Municipal Bankruptcy: An Overview for Local Officials
Editor's Note: Information on bankruptcy filings in Detroit, Michigan and Stockton, California was added on October 7, 2013.
Cities and other municipalities falling on hard financial times is nothing new, but it is rare that any such entity files for bankruptcy as a way of addressing its massive debts. Out of nearly 89,500 municipalities in the country, there were just 239 municipal bankruptcy filings between 1980 and 2010.1 Now, a slew of high profile municipal bankruptcy cases from San Bernardino, California, to Central Falls, Rhode Island, to Jefferson County, Alabama, are increasing the visibility of municipal bankruptcies, but not necessarily making the process better understood. This guide serves as an overview of the basics of municipal bankruptcy, and boils down the municipal bankruptcy process so that officials and citizens have a framework within which to discuss whether bankruptcy is a viable option. It outlines who is involved in the process, which states permit municipal bankruptcy, when a municipality may be considered insolvent, the potential costs and benefits of the process, and more.
It is important to note that bankruptcy, specifically municipal bankruptcy, is an incredibly complicated process. Eligibility, procedures, and results differ based on the location of the municipality, where the proceedings occur, and for what purpose. This report provides an overview of the process, but is not legal advice. Additional questions about municipal bankruptcy will inevitably arise, and consultation with an attorney or expert in the field is strongly advised.
Chapter 9 Bankruptcy Overview
Chapter 9 of the Federal Bankruptcy Code provides for the financial reorganization of municipalities, including cities, towns, villages, counties, taxing districts, municipal utilities, and school districts, facing a backlog of unpaid bills.2 Chapter 9 permits both general municipalities (issuers of general obligation bonds serviced by tax revenue) and certain quasi-governmental municipal authorities (issuers of special obligation bonds serviced by project revenue) to reorganize debts. Although federal law governs Chapter 9 bankruptcy, state law significantly impacts the eligibility of municipalities to file for Chapter 9 bankruptcy and the related proceedings.
The purpose of filing Chapter 9 bankruptcy is to provide a financially distressed government body protection from its creditors while it reorganizes to make itself more fiscally stable. Reorganization of debts extends debt maturities, reduces the amount of principal debt or interest on the debt, and/or refinances the debt by obtaining a new loan. Chapter 9 is similar to Chapter 11, which is applicable to most private companies, except banks and insurance companies, in that both provide for a mechanism of restructuring obligations under the protection of the bankruptcy court’s automatic stay. This automatic stay allows municipalities to work out their finances without incurring additional debt or interest on outstanding loans.
Nonetheless, Chapter 9 bankruptcies are very different from other forms of bankruptcy. In Chapter 9 bankruptcy, there is no provision for liquidation of the municipality’s assets and subsequent distribution of the proceeds to creditors. Furthermore, unlike private companies, municipalities cannot simply dissolve, allowing creditors to take the value of municipal assets as compensation for their investments. Although municipalities cannot dissolve assets by filing for bankruptcy, dissolution3 of the municipality itself is a viable alternative. For some smaller municipalities, particularly those adjacent to larger government entities, it is feasible for a bankrupt municipality to disincorporate, pursuant to some states’ laws, effectively merging with a larger municipality. Historically, disincorporation occurred when cities became “ghost towns,” for instance, during the Great Depression. Today, dissolution usually occurs with smaller municipal entities, although it is an option for larger cities.4
Chapter 9 bankruptcies also differ with respect to the involvement of the court. In Chapter 11 corporate bankruptcy, the court is heavily involved in managing the bankruptcy and reorganization. In contrast, the court’s role in Chapter 9 bankruptcy is generally limited to determining whether the municipality is eligible to file for bankruptcy under state law, approving the bankruptcy petition, confirming a debt adjustment plan, and ensuring proper implementation of the plan. A municipality may consent to more extensive court involvement in order to obtain court order protections and eliminate the need for inefficient decision-making in multiple forums-this enforcement mechanism may be used to avoid making difficult spending cuts to programs and benefits regimes.
Chapter 9 Eligibility
States are constitutionally recognized sovereigns. Therefore, bankruptcy is not a legal option for state governments, although it is an option for political subdivisions of state government. As defined by the U.S. Bankruptcy Code,5 a “municipality” is a political subdivision or public instrumentality of a state. Since municipalities are independent entities from state government, they are eligible for Chapter 9 filings under federal law. Importantly, though, municipal law cannot contradict state law. In “Municipal Bankruptcy and the Role of the States,” the National Association of State Budget Officers (NASBO) cites a paper published by the American Bankruptcy Institute that lays out five eligibility criteria for municipal bankruptcy:
- The municipality must have specific authority to file for Chapter 9 bankruptcy from the state;
- The municipality must be insolvent;
- The municipality must prove its desire to adopt a plan to adjust its debt;
- The municipality must satisfy at least one of four specified conditions to demonstrate that it has obtained or tried to obtain an agreement with its creditors, that it is not feasible to negotiate with its creditors holding at least the majority of the claims in each class that the entity intends to impair under its debt adjustment plan, or that it has reason to believe its creditors might attempt to obtain preferential payment or transfer of the entity’s assets, and;
- The municipality must show that it has filed for bankruptcy in good faith.
The first two eligibility requirements merit further assessment. Municipalities do have the autonomous power to file for bankruptcy without state involvement. Although municipalities generally handle bankruptcy proceedings without state interference, state law governs whether municipalities may file for bankruptcy at all.
There are twenty-four states that authorize or conditionally authorize municipal bankruptcy, three states that grant limited authorization, and two states that prohibit municipalities from filing for Chapter 9 bankruptcy. Twenty-one states provide no specific authorization regarding municipal bankruptcy at all. Municipalities in the states lacking authorization are not eligible to file.
Regarding the second criterion, as defined by the U.S. Bankruptcy Code,6 a municipality is insolvent when it is “generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or unable to pay its debts as they become due.” This definition is unique to municipalities. Sovereignty keeps governments from becoming insolvent per se; they are instead considered “in default” when they cannot pay even interest obligations.7 The sovereignty of governments also prevents creditors from seizing government assets, as they do in other forms of bankruptcy. In Chapter 9 proceedings, reorganization is not a seizure, but rather a refinancing process.
The statutory definition of “insolvent” played a role in at least one recent municipal bankruptcy case. Boise County, Idaho filed for Chapter 9 bankruptcy to reduce a $4 million verdict for violating the Fair Housing Act. The U.S. Bankruptcy Court for the District of Idaho rejected8 the filing for failing to prove that the county was insolvent at the time it filed for bankruptcy. The Court found that the county had been and remained capable of servicing its debts.
Chapter 9 municipal bankruptcies involve a number of independent entities, and the roles of each participant are unique to municipal bankruptcy. The debtor, creditor, courts, and in some cases, the state, are crucial to successful bankruptcy procedures and to developing ideal outcomes.
The Role of the Debtor
In Chapter 9 bankruptcy, the municipality fills the role of debtor. After filing, the municipality receives an “automatic stay” from the bankruptcy court that halts collection by creditors. The bankruptcy court then determines the municipality’s eligibility based on the criteria previously listed. Once approved, the municipality enters into the process of crafting a plan of adjustment for reducing debt. According to the State of California’s Legislative Analyst’s Office,9 the two primary tools for adjusting debt are “the ability to modify the terms of its outstanding bonds and other debt, and the authority to reject various contracts.” This may include collective bargaining agreements with public employees.
Throughout the bankruptcy process, municipalities retain their powers to collect taxes and make expenditures, as the bankruptcy court is prohibited10 from interfering with the “political or governmental affairs of the debtor.” They also retain the power to borrow money and obtain credit. Any changes offered in a plan of adjustment must be in line with existing state and local laws. This is quite relevant when it comes to taxes and spending. For example, a municipality located in a state with a cap on property tax growth would be prohibited from seeking extra revenues through property taxes above the state cap. Similarly, if a municipality has set certain similar restrictions on itself, these remain in place throughout the bankruptcy process. Creditors and the bankruptcy court must approve a plan of adjustment before it is adopted.
The Role of Creditors
A creditor is a person or company to whom a debtor, in this case the municipality, owes money. In the case of municipal bankruptcy, status as a creditor ensures that at least a portion of the debt owed to the creditor by the municipality will be included in the reorganization plan.
Each state has different rules for qualification as a creditor, including what rights are associated with creditor status, but the role of a creditor is generally more limited11 in Chapter 9 than in other forms of bankruptcy. The process broadly includes the municipality issuing a list of creditors with their bankruptcy filing. Objectors to the creditor list may file an objection to the petition, and the court will have a hearing and rule on the objection. Creditors may not propose competing plans, and the debtor’s (municipality’s) plan is binding on even dissenting creditors.
In the context of municipal bankruptcy, the definition of “creditor” is a developing area of law. Courts’ rulings on the issue will have an enormous impact on the effectiveness of municipal bankruptcies. One such area of development involves whether public pension systems and retirees count as creditors.
This is an issue of growing importance given public pension debt’s significant role in spurring Chapter 9 bankruptcy proceedings. Pension recipients and public employee pension systems argue that reducing and restructuring these plans violates their rights as creditors of the municipality. For example, when San Bernardino, California halted its $1.7 million monthly payments to the California Public Employees’ Retirement System (CalPERS), CalPERS asked the bankruptcy court to lift the city’s automatic stay and allow the retirement system to sue for the payments in state court. In this case, the judge sided with San Bernardino after determining that meeting monthly pension payments would be a “death knell” to the city,12 although the judge also agreed to allow CalPERS and other creditors to renew their challenges at a later time. Currently, litigation to determine the contractual, constitutional, and creditor rights of pension recipients and public pension systems is pending in a number of states.
In law, a “receiver” is a person that has custodial responsibility for the property of others. In the context of municipal bankruptcies, a municipality may petition the court to be put into a receivership, whereby the court will appoint an individual to exercise control over the municipality, including financial decisions. A receiver may take an alternative role in municipal bankruptcy proceedings as well. If no official of a municipality seeking bankruptcy wants to file a petition for the bankruptcy proceedings (most often because they want to avoid being named in the suit), the municipality may appoint a receiver to file a petition on behalf of the entity.
The Role of the State
State governments can play a role in the municipal bankruptcy process. As mentioned above, eligibility first requires authority granted by the state. Despite whether or not that authority exists, states have varied in their responses to the prospect of municipal bankruptcy. Some have viewed it as an opportunity to assert their influence in order to achieve certain ends. Others have treated it as a threat to bond markets and attempted to block it even when authority has already been granted.
The Rhode Island state legislature took significant action with regards to the bankruptcy of the city of Central Falls. The city was on the brink of insolvency and had asked to be placed under judicial receivership when state leaders decided to prioritize payments to bondholders in the case of a Chapter 9 filing. A new law passed just prior to the city’s bankruptcy gave bondholders a lien on ad valorem taxes and general fund revenues in hopes of preventing a ripple effect throughout the bond market that would raise borrowing costs for the state and other municipalities. Some described the legislation as the “first of its kind” in the country.13 Judge Frank J. Bailey, who approved the city’s exit from Chapter 9, described the process as happening in “record time, and record efficiency. In a way, I think this is an example – for not only Rhode Island, but maybe the nation – on how to run a Chapter 9.”14 On the other hand, the state’s actions sparked controversy; some argued that prioritizing payments to bondholders would diminish the standing of other valid creditors.
In the case of Harrisburg, Pennsylvania, the state fought hard to prevent bankruptcy over the objection of many on the City Council. Harrisburg entered into the state’s Act 47 Financial Distress program in December 2010.15 At that time, state law allowed cities to file for Chapter 9 protection. After entering the financial distress program but before it filed for bankruptcy in October 2011, the state legislature passed a one-year prohibition on Chapter 9 bankruptcy for “class three” municipalities, including Harrisburg. The city filed anyway, citing standing under financial distress. The court rejected the filing, claiming that Harrisburg did not qualify because it was not “specifically authorized” to be a debtor.
Getting to Bankrupt
The legal details of each municipal bankruptcy case are incredibly unique, shaped by a combination of federal, state, and local law. The cause of each municipal bankruptcy filing is also unique. Both the legal parameters and causes play a vital role in shaping a municipality’s path forward.
One common thread in several recent filings is the pressure of high salary and benefit costs, often coupled with falling tax revenues, putting municipalities in financial distress. The costs of salaries and benefits were an issue for the cities of Central Falls, Rhode Island, Vallejo, California, and San Bernardino, California.
Central Falls, Rhode Island
Central Falls, Rhode Island faced massive levels of debt driven by retiree pension and health benefits, along with other spending. In 2010, the city generated $16 million in tax revenues.16 It spent $21 million. The city’s three pension systems faced a combined $48 million unfunded liability, according to official estimates,17 although one market-valued assessment estimated the pension liability to be over $108 million.18 Additionally, Central Falls’ retiree healthcare system, which the city funded on a pay-as-you-go basis, had a $32 million unfunded liability.19 The city filed for bankruptcy protection on August 2, 2011, following actions taken by the state government detailed above.
Central Falls’ debt adjustment plan identified retirement costs as the main cause of its fiscal trouble. The reorganization plan cut pensions for workers who retired at the youngest age by up to 55 percent.20 The state contributed $2.6 million over several years to ensure that payments continued. The plan also cut the number of city workers, although base salaries grew slightly and employees will to receive 2.5 percent annual increases for 5 years.21 Finally, the plan included 4 percent annual property tax increases through 2017.22 The bankruptcy court approved the plan for adjustment, and Central Falls emerged from bankruptcy in October 2012.23
The plan included drastic measures and expected tension continues to linger between state and local officials. However, throughout the entire process, Central Falls managed to make all payments on nearly $19 million in general outstanding obligation bonds. Moody’s Investors Service has since raised the city’s credit rating by two steps.24
A task force assembled by the city of Vallejo, California found salary, pension, and healthcare costs to be “unsustainable” as early as in 1992.25 Barring reform, the task force predicted that they city would have to file for bankruptcy by 2010. Reform did not come, and the task force’s prediction came true in 2008. Vallejo’s bankruptcy highlights the importance of focusing on the root of each municipality’s fiscal crisis.
By the time of the city’s bankruptcy filing in 2008, nearly 80 percent of the city’s $89 million general fund budget was dedicated to salaries and benefits.26 Vallejo had $53 million in general fund supported debt, $123 million in debt obligations backed by non-general fund revenues, and a $128 million unfunded pension liability, according to a study conducted by Standard & Poor’s.27
The spending issues were coupled with a large drop in revenues. General fund revenues fell 17.8% in the four-year period leading up to 2011. Despite the drop in revenue, Standard & Poor’s blames poor management of labor contracts for the city’s bankruptcy. According to the study, twenty California cities with Standard & Poor’s debt ratings had revenue losses greater than 17% in the same time period and none of those losses resulted in bankruptcy.
Vallejo’s plan for debt adjustment focused on reducing both retiree health costs and the size of the work force. The city reduced health care payments to retirees to $300 a month, down from as high as $1,500.28 This helped lessen the health care liability by $54 million.29 The city discontinued payments on general fund supported debt, and voters approved a 1% sales tax to generate $10 million in revenue a year.30
Still, $123 million in other debt obligations and a $128 million unfunded pension liability were left untouched.31 As Standard & Poor’s wrote, bankruptcy “did not result in a renegotiation of contractual terms with the city’s largest class of creditors, its pensioners.” The city emerged from bankruptcy in November 2011, but in fiscal year 2012, salaries and benefits grew to equal 82 percent of the general fund budget. Finally, the city still faced a $3.8 million deficit.
San Bernardino, California
In 2007, a consulting firm hired by San Bernardino, California, called attention to rising public safety employees’ salaries putting city finances at risk.32 Over the next four years, the city attempted to save by cutting the workforce by 20 percent and implementing an across the board, temporary, 10 percent pay cut.33
Still, by 2012, public safety spending was taking up 73 percent of the entire general fund budget. Fiscal year 2012-2013 spending was expected to outpace revenue by $40 million.34 Labor costs were projected to grow by $10 million for the next several years, and annual pension payments doubled from their 2006 total to $25 million.35 To make matters worse, the city owed payments on a $50 million pension obligation bond, faced a $195 million unfunded pension liability, a $61 million unfunded retiree healthcare obligation, and $40 million in workers’ compensation, compensated absences, and other liabilities.36
The city filed for bankruptcy on August 1, 2012. It has since faced legal challenges from the California Public Employees’ Retirement System after it halted $1.7 million monthly payments to the system. (See discussion above) At the time of writing, the city remains under Chapter 9 bankruptcy.37
Jefferson County, Alabama
In some cases, the failure of individual spending projects drives municipalities to bankruptcy. Jefferson County, Alabama filed for bankruptcy in 2011, and in doing so became the largest municipal bankruptcy in the country’s history. A large portion of the county’s financial woes stem from the $3.1 billion that the county had borrowed beginning in 1997 from J.P. Morgan Chase and other bondholders to fund the sewage system. Some of the bond deals to upgrade the system were so plagued by corruption that they led to twenty-two convictions. In 2008, the financial crisis undermined the credit ratings of the companies that had insured the bonds and the county suffered.38 A tentative agreement with creditors to avoid bankruptcy required J.P.Morgan to provide between $750 million and $1.1 billion in concessions in restructuring the sewer debt. That agreement ultimately fell through due to differences over issues like general fund deficits and raising sewer rates, which prompted the bankruptcy filing.
Although a court rejected Harrisburg, Pennsylvania’s bankruptcy filing, it offers another example of a municipality facing financial distress largely as a result of individual projects. The city guaranteed $242 million of a $300 million trash incinerator.39 It was originally built in 1972, but repeated repairs and refinancing left it $94 million in debt by 2003, when the federal government shut down the incinerator for environmental reasons. Harrisburg borrowed another $125 million in hopes that getting the incinerator back on line with a higher capacity would draw contracts with neighboring counties. As debt soared, the city grew incapable of meeting its obligations.40 By the time of the bankruptcy filing in in late 2011, the city was past due for $65 million in payments and the size of the incinerator debt had grown to surpass the city’s other liabilities.41
Boise County, Idaho
Even if a municipality manages to avoid an explosion in personnel costs or financing expensive projects doomed to failure, they can still be hit with unexpected circumstances capable of overwhelming finances and prompting municipal bankruptcy. Boise County, Idaho sought bankruptcy protection following a $4 million legal judgment. Developer Oaas Laney LLC sued under the Fair Housing Act after the county placed restrictions on its attempt to build a residential treatment facility. The county was hit with the $4 million judgment and an additional $1.4 million in attorneys’ fees, overwhelming the county’s $9.4 million annual operating budget. A bankruptcy judge rejected the filing after finding that the county failed to prove insolvency and remained capable of servicing its debts.42
Mammoth Lakes, California
In 2006, a company called Mammoth Lakes Land Acquisition sued the city of Mammoth Lakes, California, for breaching the terms of a development contract. The company won a $43 million judgment against the city, which was more than twice the size of the city’s annual operating budget.43 The town resorted to bankruptcy in July 2012. Unlike Boise County, the court approved Mammoth Lakes’ filing. Just a few months later, though, the city was able to avoid the legal fees and the plan of adjustment approval process after it reached a settlement with the company and convinced the court to throw out the bankruptcy case.44
On July 18, 2013, Detroit, Michigan, became the largest municipality in United States history to file for Chapter 9 bankruptcy. Michigan Governor Rick Snyder declared a financial emergency in the city in March 2013 and appointed Kevyn Orr as Emergency Manager under the state’s Emergency Financial Manager Law. The law allows the state to appoint an Emergency Manager, similar to a receiver, with the power to recommend a Chapter 9 municipal bankruptcy filing.
The Emergency Manager’s initial report on city finances found at least $15 billion in outstanding obligations. This included $1.1 billion in general fund debt, $6.0 billion in enterprise fund debt, $1.8 billion in Pension Obligation Certificates, and $5.7 billion in retiree healthcare obligations. On top of that, Orr found that the city faced $3.5 billion in unfunded pension liabilities, although market-valued estimates have found the city’s unfunded liability to be closer to $9 billion.
Orr has given some indication of means for addressing the city’s debts despite the fact that the deadline for filing the city’s plan of adjustment is March 1, 2014. Part of the plan may include treating general obligation bonds as unsecured debt, allowing them to be repaid at a much lower rate. He has also expressed support for converting the city’s defined benefit pension systems to defined contribution plans.
Stockton, California, a city of 300,000, filed for bankruptcy on June 28, 2012, following months of talks with creditors trying to avert the process. The city faced a $26 million deficit for the fiscal year 2013 budget, which it closed in part by suspending $10.2 million in debt payments and cutting employee compensation by $11.2 billion. Many experts point to the collapse of the housing market as a main cause of Stockton’s revenue collapse. Indeed, between 2007 and 2008, the median home value in the city fell 44 percent.
At the time of filing, Stockton faced roughly $700 million in bond debt. Its largest creditor was the California Public Employees Retirement System (CalPERS), which claimed $147.5 million in unfunded pension costs. Other creditors included investors holding a combined $124.3 million in pension obligation bonds.
In October 2013, the city council approved a plan that would allow the city to exit bankruptcy. It included a deal with insurer Assured Guaranty to restructure $150 million in debt. The deal, which initially included 16 of the city’s 19 largest creditors, will allow the city to make payments on its pension obligation bonds until 2052, instead of 2038. The final deal hinges on city voters approving a sales tax increase in November 2013. Interestingly, the city chose not to address its unfunded pension liabilities, which prompted the ire of several bond insurers who had hoped those liabilities would be treated similarly to other debt.
Impacts of Filing for Municipal Bankruptcy
The increase in municipal bond defaults and the percentage of municipalities having budget deficits makes it apparent that an effective and efficient Chapter 9 bankruptcy proceeding can be a necessary last resort when other reforms have failed. It is important for entities to closely review the positive and negative impacts of filing for municipal bankruptcy with legal counsel, as the process and consequences are unique to every entity.
Perhaps the most obvious benefit to filing for municipal bankruptcy is the entitlement to a legal “time-out.” The automatic stay section of 362 of the Bankruptcy Code is applicable in Chapter 9 cases. The stay operates to stop all collection actions against the debtor and its property upon the filing of the petition. Additional automatic stay provisions prohibit creditors from bringing an action against municipal officers for prepetition debt or to enforce a lien arising out of taxes and assessments owed to the debtor.
Allowing the municipality to “freeze” operations, payments, and creditor demands allows municipal decision-makers to closely review their finances without the clock running down. Done properly, a close analysis illuminates where the municipality is losing the majority of its funds, and whether spending cuts or higher taxes can eventually sustain the expenditures. If not, the review acts a catalyst for lawmakers to renegotiate the terms of contracts spiraling out of fiscal control.
The emphasis on executing a proper review is extremely crucial to the effectiveness of an automatic stay, and ultimately, successful bankruptcy proceedings. If the budget reviewers employ gimmicks or short-term solutions, the problem will not only continue to exist, their detrimental effects will multiply. It is essential to objectively and realistically review the budget during this time to ensure an effective reorganization of the municipality during and after bankruptcy.
The process of refinancing debt necessarily includes the review of all government contracts, particularly those relating to government employees’ healthcare, salaries, and benefits. Municipalities may opt to reject current collective bargaining agreements and renegotiate more sustainable provisions for state employees. Although many agreements specify that the provisions withstand bankruptcy proceedings, bankruptcy courts have held that private companies may re-negotiate collective bargaining agreements based on financial savings, a legal theory that may extend to municipalities in bankruptcy proceedings. Regardless, municipal bankruptcy makes the issue immediate, and necessitates negotiation.45
When municipal bankruptcies are filed, there are really no winners. Taxpayers suffer, public employees risk losing their jobs and benefits, and it often takes years to see any positive impacts.
It is important to note that municipal bankruptcies not only affect the citizens in the city and state filing, but also have far-reaching effects nationwide. The surge in municipal bankruptcy prompted a close review of many municipalities by Moody’s Investor Services that resulted in downgrades and market uncertainty. It remains unclear whether municipal bankruptcies directly affect the issuance or purchase of municipal bonds, currently or in the future, but it is likely that as more municipalities file for bankruptcy, the market for municipal debt will inevitably suffer. Concurrently, as Moody’s continues to downgrade municipal debt, the cost of borrowing for the municipalities increases, perpetuating its financial difficulties.
The massive legal costs associated with bankruptcy proceedings and municipalities also often cloud implementation. Not only is legal counsel necessary to effectuate the proceedings, but legal counsel will likely also be necessary when creditors challenge the bankruptcy, when they challenge the automatic stay, and during negotiation proceedings. Attorneys are also needed to draft a municipality’s repayment plan to go before a judge. Further in the future, if municipalities and employee unions cannot agree on collective bargaining agreements, the issue must proceed in court, which is extraordinarily costly. Vallejo, California reportedly saved $34 million over 18 months during its bankruptcy. These savings were at least partially offset by $13 million in legal bills.46 In Jefferson County, Alabama, officials wanted to set aside $1 million per month to cover legal costs, a decision ultimately rejected by a judge, but illustrative of the enormous costs of legal representation in bankruptcy proceedings.47
Questions Municipal Leaders Should Ask Prior to Filing for Municipal Bankruptcy
Municipal leaders have much to consider when examining the ramifications of filing for bankruptcy. The first step should always be to consult with the municipality’s legal counsel. Legal counsel will more likely than not need answers to the questions below in discussing how best to proceed with municipal leaders. Municipal leaders have much to consider when contemplating filing for bankruptcy, and the following questions must be asked in considering it, and they will also likely come up as part of the court filing:
- Is the municipality authorized to file for bankruptcy under state law?
- Is the municipality insolvent? To get that answer, it means asking more questions including:
- What exactly are the finances of the municipality? Just how much does the city owe?
- Does the municipality have any reserves?
- What is the municipality’s cash flow, both present and anticipated in the future?
- What is the annual budget? Is the budget balanced?
- What cuts have already been made?
- Would any further cuts/service reductions threaten the debtor’s ability to provide the basic health and safety of its citizens?
- What are the reasons for the municipality’s debts? Do those causes include health care costs, salary costs, pension payments, court judgments, etc.?
- Does the municipality want to adopt a plan to adjust its debt?
- What are the factors that have led to fiscal trouble?
- Has the municipality previously tried to negotiate with its creditors in good faith? Be prepared to detail what steps have been and efforts made thus far, as well as the responses to them.
- Who are the creditors and how much does the city owe each?
In addition to those questions pertaining to the legal requirements to file for bankruptcy, municipal leaders must also be prepared to answer questions from residents and the media. Questioning from the public can be more intense. Leaders should be prepared to discuss answers to all of the above questions as well as explain how they believe bankruptcy will or will not be the most beneficial path for the municipality and its residents.
Although state and local governments have a number of mechanisms to overcome financial emergencies, municipalities deep in the red can turn to Chapter 9 as a last resort to overcome financial distress. The future of Chapter 9 is inextricably intertwined with how states and municipalities address current financial red flags. If the states and federal government continue to stress the limits of their budgets, the country may experience a spike in municipal bankruptcy filings. To remain prepared, discussion should begin with proactive infrastructure and policy changes to avoid descending into a circumstance where bankruptcy might be necessary. The dialogue that should follow this overview should involve lawmakers, employees, and citizens and it should include best practices tailored to each region, to ensure a financially sound future.