The good news is that public works construction projects for municipalities are projected to remain a major sector of construction activity for the foreseeable future. The not-so-good news is that municipal bankruptcy filings are on the rise, and they are likely to increase. The issues facing parties under contract with a municipality when it files for bankruptcy protection are playing out nationally in places like Stockton, California, and Detroit, Michigan. Construction lawyers now more than ever need to know the risks of a public owner filing for bankruptcy protection before project completion, and what they can do in the event it does so before the project is closed out—thereby jeopardizing the owner's ability to pay.

A public owner or municipality may file for protection under Chapter 9 of the Bankruptcy Code if it is insolvent, desires to effect a plan to adjust its debts and satisfies the other eligibility requirements under 11 U.S.C. §109(c). (How a municipality establishes "insolvency" and other "eligibility" requirements is beyond the scope of this article. These issues are complicated, invariably contested and always time-consuming to resolve.) On the petition date, and before eligibility is determined, the automatic stay provisions of Bankruptcy Code Sections 362 and 922(a) kick in, and all contract claim proceedings and legal actions against the municipality are stayed.

The stay creates complications for all creditors, including both ordinary course of business contracting parties and claimants seeking disputed amounts owed. Ordinary course of business creditors may continue to be paid post-petition, although prudence may lead them to file claims to protect their rights pending payment. Claimants seeking disputed amounts must file timely their claims with the Bankruptcy Court. Then, depending on whether the claim is contested and its priority, it ultimately may be paid only pennies on the dollar.

Municipal bankruptcy filings under Chapter 9 present many additional, unique issues not found in Chapter 11 or Chapter 7 filings. Unlike a more typical Chapter 11 or Chapter 7 filing, no bankruptcy "estate" is created in a Chapter 9 case, no trustee is appointed, and the municipality continues to be governed and controlled by its same officials. In deference to notions of sovereignty, under Chapter 9, there is no authority to order a liquidation of the entity and there exists a general reluctance by the Bankruptcy Court to interfere with the municipality's performance of its ongoing functions.

Among the earliest, and often most contentious, issues in any municipal bankruptcy are the decision whether and the terms under which the municipality will assume or reject its executory contracts. While this has most often played out in recent Chapter 9 bankruptcies between a municipality and its pension plans and labor unions, the same issues are in play for construction contracts. A contractor will, of course, want to know where it stands with its now-bankrupt client.

At a minimum, the contractor should consider promptly seeking assurances from a Chapter 9 debtor that it will be kept current if the contractor continues performing, or seeking an expedited determination from the Bankruptcy Court requiring the debtor to assume or reject its construction contract. Under the Bankruptcy Code, when the debtor rejects an executory contract, rejection is deemed a breach as of the petition date. In other words, the contractor's claim will almost certainly be treated as a general unsecured claim.

One route to potentially avoid the undesirable status of a general unsecured creditor is to determine whether or not the "public works" project that is the subject of the claim is or was being funded, in whole or in part, using "special" or "restricted" funds, versus using only the municipality's general funds. Unlike private projects, public works projects often are funded by bonds or grants, or are otherwise subject to laws that specifically restrict the use of funds to particular projects. As pointed out in the City of Vallejo (California) bankruptcy case [In re City of Vallejo (2009) 408 B.R. 280], the complexity of municipal accounting "includes a mix of laws authorizing the creation of funds; laws restricting the use of funds; facts as to the correct amount of funds available in particular funds; laws de-authorizing the funds; laws loosening the restrictions; laws and facts regarding the source of financing for the funds; and facts as to [the municipality's] discretionary allocation of amounts in the funds." Id. at p. 292.

In recognition of the unique nature of municipal accounting, the Bankruptcy Code provides special treatment or protection to special or restricted funds. Under Section 922(d), the stay does not apply to the application of "pledged special revenue," and indeed under Section 927, the holder of a claim payable solely from special revenues under applicable non-bankruptcy law shall not be treated as having recourse against the municipal debtor on account of such claim. Thus, if funding for the underlying project can be tied to such an identifiable "restricted" source of funding, it may be possible for a claimant to get relief from the stay in order to prosecute a project-related claim outside of the bankruptcy proceedings. A simplified real-life example illustrates the point.

A municipal owner issued a series of bonds for a major water project, which provided funds to design and construct, among other things, a water pipeline and pump station to supply water to the municipality. A construction contract was let to construct a pump station as part of that project, which was to be funded by the proceeds of the bond sales, as documented in the city's public records. They were "restricted" funds, meaning that they could be used to pay only for projects and costs within the bond's (or grant's) defined scope, and the municipality could not use these funds to satisfy its general obligations. Disputes developed between the contractor and the municipality during construction, resulting in the contractor's claiming significant cost overruns and the municipality's withholding the contractor's retention. Meanwhile, the municipality's financial condition had deteriorated rapidly, leading it to file for bankruptcy protection, which immediately stayed any efforts by the contractor to recover on its claim.

Because of the gridlock occasioned by the bankruptcy filing, including a year-long eligibility fight, the contractor sought legal help. Counsel was able to trace the funding sources for the payment of the project costs to restricted bond funds, and by motion was able to persuade the Bankruptcy Court to grant relief from the automatic stay. The contractor was thus allowed to file and prosecute an action in state court, after demonstrating that the claims could be litigated and, if successfully established, paid using "restricted" bond funds that could not otherwise be used to satisfy the municipality's general operating expenses, and as such, would not interfere with its proposed plan of adjustment.

For construction industry participants on public works projects, a lesson to be learned here is that it pays to know the owner's source of funding for the public works project. This could enable you to assess whether you may be protected against the risk of a municipal bankruptcy filing and, afterward, how to avoid being relegated to general, unsecured creditor status should such a filing occur.

Topics:  Chapter 9, Construction Contracts, Creditors, Debtors, Executory Contracts, Municipal Bankruptcy, Municipal Bonds, Municipalities, Public Works, Unsecured Creditors

Published In: Bankruptcy Updates, Construction Updates, Government Contracting Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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