict, towns and other municipalities struggling under financial stress can turn to Chapter 9 bankruptcy for relief.

Cities, School Districts, and Other Municipalities File Chapter 9 Bankruptcy

Cities and school districts don't use Chapter 7 or Chapter 13 the way an individual would, or even Chapter 11—the bankruptcy type most often used by businesses. Instead, municipalities seek relief under Chapter 9—a rarely used chapter with less than 700 case filings since 1937. However, that could soon change.

Recent events like the 2008 financial crisis and the COVID-19 pandemic have raised new legal concerns, with some speculating that Chapter 9 might be used by municipalities more frequently. Defined as a "political subdivision or public agency or instrumentality of a State," a municipality includes:

• cities (the largest city to file for Chapter 9 was Detroit, Michigan in 2013)
• counties (Orange County, California filed in 1994 and Jefferson County, Alabama filed in 2011)
• villages
• townships
• school districts (such as the San Jose Unified School District in 1983)
• public improvement districts, and
• highway, bridge, and gas authorities.

(11 U.S.C. §§ 101(40), 109(c).)

Will COVID-19 Force School Districts into Chapter 9 Bankruptcy?

Possibly. In regular economic times, it's almost unheard of for a school district to turn to Chapter 9 (only two educational institutions have completed Chapter 9 successfully). The problems experienced by many school districts usually involve issues more complicated than an unbalanced budget.

But COVID-19, like any economic crisis, has brought job losses, business closures, and declines in manufacturing and construction—all of which reduce the income, property, and excise tax revenues needed to fund school districts. Since many school districts were already suffering financially before the COVID-19 outbreak, severe budget cuts, and the increased costs associated with complying with social distancing rules are almost sure to hit school district budgets hard.

But it's unlikely that funding will be the only problem school districts face. The coronavirus pandemic could present another hurdle—lawsuits.

With little known about the transmission of COVID-19, school districts are at a disadvantage when it comes to protecting educators, students, and staff, opening the door for parents and other parties to file lawsuits claiming injuries due to a school district's failure to act reasonably. Considering that defense costs alone can be staggering, one or two hefty court judgments could prove too much for a district to absorb.

What Will Happen If a City or School District Files for Chapter 9?

Chapter 9 is a reorganization bankruptcy that allows the municipality to draft a plan to reorganize its debt and repay creditors, often at a discount. It gives cities, towns, counties, and other public districts protection from creditors while allowing the municipality to pay back debt through a repayment plan.

Usually, the city, school district, or other municipality negotiates with creditors to reduce the balance owed and interest on its obligations. It's also common to negotiate an extension of time to repay debts and new financing. For many, one of the most concerning obligations a city can reduce in Chapter 9 is employee retirement benefits. Discharging lawsuit judgments in bankruptcy can also prove controversial.

How Does a Chapter 9 Bankruptcy Start?

The process for authorizing a Chapter 9 municipal filing varies by state. After receiving the authority to proceed, the municipality files a Chapter 9 petition with a list of its creditors with the bankruptcy court. An appellate court justice rather than a bankruptcy judge presides over the case to avoid political involvement in the judge selection.

The bankruptcy court's limited Chapter 9 responsibilities include reviewing eligibility, approving the petition, confirming the repayment plan, and overseeing plan implementation. Under Chapter 9 bankruptcy, the federal court does not liquidate (sell) any assets. The municipality retains property unless it's otherwise part of the repayment plan. The tenth amendment of the U.S. Constitution prevents the federal court from involving itself more significantly in state financial matters.

Cities and School Districts Receive Creditor Protection

As in Chapter 7, 13, and 11 bankruptcy, the automatic stay applies in a Chapter 9 bankruptcy. The automatic stay prevents the municipality's creditors from pursuing collection efforts.

Recent Chapter 9 Bankruptcies Filed by Cities (and Counties)

After the 2008 financial crisis, several high profile Chapter 9 bankruptcies surfaced in the news, including those filed on behalf of the following municipalities:

• Vallejo, California in 2010
• Jefferson County, Alabama in 2011
• Stockton, California in 2012
• Mammoth Lakes, California in 2012
• San Bernadino County, California in 2012
• Central Falls, Rhode Island in 2011, and
• Detroit, Michigan in 2013.