Knowing Your Government: How A City Files For Bankruptcy

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    bankruptcyMost recently, Detroit became the largest municipality in U.S. history to file for bankruptcy. The state had already appointed an emergency financial manager for the city, saddled with debts totaling an estimated $18 billion.

    Overall, though, bankrupt municipalities remain extremely rare. A Governing analysis estimated only one of every 1,668 eligible general-purpose local governments (0.06 percent) filed for bankruptcy protection over the past five years. Excluding filings later dismissed, only one of every 2,710 eligible localities filed since 2008.

    If a  city becomes stretched it asks a judge’s permission to call off creditors so to speak. Under Chapter 9 of the bankruptcy code, a municipality (i.e., a city, county, town, or public authority) can file for protection from its creditors if it meets certain eligibility criteria. First, it must get approval from the state legislature. (About half the states have laws on the books that allow their cities to go bankrupt. The others would have to give permission on a case-by-case basis.) Second, it must be demonstrably insolvent—the city needs to prove that it can’t make future debt payments or that it has already missed debt payments for lack of funds. Third, the city must want to get out of financial trouble, and it must have made a good-faith effort to negotiate with its creditors before filing for bankruptcy.

    Bankruptcy for cities didn’t exist until the 1930s. As tax revenues fell during the Great Depression, thousands of municipalities failed to make their debt payments. In 1934, Congress drafted emergency legislation to give cities a way out. In its early years, the new law ran afoul of the Supreme Court, since the 10th Amendment prohibits the federal government from meddling too much in state affairs.

    As a result, modern Chapter 9 fillings don’t work quite like other bankruptcies. When a city goes bankrupt, the judge’s primary job is to make sure that it’s eligible to file and to approve its plan for paying off the debt. But federal bankruptcy judges have less control over cities than they do over other kinds of debtors. In particular, the judge can’t order a city to liquidate its assets to pay off creditors. (As one Chapter 9 lawyer said when Miami faced bankruptcy in 1996, “They can’t come pick up the fire engine.”) In addition, the city can borrow money without the oversight of the judge or her appointed trustee. (In conventional bankruptcies, a debtor would need approval from the judge for certain financial transactions.)

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