In a Chapter 9 bankruptcy, all creditors are bound to hold any kind of recovery action against a municipality upon filing a petition with the bankruptcy court. This is called automatic stay. An automatic stay also provides protection to the officers and officials of a municipality. All inhabitants of the petitioner municipality are also provided the same protection under law by the automatic stay.
A municipality is defined by the Bankruptcy Code as a “political subdivision or public agency or instrumentality of a State.” Therefore, its assets and debts should not offend constitutional guaranties of state sovereignty. As a result of the automatic stay, a creditor is held back from filing a mandamus action against an officer of a municipality on account of a prepetition debt. A creditor is also prohibited from bringing an action to enforce a lien arising out of taxes or assessments owed to the debtor against any inhabitant of the municipality.
By filing a chapter 9 bankruptcy case, the debtor municipality benefits from an automatic stay of creditor actions, affording the municipality an opportunity to negotiate a debt restructuring plan acceptable to its creditors without having to defend actions by creditors seeking to recover their claims. However, automatic stay under Chapter 9 has some limitations. This chapter does not operate to stay application of pledged special revenues to payment of indebtedness secured by such revenues. An indenture trustee or other paying agent may apply pledged funds to payments coming due or distribute the pledged funds to bondholders without violating the automatic stay.
Filing a bankruptcy petition invokes an automatic stay—basically a federal court injunction—against any action that could otherwise be taken against the municipality (which becomes the debtor upon the filing of the bankruptcy case) or its officers or employees. Even if the municipality or other protected persons take or omit to take actions related to claims against the municipality that would otherwise subject them to sanctions or liability in state or federal court, or to actions by regulatory bodies, those actions may not proceed without the claimants first obtaining the permission of the bankruptcy court.
Although the stay lasts during the pendency of the chapter 9 case, it is for the bankruptcy judge to modify or terminate the stay for cause shown. An automatic stay provides the municipality with time to raise new revenue, renegotiate contracts and restructure its debt obligations. The automatic stay gives the municipality an opportunity to focus on formulating a permanent solution.