Emerging from Bankruptcy: Notes for Municipalities and States

Committees of Jurisdiction: Law, Justice, and Ethics; Labor, Military, and Veterans Affairs

This past July, the City of Detroit filed for bankruptcy becoming the largest municipal bankruptcy in U.S. history, a title formerly held by Jefferson County, Alabama. Detroit is more than $18 billion dollars in debt and declaring Chapter 9 bankruptcy was the only “feasible option to fix the city’s finances and do what is right for the 700,000 people of Detroit,” according to Michigan Governor Rick Snyder. Ingham Circuit Court Judge Rosemarie Aquilina initially ruled that Detroit’s bankruptcy filing was unconstitutional and had to be withdrawn, but her decision was overruled by a Michigan Court of Appeals judge.

Filing for bankruptcy affects both city and state governments and can have an especially detrimental effect on public employees. Michigan is one of many states that does not allow its municipalities to file for bankruptcy without permission, and may also use an intervention program to prevent it. Every state should take steps to prevent municipal bankruptcy.

Municipal Bankruptcy
When a municipality is unable to pay its bills, fully carry out public services, or balance its budget, it is considered in financial distress. To relieve the distress, the municipality may cut public services, raise taxes on residents, or borrow from lenders. When these measures are unsuccessful, the municipality may consider filing for bankruptcy. In order to be eligible for bankruptcy, the municipality must show in its petition insolvency, a good faith attempt at negotiating a settlement with creditors, and a willingness to develop a plan to resolve its debts. Municipalities need permission from the state government before they can file in all but 15 states. Georgia is the only state that does not allow its municipalities to file for bankruptcy under any circumstances.

Municipal bankruptcies are rare in the United States, and there have only been 620 municipal bankruptcies since Chapter 9 was added to the Bankruptcy Code in 1937. Once filed, the petition must be approved by a bankruptcy judge; otherwise, the municipality cannot declare bankruptcy. Once a bankruptcy is filed, the municipality must develop a restructuring plan to be approved by the bankruptcy court in its jurisdiction. The municipality retains power over its spending and other policy decisions as stated in local constitutions, and the bankruptcy halts any lawsuits that may be against the municipality. Bankruptcies can last months or even years as in the case of Vallejo, California, which took five years to emerge.

Bankruptcy can also affect a municipality’s population. Prior to filing, Detroit cut several public services in an attempt to save money. A decrease in services combined with an increase in crime contributed to an exodus of nearly one million residents. Once the home to 1.8 million people at its peak in 1950, the city now counts a mere 700,000.

Federal Action

Historically, the federal government has not intervened in municipal bankruptcies though it came close under the Ford administration. In 1975, New York City underwent financial distress. To address this, the City created the Municipal Assistance Corporation powered by investment funds from the New York City Teachers Union. These corporate bonds helped pull the city out of debt. After seeing the municipal government’s progress, President Gerald Ford extended $2.3 billion in federal loans to the city through the New York Seasonal Financing Act of 1975.

State Action

Some states have taken non-bankruptcy approaches to their fiscal crises, namely California and New York. In response to its $26 billion budget deficit in 2009, California began issuing registered warrants (IOUs) to cover expenses and to pay bondholders. A registered warrant is a “promise to pay” issued by the State when it does not have enough funds available to pay all of its obligations. Registered warrants bear interest and are only redeemable when there is money in the General Fund. Registered warrants were also given to state employees, local governments, taxpayers for their refunds, and private businesses, and were used for approximately a year. The IOUs were able to save California $1.95 billion in 2009.

In 2012, New York passed legislation to prevent underfunded pensions (which can lead to financial crisis) for new employees. The legislation raised the retirement age for newly hired state employees, introduced progressive employee contributions, changed the vesting period, and required any new retirement benefits or enhancements to be prefunded.  

States can choose to respond or not respond when a municipality goes bankrupt. The State of California chose not to act when the City of Stockton filed for bankruptcy. But, the State of Rhode Island did choose to help one of its cities, Central Falls, emerge from bankruptcy in a year. According to a Pew Charitable Trust study, states routinely help municipalities prior to (and after) bankruptcy in developing intervention programs, due to

  • the stigma associated with bankruptcy,
  • the fear of credit downgrades,
  • contagion (which is when financial distress spreads from one city in the state to another),
  • concerns for public health and safety, and
  • the need for economic stability and growth within the states.

Intervention programs can be implemented in three ways (or a combination of them). One way is to appoint an outside person to act as a receiver, financial manager, overseer or coordinator. In Central Falls, Rhode Island, the governor appointed an outside person who took charge of their bankruptcy process. Here, the state developed steps to prevent other cities from entering bankruptcy. Another method is to designate an agency to supervise the bankruptcy process and create a restructuring plan. For example, Pennsylvania empowers its Department of Community and Economic Development to appoint a coordinator to manage its intervention plan. The third option is to create a financial control board or state appointed board or commission.

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Municipal Bankruptcy and Public Benefits

Members-of-the-Detroit-Firefighters-Association-protest-during-the-City-of-Detroits-bankruptcy-hearing-July-24-AFPPhoto Credit: The Raw StoryWhen faced with instances of financial distress or crisis, one of the hardest decisions that a municipality has to make is how to continue to pay employee pensions and/or retiree benefits. According to the Center for Retirement Research at Boston College, state pensions are 27% underfunded, meaning the money needed to cover the pensions is not readily available. Most often, the inability to pay pensions and retiree benefits is part of the reason a municipality has to file for bankruptcy. Underfunded pensions and health benefits become an issue for states when developing their restructure plans. Courts have typically viewed pension benefits as either “property interests,” meaning property to which an individual has rights, or contracts the law must uphold. As pension benefits are considered legal contracts, municipal governments will face challenges to the constitutionality of their attempts to alter them.

When Detroit filed for bankruptcy, the City was met with several lawsuits from its employees concerned that their pensions were not going to be paid, even though Michigan’s constitution states that accrued pension benefits shall not be diminished. A federal bankruptcy judge ruled against the petitioners and held that Detroit could continue with its filing of its bankruptcy case. The question remains of whether benefits that have not been accrued will be altered in response to the bankruptcy. This may set a precedent for other states when filing that see contracts with public employees as opportunities to cut costs.

State legislatures can help maintain the fiscal health of their municipalities. They can assist municipalities in exhausting all viable options before electing to file for bankruptcy. States may also offer more proactive opportunities for municipalities to avoid financial crisis generally. For example, legislatures may consider allocating technical assistance for local governments that experience chronic budget deficits. Finally, states can and should take steps to protect promises made to public employees. Workers who have spent decades upholding their end of the bargain should expect to receive what they have earned, even when a city has faltered.

  • Pew Charitable Trusts: Pew Charitable Trusts is an independent nonprofit organization that applies a rigorous, analytical approach to improve public policy, inform the public, and stimulate civic life.
  • National Association of State Retirement Administrators (NASRA): NASRA is a non-profit association whose members are the directors of the nation's state, territorial, and largest statewide public retirement systems. NASRA members oversee retirement systems that hold more than two-thirds of the more than $2 trillion in state and local government assets and that provide pension and other benefits to most state and local government employees.
  • National Conference on Public Employee Retirement Systems: The National Conference on Public Employee Retirement Systems (NCPERS) is the largest trade association for public sector pension funds, representing more than 550 funds throughout the United States and Canada. It is a unique non-profit network of trustees, administrators, public officials and investment professionals who collectively manage nearly $3 trillion in pension assets held in trust for approximately 21 million public employees and retirees — including firefighters, law enforcement officers, teachers, and other public servants.

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