Bankruptcy Law for Municipalities Chapter

Bankruptcy Law for Municipalities

Chapter 9 is the section of the bankruptcy code dealing with municipal reorganization. It is intended to provide relief for municipalities from their creditors while they try to renegotiate their debt. This may be in the form of refinancing, extending maturities, or reducing principal or interest. Most of us are familiar with the negative stigma of filing for bankruptcy, but many of us are not familiar with the many benefits municipalities can receive through a bankruptcy filing. For instance, the bankruptcy court cannot mandate that the municipality sell assets to reduce debt obligations or interfere with the daily revenue producing activities of the debtor. The debtor can also renegotiate or reject collective bargaining agreements or retiree benefit plans without going through the same procedures as Chapter 11 filers.

Chapter 9 History

The history of the municipal bankruptcy chapter can be divided into two distinct phases: the first, from the 1930s, following the Great Depression, Chapter 9 was enacted; and the second, from 1976, when Chapter 9 was amended to address the New York City financial crisis. The 1976 amendments are particularly important, because they changed Chapter 9's basic rationale. Before 1976 the purpose of Chapter 9 was solely to overcome the creditors' holdout problem. After 1976, the chapter was supposed to offer municipalities with omnibus bankruptcy proceedings, and it was expected to help localities rehabilitate from their financial troubles.

The 1930s -- Chapter 9 Birth

The origins of the municipal bankruptcy chapter lie in the period preceding the Great Depression. In those years the U.S. enjoyed phenomenal economic development, and naturally, the growing national economy also affected local governments. The hectic business activity and the ever-increasing real estate prices facilitated the expansion of local tax bases, and municipalities enjoyed an increase in revenues and investments.

In order to support the growing lifestyles and income of its constituents, many municipalities set a high level of expenditure, and entered into long-term loan agreements for utility and infrastructure projects. Unfortunately, in 1929 the U.S. economy entered into the Great Depression, and local governments were burdened with the long-term debt they had assumed earlier.

One of the most important causes of crises in the local governments was the fall in real estate prices. During the Great Depression the total assessed property value in the country declined, and as a result property tax revenues plummeted. Residents did not have the money to pay the required taxes, and municipalities were not able to sell the real estate property that they had foreclosed. Naturally, this drove an alarming number of municipalities into a financial crisis. The municipalities simply could not pay back the debts they took on in the times of economic prosperity, and in January 1934 as many as two thousand local governments were in default of approximately $18 billion in outstanding municipal debt.

Due to the gravity of the situation, debt readjustment negotiations between municipalities and their creditors were prevalent. The problem was that many of the negotiated agreements, even if they received the support of the majority of the creditors, were impossible to consummate because of the strategic resistance of a small minority. Minority creditors held out their consent, as they preferred that the municipality and the majority of the creditors would execute the agreement without them having to waive any of their own claims. The minority hoped that the execution of a debt readjustment agreement would facilitate a local financial recovery, and this recovery would enable them to recover their claims from the locality in full.

Naturally, however, municipalities and majority creditors refused to accept the minorities' opportunistic behavior. This holdout problem was so severe that no municipality was able to execute a debt readjustment agreement with its creditors.

Therefore, the solution had to come from Congress, and Chapter 9 of the Bankruptcy Act was enacted in May 1934 exactly for this purpose. The chapter enabled municipalities to file for bankruptcy, and under certain conditions to force through beneficial debt readjustment agreements on minority creditors.

The 1976 Amendment

Not so different than the 1930's, the 1970s were years of economic turmoil. Business investments languished, unemployment was rampant in the 10% range, and the country suffered from a recession accompanied by high inflation rates. The national economic situation adversely affected local governments' financial condition. On one hand, because of inflation, municipal expenditures, and especially labor expenses, increased. On the other hand, the slow business activity and unemployment caused municipal tax bases to shrink. This double negative effect drove many municipalities into severe financial difficulties.

The most important and serious crisis took place in New York. The national economic situation combined with various other factors severely affected New York's economy, and at the beginning of the 1970s the city's financial condition severely deteriorated. At the height of the New York crisis, in 1975, the financial markets refused to extend the city any more credit, and New York City did not have the funds to pay for its debt service or basic operating expenses. With no available cash, New York's officials turned to the federal government for financial assistance, but President Gerald Ford denied the city's requests for financial aid. Instead of federal assistance, President Ford recommended that New York use municipal bankruptcy proceedings to solve its financial problems. The idea was that just as corporations use bankruptcy law to deal with their financial troubles, so could the city of New York. However, Chapter 9, essentially unchanged from the form it took in the 1930s, was unable to help the City of New York. The chapter could facilitate the approval of an already existing debt readjustment agreement, but New York did not have such an agreement, nor did it negotiate one. New York needed to rehabilitate from its financial troubles, but municipal bankruptcy was meant to solve only a holdout problem - a problem that neither New York nor other municipalities at that time suffered from. Chapter 9, therefore, was of no use to New York, and it generally seemed too old and archaic for cities to use.

In order to help New York City, Congress amended Chapter 9 of the Bankruptcy Act. The new chapter was no longer confined to setting a majority voting rule for the approval of debt readjustment plans, but rather it adopted a comprehensive bankruptcy procedure designed to help distressed localities survive and deal with financial crises. First, in an attempt to make municipal bankruptcy more accessible, the new chapter eliminated the requirement of presenting a debt readjustment agreement approved by an absolute majority of the creditors prior to the filing. According to the amended chapter, all municipalities could file, even if they did not prepare a debt readjustment agreement, and even if the majority of the creditors opposed the filing. Note that the pre-filing approval requirement makes perfect sense if the bankruptcy is designed solely to solve a holdout problem. Since a holdout problem exists only when an agreement is accepted by a majority of creditors, the requirement serves as an indicator that a bankruptcy process is indeed necessary. In the case of corporations, the aim of the bankruptcy process is to provide more comprehensive proceedings, than a pre-filing approval requirement is simply an unwarranted obstacle. Since in 1976 Congress viewed municipal bankruptcy as omnibus corporate like proceedings, then the pre-filing approval requirement had to be eliminated.

Secondly, the bankruptcy procedures themselves changed: the amended Chapter 9 created an automatic stay to prevent creditors from seizing municipal property; it included a cram down provision that enabled municipalities to force through a debt readjustment agreement despite the objection of the majority of the creditors; it contained provisions that allowed municipalities to receive new financing at the expense of their old creditors; it allowed municipalities to reject and assume contracts. In short, from a limited Chapter 9 designed solely to provide a solution to the holdout problem, the chapter was amended to provide a corporate-like bankruptcy procedure for municipalities.

Chapter 9 Procedure & Bankruptcy Examples

After examining the reasons that cause municipalities to need financial protection, it becomes clearer why bankruptcy does not offer municipalities a genuine chance for rehabilitation. Bankruptcy may help the municipality to reduce the level of its debts, but it does little to address the root causes of the economic deterioration. For example, the social economic reasons that lead to a local crisis. These reasons are usually external to the municipality, and involve state or even nation-wide processes. Chapter 9 will not help the city cope with these processes, as they require more in depth and overarching solutions. Chapter 9 cannot broaden a local tax base that shrunk due to a national recession; it has little bearing on the suburbanization trends in the country; and it has no effect on the intergovernmental funds that the city receives or on the extent of unfunded mandates the state imposes. All these issues should be addressed at state or federal levels, and a simple decrease in the local debt levels provides no remedy for them.

Bankruptcy also does not attend to the city's political problems. The same officials that controlled the municipality prior to the filing continue to run it, and the bankruptcy court has no authority to intervene or to deviate from their authority. Note that since the bankruptcy process changes nothing in the locality's political structure. Therefore, the incentives that promoted local spending and caused the bankruptcy to begin with, remain in force.

This explains why municipalities that file for Chapter 9 tend to return to insolvency after only a few years. The city of Mack's Creek, for example, filed for bankruptcy in 1998, then for a second time in 2000, and then it contemplated a third bankruptcy in 2004. The city of Westminster, Texas filed on 2000, and only 4 years later filed again. The city of Prichard, Alabama filed for bankruptcy at the end of 1999, came out of the bankruptcy only in 2007, and now, talks of a new bankruptcy filing has resumed. Without addressing the cities' core problems, the bankruptcy filing offered no help, and the cities' situation quickly deteriorated again.

The weakness of the municipal bankruptcy process was the reason for Connecticut's objection to Bridgeport's bankruptcy filing in the 1990s. Back then Bridgeport suffered from a severe economic crisis. The city projected a $16M budget deficit for the years 1991-1992, and its residents were burdened with the highest effective tax rate in the state. Bridgeport was unable to finance an adequate level of public services, and even basic services, such as police protection and street cleaning, were not properly provided. Hoping to escape financial disaster, in 1991 the city filed for bankruptcy. The state of Connecticut, however, objected. The state officials did not believe a bankruptcy court to be the proper venue to solve Bridgeport's problems, and they understood bankruptcy could do more harm than good.

Not only is Chapter 9 an unsuitable mechanism for helping distressed localities, but it may very well aggravate their situation. First, bankruptcy filing harms the city's reputation as a place for residence. A bankrupt municipality is associated with poverty and misery, and this image deters businesses and individuals from locating in the city. Bankruptcy, with its uncertainties and stigma, decreases real estate prices and stifles economic activity and investments in the city. Instead of creating growth, bankruptcy may shrink the local tax base and hold the city's development back even further. Second, bankruptcy damages the city's reputation as a debtor. The creditors, harmed by the city's debt load, are reluctant to extend the city any more credit, and the city's credit rating may suffer for long period of time. Bankruptcy, therefore, vastly escalates the city's costs of borrowing, and it can block the city's access to the credit markets altogether. Indeed, bankruptcy filing jeopardizes the very resources the city needs in order to recover -- additional taxes and credit. The city may come out of the filing with less debt, but also with fewer prospects for the future.

Moreover, a municipal bankruptcy filing can produce negative implications for the state. States have a tremendous impact on the financial condition of their municipalities, and they largely influence both the local revenues and expenditures.

Due to this strong link between the state and the local economies, a default or bankruptcy filing of one municipality raises concerns about other adjacent municipalities in the same state. A local crisis may be the result of general state policies toward local governments, and it shows that the state does not take the necessary measures to maintain the fiscal health of its municipalities. The crisis, therefore, although seemingly an isolated local event, may be a sign for more widespread crises in the future, and may cause the creditors to re-evaluate the risk associated with public debt in the entire state. These concerns increase the price of credit for all public issuers in the state, even for those issuers that have no direct connection with the city's default. This claim received empirical support in various studies on the effects of the Orange County, CA bankruptcy.

Studies show that the county's bankruptcy had significant conspiring effects on the entire municipal bond market, and especially on public issuers within California.

Following the bankruptcy, there was a considerable decrease in the value of many municipal bonds, even in bonds that were issued by local governments and other public bodies that had no direct exposure to Orange County's crisis. The claim also echoes the positions of states with regard to municipal bankruptcy filings. Many states object to Chapter 9 filings, and one of the main reasons state officials provide to support the objection is the effect bankruptcy might have on other public issuers in the state.

Municipal bankruptcy filings, states fear, will have adverse effects on the credit markets all over the state, and they do not want to incur these costs.

This analysis on the effects of municipal bankruptcy sheds light on the data on municipal bankruptcy filing that was described earlier in the paper. First, it explains why there are so few bankruptcy filings to begin with. If Chapter 9 offers little in the way of rehabilitation, but it aggravates the city's economic situation, then it is not surprising that many distressed cities prefer not to file. Second, the analysis explains why most states object to municipal bankruptcies even when a distressed city is inclined to file such as Camden, NJ or Bridgeport, CT. As opposed to a city, a state internalizes all costs and benefits associated with the filing. It takes into account not only the bankruptcy's effects on the city, but also the bankruptcy's effects on the municipal bond market in the state as a whole. Since, as we have seen, the benefits of the bankruptcy, especially in the long-term are small, whereas the costs to public issuers can be substantial, states often object to municipal bankruptcies. Third, the analysis clarifies why cities that do undergo bankruptcy have the special characteristics, such as, they are extremely small, and entered the crisis due to a one-time unexpected financial calamity. Under these extraordinary circumstances, Chapter 9 can help the city recover, because the municipality essentially suffers from liquidity problems for a long time. The bankruptcy relieves the city's debt burden created by the single exogenous event, and since the city does not suffer from structural systemic problems, it can thereafter continue to function properly. In addition, in such cases, because of the city's small size, and the extraordinary circumstances of the filing, the effects of the bankruptcy on the bond market are narrower.