The recovery process doesnt 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 affect 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 communitys reputation and the governments creditworthiness. The harm to the communitys reputation could sap its economic vitality and will increase the governments 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 municipalitys 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 municipalitys 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 cant 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.
Q.1 What is the definition of bankrupt for a municipality?
A. In common parlance, bankrupt usually refers the condition of having been judged legally insolvent. However, in actual bankruptcy proceedings, the term insolvent, rather than bankrupt is used. An insolvent municipality either must not be paying its undisputed debts as they come due at the time of filing, or be unable to pay such debts when they become due in the near future. From a practical standpoint, insolvency is a cash flow test does the government have the cash to meet its obligations as they come due? Further, a government will have to demonstrate that it has accessed all of its discretionary resources (e.g., reserves) before receiving bankruptcy protection. The government will also have to show that any restrictions on funds that prevent the funds from being used to meet the debts in question are, in fact, true restrictions (e.g., user fee revenues from a city-owned water utility cannot be used to pay police salaries).
A bankruptcy hearing would be used by the court to rule if the municipality meets the definition of insolvent.
There are also other threshold requirements for eligibility for chapter 9 protection. A municipality must desire to effect a plan to adjust its debts The plan does not have to exist prior to filing, but there must be evidence that the municipality wants to effect a plan through the bankruptcy case. The municipality must also demonstrate that it has attempted to avoid the bankruptcy filing or that the filing was necessary. For example, it might demonstrate that it has negotiated in good faith with its creditors and is unable to reach an agreement.
Q.2 How common is municipal bankruptcy?
A. Chapter 9 is not common at all and is especially rare for general purpose governments. Only a few hundred cases have been filed since 1930 and only a handful of these have involved cities or counties (most have been special districts). For example, according to municipal bankruptcy lawyer James Spiotta in an interview with National Public Radio, since 1980 32 cities and towns have declared bankruptcy. Of the general purpose governments that have filed, many were very small towns that experienced an outside shock, such as the loss of a single, dominant revenue stream or losing a lawsuit.
Q.3 Can any local government declare bankruptcy?
A. Any municipality can seek bankruptcy protection, assuming it is allowed to do so by state law. A municipality is defined in the Bankruptcy Code to mean a political subdivision or public municipality or instrumentality of a state. As such, bankruptcy could apply to cities, counties, schools, and special districts, assuming that state law allows municipalities to seek bankruptcy protection.
Q.4 When would it be necessary to declare bankruptcy?
A. Filing for bankruptcy protection should be considered an absolute last resort, only to be considered after all else has failed. Bankruptcy provides latitude to alter or adjust a municipalitys obligations, but it does not fix the underlying problems that caused the deteriorated financial position, such as weak economic conditions, a poor tax base, or unsustainable choices about cost structure. Bankruptcy is a tool that can provide some relief from debt and other obligations that have been preventing the municipality from getting on a more stable financial footing, but ultimately it is the municipality that must make the choices and take the actions that lead to long-term financial sustainability.
Q.5 Under bankruptcy, do judges take over the management of municipality? For example, can the court make you sell off public property or are liens placed on public property? Does a judge determine what bills will be paid? Can a court require you to raise more taxes to pay your bills?
A. The answer to all of these questions is no. The municipality is not dissolved, and management of the municipality stays with the municipality. The municipality is its own trustees (e.g., elected officials, professional managers) decide how to manage payments to creditors. Further, a bankruptcy judge cannot change or supersede state law. For example, if a state law requires a vote of the citizens to raise taxes, a judge cannot enable the municipality raise taxes without such a vote.
Q.6 What degree of latitude does bankruptcy give a municipality to adjust or alter its obligations? Can a court eliminate labor agreements, pension obligations and/or debt obligations?
A. Bankruptcy provides broad latitude to reduce or extend and restructure the claims the government is subject to. However, there are limits on how these adjustments can be made and creditors can have a say in how adjustments are made. Further, as a practical matter is unlikely that a judge would agree to completely eliminate any obligation of the municipality. Also, remember that a judge cannot override state law. So, for example, if employee pension benefits are guaranteed or protected by state law, then a bankruptcy cannot impact them.
Q.7 What laws govern municipal bankruptcy?
A. Chapter 9 of the United States Bankruptcy code is preeminent, but a judge might look to state law for guidance in certain areas. For example damages for a rejected contract (a contract that courts adjust for the municipality) typically would reference state law on the matter.
Q.8 What are the negative consequences of bankruptcy?
A. Credit market reaction. Municipalities that seek or even seriously consider bankruptcy protection should expect a swift and harsh reaction from the credit markets. Even if bonds are ultimately paid in full, bankruptcy may leave a stigma that lasts for years, making it more difficult to access credit and/or obtain favorable rates.
Cost and distraction. Bankruptcy is an expensive affair, with consulting and legal fees potentially reaching into millions of dollars (or more for larger governments). Those standing to lose from a bankruptcy (e.g., unions) may spend a significant sum of money resisting it and the government will have to expend funds to respond. Bankruptcy will also require a great deal of staff time for the technical/legal proceedings, as well as dealing with the political repercussions and reactions from the public.
Stigma on the community. Bankruptcy will likely tarnish the good name of the community, civic pride, and the business climate. All of this will eventually hurt the economic viability of the community and further weaken local governments financial position.
Q. 9 Besides adjusting or altering obligations, what are the other advantages of bankruptcy?
A. Protection. A bankruptcy filing offers a municipalitys officers, elected officials, and residents an automatic stay against actions that might be taken by creditors. The stay lasts for pendency of the case, but the stay can be modified by the bankruptcy judge.
Breathing space. Under bankruptcy, the municipality has time to take the actions needed for financial stability. In the absence of bankruptcy protection, the municipality may spend a great deal of time fending off creditors or dealing with other consequences of the actions it is forced to take to deal with its financial challenges.
Access to an expert arbiter. Bankruptcy judges have a great deal of specialized expertise and experience in their craft. They can be very valuable in helping stakeholders reach a solution.
Q.10 What is the key differentiator between states when it comes to bankruptcy laws for municipalities?
A. The key differentiator is whether municipalities are allowed to seek Chapter 9 protection in the first place. About half of states explicitly permit Chapter 9 relief. Many of these condition bankruptcy on approval of the state for example, in one state a municipality in a financial emergency has to first be put under a special state-appointed manager who might then recommend bankruptcy if other recovery efforts fail. The other half of states are either silent on the issue of bankruptcy or prohibit it. However, in these cases it might be possible to get special legislation permitting bankruptcy for an individual municipality, but this would be very difficult.
Q.11 Since municipalities are subdivisions of the state, wouldnt state government have to bailout an insolvent municipality?
A. This is determined by state law, but in many cases the state is under no such obligation.
Anthony G. Cahill; Joseph A. James; Jean E. Lavigne; Ann Stacey. Public Productivity & Management Review, Vol. 17, No. 3, Changing Government: Pressures, Reality, Responses: Proceedings of the Sixth National Public Sector Productivity Conference. (Spring, 1994), pp. 253-264.