On July 18, 2013, the city of Detroit, Michigan declared bankruptcy.1 The city’s debt stood at $18.5 billion, more than four times greater than any other municipal bankruptcy since the modern bankruptcy code was adopted by congress.2 Despite the magnitude of the economic and social impacts of municipal bankruptcy, the topic is not diffusively understood. This two-part blog series will attempt to shed light on the municipal bankruptcy process and the legal mechanisms by which a municipality can default on its debt. In this current post, I will introduce the history of municipal bankruptcy provisions, their evolution to the current standard, and describe how these provisions vary between states.
States are entitled to set up their own respective governmental structure, such as cities, townships, or villages, etc. These entities are considered legal corporations and are eligible to file bankruptcy.3 This was not always the case. Prior to the Great Depression, when municipalities were unable to service their debt, creditors would pursue an action of mandamus in court.4 If the creditors were successful, the action of mandamus would force the municipality to increase taxes on residents in order to increase revenues.5 When the Great Depression struck this solution was no longer feasible. Decreased land value reduced municipal revenues from property taxation. Likewise, high unemployment cleaned out municipal coffers. The solution: municipal bankruptcy. In United States v. Bekins, the Supreme Court upheld Congress’ Municipal Corporation Bankruptcy Act, holding that the statute did not violate the Tenth Amendment.6 The Bekins court found that the statute was properly redrafted (compared to prior unconstitutional versions) to avoid infringing on state sovereignty, leaving it up to individual states to draft municipal bankruptcy codes as they saw fit.7
Currently, there are five conditions that must be met before a municipality can declare bankruptcy.8 The first is that the municipality must have specific authority to file for Chapter 9 bankruptcy under its respective state law.9 States have utilized that power in different ways. They either allow municipalities to declare bankruptcy through blanket authorization, or require set conditions to be met before the municipality can declare bankruptcy.10 Turning back to Detroit as an example, Michigan falls under the latter category. Governor Rick Snyder was required under Michigan Statute §141.1213 to approve Detroit’s bankruptcy before the city could default on its debt.11
In addition to Michigan, fifteen other states have set statutory conditions that must be met before a municipality can declare bankruptcy.12 Though the specific mechanisms vary by state, they generally fall into two categories: the taxing agency desiring bankruptcy must pass a resolution, or the bankruptcy declaration must receive approval by the governor or another state official.13 Twelve states provide complete authorization to municipalities to declare bankruptcy without state oversight.14 The remaining states do not authorize municipal bankruptcy, leaving creditors and defaulted debtors to renegotiate the debt without the supervision and legal mechanisms provided by a bankruptcy court.15
As municipalities face fiscal pressure to meet obligations such as unfunded pension plans, creditors may deal with them differently depending on their respective state’s bankruptcy code. The twenty-two states that do not currently authorize municipal bankruptcy should reconsider their respective stance on the matter lest they leave their municipalities with unreasonably limited financial flexibility in the face of a crisis. The interest rates two equally credit worthy municipalities pay to creditors may be substantially different, depending on how creditors factor in the possibility of their contractual terms being renegotiated in bankruptcy. In my next blog post, I will analyze Detroit’s bankruptcy proceeding and highlight important takeaways which may be indicative of how future municipal bankruptcies will play out.
Monica Davey, Mary Williams Walsh, Billions in Debt, Detroit Tumbles Into Insolvency, N.Y. Times (July 18, 2013), available at http://www.nytimes.com/2013/07/19/us/detroit-files-for-bankruptcy.html ?pagewanted =all&_r=0 ↩
The Nat’l Ass’n. of State Budget Officers, Municipal Bankruptcy & the Role of the States, (Aug. 21 2012), available at http://www.nasbo.org/sites/default/files/pdf/Municipal%20Bankruptcy%20%26%20the%20Role%20of%20the%20States.pdf. ↩
Ashton v. Cameron Cnty. Water Improvement Dist. No. 1., 298 U.S. 513, 534 (1936) (Cardozo, J., dissent). ↩
United States v. Bekins et al., 304 U.S. 27, 58 (1938). ↩
Id. at 51-2. ↩
H. Slayton Dabney, Jr., et al., Municipalities in Peril: The ABI Guide to Chapter 9, American Bankruptcy Institute, (2010). ↩
News 10, 22 States Do Not Allow Access to Chapter 9 Bankruptcy, available at http://archive.news10.net/news/pdf/State-Policies-on-Chapter-9-bankruptcy.pdf (last visited Oct. 21, 2014). ↩
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