Municipal Bankruptcies

Michael King
December 23, 2013 — 1,349 views  
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QUESTION:         The city can raise taxes, so it can pay me, right?

ANSWER:            Be careful, because municipalities can file bankruptcies!

Armageddon?

Unemployment in the City was 22%.  Median home prices fell by two-thirds.  The City's sales tax revenue dropped by almost one-third!

City management had committed itself to payment of long-term bonds on projects that were excessively optimistic.  Revenues were too low to pay back the bonds.  The City needed to raid its general fund to make payments.  The city council swept every available account.  "[T]hey stole the arts fund," and every other special fund.[i]

The City paid "above-market compensation for public employees."  "[T]he City offered generous health care benefits, to which employees did not contribute.  Retirees had their entire health bills paid for by the City."

Collective bargaining agreements with the unions "included predetermined, automatic cost of living pay increases."  "Pension spiking" became rampant.  "Pensions were allowed to be based on the final year of compensation, and only the final year of compensation, and that compensation could include essentially an unlimited accrued vacation and sick leave."  "Pension spiking" retirees were receiving "substantially greater [payments] than the annual salary that the retiree ever had."

"The City Council is in such disarray that it's taken literally years to unscramble."  The City's general fund showed millions of dollars in deficits.  The projected deficits would continue to double or quadruple into the future.

"Public safety, police and fire consumed 77% of the budget."  The police only respond to crimes in progress.  Gang-related homicides increased by 575%.  Aggravated assaults with fire arms more than doubled and the City became one of the 10 worst in the country for violent crime.

The new City Hall building was literally in receivership!

Detroit?  No, Stockton, California!

What can a municipality do in the face of such calamity?  File for bankruptcy under chapter 9 of the Bankruptcy Code. 

Why would bankruptcy help the City?  State law won't help.  The "contracts clause" of the U. S. Constitution says that no State may make a law impairing the obligation of contracts.  When a City needs to get out of contracts with government employees, for example, State law will usually not help.  Under the U. S. Constitution, Congress has the exclusive power to make uniform laws concerning bankruptcy and those bankruptcy laws impair contracts and contract rights all the time.  To break contracts and change contract rights, a municipality needs the power of the bankruptcy court. 

 

What does a municipality need to prove to file for bankruptcy?

                        Chapter 9 of the Bankruptcy Code is not very detailed and contains a misplaced comma in the very first line.  (Builds confidence in the Federal Government!)

                        Nevertheless, Section 109(c) of the Bankruptcy Code tells us what is required for a chapter 9 municipal bankruptcy filing. 

  • The debtor must be a "municipality."
  • The "municipality" must be specifically authorized either by name, under State law, or by a State officer to file for chapter 9 bankruptcy.
  • The municipality must be insolvent.
  • The municipality must desire to effect a plan to adjust its debts.
  • The municipality also must have accomplished one of the four following items:
    • It needs to have obtained the agreement of creditors with a majority of the claims being impaired under a plan of adjustment;
    • The municipality must have negotiated in good faith with creditors and failed to obtain the creditors' agreement;
    • The municipality must be unable to negotiate with creditors because of the impracticability of negotiations; or
    • The municipality believes that a creditor may attempt to obtain a preferential transfer in violation of § 547 of the Bankruptcy Code.

How does this work?

The municipality submits its petition under chapter 9 of the Bankruptcy Code.  The creditors object saying that the requirements for filing are not met.  A trial ensues. Once the court decides that the governmental entity is eligible to file chapter 9 bankruptcy, the litigation and negotiation on a "plan of adjustment" of debts ensues.  With the City of Stockton, the process of deciding whether Stockton was eligible to file for chapter 9 bankruptcy relief took approximately one year.  The process of negotiating and confirming a plan of adjustment will take longer.  After a plan of adjustment of indebtedness is approved, the municipality will need to make the payments required by such a plan. 

If the plan is approved, municipal services such as police and fire protection are unlikely to increase due to the budget constraints.  Thus, property values may continue to decline as citizens choose to "vote with their feet."  With less tax revenue, the situation may continue to spiral downward.  Nevertheless, the chapter 9 bankruptcy offers the chance to restructure obligations to stabilize finances and avoid municipal collapse.

We wish the best to the citizens and creditors of Detroit, Stockton, San Bernardino and elsewhere.  If you need to know about the risks of doing business with potentially insolvent governmental entities, you should call me.


All quotations from Findings of Fact and Conclusions of Law, In re: City of Stockton, California, USBC, E.D., Cal. Case 12-32118-C-9, April 1, 2013.

Michael King

Gammage & Burnham

Mike King is a founding partner of Gammage and Burnham, Attorneys at Law, a well known legal firm in Phoenix Arizona. His practice emphasizes business and corporate law.