The Lure and Limitations of Bankruptcy Restructuring for Municipalities

Published on PublicCEO.com.

Cities, counties and other governmental units are facing enormous financial pressures today:  growing obligations for medical benefits and pensions (particularly as the large baby boomer group hits public employee retirement age) are hitting at the same time as recession-driven declines in revenue. 

Some municipal treasuries have also taken unexpected hits as formerly safe investments (Fannie Mae, Freddie Mac and Lehman Brothers) became valueless.  In many states, like California, there are also severe legal limitations on the ability to raise additional revenues to meet projected shortfalls.

In this difficult time, many governmental units are looking at the bankruptcy of Vallejo, Calif. and threatened bankruptcy of Jefferson County, Ala. with interest, evaluating Chapter 9 municipal bankruptcy as a possible tool for dealing with growing costs and declining revenues.  There are many reasons, however, that few other governmental entities have taken that step. 

The Limits of Governmental Bankruptcy

If bankruptcy were a cheap, simple and consequence-free alternative, filing Chapter 9 would be a lot easier than balancing a budget in these difficult times.  Bankruptcy, however, is not. 

First, Chapter 9 is about debt adjustment, not debt elimination.  For an insolvent government that cannot pay its debts in full as they come due in the coming fiscal year, Chapter 9 provides a forum to stretch the obligations out over time.  It is not, however, a silver bullet for eliminating any one category of costs - whether pensions, retiree medical obligations, union contracts, obligations to developers or bond debt - which still have to be paid as bankruptcy claims, although perhaps less than 100 cents on the dollar and over many years.  (Historically, most municipal bankruptcies have paid creditors in full, but over many years.)

Second, bankruptcy involves potentially staggering legal costs over many months or years, and every extra dollar spent on legal fees is a dollar not available for critical governmental services.  In addition to their own attorneys' fees, municipalities generally must pay the attorneys' fees for the creditors' committee that Chapter 9 requires to be formed, as well as the attorneys' fees for their bondholders or credit enhancers under bond documents.  It is also extremely inefficient.  The California City of Desert Hot Springs was in bankruptcy for more than two and a half years, and it took nearly two years for it to get its plan of adjustment confirmed.  The California City of Vallejo has already been in bankruptcy for more than one year, and has spent more than $5 million in legal fees before even beginning the process of preparing a plan of adjustment. 

Third, there are other serious credit market, business, political and practical costs for a bankruptcy filing.  Governmental units are prodigious borrowers for capital projects, and the public debt markets have long memories.  Particularly for governments that have issued floating-rate short term debt, like certificates of participation that are repriced in the market on a weekly basis, even using the B-word in public discussions can radically increase their borrowing costs.  (This is true even if, as a practical matter, the debt is rated based on the financial strength of a third-party credit enhancer:  portfolio managers don't need the headache of explaining to their bosses or investors why they are holding Vallejo bonds.)  Bankruptcy is contentious and time consuming, placing enormous requirements on already stretched governmental staff.  Businesses are often not eager to move into a city that is bankrupt, and existing businesses may choose to leave.  Voters who might have paid more in taxes to restore service cuts are less likely to vote to raise taxes or approve new fees simply to pay bankruptcy lawyers and old bankruptcy claims. 

Fourth, bankruptcy code provisions (and sometimes applicable state law, because states must authorize their municipalities to file bankruptcy) limit access to governmental bankruptcy to municipalities that are "insolvent" as defined the bankruptcy code and usually require certain pre-bankruptcy negotiations with categories of creditors as a precondition to filing. 

Alternatives to Bankruptcy

For virtually all financial problems, there is usually a better, cheaper and more practical solution.  Voluntary renegotiation of key labor agreements, with full information about the difficult financial picture, as difficult as it may be, is less expensive, contentious, uncertain and disruptive as a governmental bankruptcy filing.  As a second to last resort, some states, like California, provide for a declaration of fiscal emergency that may permit limited and short term modifications even without agreement.  In contrast, if a city or county modifies or rejects a labor contract within a bankruptcy, that gives rise to damage claims that must be paid to the employees through the plan of adjustment, saddling the government with continuing financial obligations for many years in the future.

A Last Resort, Not a Destination Resort

Bankruptcy doesn't solve financial problems.  It simply provides a different, and usually more expensive, forum to work out solutions with the help of some additional tools.  For cities, counties and other governmental units facing immediate catastrophes - a developer about to levy on assets after a jury verdict, massive bond defaults - bankruptcy is a potential last resort, but even then there are specific requirements, potential pitfalls and practical limits on its availability.