Governance reform and the judicial role in municipal bankruptcy.

• Author: Gillette, Clayton P.
• Position: Introduction through III. An Affirmative Case for Governance Reform A. Fragmented Governance as a Source of Distress, p. 1150-1194

ARTICLE CONTENTS INTRODUCTION I. MUNICIPAL REORGANIZATION AND CORPORATE REORGANIZATION A. The Need for Municipal Governance Reform B. Governance Reform in Chapter n II. WHY HASN'T GOVERNANCE BEEN A FOCUS IN CHAPTER 9? A. Municipal Bankruptcy in the 1930s B. Ashton to Congress to Bekins C. New York City and the 1970s Amendments D. Selection Bias in Municipal Bankruptcy Filings III. AN AFFIRMATIVE CASE FOR GOVERNANCE REFORM A. Fragmented Governance as a Source of Distress B. Bankruptcy as a Governance Corrective IV. OBJECTIONS TO GOVERNANCE REFORM IN CHAPTER 9 A. Bankruptcy Courts Cannot Interfere with Municipal Powers B. Only the "Adjustment of Debts" Is Permitted in Chapter 9 C. Commandeering and Unconstitutional Conditions D. Will Bankruptcy Judges Make Matters Worse? E. Will Governance Reform Discourage Bankruptcy Filings? V. WHY NOT THE STATE? A. Doctrinal Constraints on State Design of Municipal Governance B. The Political Economy of Structural Reform CONCLUSION INTRODUCTION

As an increasing number of municipalities take advantage of the ability to adjust their debts under Chapter 9 of the Bankruptcy Code, the utility and efficiency of that scheme has become more apparent. (1) Fears that Chapter 9 would be incapable of handling the fiscal distress of large cities have dissipated as bankruptcy courts have deftly managed the bankruptcies of Vallejo, San Bernardino, and Stockton, California; Jefferson County, Alabama; and Detroit, Michigan. (2) These episodes have revealed that bankruptcy courts can balance the interests of the various stakeholders--creditors, pensioners, the state, and residents--involved when municipalities face fiscal distress.

Less clear is whether the dexterity that bankruptcy courts display in adjusting municipal debts has lasting effects on municipal fiscal health. Courts tend to focus almost exclusively on the debt overhang problem--that is, on reducing the municipality's debt burden to a level that permits a city to devote scarce resources to providing services rather than solely to paying creditors. To the extent that municipal distress results from a debt burden that stifles investment and diverts municipal budgets to legacy costs rather than future productivity, the ability to pare down a municipality's debt may be sufficient.

But municipal distress--especially the distress of a substantial city--rarely is simply a matter of too much debt. Failed budget policies do not arise autonomously, disaggregated from the political environment in which they are devised. Rather, with the exception of cases in which municipalities face some exogenous shock, such as a crippling tort suit or natural disaster, or in which local governments suffer from broad economic disruptions beyond their control, local fiscal crises usually are caused by a governance structure that tolerates financial decisions in which the benefits and costs of public expenditures are misaligned. The disparity may be temporal. Local political officials concerned about electoral success or opportunities for higher office may favor programs that promise short-term benefits paid for through long-term costs. Alternatively, the mismatch may be spatial. Programs that produce highly concentrated benefits in some districts within the locality may be financed by imposing costs on neighboring districts, with the result that the commons of the municipal budget faces overuse. (3) Or, officials may adopt policies that confer inefficient benefits on small, concentrated groups and discourage electoral redress by spreading the costs among the diffuse electorate. (4)

The institutions of local governance that permit these misalignments tend to be entrenched in city charters or bureaucratic regimes, and left unchallenged, they survive even after bankruptcy proceedings adjust the debts to which they have given rise. According to the conventional wisdom, Chapter 9 has little to say about these issues other than to preclude the bankruptcy court from usurping the political or governmental powers of the municipal debtor. (5) If the conventional wisdom is correct, Chapter 9 cannot meaningfully reduce the risk of recidivism for a financially distressed municipality. The debt adjustment provided by Chapter 9 offers temporary relief before the next crisis, not a thoroughgoing remedy aimed at the root causes of municipal distress.

This Article challenges the traditional account. We contend that municipal bankruptcy can and should address governance failures where they contribute to financial failures. We argue that this conclusion follows from an appreciation of the similarities between municipal corporations and the for-profit corporations that are reorganized in Chapter 11 of the Bankruptcy Code. Where governance failures contribute to corporate financial distress, no one would treat governance reform as irrelevant to the reorganization of a corporation. Carefully crafted governance rules were a central feature of the Chrysler bankruptcy, (6) and governance rules figure prominently in most other substantial Chapter 11 cases as well. From a purely functional perspective, governance reform is even more essential to an effective Chapter 9 municipal bankruptcy than it is in Chapter 11, since at least some stakeholders in insolvent municipalities are more dependent on those entities than are stakeholders in insolvent firms.

Municipal bankruptcy does not just facilitate governance reform: in many cases, the logic of the municipal bankruptcy process requires governance reform. The public--and inherently political--nature of municipal debtors has traditionally been seen to preclude the use of Chapter 9 for anything other than reducing a municipality's debt. (7) Our position is that the political nature of municipal fiscal distress has precisely the opposite implication. The financial distress of a substantial municipality nearly always signals that its politics are dysfunctional. The same entrenched political environment that exacerbates fiscal instability may also frustrate efforts to initiate reforms necessary to escape a cycle of financial irresponsibility. That entrenchment can be overcome only by the inducement or imposition of structural reforms from outside the municipality.

Ideally, the outside catalyst would be the state, which retains substantial authority over its political subdivisions. But political entrenchment may also constrain the state from inducing or imposing structural reforms that are needed for fiscal stability. Where that is the case, and where the state accedes to a municipality's use of the federal bankruptcy courts, we conclude that the bankruptcy judge should and does have leeway to induce necessary reforms. Yet discussions of Chapter 9 consistently ignore the possibility of governance reform, even where it is essential to revive a financially failed municipality. Although conventional wisdom suggests that governance reform in bankruptcy infringes on state sovereignty, which perhaps explains its neglect, we contend that governance restructuring in Chapter 9 passes constitutional muster.

Two decades ago, Michael McConnell and Randal Picker made the most comprehensive argument to date for moving beyond the debt-adjustment model of municipal bankruptcy. (8) They contended that municipal bankruptcy should permit reorganization of municipal structures in ways that were analogous to the reorganization of firms in Chapter 11. For McConnell and Picker, the expanded powers of the court would include authority to mandate "politically unpopular reforms," (9) such as authority to collect taxes to pay preexisting debt; to order reductions in expenditures; to sell municipal assets; and perhaps even to reorganize the boundaries of or to dissolve the debtor municipality based on applicable state-law principles. (10) McConnell and Picker advocated that these reforms take place in state bankruptcy proceedings rather than in federal bankruptcy court. (11) Implicit in McConnell and Picker's recommendations is an optimistic story of a benign state willing and able to enact reforms that facilitate municipal fiscal discipline.

We share McConnell and Picker's intuition that relief for fiscally distressed municipalities necessarily entails more than debt reduction. We focus, however, on the design of municipal decision-making institutions rather than boundaries or tax decisions, and look to the federal bankruptcy court as the catalyst for reform. Where the state intervenes to redress structural difficulties that cause fiscal distress, there may be little need for bankruptcy court intervention. But where the state fails to do so because of its own political constraints, rather than as a consequence of a deliberate decision, we find fewer reasons to preclude bankruptcy courts from filling the gap. While state political inertia has always been a concern, its salience has increased considerably in the two decades since McConnell and Picker wrote their classic article. In short, we view bankruptcy court intervention into municipal governance as an option, not a requirement. It is warranted by the same entrenchment problem that has led commentators to advocate for more intensive judicial intervention in other public arenas, such as voting rights or prison reform, where political incentives inhibit changes that one might otherwise prefer be made through the political process. (12) Indeed, we anticipate that the very presence of the option will make its exercise less necessary, as states otherwise politically constrained from enacting necessary reforms for distressed municipalities may prefer to do so themselves, rather than leave the task to bankruptcy courts.

The Article proceeds as follows. Part I explores the similarities between the roles of municipalities and private corporations as providers of services, but emphasizes that the monopoly position of the former justifies a greater concern for protecting municipalities' ongoing viability...