Municipal Bankruptcy Can Restore Financial Stability

Jan. 17, 2013

By Todd C. Ringstad

The threat of bankruptcy still haunts California. State and municipal finances have been improving, yet last year three cities filed for Chapter 9 bankruptcy: Stockton, San Bernardino and Mammoth Lakes.

Around the country, Jefferson County, Ala. went belly up. Detroit, Mich. is close, and even might be dissolved by the state of Michigan.

Despite the recent surge in Chapter 9 filings, municipal bankruptcies still are relatively rare. There were just 12 of them filed in the United States in all of 2010.  During that same year, there were nearly 60,000 business bankruptcies under Chapter 13 of the federal Bankruptcy Code; and more than 1,500,000 individual, non-business bankruptcy cases filed under Chapter 7.

So municipal bankruptcy is a rare and little understood event.  Under Chapter 9 of the Bankruptcy Code, a “municipality” is a political subdivision, public agency or instrumentality of a state.  Counties, cities and various municipal agencies have successfully filed for bankruptcy protection.

Federal law governs bankruptcy and guarantees the right of individuals and business entities to seek bankruptcy protection, with certain limitations.

10th Amendment

However, the right to seek bankruptcy protection is not guaranteed to municipalities.  Under the 10th Amendment to the U.S. Constitution, all powers not delegated to the United States by the Constitution, nor prohibited by it to the states, are reserved to the states.

Following that, the 10th Amendment limits the federal government’s ability to mandate bankruptcy protection for municipalities.  The right to establish and govern municipalities within the boundaries of the state is essential to the sovereignty of the state.  Thus, municipalities cannot resort to bankruptcy protection without the authorization of the state.  This is a critical distinction between consumer and business bankruptcy (Chapters 7 and 13) and Chapter 9 for municipalities.

Twenty-six states have passed laws that permit municipalities, under certain circumstances, to file for bankruptcy.  Twenty-three states have no laws authorizing municipalities to file under Chapter 9.  One state, Georgia, has passed a law that specifically prohibits municipalities from filing bankruptcy.  Finally, Illinois does not permit a municipality to file Chapter 9, but has enacted a complicated path that could lead to such authorization.

AB 506

After Vallejo filed for bankruptcy in 2008, California placed some restrictions on the ability of municipalities to file for bankruptcy.  AB 506, signed into law by Gov. Jerry Brown in 2011, requires that a municipality with financial problems must work with a mediator for a “neutral evaluation.” The evaluation lets interested parties meet with the municipality in a structured setting in an attempt to negotiate a resolution to the municipality’s financial problems. The parties could include a committee of creditors, pension funds and unions.

A municipality can avoid the mediation process by declaring a state of emergency by a majority vote of its governing body, such as a council or board of supervisors. The state of emergency must jeopardize the health, safety or well-being of the public; and the municipality must be unable to pay its obligations within 60 days. The municipality then proceeds directly to the filing for relief under Chapter 9.

Federal law also places restrictions on a municipality’s ability to file for protection under Chapter 9 of the Bankruptcy Code.  The municipality must be insolvent — that is, unable to pay its debts as they become due.  The municipality must show that it is working to pay its debts, and isn’t just delaying or frustrating creditors.  And the municipality must demonstrate that it negotiated in good faith with creditors before filing for bankruptcy protection, except in exigent circumstances.

Bankrupt cities

The city of San Bernardino filed for bankruptcy in August 2012, declaring a fiscal emergency and avoiding the mediation process.  According to its bankruptcy filings, the city’s general fund plunged to $150,000 before the bankruptcy filing, or about 71 cents for each of 210,000 residents.

Stockton filed in June 2012 after going through the mediation process. During mediation, Stockton reached preliminary agreements with about 30 percent of its creditors.

The California Public Employees Retirement System has the dubious distinction of being the largest creditor for both Stockton and San Bernardino.

Mammoth Lakes filed a petition under Chapter 9 in July 2012 after going through mediation. Its problems were somewhat different from the other cities because it is a small city that lost a $43 million breach-of-contract judgment to a developer.  Mammoth Lakes used the mediation effectively and reached agreement with a number of its creditors before the bankruptcy was filed.

The goal in each of these bankruptcy cases will be the confirmation of a plan of debt adjustment. The plan will allow these municipalities to adjust their obligations to their creditors and emerge from bankruptcy solvent and able to meet future obligations.

The bankruptcy process will allow these cities a breathing spell in which they can avoid paying some of their obligations, while working to reach agreement with creditors and confirm a plan of adjustment.  Bankruptcy offers these beleaguered municipalities an opportunity to reclaim a level of fiscal responsibility and solvency that has been lost in a sea of red ink.

Todd C. Ringstad is an attorney with Ringstad & Sanders Inc. in Irvine.