Municipal Bankruptcy Explained: What it Means to File for Chapter 9

This month, however, Orange County finally lost its dubious claim to fame.

On November 9, political leaders in Jefferson County, Alabama — home of Birmingham, the state’s largest city — asked a federal bankruptcy court to help the county restructure debt of more than $4 billion. The county’s debt burden stems from a disastrous investment in a local sewer system and amounts to nearly $7,000 for each of the 658,000 men, women and children who call the county home. That a bankruptcy declaration of such magnitude is possible has raised alarms nationally over whether more municipal crises may be on the way.

In this explainer, Stateline examines what it means when a municipality files for Chapter 9 bankruptcy — and why states should care.

What is Chapter 9? It’s the portion of the federal bankruptcy code that applies to municipalities. Created by Congress in 1937, it allows municipalities to seek court protection in the event of fiscal crisis and is meant to ensure that basic government functions can continue while policy makers restructure their debt.

Chapter 9 differs from other sections of the bankruptcy code, such as Chapter 11 and Chapter 13, which generally provide court relief to cash-strapped businesses and individuals, respectively.

Who can file for Chapter 9? Only municipalities — not states — can file for Chapter 9. To be legally eligible, municipalities must be insolvent, have made a good-faith attempt to negotiate a settlement with their creditors and be willing to devise a plan to resolve their debts.

They also need permission from their state government. Fifteen states have laws granting their municipalities the right to file for Chapter 9 protection on their own, according to James Spiotto , a bankruptcy specialist with the Chicago law firm of Chapman and Cutler. Those states are Alabama, Arizona, Arkansas, California, Idaho, Kentucky, Minnesota, Missouri, Montana, Nebraska, New York, Oklahoma, South Carolina, Texas and Washington.

The remaining states all want a say in the process, in some cases requiring that municipalities receive state approval before they file. One of those states, Pennsylvania, is now in the process of challenging the bankruptcy declaration made by its own capital city, Harrisburg, in October.

Georgia is the only state that does not allow its municipalities to file for bankruptcy under any circumstances. Georgia municipalities in severe fiscal trouble “are left to work things out within the state political system,” says Paul Maco, a municipal bankruptcy expert and partner with the Vinson & Elkins law firm in Washington, D.C. That could include asking the legislature for emergency funds.

States have plenty of serious fiscal problems, too. Why can’t they file for bankruptcy? States have not been granted that authority by Congress, nor have they sought it.

The idea of allowing state bankruptcy was floated earlier this year by Newt Gingrich, the former U.S. House speaker and current presidential candidate, and Jeb Bush, the former Florida governor. In a Los Angeles Times op-ed , the two Republicans argued that bankruptcy would be a way for strapped states such as California and Illinois to tackle their enormous debts, particularly for public pensions and other retirement benefits.

State leaders from both parties repudiated the idea. “The mere existence of a law allowing states to declare bankruptcy only serves to increase interest rates, raise the costs of state government and create more volatility in financial markets,” Nebraska Governor Dave Heineman, a Republican, and Washington Governor Chris Gregoire, a Democrat, said in a joint statement .

The last time any state came close to bankruptcy — by defaulting on its loans- was during the Great Depression, when Arkansas racked up $160 million in debt on what was then a $14 million annual budget.

How common are municipal bankruptcies? Very rare. Since 1937, when Congress added Chapter 9 to the federal bankruptcy code, about 620 municipalities have filed for bankruptcy. That’s fewer than 10 a year. In the last year alone, by comparison, there were nearly 12,000 bankruptcy filings under Chapter 11 and 418,000 under Chapter 13, according to the administrative office of the U.S. Courts .

Most municipalities that do file for bankruptcy are special tax districts and small jurisdictions that do not issue public debt. Municipal utilities are a common example.

What happens once a municipality files for Chapter 9? Municipal finances move into the jurisdiction of the courts, but not in the way that corporate or personal finances in Chapter 11 or Chapter 13 cases do. Under those sections, courts have broad leverage to control the finances of the company or individual to chart a path forward. In addition, creditors have more leverage, such as by foreclosing on the home of a bankrupt individual.

In Chapter 9 bankruptcy, creditors cannot, for instance, foreclose on a municipal building to recoup the money they are owed. More importantly, the courts themselves have no authority to make spending or other policy decisions on behalf of the municipality. That power remains with the locality under the U.S. Constitution. Under Chapter 9, municipalities must come up with their own debt restructuring plans, and courts approve or reject it with input from other stakeholders.

If it is still up to the municipality to come up with a plan of action, what is the purpose of entering bankruptcy court in the first place? Bankruptcy is a last resort, but two key advantages are time and legal protection. Filing for bankruptcy gives policy makers some breathing room by changing a political process into a judicial one. It also can halt lawsuits that are likely to ensue if a municipality defaults on its debts.

What are the risks associated with municipal bankruptcy? Local leaders shudder at the notion of bankruptcy, and for good reason.

A Chapter 9 filing immediately raises the likelihood of a credit rating downgrade and, as a result, higher future borrowing costs for the government. The damage to a municipality’s image may result in an exodus of residents or less business investment, which can hit government tax collections and make the underlying budget crisis worse. Public workers worry about slashed salaries or benefits, and all residents could see higher taxes, loss of services or deferred maintenance on necessities such as schools, roads and bridges — although those consequences can precede bankruptcy, too. Even before Jefferson County declared bankruptcy this month, it had laid off more than 500 employees, closed four satellite courthouses and reduced law enforcement services .

What does it mean for states when a municipality goes bankrupt? States cannot simply brush off municipal bankruptcies. For starters, a bankruptcy can saddle states with significant new responsibilities and the political risks that accompany them. Rhode Island has named a receiver to oversee the finances of Central Falls, which declared bankruptcy in August amid the politically toxic possibility of reneging on pension promises made to public workers.

Local credit problems can have a statewide ripple effect, too. State officials in Alabama and Rhode Island fear that their states’ credit ratings could be downgraded because of individual municipal bankruptcies. Rhode Island was so worried about Wall Street’s reaction to fiscal crisis in some of its municipalities that it approved special legislation guaranteeing that bondholders — not residents of those municipalities — have the first claim to local tax money.

How long do municipal bankruptcy cases typically take? It depends on the size and complexity of the case. For large jurisdictions with more debt, the process can be a matter of years, not months. Vallejo, California — a city of about 118,000 that faced $50 million in debt tied to unfunded pension and other promises — filed for bankruptcy in 2008. It emerged this August .

How does day-to-day life change in bankrupt municipalities? This, also, depends on the size of the jurisdiction and the scope of its problems. In municipalities where residents depend a great deal on government for employment or services, the effects can be serious. In Bridgeport, Connecticut, which declared bankruptcy in 1991 (though the declaration was later voided), many residents moved away after the filing, shrinking the city’s tax base even further.

But that is not always the case. Residents and businesses in some of the municipalities that have recently declared bankruptcy stress that life does not stop once a Chapter 9 filing is made. The frequent but incorrect perception, they say, is that tumbleweeds blow across downtown streets and businesses close their doors.

“Regardless of what happened, people are doing what they do,” says Brian Hillson, president and CEO of the Birmingham Business Alliance in Jefferson County, which had been facing the threat of bankruptcy for more than three years before it officially filed this month. “They’re getting up and they’re going to work.”