When Recovery Fails
The recovery process doesn’t always go as planned. When a local government slips deeper into fiscal distress, it might have to contemplate more dramatic options. More common is state intervention in the business of distressed municipality. Municipal bankruptcy is incredibly rare and GFOA strongly recommends that governments take every possible step to avoid it.
First, understand what role the state government has in helping distressed local governments in your state. Laws between states vary, but policy interventions can fall into three major categories.
- The state does not formally recognize distressed local governments, but attempts to provide relief measures for local government with lower financial capacity. These measures include grants, guaranteed loans or bonds, or economic development tools.
- Formal distress legislation is written towards specific local governments that have become distressed. This approach is ad hoc.
- A statewide policy toward distressed local governments is written into law. Among other things, such legislation generally establishes criteria for defining distress, defines processes used to correct conditions causing distress; and establishes the criteria for determining when it is appropriate to discontinue corrective programs. Specifics vary widely between states.
Next, develop a strategy on how to use the tools available. For those local governments whose state falls in the first category, how might state assistance help finance sustainable recovery strategies?
Those local governments in the second category may need to work closely with local legislators to push forward and craft favorable legislation.
Those finding themselves in the third category should do their best to understand the programs available and how to use them. A few general points to bear in mind are:
- Such programs are usually reactive. They only come into effect after severe distress has occurred (e.g., defaulting on a bond, missing payroll).
- State programs often focus in on managerial, technical remedies and do not address deeper structural problems such as changing demographics or an erosion of the local economic base.
- Programs often assume that distress is a short-term phenomenon that will disappear upon corrective managerial action.
So, while such programs are certainly laudable, the Recovery Leader must be wary of their limitations and compensate appropriately by looking beyond managerial solutions and keeping an eye on the long-term.
GFOA recommends that municipalities make every effort to avoid bankruptcy. This is because, first, bankruptcy will exact a serious cost on the community’s reputation and the government’s creditworthiness. The harm to the community’s reputation could sap its economic vitality and will increase the government’s cost of borrowing. Besides these costs, the cash outlays required to go through the court proceedings are significant. Legal and consulting fees and staff time preparing for hearings and responding to requests for information could easily reach into the millions of dollars (and more for larger governments). Finally, bankruptcy is not a cure-all. As a practical matter, a judge is unlikely to completely void any of the municipality’s obligations (so debts and bondholders will still need to be paid). Also, as a matter of law, a judge cannot override provisions of state law that may be contributing to the municipalities financial distress, such as public employee pension benefits that are guaranteed by state law. Further, the municipal government is not dissolved by bankruptcy and although bankruptcy may provide some additional latitude to local government officials, in the end, it is the municipality’s management and elected officials who still must make the hard choices required to reach financial health.
For these reasons, municipal bankruptcy is exceeding rare. Only a handful of cases have been filed by general purpose governments since 1930 and many of these were by very small towns that experienced a financial shock from an outside event.
When all else fails in the recovery process, local governments may have the ability to file for protection under chapter 9 of the United States Bankruptcy Code. If bankruptcy becomes a serious option, then the local government should first engage stakeholders on the possibility of renegotiating obligations in order to avoid bankruptcy. Labor unions may prefer to renegotiate rather than submit to the possibility of having their contract voided in court. Creditors may be willing to restructure debts.
Governments need to consider all other possibilities to resolve their fiscal distress and gain a clear understanding of what bankruptcy can and can’t do before moving forward. Below are key questions about bankruptcy. Guidance on these questions is provided with assistance by the authors of Municipal Bankruptcy: Avoiding and Using Chapter 9 in Times of Fiscal Stress.