Cities Can File Bankruptcy, Too!

July 7, 2008 11:58 am Published by

Bankruptcy’s in the news – again, but this time it’s not the usual individual or small business involved with bankruptcy court.  And it’s not one of the big manufacturing companies, either.  I’ve been reading about two cities, Vallejo, California, and McCall Idaho.  As a bankruptcy attorney in Indiana, I’ve helped tens of thousands of people through the process of bankruptcy.  I don’t typically work with cities and towns, but with individuals, families, and small businesses.  The fact is, though, that cities and towns file for bankruptcy, too.  For most of our history in this country, cities and towns weren’t eligible for bankruptcy protection. During the Great Depression, when more than 2000 municipalities were forced to default on their debts during Roosevelt’s presidency, laws were enacted that allowed municipalities to file bankruptcy.  A new section of the bankruptcy code, Chapter 9, was approved just for municipalities. (In an earlier bankruptcy blog, Yes, Your Business Can File Bankruptcy Without You, I talked about Chapter 7, Chapter 11, and Chapter 13 for individuals and businesses.) 

The three main causes for bankruptcy among individuals are job layoff, unusual medical expenses, and divorce. In the past year, falling home prices and property destruction due to floods, storms, and hail damage have all added to the pain.  In the case of municipalities, the big three causes appear to be losing big lawsuits, mismanagement, and distress in the economy.  Just as with individuals, when a municipality’s credit rating declines, it has trouble getting new credit to use for expenses (meaning to provide regular services to the people who live there).

When a Chapter 9 bankruptcy is filed, there’s one major difference as compared with individual or business bankruptcy.  There’s no provision in Chapter 9 for liquidating assets and using the money to pay creditors, as would happen in other forms of bankruptcy.  Usually reorganizing debt (bonds issued by the municipality) means lengthening the maturity date of the bonds to buy more time for repayment, or reducing the interest rate on the bonds.  Since “something’s gotta give”, as the saying goes, essential services may be reduced in that city, county, or town, even cutting back fire and police staffing or reducing social services staff. Projects such as building new bridges or new schools will probably be put on hold.  Most important, a city filing bankruptcy carries a much worse stigma than a corporation or even an individual. Municipalities will try anything to avoid using Chapter 9.

The first large municipal bankruptcy was filed in 1991 by Bridgeport, Connecticut.  The largest Chapter 9 was Orange County, California in 1994. New York City came very close to bankruptcy in 1975, but with Congress’ help, never went over the edge. What’s happened in McCall is that they owe $5 million to a contractor for remedying environment concerns, and that contractor is suing to have the debt all paid now.  Meanwhile, in Vallejo, ongoing negotiations with the fire and police unions have exhausted the city’s reserve funds.

In both cases, the problems have been building for years, with each administration trying to stave off the inevitable.  Although, as I said, my everyday work is not with municipalities but with individuals, the news out of Vallejo and McCall reinforces my plea for people to deal with financial problems early on.  The earlier in the process people begin to strategize and take steps to mitigate the problems, the more options will be open to them.  I’m no doctor, but when it comes to bankruptcy, early treatment offers the best chance for a cure!

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This post was written by Mark Zuckerberg

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