Chapter 9 and State Law: the Dubious Applicability of the Supremacy ...

Many commentators have assumed that the Supremacy Clause of the federal constitution settles the issue. I don't think it is so cut and dry. Bankruptcy always starts with inputs from "applicable non-bankruptcy law," which generally means state law. This is the basic holding in Butner v. US. Thus, whether a manufactured home is treated as personalty or realty in bankruptcy--critical for the question of whether a mortgage on the trailer can be crammed down in Chapter 13--depends on state law.

While the inputs to bankruptcy law are from applicable non-bankruptcy law, bankruptcy does sometimes alter non-bankruptcy rights. For example, the federal Trust Indenture Act makes bondholders' right to payment is sacrosanct outside of bankruptcy, but is trumped by federal bankruptcy law. So too are certain statutory liens arising from state (or federal) law voided per section 545.

Thus, the basic structure that everyone is used to in bankruptcy is that we start with non-bankruptcy law, but it can be trumped by bankruptcy law. But Chapter 9 is weird. While most bankruptcy lawyers approach Chapter 9 through the lens of Chapter 7/11/13 practice, I'm not sure that accurately captures what Congress was doing when it created Chapter 9. 

Chapter 9 is a financial restructuring mechanism for municipalities, which are quite different from consumers or businesses given their political nature, their potential taxing power, and the fact that they exist at the pleasure of the states and are fiscally tied to them.  One could easily imagine Congress creating Chapter 9 as a free-standing statute that is not part of the Bankruptcy Code. In other words, there's a danger of reading too much of other bankruptcy law into Chapter 9 just by virtue of our municipal finance restructuring statute being placed into Title 11 and piggybacking on some other Title 11 provisions.  

Chapter 9, after all, doesn't simply take Chapter 11 and apply it to municipalities. Whereas Chapters 3 and 5 of the Code apply to Chapter 7, 11, and 13 cases, they do not do so wholesale to Chapter 9. Instead, as section 103(f) provides, only those sections from chapters other than chapter 1 that are specified in section 901 apply to Chapter 9 in addition to Chapter 9's own provisions.  

Beyond this, however, Chapter 9's provisions represent a particular solicitude for state law that just isn't found elsewhere in Title 11.  

First, Chapter 9 defers to the states on whether to let municipalities file at all. Just because there is a federal statute enabling municipal bankruptcy does not mean that municipalities may take advantage of it.  (Cf. City of Tacoma v. Taxpayers of Tacoma, 357 U.S. 320 (1958) (city's right to apply for a hydroelectric dam permit under the Federal Power Act trumps state law restriction.)) Arguably the power to keep a municipality from filing for bankruptcy at all includes the ability to condition the restructuring either as part of a filing authorization or via general state law.

[To be sure, there's an example of this outside of Chapter 9:  section 522 lets consumer debtors choose between state and federal property exemptions...unless the state of the debtor's residence opts to allow only the state exemptions. So federal law defers to state law here. Not clear what this means for a state like Delaware with different state exemptions if a consumer files for bankruptcy.]

Second, Chapter 9 does not incorporate many of the key provisions in the rest of the Bankruptcy Code that provide that the bankrutpcy inputs are from state law. For example, section 541 (property of the estate) is not incorporated in Chapter 9. Similarly, Chapter 9 does not incorporate the priority scheme of sections 726/725/507 nor does it incorporate that priority scheme indirectly via section 1129(a)(7). That raises a question about whether a state law priority system would apply in Chapter 9 in the absence of a federal priority system to the contrary. This was argued by Merrill Lynch, unsuccessfully, in the Orange County bankruptcy.  See County of Orange v. Merrill Lynch & Co., 191 B.R. 1005, 1018 (C.D. Cal. 1996).

But just because Merrill didn't prevail on its argument doesn't mean that there isn't something there. And when combined with the first point, it suggests that perhaps states can impose their own priority system in Chapter 9 as a condition of permitting a municipality to file. There might be issues if that priority system sprang only upon a Chapter 9 filing, but to the extent the priorities existed outside of bankruptcy, it's not clear why or through what statutory provision federal law would be changing state law priorities.

Third, the existence of section 903 arguably bolsters this reading:  903 clarifies that states can still have state law compositions, just that they cannot bind non-consenting creditors. But by going through the plan confirmation requirements of Chapter 9, one can bind those creditors, of course. The implication is that they can be bound to a state law priority system. 

Fourth, there is section 904, which sharply limits the bankruptcy court's ability to direct municipal action regarding its political process or revenues and assets. To the extent that state law requires a municipality to take or not take action, it would seem that section 904 would prevent federal law from trumping it. In other words, yet another ceding of federal supremacy as part of a federalist bargain to enable municipalities to restructure their debts while still respecting states' sovereign rights. 

Finally, there is the enigmatic section 943(b)(4), which would seem to defer to applicable non-bankruptcy law. That provision would appear to explicitly allow state law priority systems into Chapter 9. To be sure, one could also argue that 943(b)(4) proves too much if taken literally as it would incorporate the Contracts Clause and thus prevent any contractual impairment in Chapter 9, but I think that the Bankruptcy Clause would have to override the Contracts Clause if Chapter 9 is constitutional in general.

All of this is to say that I'm doubtful that the Supremacy Clause really answers the question of whether state law priorities or other provisions like Michigan Const. Art. IX, cl. 24 (or similarly Illinois Const. Art XIII, cl. 5) apply in bankruptcy.  Instead, I think there's a quite reasonable reading that Chapter 9 was deliberately designed to defer to state law provisions. The legislative history of Chapter 9 may clarify some of this, but from the statute itself, I think it's a fair reading to assume that state law applies. 

That said, it will be bankruptcy judges who have the first crack at this nut. And they are not likely to understand Chapter 9 as being fundamentally different from other chapters of the Bankruptcy Code regarding federal supremacy. But an appellate court that is not freighted with the lens of bankruptcy practice might take a different view.