by Claire Zillman

The Depression-era bankruptcy code provision known as Chapter 9, which lets local governments seek protection from creditors while restructuring debt, is a rarely used tool.

Since 1937 there have been a total of just 623 Chapter 9 filings in the United States, with 252 of them coming in the past 30 years. Compare that to the 13,500 Chapter 11 filings entered in 2010 alone. 
Yet with local governments throughout the U.S. continuing to suffer the lingering effects of a sputtering economy, state lawmakers are apparently sensing a possible surge in new Chapter 9 filing--and are moving to stop it before it starts. 

Consider Pennsylvania, where the capital city of Harrisburg--as detailed in the July/August issue of sibling publication The American Lawyer--is teetering on the brink of insolvency.

Facing a debt load of $300 million, Harrisburg has enrolled in Pennsylvania's so-called Act 47 program for distressed municipalities and is now weighing a state-approved recovery plan that calls for the sale of municipal assets, a wage freeze for city workers, and the renegotiation of union contracts. The Harrisburg City Council is to vote on the package July 19. Should the council reject the plan, Mayor Linda Thompson must come up with an alternative solution to the city's fiscal problems.

The vote on the Act 47 plan comes some eight months after the City Council hired Cravath, Swaine & Moore pro bono for advice on how to address its mounting financial woes. Cravath, which is now counseling the city on the state-issued recovery package, was initially brought in to advise on the ramifications of a possible bankruptcy filing.

But Chapter 9 is no longer an option. Last month Pennsylvania lawmakers passed a law that prohibits any financially distressed third-class city in the state--a category that includes Harrisburg--from filing for bankruptcy through June 2012. 

Sean Scott, a Mayer Brown partner who represents institutional lenders and bank groups in workouts and bankruptcy proceedings, wasn't surprised by the move. "What we're seeing in Pennsylvania is consistent with what's happening across the country," Scott says.

In fact, about 25 states already either bar municipal bankruptcy or do not specifically authorize it. Several states that do authorize such filings are, like Pennsylvania, moving to block, delay, or otherwise make the Chapter 9 process harder for cities to pursue. Those states include:

--California The state assembly passed a bill June 2 that would require local government agencies to engage in a neutral mediation process before declaring bankruptcy. A state Senate subcommittee has asked the bill's author, Assemblyman Bob Wieckowski, to make some minor revisions to the legislation before it moves on to another Senate subcommittee. If passed by the state Senate, the bill could land on Governor Jerry Brown's as soon as late August.

--Michigan Governor Rick Snyder signed legislation in March that expands the power of state-appointed emergency financial managers to include the right to terminate union contracts. The law, which offers struggling local governments and school districts assistance at an earlier stage, is aimed at stopping fiscal emergencies before they start in order to prevent full-blown bankruptcies, according to a statement by the bill's sponsor, Representative Al Pscholka.

--Rhode Island In May the state Senate approved a bill that in the event of a bankruptcy filing, forces  municipalities to give their lenders a first lien on both general and property tax revenue, according to The Providence Journal. By requiring that money to go to paying off bond debt, the bill could encourage other creditors to negotiate to avoid a Chapter 9 filing, says James Spiotto, who heads Chapman and Cutler's special litigation, bankruptcy, and workouts practice and tracks Chapter 9 filings closely.

The Rhode Island bill--which passed both houses of the state legislature and awaits the signature of Governor Lincoln Chaffe--probably won't help the small city of Central Falls. The New York Times reported Tuesday that Central Falls, saddled with massive pension obligations, is poised to file for Chapter 9 protection.

Meanwhile, lawmakers in Indiana--one of 21 states lacking a specific process for authorizing a municipal bankruptcy--appear to be more divided on the subject.

A bill recently before both houses of the state legislature would allow fiscally distressed municipalities to request the appointment of an emergency financial manager with the authority to renegotiate contracts and slash spending. Under the state Senate's version of the legislation, bankruptcy remained an option if the financial manager failed to restore fiscal order. The state House, however, stripped the bankruptcy option from the bill. With lawmakers failing to reach consensus, the legislation died. 

Despite the Indiana bill's ultimate death, Mayer Brown's Scott says it is further proof that state governments recognize that they need mechanisms in place to address cities' financial distress: "States are not necessarily saying Chapter 9 is a bad thing, they just want it to be the option of last resort."  

One of the key factors pushing states to try to head off potential municipal bankruptcies, Spiotto notes, is a fear of the wider damage that a filing by even a single city can do to the credit ratings--and ability to borrow--of other municipalities and states themselves.

Leon Barson, a restructuring partner at Pepper Hamilton who worked on the bankruptcy of Westfall Township in Pennsylvania in 2009, echoes that sentiment.

"States are worried about the ripple effect," says Barson, who believes that eliminating the bankruptcy option for local governments altogether is a mistake. "You cannot restructure a municipality's obligations out of court unless the agreements are consensual." he says, noting that getting such agreements is sometimes just not possible.

That's one reason that Mayer Brown's Scott says he expects the number of Chapter 9 filings to inch upward, even with the introduction of legislation that's intended to limit them. 

"I think we will see more Chapter 9 filings because it gives the option for non-consensual restructuring," he says. "Given the number of stake holders involved, the diverse interests of lenders, and the overlaying political process, municipalities face a more challenging restructuring process than, say, a company doing a workout in a private context."