Since the publication of our two-part municipal bankruptcy series (see NYLJ, March 4, 2010, and May 6, 2010), the strain of rising pension costs, declining tax revenues, and onerous debt obligations has become more acute for many struggling municipalities. Recent decisions regarding Bankruptcy Code section 904, which constrains a bankruptcy court’s oversight of a municipality’s assets and spending power, have affirmed the proposition that a municipal debtor has full discretion to modify its obligations without court approval. Most recently, the courts presiding over the Stockton and Jefferson County cases have clarified the scope of section 904 to afford a municipal debtor the unfettered right to pay creditors on account of their prepetition claims during the pendency of its chapter 9 case.

Statutory Background

Chapter 9 has evolved over the years to keep up with the advances of municipal finance while also ensuring that the provisions of it do not encroach upon the municipal debtor’s sovereignty. In drafting chapter 9 and its predecessor under the Bankruptcy Act of 1898, chapter IX, Congress had to take care not to violate the Tenth Amendment, which bars Congress from interfering with the sovereign affairs of the states. Indeed, in the 1930s, the Supreme Court struck down a jurisdictional provision of the statutory predecessor to chapter 9 as unconstitutional because it permitted bankruptcy courts to interfere with municipal property or revenues if such property was not necessary "in the opinion of the judge for essential governmental services."1