Rethinking Roadblocks to Municipal Bankruptcy

• Jurisdiction: United States,Federal
• Publication year: 2022
• Citation: Vol. 38 No. 2

Rethinking Roadblocks to Municipal Bankruptcy

Tejas Dave

RETHINKING ROADBLOCKS TO MUNICIPAL BANKRUPTCY

Abstract

This Comment argues that Congress should remove roadblocks that prevent municipalities from easily filing for bankruptcy. It shows that statutory and ad hoc roadblocks allow states and the federal government to exert excessive pressure on fiscally distressed municipalities. Further, while scholars claim that the Bankruptcy Code provides bankruptcy courts with too little power to adjudicate municipal bankruptcies and that municipal fiscal distress should be resolved by states, this Comment argues that federal bankruptcy courts are the proper venue to resolve municipal distress and that these courts have sufficient power. This power could be used more effectively by removing chapter 9's insolvency requirement and inducing states to allow quicker access to bankruptcy courts.

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Table of Contents

Introduction.............................................................................................279

I. Background...................................................................................282

A. A Brief Overview of Municipal Bankruptcy.............................. 282

1. The Specific Authorization Requirement Makes States Into Gatekeepers To Municipal Bankruptcy .............................. 284
2. The Insolvency Requirement Prevents Distressed Municipalities From Receiving Bankruptcy Protection ..... 287

B. States and the Federal Government Often Set Up Ad Hoc Roadblocks Preventing Municipalities From Filing for Bankruptcy ................................................................................ 289
C. The Policy Behind Bankruptcy Requires Keeping in Mind the Interests of Residents of Distressed Municipalities and Allowing Quicker Access to the Bankruptcy Court.................................. 290
D. Criticisms of Municipal Bankruptcies Are Not Well-founded .. 295

II. Argument........................................................................................297

A. Federal Courts Are the Proper Venue for Municipal Debt Resolution ................................................................................. 297

1. The Federal Government Has Long Been Involved in Municipal Debt Crises ........................................................ 298
2. Federal Courts Are Not Powerless When Adjudicating Municipal Bankruptcies...................................................... 300
3. The Bankruptcy's Code Restrictions on Bankruptcy Courts Result in Creative Solutions ............................................... 303

B. Congress Should Remove Roadblocks To Municipal Bankruptcy ................................................................................ 305

1. Barriers To Municipal Bankruptcies Allow the State and Federal Government to Exercise Excessive Control Over Municipalities ..................................................................... 305
2. The Salience of Moral Hazard Is Overstated..................... 309
3. Gatekeeping Lengthens the Time to and Cost of Resolution........................................................................... 311
4. Congress Should Remove the Insolvency Requirement...... 311
5. The Federal Government Should Induce States Into Allowing Their Municipalities Easier Access to Bankruptcy Proceedings ........................................................................ 314

Conclusion.................................................................................................315

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Introduction

Municipal bankruptcies necessarily involve every level of government. Municipalities are only allowed to file for bankruptcy under chapter 9 of the Bankruptcy Code (the "Code"), and chapter 9 applies only to municipalities.¹ Municipalities must be "specifically authorized" by their states to file for bankruptcy.² The federal government provides the forum and statutory framework under which municipal bankruptcies are litigated, and the Constitution gives Congress the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States."³ Constitutional concerns and principles of federalism have shaped the history of municipal bankruptcies⁴ and continue to shape how bankruptcy courts adjudicate municipal bankruptcies.⁵ All non-bankruptcy resolutions of municipal debt must involve municipalities and state governments, and some cases may also include the federal government.⁶ For example, some states have financial control boards that take over distressed municipalities while trying to resolve debt issues.⁷ Finally, the federal government has long been involved in municipal debt markets⁸ and has intervened directly to address financial distress in Puerto Rico, Washington, D.C., and New York City.⁹

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To file for bankruptcy, municipalities must satisfy stricter filing requirements than other debtors.¹⁰ The strict filing requirements are coupled with specific statutory limitations on state and federal government activities as they relate to the debtor municipality.¹¹ The stricter requirements, and particularly the requirement that a debtor municipality be insolvent before filing, along with post-filing limitations, create a window and motive for state and federal governments to strong-arm municipalities into adopting their preferred debt resolution strategies. The restrictions also exacerbate the municipality's debt problems as they extend the time required to resolve debt issues and may force the municipality to continue adding to its pile of debt.¹²

The literature around municipal bankruptcy tends to portray distressed municipalities as having incurred too much debt and then refusing to make difficult decisions, such as tax increases and service cuts, to pay back the debt.¹³ Under this view, municipalities threaten to file for bankruptcy to force state and federal governments into bailing them out.¹⁴ State and federal governments acquiesce to these threats because failing to do so would lead to contagion in municipal bond markets or would violate implicit guarantees potentially priced into the cost for municipal credit.¹⁵ Starting from this diagnosis, this view suggests either dramatically increasing the power of the bankruptcy court by allowing it to raise taxes, cut spending, and sell municipal property,¹⁶ or

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dramatically scaling back the bankruptcy court's power by allowing it only to bind creditors who holdout from resolution plans.¹⁷

This Comment rebuts the argument that municipalities threaten to file for bankruptcy to force federal and state governments to bail them out. Instead, federal and state governments use bailouts along with longstanding and ad hoc roadblocks to prevent municipalities from accessing bankruptcy courts. These access restrictions allow states and the federal government to exert greater control over distressed municipalities than they would have in a bankruptcy proceeding.¹⁸ Further, these roadblocks increase the time and cost required to resolve a municipality's debt situation.¹⁹

This Comment further argues that bankruptcy courts have sufficient power to resolve municipal bankruptcies, and that if the federal government wants chapter 9 to be a useful tool, it should relax the statutory filing requirements and provide states with incentives to allow their municipalities easier access to bankruptcy courts. Doing so would allow municipalities timely access to bankruptcy protection and allow the municipalities to retain autonomy in the process. Those outcomes would be consistent with the goals of bankruptcy generally and with principles of federalism.

The Comment proceeds as follows: Part II provides some background on municipal bankruptcy, illustrates the roadblocks faced by municipalities trying to file for bankruptcy, discusses the policy underlying bankruptcy, and explains the literature's criticisms of municipal bankruptcy. Part III argues that federal bankruptcy courts are the proper venue for municipal debt resolution and that chapter 9's filing requirements should be relaxed. Part IV concludes.

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I. Background

A. A Brief Overview of Municipal Bankruptcy

Chapter 9 is used infrequently. Only 29 municipalities filed for bankruptcy between 2001 and 2017.²⁰ Detroit, with more than $18 billion in debt, filed for bankruptcy in 2013, making it the largest municipal bankruptcy case to date.²¹

Municipalities can only file for bankruptcy through chapter 9 of the Code, and chapter 9 applies only to municipalities.²² Congress first provided for municipal bankruptcies in 1934, with a predecessor to chapter 9, in response to the Great Depression, primarily to overcome issues posed by holdout debtors.²³ During the Great Depression, many fiscally distressed municipalities negotiated debt adjustment plans with their creditors but could not carry out those plans because of the "strategic resistance of a small minority" of creditors, or holdouts.²⁴ Federal municipal bankruptcy legislation allowed a court to make debt adjustment plans binding on holdout creditors.²⁵

The Supreme Court held this legislation to be unconstitutional in 1936.²⁶ Congress enacted some minor, potentially irrelevant, revisions to the statute, which the Supreme Court upheld in 1938.²⁷ In 1976, responding to New York City's fiscal crisis, Congress substantially updated Chapter 9 to what we see now.²⁸

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An entity can file for bankruptcy under chapter 9 "if and only if such entity":²⁹

(1) is a municipality;
(2) is specifically authorized . . . by State law. . .;
(3) is insolvent;
(4) desires to effect a plan to adjust such debts; and (5)

(A) has obtained the agreement of creditors holding at least a majority in amount of the claims of each class . . .;
(B) has negotiated in good faith with creditors and has failed to obtain the agreement of creditors . . .;
(C) is unable to negotiate with creditors because such negotiation is impracticable; or
(D) reasonably believes that

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