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What Happens When a City Files for Bankruptcy?
Bankruptcy has been in the news a lot lately, and not just because individuals are seeking bankruptcy protection. Thanks largely to the economic strain in much of the country, municipalities are now considering bankruptcy in large numbers.
But what happens when a city, town or county files a bankruptcy petition? Here’s a look.
Chapter 9 Bankruptcy: For Municipalities Only
Individuals can file for bankruptcy under Chapter 7, Chapter 11, Chapter 12, Chapter 13 of the U.S. Bankruptcy Code. When cities file, though, they must do so under Chapter 9, a type of bankruptcy designed during the Great Depression to help municipalities in distress.
Here’s a look at how Chapter 9 bankruptcy works.
Two main reasons cities file: According to insiders, municipalities that choose Chapter 9 protection tend to do so for one of two reasons. Either they’re faced with a one-time catastrophe that prevents them from repaying their creditors, or their financial structure is fundamentally unsound and unsustainable. Cities with the former problem may move into and out of bankruptcy more quickly than those with the latter problem, which may spend more time negotiating with creditors and considering bankruptcy alternatives.
Eligibility for bankruptcy: Not all municipalities are legally permitted to file for bankruptcy. Eligibility is regulated by state laws, and in some states no district can seek Chapter 9 protection. Elsewhere (as in California), any municipality has the bankruptcy option and in still other places, judges decide on a case-by-case basis whether or not a town can file.
Chapter 9 capabilities: Once a town enters bankruptcy protection, Chapter 9 gives it the ability to negotiate labor contracts that might otherwise have been off-limits because of union laws. In some cases, negotiating pension terms or other benefits allows the city to seriously cut costs in a way that it couldn’t have done without the protection of the bankruptcy court.
Pre-filing negotiations: In some cases, the mere threat of a Chapter 9 bankruptcy is enough to convince creditors and other groups to negotiate with a municipality. Because bankruptcy can mean that creditors lose a significant amount of the money they invested in a town, many are willing to accept a deal to prevent the town from filing a petition.
Chapter 9 frequency: Despite the threats of municipal bankruptcies that pepper newspapers, actual Chapter 9 filings are fairly rare. This is partly because once towns recognize bankruptcy as an option, they and their creditors have lots of non-bankruptcy alternatives available, including raising taxes, raising fees, cutting costs, negotiating payment terms and more. Plus, politicians are often reluctant to have a municipal bankruptcy on their record, which can look bad in future elections.