The 'Insolvency' and 'Good Faith' Requirements: How Chapter 9 of the US Bankruptcy Code Governs Municipal Filings

When a federal bankruptcy judge gavels a municipal insolvency hearing to order, the first question is not how much debt the city owes, but whether it has state permission to be in the courtroom at all. Under Chapter 9 of the US Bankruptcy Code, a city facing financial collapse cannot simply file a petition and halt its creditors.

It must first clear a series of stringent legal thresholds designed to protect state sovereignty. The actionable takeaway for local officials and bondholders is clear: Chapter 9 is not a right, but a heavily gated privilege that requires proving cash-flow insolvency and demonstrating a documented history of failed negotiations.[1][5]

The modern framework for these filings dates back to 1937, when Congress enacted the revised Municipal Bankruptcy Act after the Supreme Court struck down an earlier 1934 version. The justices ruled that the original law improperly interfered with the Tenth Amendment, which guarantees state sovereignty over internal affairs. To survive constitutional scrutiny, the 1937 legislation—and the subsequent 1976 revisions that shaped today's Chapter 9—severely limited the power of federal bankruptcy courts over local governments.[1]

Because of those constitutional limits, a federal judge cannot order a city to liquidate its assets, sell its fire trucks, or raise its property taxes to pay off bondholders. "There is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors," the United States Courts' official guidance states. Instead, the court's role is restricted to approving the petition, confirming a plan to adjust the debts, and ensuring that the plan is implemented.[1]

To even reach the planning stage, a municipality must satisfy four specific eligibility requirements outlined in 11 U.S.C. § 109(c). First, the city, county, or special district must be specifically authorized to file for bankruptcy by its state government. Second, it must be legally insolvent. Third, it must desire to effect a plan to adjust its debts. Finally, it must prove that it has negotiated in good faith with its creditors or that such negotiations were impracticable.[1][2]

The insolvency requirement for municipalities differs fundamentally from the standard applied to private corporations. In a Chapter 11 corporate bankruptcy, a company can file if its liabilities exceed its assets—a balance-sheet test. For a municipality, 11 U.S.C. § 101(32)(C) dictates a strict cash-flow test. A city is only insolvent if it is "currently not paying its debts as they become due" or is "unable to pay its debts as they become due."[2][5]

This distinction means a municipality can carry massive, unfunded pension liabilities or billions in long-term bond debt, yet remain ineligible for Chapter 9 protection as long as it can still make its current monthly payments. The forward-looking nature of this test forces city financial officers to project their cash flows precisely, proving to the court the exact date when the general fund will run dry and essential services will fail.[3][5]

If a city proves it is out of cash, it must then prove it tried to avoid the courtroom. The "good faith" negotiation requirement acts as the final gatekeeper. Before filing, the municipality must attempt to reach a consensual restructuring agreement with the creditors who hold at least a majority of the claims in each class that the city intends to impair.[1]

Documenting these negotiations is a rigorous administrative burden. City attorneys must record every mediation session, every term sheet proposed, and every rejection received from bond insurers and public unions. If a creditor objects to the bankruptcy filing, the court will hold a hearing specifically to evaluate whether the city's pre-filing negotiations were genuine or merely a strategic formality.[1]

"The court may dismiss a petition if it determines that the debtor did not file the petition in good faith or that the petition does not meet the requirements of title 11," the federal rules mandate. If a judge dismisses the case, the city loses the protection of the automatic stay, leaving it vulnerable to immediate lawsuits and revenue seizures by its creditors under state law.[1]

When a city successfully clears these hurdles and the court enters an order for relief, the automatic stay takes effect. This injunction halts all collection actions against the municipality and its officials. It prevents bondholders from filing mandamus actions—lawsuits demanding that city officers raise taxes or divert funds to pay prepetition debts.[1][4]

However, the automatic stay has a critical exception for special revenue bonds. Under 11 U.S.C. § 928, bonds secured by specific project revenues—such as water and sewer fees or toll road collections—continue to be serviced during the bankruptcy. The city must keep applying those pledged revenues to the debt, ensuring that essential infrastructure projects do not default while the broader municipal budget is restructured.[1][2]

General obligation bonds, which are backed only by the city's full faith and credit and its general taxing power, do not receive this protection. During the Chapter 9 case, the municipality is not required to make principal or interest payments on general obligation debt. These unsecured claims are subject to deep cuts, or "haircuts," under the final plan of adjustment.[1]

Unlike Chapter 11, where creditors can propose their own competing reorganization plans if the debtor takes too long, Chapter 9 leaves the municipality in exclusive control. Only the debtor city can file a plan for the adjustment of its debts. This exclusivity prevents creditors from indirectly dictating local government policy by forcing a plan that slashes public services to maximize debt repayment.[1][4]

To confirm the city's plan, the bankruptcy judge must determine that it is both feasible and in the "best interests of creditors." In a corporate case, this test requires that creditors receive at least as much as they would in a liquidation. Because a city cannot be liquidated, courts interpret the municipal "best interests" test to mean that the proposed plan offers a better alternative for creditors than simply dismissing the case and leaving them to fight over a depleted tax base in state court.[1]

The confirmation of the plan binds all dissenting creditors and discharges the municipality's adjusted debts. Once the judge approves the restructuring, the city emerges from federal protection with a new balance sheet, but the process leaves a lasting scar on its credit rating. The legal architecture of Chapter 9 ensures that bankruptcy remains a difficult, heavily scrutinized last resort, forcing local governments to exhaust every other financial mechanism before seeking shelter in federal court.[3]