Bankruptcy Is An Ugly Option for Cities

Earlier this month the Harrisburg, Pa., city council threw itself on the mercy of federal bankruptcy court, hoping to find a less onerous solution to its debt woes than the workout plans proposed by the state of Pennsylvania and by the city's own mayor. Last week, a bankruptcy judge mercifully threw the case right back out of court after finding that the filing by a majority of council members was illegal. "For Chapter 9 bankruptcy to work, all of the branches of a municipality must be on the same page," the judge explained.

The faith that council members put in the court for a better deal was misguided. It came from a mistaken notion that Chapter 9, which regulates government filings, is similar to business bankruptcy law, where judges have discretion to take control of a firm's finances, void contracts, and even push creditors to forgive debts or else risk liquidation of a company at cents on the dollar. This misconception about Chapter 9 goes well beyond the naïve Harrisburg council members.

As local governments struggle under rising debt (including pension debt) and stagnating revenues, some local officials in distressed cities are invoking bankruptcy as an option, especially in cases where the political process has broken down. Earlier this year, some very smart people in Washington even suggested that states, which cannot place themselves in bankruptcy, be allowed to do so to solve their pension and employee compensation problems. One argument repeated over and over by advocates of this option was that a bankruptcy judge would void onerous union contracts and pension obligations. In Greek theater, critics once called this the "deus ex machina" ending, where a god in a chariot descended on the stage and untangled all of the complications of a plot that the playwright couldn't resolve in any other way.

But there is no deus in municipal bankruptcy law; instead, parties involved must do exactly what they have failed to otherwise do, which is to sit down and negotiate their way to a settlement with the judge serving as a referee. And elected officials who somehow think that bankruptcy will give them political cover when they have to cut services and raise taxes are just kidding themselves. Taxpayers rarely blame the consequences of a municipal bankruptcy on the judge.

Vallejo, Ca., spent than three years in Chapter 9 after its city council voted unanimously to file for bankruptcy in part because of fiscal difficulties brought on by onerous pension obligations and expensive employee contracts. The filing cost the city some $8 million in legal bills and didn't prevent a 40 percent reduction in the ranks of cops and firefighters and cutbacks in basic road maintenance, parks and libraries. A judge ruled the city could cancel some union contracts, and Vallejo negotiated a more rational pension formula for new hires, but the city's pension system for current employees remained largely untouched by bankruptcy. Mostly what Chapter 9 seems to have accomplished in Vallejo was to persuade other nearby municipal governments and their unions to work out their fiscal problems outside of court.

Still, local politicians continue to call Chapter 9 a solution. When Jefferson County, Al., earlier this month filed the largest municipal bankruptcy in U.S. history, some officials said the move was necessary because the county couldn't get creditors to offer more than $1 billion in concessions on some $3.2 billion debt. But the county and its creditors have been negotiating for three years and have come close to an agreement before. Now the clock starts ticking all over again, and it's unlikely that the county will exit from bankruptcy without having to impose higher taxes and fees of the sort that its commissioners were hoping to avoid.

The Jefferson County case exemplifies the differences between municipal and private bankruptcies. If a private company had the sort of debt-to-revenue ratios of Jefferson County, and its top officers had the track record for corruption of the Alabama county's political class, it's likely that a bankruptcy judge would quickly grant a motion to liquidate Jefferson and help creditors salvage what little they could out of a situation rife with fraud and mismanagement.

But governments don't get liquidated and judges can't impose solutions on them that might violate citizens' constitutional rights. When Orange County, Ca., tried to emerge from bankruptcy in the mid-1990s with a workout plan that included tax increases to pay for debt restructurings, officials still had to seek approval from voters, who rejected the new taxes and sent negotiators back to the drawing board. A judge couldn't just demand the county institute the tax.

If it sounds like the benefits of Chapter 9 are extremely limited, that's because they are. In some cases when public unions are absolutely uncooperative, a bankruptcy filing may finally bring them to the negotiating table, though in many places, officials can gain as much leverage by waiting for contracts to expire and then seeking new terms, instead of risking years in Chapter 9.

We've yet to see the flood of municipal bankruptcies some have predicted since the financial meltdown of 2008. Still, it's clear that some cities and towns that have been under fiscal stress for years are now teetering on the edge of insolvency. Detroit Mayor Dave Bing warned recently that without substantial cuts in spending the city will run out of money soon. Rhode Island legislators became so concerned about the fiscal situation of some of its municipalities that the state passed a law requiring that bondholders be paid first in any places where there arose a cash crunch. A number of California mayors have warned that without pension reform, their cities face insolvency at some point in the not-too-distant future.

The solutions to these crises rest not in bankruptcy court, but in statehouses and city halls. In the end, keeping cities out of bankruptcy is a better deal for taxpayers most of the time.