Why Aren’t There More Chapter 9 Bankruptcies?

After the housing market collapse, many cities and towns fell on hard times and have yet to recover.  In quite a few communities, housing prices remain low, municipal debt levels are unsustainable, and attempts to raise revenue have been rejected by voters—who are often cash-strapped themselves.  Bankruptcy offers breathing room, political cover for tough decisions, and the chance to renegotiate collective bargaining agreements and restructure debt.  The bankruptcy process is frequently used by businesses and individuals seeking a “fresh start.”  Why don’t more distressed municipalities file bankruptcy?

The law governing municipal bankruptcies is found in Chapter 9 of the Bankruptcy Code. Municipalities include cities, towns, counties, school districts, and municipal utilities. [1]  The purpose of Chapter 9 is to allow a struggling municipality a breathing spell, during which the municipality can propose a plan to pay its creditors while continuing to provide services to the public.  When a municipality is considering filing bankruptcy, it is a difficult decision. [2]  What are some of the factors giving municipalities pause?

Interest Rates Are Low– A distressed municipality may be able to get by for a few years by engaging in further borrowing, cutting services, or raising taxes in order to meet its obligations.  Interest rates are currently quite low, and these low rates have helped many troubled municipalities get by for a few years, in the hopes that their local economies will improve and tax revenues will rise.

Politics– Getting politicians to agree on a course of action is difficult in the best of times.  Getting politicians to agree to a bankruptcy filing with the knowledge that hard choices will follow, such as whether to reduce city services, cut pensions, renegotiate union contracts, or raise taxes—all decisions that may cost them their seats in the next election—is an especially difficult task.

Reputational Harm– Citizens are not proud to live in a bankrupt city, nor are leaders proud to lead one.  Even though municipal bankruptcies are becoming more common, a stigma remains.

Pushback from the State– States worry that if one of their cities files bankruptcy, this will make the state itself seem like a risky borrower.  Therefore, in order to keep their own borrowing costs down, states will often take steps to discourage municipalities from filing bankruptcy.  Federal bankruptcy law requires that there be state legislation enabling a state’s municipalities to file bankruptcy.  Many states have put up hurdles that municipalities must clear in order to file bankruptcy, and some states have prohibited municipalities from filing under any circumstance.

Pushback from Creditors and Other Stakeholders– Bondholders, unions, pension funds, and other stakeholders will frequently work to prevent a municipality from filing bankruptcy.  They do this because bankruptcy would allow a municipality to reduce, extend, or restructure its debt obligations, renegotiate collective bargaining agreements, and obtain a discharge.  Also, in Chapter 9, the municipality has an exclusive right to file a plan of adjustment.  This means that creditors may not submit alternative plans like they could in a commercial Chapter 11 case.  Instead, creditors may only approve or reject the plan proposed by the municipality.  This exclusive right to file a plan helps municipalities force creditors to the bargaining table.  Because bankruptcy gives a municipality so many tools, creditors and other stakeholders will typically be in a worse bargaining position after a city files bankruptcy.  Therefore, they will fight to prevent a bankruptcy filing, and if a municipality files, they will argue that the municipality does not meet the eligibility requirements for bankruptcy protection.

Lack of a Model Turnaround Story– Troubled municipalities are a bit like Tolstoy’s unhappy families: each is troubled in its own way.  Not many municipalities have elected to file bankruptcy in the past, and the success stories that exist (e.g., Orange County) tend to have unique circumstances that are not likely to be replicated in every case.   It is too early to determine whether the recent bankruptcies of Stockton, San Bernardino, and Detroit should be counted as successes.  Even if these cities succeed in turning themselves around, it is not clear that other municipalities—which may have their own unique problems—will follow them into Chapter 9.

Monetary Cost– When a municipality files bankruptcy, professionals including attorneys and accountants will be necessary to guide the municipality through the bankruptcy process.  While the fees of these professionals are usually quite small compared to the overall debt obligations of a municipality, these fees will increase a municipality’s debts to some degree.

Negative Effect on a Municipality’s Ability to Borrow– Having a bankruptcy filing on one’s record is never helpful when trying to access credit markets.  That said, any city that is considering filing bankruptcy is probably already having trouble obtaining credit.  Investors may prefer to lend to a city that is coming out of bankruptcy rather than one that is about to go in, so it is not clear how much a bankruptcy filing will harm a distressed municipality’s ability to borrow.

Ideally, distressed municipalities will make changes that will allow them to pay their creditors, provide good communities for their citizens, and avoid having to file bankruptcy.  For some distressed municipalities, however, it will be too late, and bankruptcy will be the best way to turn a difficult situation around.  But bankruptcy is a tough sell for the reasons described above.  Few municipalities have gone this route, and it is not apparent that municipal bankruptcies will become more common in the future.

[1] Section 101(40) of the Bankruptcy Code defines “municipality” as a “political subdivision or public agency or instrumentality of a State.”

[2] Creditors cannot force a municipality into an involuntary bankruptcy under Chapter 9.  The choice of whether to file bankruptcy lies with the municipality itself.