A new fulcrum point for city survival.

• Author: Parikh, Samir D.
• Position: III. A New Fulcrum Point B. Managing the Restructuring Mechanism: State Primacy and Reversing Devolution During Financial Distress through Conclusion, with footnotes, p. 258-298

2. Managing the Restructuring Mechanism: State Primacy and Reversing Devolution During Financial Distress

   The term "devolution" describes a state's delegation of power and management of local affairs to municipalities and their residents. This practice is the foundation of the "home rule" movement, which seeks to "ensure[] that governmental power is exercised closest to the people." (201) Devolution must be reversed during municipal financial distress.

   As noted above, municipalities are plagued by cost shifting, and policymakers are consumed with discovering ways to minimize this practice. (202) When a municipality is financially distressed, however, cost shifting's harm has already been realized, and the inquiry must shift to determine which parties are in the best position to bear legacy costs and prevent a financial crisis. Among all key constituencies, states and state officials are best positioned and properly incentivized to address municipal distress in an efficient, meaningful, and sustainable manner.

   States are primarily concerned with municipal distress due to contagion risk. (203) Not unlike individuals, states are "enormously concerned with their credit rating." (204) A state's credit rating affects borrowing costs and access to credit. The rating holds enormous implications for many key operational issues. Unfortunately, unlike individuals, a subnational government's debts and financial health are extremely difficult to assess. (205) As noted above, cost-shifting practices abound, and the effects of these practices are not entirely clear to lenders and bondholders. Consequently, perception plays a large role in evaluating a state's creditworthiness, which explains contagion risk. Professor Gillette notes that "[i]n theory, contagion should not occur because investors [and lenders] will distinguish financially healthy jurisdictions from distressed ones." (206) But the municipal borrower market is an opaque market characterized by limited disclosure that precludes accurate risk assessment. (207) Consequently, default risk is premised on a number of factors outside the state's control. Standard & Poor's, one of the preeminent municipal debt rating agencies, considers local government financial difficulties among its broad set of criteria for establishing a state's credit rating. (208) Distress in one municipality can affect the credit rating for other municipalities within that state and infect the state itself. Various studies have reached inconsistent results, but there is evidence that the contagion from New York City's near default in the 1970s affected borrowing costs for other local municipalities and the state. (209) Though this contagion effect may be temporary, the phenomenon and its potential harm cannot be ignored. (210)

   Furthermore, essential services customarily provided by municipalities, including fire, police, health, and safety services, are implicitly guaranteed by the state. Distressed municipalities are often unable to pay for essential services. Service interruptions create a gaping hole into which the state is forced to plunge. As summarized by Pennsylvania Governor Tom Corbett, "municipal governments [should address] their own problems and com[e] together to develop a fiscal recovery plan when necessary.... But when that fails to happen, the state has to take action to ensure public safety." (211) For example, in 2011, the City of Camden, New Jersey was forced to cut the city's police force, which led to an increase in crime in the city. (212) New Jersey Governor Chris Christie had no choice but to redirect state troopers to patrol Camden to address the shortfall. (213)

   States have also arguably guaranteed their municipalities' pension obligations. As of 2008, "there [were] over 2,500 different public employee retirement systems providing benefits to the over 20 million" public sector employees. (214) Approximately "1,659 of [these systems] are municipal, while 218 exist at the state level." (215) Government plans are not protected by the Employee Retirement Income Security Act (ERISA) or backstopped by the Pension Benefit Guarantee Corporation; (216) thus, this burden could fall on the state. And the burden is staggering. Pension systems are estimated to be underfunded by as much as $4.4 trillion. (217) Like any guarantor, states are incentivized to ensure that the primary obligor does not default on its obligations. (218)

   Finally, the state is uniquely positioned to lead the restructuring effort. State officials can facilitate necessary borrowing from the credit markets and relax state law borrowing restrictions. The state can allow the municipality to raise taxes or engage in revenue-generating practices that may otherwise be restricted under state law. And state officials are best situated to understand macro trends within state borders.

   One key criticism of reversing devolution is that state officials' intervention compromises the integrity of the local municipal democracy. (219) Unfortunately, this is a necessary evil during financial distress. As we saw with New York City in the 1970s, local officials are sometimes too beholden to local interests to effectuate necessary change. (220) Local officials may be "imperfect agents of their [own] constituents" and are prone to "make decisions that serve personal political objectives." (221) Painful resource adjustment is difficult to achieve without abundant supplies of political will and political capital. Consequently, local officials are often tempted to make adjustments at the periphery, which quickly devolves to cost shifting. Political paralysis is common. (222)

   Also, by the time a crisis materializes, local officials may be seen as being so closely aligned with the political forces responsible for the financial distress that current and prospective creditors may balk at any continued involvement. This disapproval frustrates negotiations with current bondholders and employees, and it may restrict access to credit markets.

   Fundamentally, destabilizing financial distress is a complex problem demanding expertise that local officials rarely possess. (223) Local officials often have had many years to try to address structural problems. Affording these officials additional time is potentially irrational. Finally, the threat of reversing devolution serves as another means to encourage local officials to internalize the benefits and costs of their actions. (224)

3. Addressing the Contracts Clause

   A properly functioning debt adjustment mechanism will primarily reduce a municipality's debt burden by targeting (1) labor costs and benefits and (2) bondholder debt. I focus on these two debt classes because they disproportionately affect a municipality's capital structure. (225) Even minor concessions within these classes can have a significant effect on a municipality's viability.

   Not surprisingly, unilateral modification of these obligations is extremely difficult. Historically, distressed subnational governments have attempted to alter or defer payment obligations related to these two debt classes. Parties seeking to block these modifications have relied on state and federal constitutional provisions and have enjoyed protection in the courts. (226) Subnational governments have perhaps overreacted to defeats and unwittingly abandoned these battle lines. By conceding this high ground, however, distressed municipalities lack the leverage necessary to obtain meaningful concessions in restructuring negotiations. This fact, coupled with the disastrous dynamics that already exist in most states, embolden holdouts.

   In the following subsection, I argue that the Contracts Clause, as it appears in the Constitution and various state constitutions, has been widely misunderstood. In fact, by utilizing carefully tailored, temporary contractual modifications, distressed municipalities have far more leverage and bargaining power than they likely suspect.

   1. A New Perspective on the Contracts Clause

      The vast majority of states employ a contractual approach in protecting labor benefits and debt obligations owed to bondholders. (227) This means that states view these debts as contractual obligations even where benefits and entitlements are not specifically delineated in a written agreement. Consequently, any attempt by a subnational government (228) to unilaterally modify labor benefits or bondholder debt is subject to the Contracts Clause.

      Article 1, Section 10 of the U.S. Constitution provides that "[n]o State shall ... pass any ... Law impairing the Obligation of Contracts." (229) This seemingly rigid prohibition coupled with a host of undefined terms has fed a litany of scholarly debates regarding the Clause's intent, meaning, and scope. (230) The Clause's terse language has also created a widely held misconception that the prohibition is absolute. (231) Fortunately, this scholarly cacophony dissipates within the judiciary. Contracts Clause jurisprudence has evolved slowly, but most courts have coalesced around key tenets. Courts have acknowledged that the Constitution is not a suicide pact, (232) and case law has been surprisingly uniform on the Clause's primary facets and exceptions, offering municipal debtors a surprising degree of bargaining leverage with unions and bondholders.

   2. The Federal Judiciary's Approach to the Contracts Clause

      Shortly after ratification of the Constitution, the Supreme Court was tasked with resolving the Contracts Clause's apparent ambiguity. The initial resolution promoted a "muscular restraint on state authority." (233) In a series of cases beginning in 1810, the Court staked out clear parameters by (1) interpreting the term "contract" broadly, (2) applying the Clause to both private contracts between individuals and public contracts between the state and individuals, and (3) adopting a near absolute prohibition on contract impairment by interpreting the term "impair" as equivalent to "alter." (234) The...