SAVING CITIES OR EXPLOITING CREDITORS? STATE REDIRECTION OF MUNICIPAL ASSETS.

• Author: Gillette, Clayton P.

Introduction: State Reduction of Municipal Assets 753 I. State Responses to Municipal Debt Burden 757 II. The Nineteenth-Century Dissolution Cases 760 A. Railing Against Debt: State Reactions to Municipal Defaults 760 B. Holdouts or Holdups? Motive and Dissolution 774 III. Diversion of Assets to New Creditors 783 A. Asset Stripping Through Bankruptcy Remote Entities 783 B. The Temporal Issue--Future Consequences of Current Asset Stripping 787 Conclusion 799 INTRODUCTION: STATE REDUCTION OF MUNICIPAL ASSETS

States faced with fiscally distressed municipalities typically must confront creditor demands for payment, the satisfaction of which would threaten the provision of local public services. A state that attempts to strike the delicate balance between assisting its local governments and maintaining relationships with creditors has substantial options. The state can, of course, simply provide funding to municipalities, perhaps conditioned on municipal reforms that address the problem of moral hazard. (1) Alternatively, states may assert authority over the municipality either in concert with or in substitution of municipal officials (2) and attempt to negotiate solutions with creditors or grant creditors priority in municipal revenues. (3) The state may also authorize and encourage the municipality to adjust its debts, primarily by entering Chapter 9 of the federal Bankruptcy Code. Each of these efforts may bring some relief to municipal budgets. But they have very different effects on creditors, and thus on the potential incentives that future creditors may have to invest in municipalities of the state.

Providing direct relief to the distressed municipalities or dictating priorities in revenues may permit payment of creditors in full. States may exercise that option in order to signal future creditors that debts will be paid. The importance of such signals to maintain the creditworthiness of municipalities is embodied in provisions such as the New York State Constitution's requirement that cities pledge their faith and credit to debts and exceed real estate tax limits if necessary to pay those debts. (4) Another example is a provision in the General Laws of Rhode Island that requires cities grant creditors "first liens" on tax revenues and thus requires payment of debts prior to other municipal expenses. (5)

Other jurisdictions have been less solicitous of creditors and have embraced some form of the third alternative. States that permit their municipalities to enter bankruptcy essentially signal the possibility that creditor claims will be adjusted in those proceedings. (6) Current law prohibits states from enacting their own version of unilaterally compromising debts of their municipalities. But states may also attempt to shift the costs of municipal fiscal distress from residents to creditors by altering the nature of the underlying debt obligation rather than directly reducing the amount of indebtedness. That may take the form of shifting assets initially used to support debt to a new set of creditors. Those efforts were prominent in the late nineteenth century, as states altered debtor municipalities' boundaries and taxing authority on which existing creditors had relied. More recently, states have attempted to assist distressed municipalities through more subtle means of shifting assets. (8) Both New York State and Illinois, for example, have diverted to new state entities tax revenues previously available to creditors of distressed cities in an effort to generate capital to which those cities would not otherwise have access, and thus allow the continuation of municipal services that face reduction or elimination. (9) The nineteenth-century versions of asset shifting typically failed on the ramparts of the U.S. Constitution's Contracts Clause or similar creditor protections. (10) One might readily dismiss those nineteenth-century analogues as sufficiently antiquated or born of different circumstances to reject their applicability to the more contemporary state interventions on behalf of distressed municipalities. The effects of the nineteenth-century strategies on creditors, however, bear enough similarity to recent instances of redirecting assets that it is useful to determine the implications of those earlier legal challenges for contemporary forms of municipal finance.

In this Article, I address those similarities and explain why, even if the early cases remain persuasive authority for the limits of state intervention, they do not inevitably invalidate the current interventions.

States that attempt to reduce municipal debt burdens by shifting assets are not necessarily acting inappropriately, notwithstanding adverse effects on existing creditors. Bond creditors may be better positioned than residents to monitor municipal fiscal performance. (11)

Where that is the case, allocating fiscal risks to those creditors rather than to residents or other creditors might induce bondholders or their representatives to act in a manner consistent with their monitoring advantage. A state that shifts risks to creditors may therefore be allocating that risk efficiently. Alternatively, a state might reasonably conclude that it is more important to maintain municipal services than to ensure full payment to creditors, and thus seek to reallocate risks ex post, regardless of which group was better able to monitor budgets ex ante. The very existence of a municipal bankruptcy regime implies that there are circumstances in which concerns for municipal fiscal health prevail over concerns that obligations to creditors will suffer diminution.

Nevertheless, states that offload risks to creditors may also be acting strategically, favoring the imposition of current costs on creditors and long-term costs on future officials and residents who bear the risk that credit markets will demand higher interest rates from defaulting localities. State officials who consider themselves accountable to current residents may have political incentives to engage in that form of risk-shifting. Those incentives may be enhanced where creditors comprise non-residents or represent distant capital markets. (12) Where states interfere with creditors' payments, either by authorizing municipal bankruptcy or by altering the underlying obligations, evaluation of the propriety and substance of that intervention may depend on whether one believes that the state was motivated by the benign story of efficient allocation of risk and maintenance of municipal services or the malign story of exploiting creditors.

In this Article, I suggest that the underlying purpose for which the state diverts assets from cities should determine the legality of the strategy, notwithstanding the similar effects on creditors that result from using the strategy for different purposes. The legal implications may differ if the state diverts assets primarily to exploit non-resident creditors who have little voice in the decision than if the state adopts the same strategy to ensure continued delivery of a distressed municipality's services. I claim that the nineteenth-century cases reveal a willingness to sacrifice creditor security even where unnecessary to maintain the debtor municipality's fiscal status and that courts intervened to mitigate such strategic behavior when they observed it. More contemporary diversions, however, appear to have been undertaken to ensure that the debtor municipality survives liquidity crises and can provide the services for which the municipality was created. In effect, the courts appear to demand that the state balance the need for creditor security against municipal fiscal stability and tend to permit diversions that facilitate municipal access to need capital. But the cases neither speak in those terms nor involve much analysis of how shifting assets will reduce creditor recovery, perhaps because--in the nineteenth-century cases, at least--the reduction of creditor security was near total. Thus, the cases appear to reveal judicial concern for what I refer to as the state's motive, that is, judicial suspicion that the state is acting strategically rather than engaging in the kind of balancing that might justify some increase in creditor risk.

Part I provides a brief discussion of overriding principles that govern the capacity of states to alter the debts of their political subdivisions.

Part II then discusses several of the major Supreme Court nineteenth-century decisions that addressed efforts by states to reduce creditor access to pledged assets of defaulting municipalities. Those efforts entailed dramatic changes to municipal legal status and geography, such as shifting municipal boundaries and claiming that reformed municipalities did not incur the obligations of their predecessors. Most importantly, Part II discusses not only what states did on behalf of their distressed localities, but why.

Part III discusses more contemporary versions of asset shifting. It also explores the difficulties inherent in determining the effects that even benign efforts to divert revenues have on current creditors. In particular, Part III discusses the significance of stable market values for existing securities during and after the period when the state has created a diversion strategy. Some courts have relied on market values to conclude that current creditors are unharmed by the diversion of assets from the debtor. This Part, however, contends that consideration of market values at the time of litigation over the propriety of allegedly impairing legislation cannot predict potential adverse effects of the diversion strategy in the distant future.

1. STATE RESPONSES TO MUNICIPAL DEBT BURDEN

   In the absence of legal constraints, a state could readily shift the risk of fiscal distress simply by compromising municipal debts, leaving debtors with unencumbered access to assets previously pledged to the payment of debt service. In effect, a state could impose its...