March 27, 2014 Articles

When Negotiations Are "Impracticable": Detroit and Chapter 9 Eligibility

The troubled Motor City satisfies a key condition to bankruptcy filing.

By Brendan M. Gage

The Bankruptcy Court for the Eastern District of Michigan recently determined that the City of Detroit was eligible for relief under Chapter 9 of the Bankruptcy Code. See In re City of Detroit, Mich., 504 B.R. 97 (Bankr. E.D. Mich. 2013). In rendering its decision, a major issue addressed by the court was whether Detroit satisfied one of the four eligibility conditions in 11 U.S.C. § 109(c)(5). The court concluded that while Detroit did not negotiate with creditors in “good faith” prior to filing its bankruptcy petition under section 109(c)(5)(B), its failure to do so did not prevent the city from qualifying as a Chapter 9 debtor because such prepetition negotiations were “impracticable” under section 109(c)(5)(C).

The court’s decision highlights the need for the prospective Chapter 9 debtor to conduct a prepetition analysis of whether it should attempt negotiations with creditors in light of section 109(c)(5). This determination is important because the failure to satisfy section 109(c)(5) could result in dismissal of the debtor’s bankruptcy petition. See, e.g., In re Sullivan Cnty. Reg’l Refuse Disposal Dist., 165 B.R. 60, 83 (Bankr. D.N.H. 1994); In re Ellicott Sch. Bldg. Auth., 150 B.R. 261, 266 (Bankr. D. Colo. 1992). To guide the prospective Chapter 9 debtor, this article provides an overview of section 109(c)(5) and analyzes how the City of Detroit was able to meet this key requirement.

Eligibility Requirements of Chapter 9
There are five mandatory requirements for relief under Chapter 9, which the debtor must establish by a preponderance of the evidence. Int’l Ass’n of Firefighters, Local 1186 v. City of Vallejo (In re City of Vallejo), 408 B.R. 280, 289 (B.A.P. 9th Cir. 2009). Generally stated, the first four requirements (contained in sections 109(c)(1)–(4)) provide that the debtor must be “an insolvent municipality which is specifically authorized to be a Chapter 9 debtor under state law and which desires to effect a plan to adjust [its] debts.” In re Connector 2000 Ass’n, Inc., 447 B.R. 752, 758 (Bankr. D.S.C. 2011) (internal quotation omitted). The fifth requirement is set forth in section 109(c)(5).

Overview of Section 109(c)(5). By its terms, section 109(c)(5) can be satisfied by the debtor four different ways. In re Valley Health Sys., 383 B.R. 156, 162–63 (Bankr. C.D. Cal. 2008) (section 109(c)(5) provides four distinct options because it is written in the disjunctive). First, the debtor may “obtain[] the agreement of creditors holding a majority in amount of the claims in each class” the debtor “intends to impair under a [Chapter 9] plan . . . .” 11 U.S.C. § 109(c)(5)(A). Second, the debtor may show that it “has negotiated in good faith with creditors” but failed to obtain an agreement on the terms of a plan. Id. § 109(c)(5)(B). Third, the debtor may show that it “is unable to negotiate with creditors because such negotiation is impracticable.” Id. § 109(c)(5)(C). Finally, the debtor may show that it “reasonably believes that a creditor may attempt to obtain a [preferential] transfer.” Id. § 109(c)(5)(D).

Legislative history. Section 109(c)(5) is the product of a Congressional compromise. Under the former Bankruptcy Act, the debtor was required to file its Chapter 9 petition with a reorganization plan preapproved by 51 percent of creditors. See In re Cottonwood Water & Sanitation Dist., Douglas Cnty., Colo., 138 B.R. 973, 975–76 (Bankr. D. Colo. 1992). The preapproval requirement could not be met by large cities, and in the wake of the financial crisis of the mid-1970s, Congress sought to eliminate it. Id. at 977–78. Fearing easy access to Chapter 9, the municipal bond community resisted, forcing Congress to compromise. 2 Collier on Bankruptcy ¶ 109.04[3][e] (Henry J. Sommer & Alan N. Resnick eds. 16th ed. 2011). In 1976, Congress passed an amendment retaining the preapproval provision, but it added the impracticability condition and others as alternatives. Id. These alternatives have been largely retained in section 109(c)(5).  

Section 109(c)(5)(A): The Plan Acceptance Condition. A vestige of the Bankruptcy Act, the plan acceptance condition of section 109(c)(5)(A) is a difficult condition to satisfy. Prepetition, the debtor must have a Chapter 9 plan proposal accepted by a majority in amount of claims in each class the debtor intends to impair under a plan. 11 U.S.C. § 109(c)(5)(A). Case law under this condition is scant as few debtors have been able to garner such a consensus amongst their typically diverse and acrimonious body of creditors. 

Section 109(c)(5)(B): The Good Faith Negotiation Condition. While section 109(c)(5)(A) assumes successful prepetition negotiations, section 109(c)(5)(B) does not. Instead, the debtor must show that it “has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class” the debtor “intends to impair under a plan.” 11 U.S.C. § 109(c)(5)(B).

Courts interpret section 109(c)(5)(B)’s reference to a “plan” to require the debtor to make an initial showing that prepetition negotiations with creditors revolved around a specific Chapter 9 plan proposal. See, e.g., Sullivan Cnty., 165 B.R. at 78. Although courts have stopped short of requiring a formal plan, the necessary substance of the plan proposal remains unclear. See, e.g., Vallejo, 408 B.R. at 297 (“[S]ome outline or a term sheet of a plan which designates classes of creditors and their treatment is necessary.”); Sullivan Cnty., 165 B.R. at 78 (“[S]ome sort of comprehensive plan is required . . . .”).

As a practical matter, formulating a detailed plan proposal should help the debtor identify the universe of creditors with whom it must negotiate. For example, if the debtor contemplates paying a class of creditors in full, that class is not “impaired” under the plan and negotiation with the class is unnecessary. See In re Town of Westlake, Tex., 211 B.R. 860, 867–68 (Bankr. N.D. Tex. 1997).

Apart from establishing the existence of a plan proposal, the debtor must also demonstrate that it negotiated in “good faith.” The good faith inquiry is a particularly intricate analysis because courts recognize that negotiation is a two-way street requiring “some very minimal burden of reciprocity be placed on parties with whom a debtor must negotiate.” Westamerica Bank v. Mendocino Coast Recreation and Park Dist. (In re Mendocino Coast Recreation & Park Dist.), No. 12–CV–02591–JST, 2013 WL 5423788, at *7 (N.D. Cal. Sept. 27, 2013). Accordingly, courts generally review the timeline of the negotiations and focus on (1) the degree of the disclosure about the proposed bankruptcy plan; (2) the time creditors were given to respond; and (3) the responses of the creditors. See id.

If the debtor presents a sufficiently detailed plan proposal and gives creditors a reasonable time to respond, then the burden shifts to creditors to make counter-proposals. See Detroit, 504 B.R. at 176. For any class that then responds with an immutable position, the debtor is deemed to have satisfied the good faith requirement with respect to that class. See In re City of Stockton, Cal., 493 B.R. 772, 792–93 (Bankr. E.D. Cal. 2013). The good faith inquiry’s focus on the prepetition behavior of the debtor and its creditors makes satisfying section 109(c)(5)(B) difficult to predict.

Section 109(c)(5)(C): The Impracticability Condition. The impracticability condition of section 109(c)(5)(C) is probably the easiest condition to satisfy, given its broad interpretation by courts. Congress did not define “impracticable.” Consequently, courts look to the plain meaning of the term. “‘Impracticable’ means ‘not practicable; incapable of being performed or accomplished by the means employed or at command; infeasible.’” Valley Health Sys., 383 B.R. at 163. Likewise, “impracticability” means “[a] fact or circumstance that excuses a party from performing an act . . . because (though possible) it would cause extreme and unreasonable difficulty.” In re New York City Off-Track Betting Corp., 427 B.R. 256, 277 (Bankr. S.D.N.Y. 2010) (internal citations omitted). In applying these broad definitions, courts have concluded that the impracticability determination is “a fact-sensitive inquiry that ‘depends upon the circumstances of the case.’” Id. (quoting Vallejo, 408 B.R. at 298).

The debtor can satisfy the impracticability condition based on the “sheer number” of its creditors. See, e.g., In re Pierce Cnty. Hous. Auth., 414 B.R. 702, 713–14 (Bankr. W.D. Wash. 2009) (over 7,000 creditors and interested parties); Stockton, 493 B.R. at 794 (2,400 retirees and “no natural representative capable of bargaining on their behalf.”). But see Ellicott Sch. Bldg. Auth., 150 B.R. at 266 (no allegations of impracticable negotiations and debtor held public meetings to which all bondholders were invited). These cases illustrate that the impracticability condition should be easier to meet for larger municipalities who tend to have more creditors.

However, the debtor can also demonstrate impracticability in situations other than those necessarily encountered by large municipalities. For example, the debtor can show impracticability by the “need to file a petition quickly to preserve [its] assets.” Vallejo, 408 B.R. at 298; see In re Boise Cnty., 465 B.R. 156, 169 (Bankr. D. Idaho 2011) (county anticipated imminent execution on cash accounts); In re Cnty. of Orange, 183 B.R. 594, 607–08 (Bankr. C.D. Cal. 1995) (lenders demanded additional collateral and threatened to liquidate portfolio). The debtor also can show impracticability when there is a “need to act quickly to protect the public from harm,” City of San Bernardino, Cal., 499 B.R. 776, 786 (Bankr. C.D. Cal. 2013), or a breakdown in negotiations with a large creditor. See Off-Track Betting Corp., 427 B.R. at 278; In re Villages at Castle Rock Metro. Dist. No. 4, 145 B.R. 76, 85 (Bankr. D. Colo. 1990). None of the above examples are exhaustive and often the debtor’s situation is a blend of them.

Section 109(c)(5)(D): The Preference Condition. The final alternative is the preference condition of section 109(c)(5)(D). This provision requires the debtor to show it “reasonably believes that a creditor may attempt to obtain a [preferential] transfer” under section 547. 11 U.S.C. § 109(c)(5)(D). Section 547 avoids certain kinds of prepetition transfers of the debtor’s property interests to creditors. See id.§ 547(b). Although the case law is sparse, an attempt to execute a judgment on the debtor’s property may constitute—or help to effectuate—a “transfer” of the debtor’s property that satisfies the preference condition. See Boise Cnty., 465 B.R. at 170 (finding creditor’s attempt to execute on debtor’s accounts satisfied § 109(c)(5)(D)).

The Detroit Decision
In its opinion, the bankruptcy court analyzed whether Detroit satisfied either the good faith negotiation or the impracticability condition in section 109(c)(5). The court did not address the plan acceptance or the preference condition presumably because the city conceded that they were inapplicable.

Detroit did not negotiate with creditors in good faith. The court first held that the city failed to carry its burden of establishing that it had engaged in good faith negotiations with creditors. Detroit, 504 B.R. at 176. The court concluded that Detroit’s initial bankruptcy proposal was “[c]haritably stated . . . very summary in nature.” Id. at 175. The city had submitted a 128-page document to creditors in which the proposed treatment of $3.5 billion in underfunded pension liabilities were discussed in three bullet points. Id.

Next, the court determined that the city’s approximately 30-day time frame for creditor negotiations was too short. Id. at 176. Within that period, the city permitted creditors a week to request additional information which was furnished in an “electronic data room.” Id. at 175.Access to the room was conditioned on signing a confidentiality and release agreement, which “created an unnecessary hurdle for creditors.” Id.

The vagueness of the city’s proposal and the short amount of time allotted for creditor responses meant that the burden had not shifted to creditors to make counter-proposals. Id. at 176. The city’s credibility was also in question after admitting during the eligibility trial that its meetings with creditors were not negotiations. Id. Substantively, the meetings were “primarily presentational” and “gave little opportunity for creditor input or substantive discussion.” Id.

Ironically, in analyzing whether the city had filed its bankruptcy petition in good faith under section 921(c), the court suggested that Detroit would have been better off not attempting negotiations with creditors and filing bankruptcy sooner. Various creditors maintained that Detroit’s attempted negotiations were a ruse and concealed the city’s real plan to impair pension obligations in bankruptcy. The court rejected this theory of bad faith but not before noting that:

City officials . . . could have avoided the appearance of pretext negotiations, and the resulting mistrust, by simply announcing honestly that because negotiating with so many diverse creditors was impracticable, negotiations would not even be attempted. The law clearly permits that, and for good reason. It avoids the very delay, and, worse, the very suspicion that resulted here.

Id. at 186–87. In other words, Detroit could have avoided creditor negotiations altogether by just filing bankruptcy and asserting satisfaction of the impracticability condition.

Negotiation with Detroit’s creditors was impracticable. Having concluded that the city failed to satisfy the good faith negotiation condition, the court turned to the impracticability condition. The court found that negotiations with Detroit’s creditors was impracticable chiefly because of the city’s large number of creditors and enormous debt. Detroit, 504 B.R. at 178. Potentially billions of the city’s debt was held by unidentified and unrepresented bondholders. Id. at 177–78. The city’s list of creditors was over 3500 pages and contained more than 100,000 names. Id. at 177. The city was also quickly running out of liquidity. Id. at 179.

Furthermore, the court concluded that negotiations with the city’s various retiree associations were impracticable due to their immutable position. Id. Representatives from the associations testified that they would never negotiate a reduction in the billions of underfunded and accrued pension benefits because they considered them to be fully protected by the Michigan Constitution. Id. at 178. Some retirees had asserted this position when they filed lawsuits against Detroit in an attempt to block the city’s bankruptcy. Id. at 179. Many retirees also lacked a representative to negotiate on their behalf. Id. at 178. Union leaders could not bind non-member retirees and the various voluntary retirement associations would have left the acceptance or rejection of any settlement offer up to each individual retiree. Id.

Ultimately, “when Congress enacted the impracticability section, it foresaw precisely the situation facing the City of Detroit,” the court remarked. Id.

The case law demonstrates that the impracticability condition of section 109(c)(5)(C) is the easiest condition for the prospective Chapter 9 debtor to satisfy. The three other conditions of section 109(c)(5) are generally either too difficult or vague. Detroit was able to rely principally on its sheer numbers of creditors and enormous debt to meet the impracticability condition and sidestep its failure to engage in good faith negotiations with creditors. Based on the case law, smaller municipalities that lack many creditors and colossal levels of debt should likewise be able to satisfy the impracticability condition and avoid creditor negotiations if they can identify some event or circumstance that requires an immediate bankruptcy filing. Still, the prospective Chapter 9 debtor is best advised to attempt prepetition negotiations with creditors if possible. A subsequent impasse may then provide the debtor with evidence that negotiations with creditors have become (or were always) impracticable.

Keywords: bankruptcy and insolvency litigation, Detroit, Chapter 9 eligibility, Bankruptcy Code

Brendan M. Gage – March 27, 2014