Special Purpose Municipal Entities and Bankruptcy: the Case of Public Colleges

• Publication year: 2020

Special Purpose Municipal Entities and Bankruptcy: The Case of Public Colleges

Matthew A. Bruckner

SPECIAL PURPOSE MUNICIPAL ENTITIES AND BANKRUPTCY: THE CASE OF PUBLIC COLLEGES

Matthew A. Bruckner^*

Abstract

This Article builds on the municipal bankruptcy literature by showing why the common analogy between corporate shareholders and city residents does not hold in the case of certain special purpose municipal entities. For example, some scholars argue that "local residents" are best situated to avoid municipal financial distress by preventing it ex ante through the political process or remedying it ex post by repaying creditors through increased taxes. But residents' ability to avoid financial distress is limited when a special purpose municipal entity spans political boundaries or tax jurisdictions because it is not clear who counts as a "local resident" in such cases. These boundary-spanning entities include certain hospitals and institutions of higher education. Instead of residents, this Article concludes that either creditors or the state are better situated to address the financial distress of boundary-spanning special purpose municipal entities, such as public institutions of higher education.

This Article also reviews every decision where eligibility for relief under chapter 9 of the Bankruptcy Code was contested and distills a set of definitions for "municipality" that can be used to determine whether an entity must seek relief under chapter 9 (or if chapter 11 is available). Then, this Article applies those definitions to public institutions of higher education and determines that they, unlike private institutions, are eligible for relief only under chapter 9 of the Bankruptcy Code. This is the same set of provisions under which Detroit, Michigan and Stockton, California sought relief. But because many states restrict access to chapter 9 entirely, access to the bankruptcy courts may be completely unavailable for public institutions of higher education in those states.

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Introduction.............................................................................................343

I. Many Public IHEs are Financially Distressed..........................346
II. The Bankruptcy Reorganization Toolkit..................................349
III. It's Likely That Public IHEs May Not File Chapter 11..........354

A. The Political Subdivision Case Law......................................... 356
B. Application to Public IHEs....................................................... 358
C. The Instrumentality of the State Case Law............................... 360
D. Application to Public IHEs ....................................................... 364
E. The Public Agency Case Law ................................................... 366
F. Application to Public IHEs....................................................... 367

IV. Who Can Avoid the Financial Distress of Public IHEs?........ 368

A. Residents as Risk Bearers ......................................................... 369
B. Creditors as Risk Bearers ......................................................... 372
C. State Financial Boards as Risk Bearers ................................... 375

V. How to Optimize Public IHEs' Financial Discipline?.................378

Conclusion.................................................................................................381

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Introduction

Financial distress continues to plague institutions of higher education (IHEs), including public IHEs.¹ For example, in 2019 Alaska threatened to slash its higher education budget by $135 million, equivalent to a "41 percent reduction in state funding."² The severity of these cuts prompted an "unusual" letter from the University of Alaska's accrediting body, the Northwest Commission on Colleges and Universities, to the Alaska Legislature warning that the cuts could "potentially jeopardize the accreditation status of these institutions."³ Also arguing against the cuts, University of Alaska president Jim Johnsen claimed that the size of these reductions would force the system to:

abruptly halt[] numerous student career pathways midstream, eliminat[e] services or shut[] down community campuses or universities[,] . . . discontinu[e] . . . programs and services with little or no notice, and that in turn will have ripple effects, damaging UA's ability to generate revenue and causing even greater harm across the state.⁴

In response to these cuts, the University of Alaska system declared a "so-called financial exigency," which would allow employees, including tenured professors, to be quickly fired and programs, or even entire campuses, to be closed.⁵ Financial exigency has been called the "the academic equivalent of bankruptcy reorganization . . . ."⁶ But why not use the regular bankruptcy system? After all, debtors in a bankruptcy proceeding gain access to a set of tools for resolving that entity's financial distress.⁷

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As discussed in several earlier articles, bankruptcy reorganization is functionally unavailable to nearly all IHEs because the Higher Education Act (HEA) makes entering bankruptcy "an effective death sentence" for most IHEs.⁸ I've argued that this should be changed.⁹ But even if the HEA were to be amended, bankruptcy reorganization would remain unavailable for many public IHEs because of state restrictions on bankruptcy access.

This Article highlights that public IHEs are, in many states, doubly barred from bankruptcy reorganization—one legal bar and one economic. By analyzing the existing case law on access to chapter 9 of the Bankruptcy Code, this Article concludes that public IHEs are likely to be classified as municipalities for bankruptcy purposes, meaning they are barred from using chapter 11. Instead of using chapter 11, they may use chapter 9, if they have access at all. Access to chapter 9 is severely restricted, with "[o]nly twelve states specifically authoriz[ing] chapter 9 filings. Fifteen state[s] offer some limited form of chapter 9 filings for municipalities. The remaining 23 states do not authorize chapter 9 filings for municipalities."¹⁰ In other words, in approximately half the states, public IHEs have no access to bankruptcy reorganization in any form.¹¹

Finally, this Article engages with the literatures on municipal financial distress and the governance of financially distressed entities to consider their application to public IHEs. Municipal bankruptcy law must balance the interests

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of a state's residents, local (the municipality's) residents, and their creditors. This Article analyzes whether "residents," creditors, or state financial boards are best situated to prevent or remedy the financial distress of public IHEs. In doing so, this Article builds on the municipal bankruptcy literature by showing why the common analogy between corporate shareholders and city residents does not hold in the case of certain special purpose municipal entities.

For example, some scholars argue that "local residents" are best situated to avoid municipal financial distress by preventing it ex ante through the political process or remedying it ex post by repaying creditors through increased taxes or selling municipal assets. But residents' ability to prevent or remedy financial distress is limited when a special purpose municipal entity spans political boundaries and tax jurisdictions. These boundary-spanning entities include certain hospitals and institutions of higher education. In addition, it is not clear who counts as a "local resident" in such cases. This Article concludes that neither creditors¹² nor the state are necessarily better situated to prevent or remedy the financial distress of boundary-spanning special purpose municipal entities, such as public institutions of higher education. But local "residents" should clearly not bear that burden.

In conclusion, this Article argues that because public IHEs cannot currently reorganize in bankruptcy and because states have not created higher education financial control boards, many public IHEs suffer unnecessarily, harming students, residents, faculty, staff, and others. states need to reorganize their higher education systems and choose a path forward for their public IHEs.

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I. Many Public IHEs are Financially Distressed

Even before the losses IHEs are anticipating because of the novel coronavirus, SARS-CoV-2, many public IHEs were in financial trouble.¹³ On an inflation-adjusted basis, funding for public IHEs is down substantially since the 2008 recession, with twenty states cutting per student support "by more than 20 percent," and nine states cutting more than 30 percent.¹⁴ And the cuts continue. Alaska just cut approximately twenty percent of its planned allocation to the University of Alaska system (after threatening a forty percent reduction).¹⁵ The threatened cuts were expected to result in "massive" layoffs, and a drop "in student enrollment because of program eliminations and reputational damage to the institutions."¹⁶ But even the smaller reduction would result in restrictions, administrative consolidation, and restructuring.¹⁷

In Wisconsin, state funding dropped by "$362 million from fiscal 2012 to 2017," forcing "campuses to lay off employees, freeze vacant positions, consolidate administrative functions, cut back on academic advising and offer fewer course sections."¹⁸ Similarly, the University of Puerto Rico expects to receive less than half the appropriation it has historically received from the Puerto Rican government.¹⁹

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It is not clear that public IHEs will have to endure the "transformative realignment" that some commentators have long predicted for the entire higher education sector—though the current pandemic will surely have long-lasting effects.²⁰ But it is also undeniable that some IHEs that are currently struggling will merge or close.²¹ Scores of IHEs close every year,²² including more than two dozen public IHEs in...