The Politics of Municipal Bankruptcy

State governments’ attempts in Alabama and Pennsylvania to avoid or dismiss high-profile and long-anticipated municipal bankruptcy filings have been making headlines in recent months.  Readers may also remember that, at the end of last year, Michigan’s state government refused to authorize the City of Hamtramck’s municipal bankruptcy filing.  The press has reported on these events here, here, and here.
States are also revisiting their municipal bankruptcy laws and seeking to curtail access to federal bankruptcy.  In Pennsylvania, Governor Corbett signed a bill on October 20, 2011, setting forth a procedure for the Governor to declare a fiscal emergency and petition for the appointment of a receiver to develop a recovery plan on behalf of a financially distressed municipality.  The bill also requires the Commonwealth’s prior written authorization before such receiver can file for federal bankruptcy protection.
Up until recently, California had a broad enabling statute.  On October 9, 2011, however, Governor Brown signed into law Assembly Bill 506, which will require cities, counties, districts, public authorities, public agencies, and other public subdivisions to mediate with “interested parties” prior to seeking federal bankruptcy protection.  To bypass mediation, a municipality must declare a fiscal emergency and adopt a resolution by a majority vote of its governing board, after a noticed public hearing and public comment, finding that the financial state of the municipality jeopardizes the health, safety, or well-being of the residents within its jurisdiction or service area, and that the municipality will run out of money to pay its obligations within 60 days.  As reported in an earlier post, a similar version of this bill was introduced in the 2009-2010 legislative session, but failed to pass.
States’ efforts at curtailing municipalities’ access to federal bankruptcy protection appears to be motivated by their concern about the potential “by-products” or “side effects” of bankruptcy.  For example, Pennsylvania’s effort to limit a municipality’s access to bankruptcy protection may be motivated by the concern often voiced by commentators and analysts that municipal bankruptcy filings will impair municipalities’ or the state’s borrowing power and/or increase the cost of borrowing.  California’s law appears to have been enacted (at least in part) in response to the In re City of Vallejo case, in order to prevent municipalities from filing petitions for the sole purpose of rejecting collective bargaining agreements.  California’s law specifically includes as an interested party to the mediation a union that, under its collective bargaining agreements, has standing to initiate contract or debt restructuring negotiations with the municipality.
Although, intuitively, it would seem that the reforms contravene the “fresh start” purpose of the Bankruptcy Code, the reforms appear to be sanctioned by the Bankruptcy Code.  Congress appears to have intended for states to exclusively control municipalities’ access to federal bankruptcy relief.  Because of the tensions between the sovereign power of the states over their subdivisions pursuant to the Tenth Amendment, and the debt adjustment powers available under federal law, the Bankruptcy Code expressly provides that a municipality’s eligibility to be a chapter 9 debtor is limited by state law.  Section 109(c)(2) of the Bankruptcy Code requires, among other things, that a municipality be “specifically authorized, in its capacity as a municipality or by name, to be a [chapter 9] debtor … by State law, or … by a governmental officer … empowered by State law.”  Currently, 26 states have statutes that authorize, in some form, municipal bankruptcy filings, although some of those states impose certain pre-conditions to seeking relief under chapter 9.  Other states have no authorization statutes, and at least one, Georgia, explicitly prohibits municipal bankruptcy filings.
There may be a benefit to having clearer authorization requirements codified within state statutes.  Chapter 9 protection is not as simple as it may seem, and a municipality’s eligibility to pursue debt adjustment under the Bankruptcy Code is often challenged by creditors and can result in costly litigation before the chapter 9 case can proceed.  For example, California’s mediation requirement may help clarify one often-litigated eligibility requirement:  that a potential chapter 9 debtor negotiate in good faith with prepetition creditors—or show that it is unable to do so.  Although many courts have interpreted the good faith negotiation requirement imposed by section 109(c) of the Bankruptcy Code as relatively easy to satisfy, creditors in recent cases such as In re City of Vallejo nonetheless have objected to whether a municipality has satisfied this requirement.  California’s pre-filing mediation requirement may impose costs and inefficiencies on the municipality’s restructuring process, but such requirement may ultimately save the municipality the time and expense of litigating the good faith negotiation or state authorization requirements before a bankruptcy judge prior to entry of the order for relief.
Although municipal bankruptcies are still relatively rare, in light of many city governments’ budget shortfalls, and the consequences that a municipal bankruptcy can have on residents, public employees, pensioners, and bondholders, more states may follow Pennsylvania’s and California’s lead and consider discretionary access to chapter 9 through use of a gatekeeper, such as a receiver or neutral mediator.  On the other hand, some states might recognize that municipalities generally treat federal bankruptcy filings as a last resort, because seeking to adjust debts under chapter 9 can be time-consuming and expensive.
A municipality’s problems are often not just fiscal but also political problems, and – inside or outside of federal bankruptcy protection – there is no escaping that any restructuring will entail difficult choices that will require significant political will.