Municipal bankruptcies under Chapter 9 of the Bankruptcy Code, 11 U.S.C. §§ 901-946 (Chapter 9), are rare. These cases are often filed to adjust bonded indebtedness and pension obligations. Congressional authorization for Puerto Rico and its instrumentalities to file for bankruptcy under the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) was similarly out of concern for excessive bond debt and pensions.

Nonetheless, bonds and pensions are not the only liabilities that municipal or territorial debtors incur. Like corporate debtors, governmental entities incur trade debts and other liabilities. Creditors providing goods or services during a debt adjustment case may face obstacles in collecting what are typically considered “administrative claims” in a corporate reorganization.

Introduction to Chapter 9 and Title III of PROMESA

Chapter 9 generally provides for the adjustment of municipal debts in bankruptcy court. Although it incorporates many sections from the Bankruptcy Code, Chapter 9 has unique provisions and differences from corporate bankruptcies.

For example, unlike cases of individual or corporate debtors, bankruptcy courts have limited authority to control a Chapter 9 debtor. These limitations are mandated by the states’ reservation of powers in the 10th Amendment to the Constitution. See, United States v. Bekins, 304 U.S. 27 (1938). The 10th Amendment accordingly underlies many of the policies reflected in Chapter 9, including a prohibition against the bankruptcy court interfering with the municipal debtor’s political powers, governmental powers, property, or revenues. See, 11 U.S.C. § 904. Consequently, these differences can have a substantial effect on creditors’ claims and recoveries in Chapter 9 as opposed to other bankruptcies.

Title III of PROMESA, 48 U.S.C. §§ 2161-2177 (Title III), provides a remedy similar to Chapter 9 that enables Puerto Rico and its “territorial instrumentalities” to adjust their debts without the consent of creditors. See, id. §§ 2104, 2162, 2166. Among other things, PROMESA established a Financial Oversight and Management Board for Puerto Rico (the Oversight Board). Although Puerto Rico is not a state for purposes of the 10th Amendment — see, Franklin California Tax-Free Tr. v. Puerto Rico, 805 F.3d 322, 344 (1st Cir. 2015) aff’d, 136 S. Ct. 1938 (2016) — Congress concluded that, much like Chapter 9, Title III should provide the Oversight Board and Puerto Rico with protections and control. See, In re Fin. Oversight and Mgt. Bd. for Puerto Rico, 2017 WL 5501317, at *3 (D.P.R. Sept. 14, 2017). Without limitation, unless the Oversight Board consents, the court may not interfere with the debtor’s political powers, governmental powers, property, or revenues. See, 48 U.S.C. § 2165.

Allowance and Payment of Administrative Claims

Given the autonomy afforded to debtors under Chapter 9 and Title III, debtors generally have discretion to pay prepetition or postpetition debts without prior court authorization. See, e.g., Matter of Sanitary and Imp. Dist. No. 7 of Lancaster County, Neb., 96 B.R. 967, 972 (Bankr. D. Neb. 1989). This discretion is often restricted, however. Cash flow constraints, disputes over goods or services, political pressure, or other causes may force a debtor to pick and choose which postpetition creditors will be paid in the ordinary course.

Both Chapter 9 and Title III provide that — unless the creditor agrees otherwise — claims specified in 11 U.S.C. § 507(a)(2) must be paid in full on the effective date of any confirmed plan of adjustment of debts. See 11 U.S.C. § 943(b)(5); 48 U.S.C. § 2174(b)(4). Section 507(a)(2) provides an order of priority and lists “administrative expenses allowed under section 503(b)” of the Bankruptcy Code as second in line. Thus, an allowed administrative claim is one of the best outcomes for an unsecured creditor in a Chapter 9 or Title III case.

Necessary Costs of Preserving the Estate Under 11 U.S.C. § 503(b)(1)(A)

Section 503(b)(1) of the Bankruptcy Code provides a nonexclusive list of administrative claims. Among others, “the actual, necessary costs and expenses of preserving the estate” are administrative claims. See, 11 U.S.C. § 503(b)(1)(A). In corporate reorganizations, the test for allowance of such claims is typically as follows: 1) the claim must have arisen postpetition, rather than from a prepetition transaction with the debtor; and 2) the consideration supporting the claim must have benefitted the bankruptcy estate in some demonstrable way. See, In re FBI Distrib. Corp., 330 F.3d 36, 42 (1st Cir. 2003).

The theory behind administrative claims is that parties induced to supply goods and services to a debtor in bankruptcy are entitled to priority treatment. See, e.g., Matter of Jartran, Inc., 732 F.2d 584, 586-87 (7th Cir. 1984). However, given the policies and statutory structures of Chapter 9 and Title III, creditors with claims that arise postpetition may not fit the traditional test for administrative priority.

Chapter 9 and Title III incorporate only particular provisions of the Bankruptcy Code. Section 541, which defines “property of the estate,” is not incorporated. See, 11 U.S.C. § 901; 48 U.S.C. § 2161. Rather, where the terms “property of the estate” are used in the Bankruptcy Code, both Chapter 9 and Title III replace them with “property of the debtor.” See, 11 U.S.C. § 902(1); 48 U.S.C. § 2161(c)(5).

Section 363 of the Bankruptcy Code, which regulates the use, sale or lease of property, is similarly omitted from Chapter 9 and Title III. See, 11 U.S.C. § 901; 48 U.S.C. § 2161. Unlike a Chapter 11 corporate reorganization, neither Chapter 9 nor Title III include the concept of a debtor in possession. See, 11 U.S.C. §§ 901, 1101, 1107; 48 U.S.C. § 2161.

“By virtue of § 904, a debtor in Chapter 9 retains title to, possession of, and complete control over its property and its operations, and is not restricted in its ability to sell, use, or lease its property.” See, In re Valley Health System, 429 B.R. 692, 714 (Bankr. C.D. Cal. 2010); see also, In re City of Detroit, 841 F.3d 684, 697-98 (6th Cir. 2016). A similar provision is included in Title III at 48 U.S.C. § 2165. See, Fin. Oversight and Mgt. Bd. for Puerto Rico, 2017 WL 5501317, at *3.

Based upon these principles, at least one Chapter 9 court has denied allowance of administrative claims under 11 U.S.C. § 503(b)(1)(A). In In re New York City Off-Track Betting Corp., 434 B.R. 131,
141-42 (Bankr. S.D.N.Y. 2010), the court held that “[b]ecause a chapter 9 debtor’s property remains its own and does not inure into a bankruptcy estate as provided by section 541 of the Bankruptcy Code, there can be no administrative expenses for ‘the actual and necessary costs of preserving the estate’ as contemplated by section 503(b)(1)(A) of the Bankruptcy Code.” (emphasis added). Commentators may criticize this decision, but Chapter 9 and Title III creditors should not disregard the reasoning or result. See, Andrew Minear, Unfortunate Consequences of a Patchwork Chapter, 32 Am. Bankr. Inst. J. 38 (December 2013). The posture of a case may determine whether the court will allow an administrative claim under 11 U.S.C. § 503(b)(1)(A). In In re Craig County Hospital Authority, 572 B.R. 340, 350-51 (Bankr. N.D. Okla. 2017), a liquidating trustee objected to administrative claims, arguing that the court should follow the holding in the Off-Track Betting case. The court rejected this argument.

In particular, the debtor had proposed and confirmed a plan that provided for allowance and payment of administrative claims. The court viewed the disallowance of claims for services essential to the debtor’s ongoing postpetition operations would be akin to a “bait and switch.” Id. at 351. Accordingly, postpetition creditors should scrutinize any proposed Chapter 9 or Title III plan to ensure there is no ambiguity in the standards for allowing and paying administrative claims.

Finally, creditors seeking administrative priority should consider attempting to avoid the statutory requirement of “preserving the estate” in 11 U.S.C. § 503(b)(1)(A). Section 503(b)(1) contains a non-exhaustive list of “administrative claims.” Some courts have allowed payment of administrative priority claims even though the claimant did not provide a benefit to the bankruptcy estate in a corporate reorganization. These cases are based upon “fundamental fairness,” and primarily rely upon the reasoning of the Supreme Court’s decision in Reading Co. v. Brown, 391 U.S. 471 (1968). The “fundamental fairness” exception is most often recognized when the debtor’s postpetition operations cause tortious injuries to third parties or when the claim arises from postpetition actions that deliberately violate applicable law and damage others. See, In re Healthco Intern., Inc., 272 B.R. 510, 513 (BAP 1st Cir. 2002).

Decisions adopting the fundamental fairness theory may be of little assistance to a postpetition creditor in Chapter 9 or Title III, however. Some principles in corporate reorganizations simply do not apply in municipal bankruptcies. See, In re Richmond Unified Sch. Dist., 133 B.R. 221, 224-25 (Bankr. N.D. Cal. 1991). The Reading decision in particular is based upon the equity of having prepetition creditors bear the cost of a court allowing a bankruptcy estate to continue operating for the creditors’ benefit. See, Reading, 391 U.S. at 478-79. While corporate bankruptcy is intended to preserve enterprise value for creditors, a primary purpose of municipal bankruptcies is to ensure public services. See, In re Mt. Carbon Metro. Dist., 242 B.R. 18, 34 (Bankr. D. Colo. 1999).

Thus, the equities underlying the fundamental fairness doctrine may not be applicable in Chapter 9 or Title III. The Bankruptcy Court for the Northern District of Alabama denied a request for administrative claim priority that was largely premised upon the Reading decision. However, the claim at issue was a contested tax refund, and the facts and ruling may be distinguishable depending upon the circumstances. See, In re Jefferson Cnty., Ala., Case No. 11-05736, Transcript at Docket No. 2931 (Bankr. N.D. Ala. June 19, 2015).

Other Potential Administrative Expenses Under Section 503(b)

The aforementioned limitations with respect to claims under 11 U.S.C. § 503(b)(1)(A) may not be applicable to other enumerated administrative claims that are not limited to preserving the municipal debtor’s “estate.” For instance, the “actual, necessary costs and expenses of closing a health care business” are entitled to administrative priority. See, id. § 503(b)(8). Also, creditors that make “a substantial contribution in a case” under Chapter 9 or Title III are entitled to an administrative claim for “actual, necessary expenses.” See, id. § 503(b)(3)(D); 48 U.S.C. § 2161(a), (d). This provision, however, is generally limited to a creditor’s contribution to the actual case, as opposed to the debtor’s ongoing operations. See, Matter of Consol. Bancshares, Inc., 785 F.2d 1249, 1253 (5th Cir. 1986).

In addition, creditors that provide goods to a debtor within 20 days prior to the commencement of the Chapter 9 or Title III case may be entitled to an administrative claim for the value of such goods. See, 11 U.S.C. § 503(b)(9).

Preapproval of 503(b) Administrative Expense Claims

Postpetition creditors that are concerned about payment may ask the debtor for prior court approval of an administrative claim before providing goods or services. For the reasons discussed earlier in this article, the court may only grant such request with the debtor’s consent.

In particular, Chapter 9 and Title III omit 11 U.S.C. §§ 364(a) & (b), which generally provide that debtors can incur unsecured trade debt in the ordinary course of business, or with court approval outside the ordinary course, and such debt will be treated as administrative claims. See, id. § 901, 48 U.S.C. § 2161(a). Pursuant to 11 U.S.C. § 364(c), however, debtors may request preapproval of unsecured credit with “priority over any and all administrative expenses of the kind specified in section 503(b)(1).” See, 11 U.S.C. §§ 364(c), 901; 48 U.S.C. § 2161(a).

One recent example of administrative claim approval was in the Title III case of the Commonwealth of Puerto Rico. The Oversight Board requested, and the court approved, administrative claim treatment for any unpaid postpetition utility services. See, In re Commonwealth of Puerto Rico, Case No.
17-03283, Order at Docket No. 1016 (D.P.R. Aug. 11, 2017).

Confirmation Standards May Not Protect Unsecured Creditors

An unsecured creditor that cannot fit its claim into an administrative category does not have much leverage in a Chapter 9 or Title III case. If anything, the creditor will have to rely upon the plan confirmation terms to obtain as large of a return as possible.

The Chapter 9 or Title III debtor’s broad autonomy is restricted with respect to plan confirmation. By pursuing confirmation of a plan, the debtor necessarily consents to the court enforcing the confirmation provisions in Chapter 9 or Title III, as applicable. See, In re County of Orange, 179 B.R. 195, 200 n.13 (Bankr. C.D. Cal. 1995).

One confirmation standard with arguably superficial appeal to unsecured creditors is the “best interests of creditors” test. See, 11 U.S.C. § 943(b)(7), 48 U.S.C. § 2174(b)(6). In Chapter 9, courts generally agree that the debtor need only show “that a proposed plan provides a better alternative for creditors than what they already have.” See, In re City of Stockton, Cal., 542 B.R. 261, 285 (BAP 9th Cir. 2015) (citations and quotations omitted).

Unfortunately for the unsecured postpetition creditor, showing that a proposed plan provides a better alternative for creditors is often easy to establish. Chapter 9 and Title III creditors cannot propose a plan, cannot have a trustee appointed, typically cannot force a sale of municipal assets under applicable law, and the only alternative to a debtor’s plan is dismissal, which is most likely worse than a plan. See, id.

The fair and equitable standard may also be a contested issue at confirmation. See, 11 U.S.C. §§ 901, 943(b)(1), 1129(b); 48 U.S.C. §§ 2161, 2174(b)(1), (c). In corporate reorganizations, this generally requires, among other things, that unsecured creditors be paid in full before equity investors retain or receive any property. See,11 U.S.C. § 1129(b)(2)(B).

In Chapter 9 and Title III, however, unsecured creditors will find little comfort with this rule. See, In re Corcoran Hosp. Dist., 233 B.R. 449, 457-58 (Bankr. E.D. Cal. 1999). The fair and equitable standard has been held to merely require that unsecured creditors receive all they can reasonably expect under the circumstances. See, In re Hardeman County Hosp. Dist., 540 B.R. 229, 239 (Bankr. N.D. Tex. 2015). When dealing with governmental debtors, creditors cannot expect that all future cash go toward paying unsecured creditors because the debtor must retain sufficient funds to continue to provide future governmental services. See, id. Thus, for plan confirmation purposes, unsecured creditors are not assured a full recovery.

Conclusion

Unsecured trade creditors that provide services to debtors in Chapter 9 or Title III are not guaranteed the protections typically enjoyed in a corporate reorganization. Creditors are well advised to be aware of their limited remedies and to plan accordingly.

At a minimum, creditors should bring to the court’s attention any ambiguity in a plan regarding the standard for allowing administrative claims. If a creditor provides essential services or has some exercisable leverage, it may be prudent to request that the debtor seek preapproval of an administrative claim. Otherwise, the unwary postpetition creditor may find itself treated as a general unsecured creditor that is unlikely to enjoy a full recovery upon confirmation of a plan.

Republished with permission. This article first appeared in the February 2018 issue of The Bankruptcy Strategist.