Governance reform and the judicial role in municipal bankruptcy.

• Author: Gillette, Clayton P.
• Position: III. An Affirmative Case for Governance Reform B. Bankruptcy as a Governance Corrective through Conclusion, with footnotes, p. 1195-1237

2. Bankruptcy as a Governance Corrective

   In this Section, we propose that the current Bankruptcy Code, and in particular, the requirement that a plan of adjustment be "feasible," (208) provides the doctrinal basis for a bankruptcy court serving as a catalyst for governance reform. Before explaining that issue more fully, we note that bankruptcy filings may alter political dynamics that frustrate reform, even without judicial prodding for specific organizational structures.

   First, although a city's leadership may be reluctant to endorse reform under ordinary conditions, given the political costs of challenging beneficiaries of the existing system, fiscal distress that is severe enough to require a bankruptcy filing is likely to diminish the leverage of proponents of the status quo; and a mayor who files for bankruptcy may feel that there is little more to lose, given the political costs she will already have incurred by declaring the need for bankruptcy. If the state has special provisions for distressed cities and local officials have been replaced by an emergency manager, as in Detroit, (209) the willingness to pursue structural reform may be even greater. Bankruptcy may thus create political opportunities that did not previously exist. Indeed, one benefit of permitting structural reform in bankruptcy may be that the existence of the option makes its exercise unnecessary since the locality may prefer to restructure on its own rather than risk external imposition. (210)

   Second, and relatedly, bankruptcy can centralize decision-making authority and diffuse opposition. Outside of bankruptcy, a proposal to change governance arrangements would need to be vetted with the city's voters and with the officials that would be affected, even if neither had formal veto power over reform. From their perspective, reform may have significant downsides and little immediate upside. In bankruptcy, the reforms can be included as part of a single package that also includes a substantial reduction of the city's debt load. For voters especially, reform may be more palatable as part of the combined proposal. Overall, incorporation of governance into municipal bankruptcy would considerably strengthen the hand of city leaders who wish to effect reform (and weaken the hand of leaders who are themselves an impediment to reform), since city leaders could rightly say that they have no choice but to include governance reform in their restructuring proposal. (211)

   Suppose, however, that the municipal decisionmakers are reluctant to pursue reform, even after the municipality has filed for bankruptcy. How can the bankruptcy court intervene? Chapter 9 makes clear that the debtor alone has authority to file a plan of adjustment. (212) Thus, under current law, the bankruptcy court would not be entitled to dictate the terms of structural reform. Nevertheless, the bankruptcy court is permitted to confirm the plan only if it satisfies certain criteria, and courts can use those criteria to induce--or effectively compel--debtors to propose desirable reforms. (213) Some legislative history suggests that plan-confirmation standards would incorporate the principles of cases in which courts considered whether the debtor was making full use of its taxing powers. (214) While isolated statements in the legislative history of what is now Chapter 9 are not by themselves strong evidence that courts can mandate municipal tax increases, (215) both the logic and language of Chapter 9 suggest that a bankruptcy judge can reject a plan that fails to address obvious governance dysfunction.

   McConnell and Picker concluded that the requirement that a plan be "in the 'best interests of the creditors'" provides the most obvious basis for judicial leverage but were skeptical that the clause was intended to give the court broad discretion to second-guess the city's financial arrangements. (216) We focus instead on the requirement that a proposed restructuring plan cannot be approved unless it is "feasible." (217) If fragmented governance has contributed to fiscal irresponsibility in the first instance, then a bankruptcy judge cannot properly conclude that the debtor's restructuring plan is feasible if it leaves in place a political structure that threatens to return the municipality to insolvency. Even if the municipality adjusts its balance sheet dramatically, dysfunctional governance will encourage a prompt return to fiscal profligacy. Indeed, this very risk became an issue in the Detroit bankruptcy proceedings. The bankruptcy judge appointed an independent expert to assess the feasibility of Detroit's restructuring proposal. The expert defined feasibility in terms of the following question:

   Is it likely that the City of Detroit, after the confirmation of the Plan of Adjustment, will be able to sustainably provide basic municipal services to the citizens of Detroit and to meet the obligations contemplated in the Plan without the significant probability of a default? (218) Although the feasibility expert concluded that Detroit's plan met this standard, she raised concerns about Detroit's failures to incorporate governance reform into the restructuring. "This bankruptcy has been largely focused on deleveraging the City," she noted, "often to the exclusion of fixing the City's broken operations." (219) As a result, she concluded, "[T]he operational restructuring that often occurs with commercial reorganizations will be left largely to Mayor Duggan and his managers for the post confirmation period." (220) Implicit in that statement was a view that, absent additional governance reform, there remained serious questions about the feasibility of Detroit's restructuring. A perceived lack of authority to address those issues, rather than their irrelevance, perhaps explains why the independent expert and ultimately the bankruptcy judge deferred to local officials to redress some of the core causes of Detroit's distress.

   At first glance, there may seem to be a temporal mismatch between the feasibility requirement and concerns about the consequences of poor governance. "Feasibility," on this understanding, would be concerned only with short-term financial viability; while the effects of poor governance are likely to fester over multiple years of deficits, mismanagement, and inappropriate expenditures before crisis reemerges. (221) Thus, governance reforms that are intended to forestall long-term distress might seem to be a poor fit for a test that focuses on the near future. Indeed, even the parties themselves may not seem to have incentives to respond to judicial recommendations of long-term governance restructuring because they receive no benefit from the effort. (222)

   But feasibility for a municipality inherently requires attention to long-term financial solvency. The need to consider the long term is most obvious where restructuring existing obligations entails deferring payments rather than simply eliminating them. New York State's efforts to restructure New York City debt, for example, included an exchange of short-term notes for bonds with a maturity of up to twenty years. (223) Detroit issued $1.28 billion of new bonds, with maturities ranging from eight to thirty years, as part of its plan of adjustment. (224) Confirmation of a plan that restructures existing debt or requires the issuance of new long-term debt implies that the debtor will be able to make debt service payments when due. A plan cannot be considered genuinely feasible if it extends maturities but does nothing to increase the probability that payments will be forthcoming at the new maturity date. Creditors who accept extended maturities will expect the municipality to take measures to avoid the need for additional adjustment during the period when their bonds are outstanding. The same is true of other stakeholders, such as pensioners, whose obligations may have been adjusted in bankruptcy, but who remain entitled to postbankruptcy payments into the long-term future for services already rendered. (225) Given their long-term stake, creditors who are the beneficiaries of restructured obligations have good reason to respond to judicial suggestions or even to offer recommendations for restructuring without judicial prompting once it becomes apparent that there is legal authority for incorporating such measures into a plan.

   Once we recognize that municipal bankruptcy is not solely intended to restructure debt but to permit revival of municipal services, (226) the case for a long-term view of feasibility becomes even stronger. As the court in the Detroit bankruptcy noted, "feasibility" in the municipal context includes not simply avoiding default but also the ability "to sustainably provide basic municipal services to the citizens of Detroit...." (227) Just as degradation of services from poor governance is likely to occur slowly, emergence from service-delivery insolvency also takes time. Reestablishing a tax base after a long period of depopulation, rebuilding dilapidated infrastructure, and scaling up a municipal workforce that may have been decimated during a period of fiscal distress require long-term arrangements. (228) As in the case of extended-debt obligations, if feasibility involves obligations that can only be satisfied in the long term, it is appropriate to include within the remedial scheme measures that themselves will return benefits on a similarly extended time horizon.

   While we recognize that our proposal varies significantly from the common understanding of the pure debt adjustment function of Chapter 9 and could conflict with a broad interpretation of [section] 904's prohibition of nonconsensual judicial interference with any of the debtor's political or governmental powers, our proposal is less radical than it initially appears. First, as we have noted, it is commonly recognized that bankruptcy courts have the capacity to do indirectly what they cannot do directly by refusing to...