November 2011
A Look at the History
of Municipal Bankruptcy
About the National Association of Counties
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November 2011
A Look at the History
of Municipal Bankruptcy
A Publication of the Research Division
of NACo’s County Services Department
Written by
Jacqueline J. Byers
Director of Research
November 2011
For more information about this publication or
the programs included, please contact:
National Association of Counties
Research Division
a Phone: 202.393.6226
� Website: www.naco.org
A Look at the History of Municipal Bankruptcy
3
In 1995, Orange County, CA became the largest municipality, and the rst county, to declare bankruptcy under
Chapter 9 of the United States Code. In recent months, Jefferson County, AL has had to face a bankruptcy ling
and the cities of Vallejo, CA, Central Falls, RI and Harrisburg, PA have also led for bankruptcy. With the current
economic slowdown, declining housing values and revenue shortfalls facing many local governments, bankruptcy is
once again a looming issue for many local governments.
Following the devastation of Hurricanes Katrina and Rita, several southern parishes and counties took a long hard
look at bankruptcy. The longstanding economic downturn and the looming debt for employee retirement benets,
including healthcare, have many counties facing a struggle to survive.
What issues can bring a county government to the brink of bankruptcy? What role do the states play in addressing
municipal scal stress? What are the states’ roles in handling municipal scal stress? How can a county prevent ling
for bankruptcy? A quick look at the lessons learned from the Orange County bankruptcy, as well as the history of
other municipal bankruptcies, will help shed light on this issue.
Municipal Bankruptcy
National Association of Counties • November 2011
4
Chapter 9
The US Bankruptcy Code was amended in 1934 to allow
municipalities to declare bankruptcy. Chapter 9 of the
US Bankruptcy Code was developed in 1934 when
municipalities faced the strain of the Great Depression
and has been amended multiple times since it was
declared constitutional in 1937. In 1933, 24 mayors
marched on Washington asking President Roosevelt
for federal loans to help them meet their local nancial
responsibilities.
1
Although nearly everyone on Capitol
Hill was sympathetic, no one was in favor of loaning
them federal funds. President Roosevelt was opposed
to loaning money to local governments because he
believed 1) the demand might increase to more than
$10 billion and 2) local governments would have to
surrender their independence to Washington and the
federal government.
2
As a result of the President’s deci-
sion and with his support, legislation was drafted for
what became Chapter 9 of the Bankruptcy Code that
would allow them to declare bankruptcy. Section 109
of the Bankruptcy Code establishes four conditions
that a municipality must meet to declare bankruptcy
under Chapter 9:
•
The entity must be a municipality (dened in the
Code as a “political subdivision or public agency
or instrumentality of the state.”)
•
It must be specically authorized by its state to
be a debtor
•
It must be insolvent
•
It must desire to reorganize debts
1 Time Magazine, June 12, 1933
2 Time Magazine, June 12, 1933
Chapter 9 provides municipalities with protection
from creditors while at the same time giving them the
space and time to adjust their debt. Since the estab-
lishment of Chapter 9 bankruptcy fewer than 500
municipalities have led for bankruptcy and most of
these have been special purpose districts. Chapter 9 is
similar to private sector bankruptcy in that it gives the
debtor breathing room from its creditors and allows
the county or city an opportunity to reorganize its
debt. The ling must be voluntary on the part of the
debtor. Even though municipal bankruptcy is similar
to private sector bankruptcy, it differs in several ways.
A private sector bankruptcy allows for the liquidation
of the debtor’s assets in order to pay creditors in the
reorganization phase. Since municipal governments
perform essential public duties, their assets cannot be
liquidated. In this way, the federal bankruptcy court
has very little power. It cannot liquidate assets and it
cannot, assign a trustee to oversee the case, because
of the 10
th
Amendment reserves certain rights to
states. The bankruptcy court does not involve itself in
matters of local politics.
Role of the State
The protection of the sovereignty of the states is
what made writing a federal bankruptcy statute for
local governments problematic. The original munici-
pal bankruptcy code legislation was ruled to be in
violation of the 10
th
Amendment in 1934 by the U.S.
Supreme Court
3
and had to be amended in 1937 to be
constitutional.
The role of the state in municipal bankruptcy is
crucial. The state must give specic authorization to
the municipality to declare bankruptcy. Some states
have authorization statutes that allow municipalities
to le Chapter 9 bankruptcy, often with precondi-
tions. Georgia and Iowa are 2 of the 25 states that
do not allow their municipalities to le bankruptcy.
Others, like Alaska and Alabama, do not have statutes
on the subject at all, meaning that since they do not
give specic authorization to do so, municipalities
may not le Chapter 9. Because the municipality is
under control of the state, the state can set precondi-
tions to bankruptcy or do anything in its power to
prevent the municipality from declaring bankruptcy.
3 Ashton v. Cameron County Water Improvement Dist.
No. 1, 298 U.S. 513, 532 (1936).
A Look at the History of Municipal Bankruptcy
5
By having to go through the state to declare bank-
ruptcy, the municipality is at the mercy of the state
and how it decides to handle the scal problem. The
state, in its gatekeeper function, does not have to
allow the municipality to even declare bankruptcy. In
that case, the state would be looked upon to provide
nancial and technical assistance in order to bail the
county out of its nancial distress. Some states, like
New York and Pennsylvania, have enacted munici-
pal distress statutes which are the equivalent of state
bankruptcy procedures. In the case where the state
does allow the ling of the bankruptcy petition, they
can appoint a trustee to oversee the bankruptcy and
prepare a readjustment plan.
To recap, for a municipality to be eligible for Chapter 9:
•
The municipality must be authorized to be a
debtor by state law
•
The municipality must be insolvent
•
The municipality must want to adjust its debts
•
And must deal with its creditors in one of several
specied ways.
Generally, a state will do what it can to prevent a
municipality from ling for bankruptcy. The bank-
ruptcy will not only affect the credit and bond rating
of the participating county, but it could also have a
negative effect on the rest of the state. According to
US News and World Report
4
, in the week after the
Orange County bankruptcy ling, share prices of
single state California closed-end muni-bond funds
dropped by an average of 5 percent. The risk for all
municipal bonds across the nation is also raised as a
result of municipal bankruptcy.
4 US News and World Report, December 11, 1994
Why Bankruptcy?
How do counties get to the point of going bankrupt?
It is important to note that not all scally distressed
counties or municipalities le for bankruptcy even
when that option is available. All sides try to prevent
that situation from happening. But what causes a
county’s scal situation to become so dire that bank-
ruptcy is a legitimate option?
There are many reasons for extreme scal
distress in counties. An Advisory Commission on
Intergovernmental Relations report examined many
of the root causes of nancial distress on municipali-
ties.
5
The report found that “the principle cause of
nancial emergencies in the 1972-83 period continued
to be unsound nancial management.” Bad budgeting
and accounting practices led to losses in liquidity, the
study found. In the case of Orange County, some bad
investments led to over $1 billion in losses.
There was another underlying cause for the Orange
County bankruptcy. In the state of California,
Proposition 13 had severely limited all counties’ abil-
ity to raise revenue through property tax. With this
in mind, counties felt pressured to raise revenue in
other capacities. The Orange County Investment Pool
was creating that needed revenue. State cutbacks, in
general, have left counties grasping for ways to fund
programs that are essential to life in their county,
especially in the areas of health and human services.
These unfunded mandates and reduction in state
funds in general have forced many counties into a
nancial bind.
5 Bankruptcies, Defaults and other Governmental Financial
Emergencies, Advisory Commission on Intergovernmental
Relations, March 1985
National Association of Counties • November 2011
6
Another cause of nancial hardship that the report
identied is the result of court judgments against
municipalities. This is especially true for smaller
governments that are hit with large sum judgments.
For example, Bay St. Louis, Mississippi was issued a
$375,000 judgment by federal district court while the
total budget of the city was $728,294. The bankruptcy
was dismissed because the city couldn’t comply with the
court order to borrow the money from a bank and had
to turn to the state to get approval to borrow money
to successfully pay the judgment. In 1984, Wapanucka,
Oklahoma faced a similar situation where it had insuf-
cient funds to satisfy a judgment against the town. As
a result of court rulings, small governments can nd
themselves in a hole for which they had not budgeted.
These examples may only be a preview of things to
come for county governments. The report concludes
that “the trend toward a broadening of local govern-
ment liabilities and exposures to lawsuits appears likely
to cause more emergencies in the future.”
Yet another reason for nancial hardship is demo-
graphic changes, especially when local governments
lose their population and their tax base. This issue
is currently under debate in Pittsburgh, PA. Although
they have not led for bankruptcy, years of out-migra-
tion in the area has caused the city to lose 50 percent
of its population in the last 50 years, ravaging its tax
base. It is nearly impossible to keep up with services
when half of the tax base has left. Allegheny County,
PA felt the crunch as well, since many of the commu-
nities in the county, not just Pittsburgh, are experi-
encing the same loss of population.
Jefferson County, AL
In the current economic environment many coun-
ties are struggling with major revenue shortfalls and
grappling with meeting their economic responsibili-
ties. Primary among recent counties in this situation
is Jefferson County, AL. Jefferson County has been on
the brink of bankruptcy for a number of years, largely
due to actions taken to repair and rebuild its sewer
system to settle a lawsuit for violating the Clean Water
Act in 1996. The county sold bonds to nance the proj-
ect raising $555 million. The county also purchased a
derivative connected to some of the xed rate debt.
After nearly 10 years of renancing and occasional
accusations of corruption by local government of-
cials (several were found guilty) the county saw itself
unable to pay its debt and on the verge of bankruptcy.
The county initiated a new tax to increase revenue
and raise the potential of paying its debt, but the tax
was struck down by the State Supreme Court on a
technicality. After attempting for the last three years
to renegotiate the sewer debt to avoid default, the
county nally reached an agreement with its creditors
in mid September 2011 to stave off bankruptcy.
6
Unfortunately, on November 20, 2011, the agreement
with their creditors fell apart because the creditors
apparently refused to go along with the economic
concessions that had been negotiated earlier. The
county then voted to le the petition for Chapter 9
bankruptcy citing $5 billion indebtedness, making it
the largest municipal bankruptcy in U.S. history.
Other Governments Consider
Bankruptcy
Another county that resorted to bankruptcy to settle
the amount it owed because of a lawsuit is Boise
County, ID. The county was involved in a lawsuit
brought by a developer who balked at the restrictions
the county placed on its development of a proposed
residential treatment facility that would house 72
boys in the small county. The developer brought suit
under the federal Fair Housing Act and won a judg-
ment of $4 million and $1.4 million in attorney’s fees.
The county both appealed the decision and attempted
to negotiate an agreement with the developer but
both failed. With a county operating budget of less
6 Marketwatch.com, September 16, 2011
A Look at the History of Municipal Bankruptcy
7
than $10 million, this county of 7,500 people had no
choice but to le for bankruptcy. Upon review by the
federal bankruptcy court in Idaho, the judge’s nding
was that the county had sufcient funds available to pay
the judgment against it and still maintain services for its
residents and dismissed the case, on September 2, 2011,
denying the bankruptcy petition.
7
Nassau County, NY is in a state that does not allow
municipal bankruptcy. As observers watched over the
years, they saw that this wealthy county outside of
New York City which had little or no tax hikes was
getting deeper and deeper into debt. Former County
Executive Tom Suozzi came into ofce to a system
where the convoluted and inconsistent tax assessment
system left the county holding the bag for refunds to
homeowners who challenged their school tax assess-
ments. This at a time that the county was giving 65
percent of the collected tax revenue to a school district
over which it no control. Most challengers won their
appeals. In recent years these overpayment refunds
have been in the tens of millions forcing the county to
borrow $100 million each year in short term loans to
refund tax overpayments to homeowners. Coupling
these refunds with the ongoing economic recession,
increasing healthcare costs, social services delivery
cost increases, police overtime and union contracts,
the county saw its average tax bill go to $11,500, one
of the highest in the country and in late 2010, saw
7 Idaho Statesman, September 3, 2011
its credit rating downgraded making it even harder to
borrow the money it needed each year.
Finally, the state of New York stepped in appointing
the Nassau Interim Finance Authority, which took
over the county’s nancing and put a stop to the short
term borrowing.
8
Finance Authority members believe
that the county’s bookkeeping system needs exami-
nation and that the hopes the county executive has
to realize concessions through future labor contract
negotiations may go unrealized. However, the author-
ity’s role is to work with the county executive and
other county ofcials to help stabilize the county.
Prevention of Bankruptcy
There are some alternatives to declaring bankruptcy.
As we have seen, nancial hardship can come without
warning, pushing county governments to the brink of
bankruptcy. There are some measures available for
preventing that fall off the cliff.
State Bailout
It is usually the state that comes to the rescue of its
failing local governments. Since many states are the
gatekeepers of bankruptcy, they can do anything
allowed constitutionally in order to prevent that
from occurring. State bailouts are one way the state
can prevent a municipal bankruptcy. This happened
in 1990 in the case of Butte County, California. Butte
8 New York Times, January 26, 2011
National Association of Counties • November 2011
8
County was on the verge of becoming the rst county
to declare Chapter 9 bankruptcy before the state
assembly stepped in at the 11
th
hour and voted to
provide the county with a $15 million bailout.
The bailout, however, is only a temporary stopgap
and doesn’t necessarily solve a long-term scal crisis
the municipality may be in. This is the situation New
York City found itself in during recent budget years.
City ofcials turned to Albany for recurring revenues
and savings but Governor Pataki responded with one-
shots, money available only for one scal year. New
York City had already raised property taxes and was
seeking to impose a commuter tax. The state, like
most states in the Union, was also facing its own
budget gap and nding it difcult to nd the desired
long-term aid for local governments.
Local Cuts
State bailouts are not a reliable resource because of
today’s budget shortfalls. In order to prevent scal
catastrophe, county governments are cutting back
programs, spending, and employment to manage
their decits. In 1990, Butte County
9
cut everything it
could before threatening bankruptcy. Closing librar-
ies, slashing payrolls, and freezing cost of living raises
to employees were some of the methods the county
turned to in order to save money. Any further cuts
would have rendered the county government useless.
As previously discussed, New York City has tried to
generate more revenue by raising property taxes
18.5% and has cut signicant spending to adjust its
nances. Other programs potentially facing cuts
included drug counseling programs in city jails and
9 Los Angeles Times, September 22, 1989
scaling back summer school for children whose pres-
ence was not mandatory. But citizens have not been
receptive to a tax hike.
Voters rejected a referendum following Orange
County’s bankruptcy that would have increased
countywide sales tax by .5% for 10 years. The County
was forced to cut 41% of the General Operating
Budget and reduced full-time positions by 16%.
In mid 2010, Modoc County, CA hired a bankruptcy
attorney, as well as requested a $12.5 million loan
from the state of California. For more than a decade,
Modoc County had been funding its hospital using
money intended for other purposes, such as educa-
tion and transportation projects. An audit in 2009
by the state controller’s ofce determined that the
county was violating state law by shifting dollars away
from their intended purpose, prompting the county’s
current nancial crisis.
On August 31, 2010 voters in Modoc County were
able to avoid bankruptcy by approving a $195-a-year
parcel tax in order to fund the county’s hospital. The
new parcel tax is set to generate $3.1 million a year
for the hospital.
10
Other Options
Insurance
In response to the rise in court actions against munic-
ipalities, many counties are obtaining some form of
liability insurance. This would prevent a large court
judgment from crippling the budget and the county’s
ability to perform its governmental functions.
10 Associated Press, September 1, 2010
A Look at the History of Municipal Bankruptcy
9
Oversight Boards
We have seen that when a municipality declares bank-
ruptcy, it does so under state law. This leaves the
municipality under the jurisdiction of the state during
the bankruptcy proceeding. The state can impose a
trustee to oversee the municipality’s bankruptcy and
its reorganization plan. While the state can give aid to
the troubled municipality, it may also impose an over-
sight board in the municipality in order to prevent
bankruptcy or default. These boards are put in place
for governments that have been in a scal crisis for
some time. A board was put in place in New York
City in 1974 to oversee the City’s budget and the state
and federal government provided loans to the City to
survive the crisis. The Control Board was responsible
for most nancial decisions in the City and helped
prevent New York from declaring bankruptcy.
More recently, a control board was put in charge of
the nances of Nassau County, NY after its failure to
maintain and manage its own nances.
In 1991, the state of Pennsylvania created the
Pennsylvania Intergovernmental Cooperation
Authority (PICA) to oversee Philadelphia’s nancial
situation, including the approval of a long-term scal
plan, authority to issue bonds, and power to withhold
state funds in the event that the government was not
following the plan. One of the advantages of a state
oversight board is that it is able to protect the elected
ofcials from blame for difcult nancial decisions.
The Board is usually dissolved when the municipal-
ity is able to meet certain criteria, such as balancing
the budget for consecutive years or repaying debt.
The Board may also prove sufcient in re-establishing
the municipality’s bond status and improving inves-
tor condence to make it easier for the municipality
to re-enter the bond market, one of the major issues
facing bankrupt governments.
National Association of Counties • November 2011
10
What Happens after Declaring
Bankruptcy?
Initially, a municipality that has declared itself bank-
rupt by being insolvent can expect to be punished by
the markets. How long this punishment will last can
be based on the following factors:
•
The degree to which debt holders and guaran-
tors are made whole
•
The strength of the negotiated settlement or the
plan for adjustment
•
How much the stakeholders buy in or cooperate
•
Whether voters and/or elected ofcials have
contributed to the settlement or plan by approv-
ing new taxes, fees or other revenue sources
•
Whether the municipality can show that it has stable
and effective leadership and management in place
•
How well the municipality communicates with
the market and how timely and transparent the
nancial information is
•
How well the settlement or plan of adjustment is
implemented and monitored
Access to the capital markets will be more expensive and
more limited than in the past. However, if the munici-
pality focuses on the above factors, it can emerge from
the effects of bankruptcy in a stronger and more stable
nancial situation that before they led.
11
11 Municipal Bankruptcy: Avoiding and Using Chapter 9 in times
of Fiscal Stress, John Know and Marc Levinson, Orrick, 2009
Conclusion
In today’s scal crisis, statewide budget decits are
the norm. In turn, there is more pressure on county
governments to continue to provide services at the
same time they are addressing declining revenue
streams. Bankruptcy, however, should be an absolute
last option for struggling counties.
“Chapter 9 really puts the judge more in the position
of being a referee than somebody who can really run
the county, said Paul S. Maco, partner with the rm
of Vinson & Elkins who led the ofce of Municipal
Securities at the Securities and Exchange Commission
during the bankruptcy of Orange County, CA.
“Chapter 9 doesn’t take away the difcult political
decision-making needed to address a nancial credit
problem. Their (Orange County’s) path out of bank-
ruptcy was difcult.”
12
We have seen that once bankruptcy is declared, it
effects not only the county’s credit rating but also may
affect the entire state’s rating, making it that much
more difcult to provide services. The important
thing is to know the state law regarding bankruptcy
and scally distressed governments and to use all
means to prevent the bankruptcy.
12 Bankruptcy Rarely Offers Easy Answer for Counties, New
York Times, November 10, 2011
A Look at the History of Municipal Bankruptcy
11
Sources
11 U.S.C. § 109
11 U.S.C. § 901 to 946
Advisory Commission on Intergovernmental Relations. “Bankruptcies, Defaults, and Other Local Government Financial Emergencies.”
March, 1985
Bancroft, Ann. “Assembly Votes $15 Million Bailout for Butte County.” San Francisco Chronicle, September 1, 1990.
Berman, David R. “Takeovers of Local Governments: An Overview and Evaluation of State Policies.” Publius, The Journal of Federalism.
Summer 1995.
Bishop, Katherine. “County vs. State on Bankruptcy Issue.” The New York Times, September 10, 1990.
Briem, Christopher. “Bankruptcy for Pittsburgh must be Avoided.” Pittsburgh Tribune Review, November 22, 2002.
California Law Revision Commission. “Recommendation: Municipal Bankruptcy.” November, 2001.
Cooper, Michael. “Mayor Dueling with Governor on Solutions to Shortfall.” The New York Times, January 28, 2003.
Cooper, Michael. “Mayor’s Budget Needs Help from Albany and Labor.” The New York Times, January 29, 2003.
Eastern District of Washington. “Municipal Bankruptcy – Chapter 9.” Public Information Series, December 1998.
Flickinger, Barbara and Katherine McManus. “Bankruptcy Aftershocks.” Public Management, January 1996.
Fulton, William. “Cleaning Up Orange County.” Planning, February 1996.
Impoco, Jim, et al. “Trouble in Paradise.” US News & World Report, December 19, 1994.
Orange County, California. “Orange County Bankruptcy Recovery – One Year Later.” www.oc.ca.gov
Park, Keeok. “Municipal Bankruptcy in the United States: The Causes, Procedures, and Remedial Strategies.” Presented March 15-17, 2001.
Petersen, John E. “It’s Better Not to Belly-Up.” Governing, February 1995.
Petersen, John E. “A Guide to the Municipal Bond Market: The Post-Orange County Era.” Governing, November 1995.
Public Law Research Institute. “Municipal Bankruptcy: State Authorization Under the Federal Bankruptcy Code.” www.uchastings.edu
Municipal Bankruptcy: Avoiding and Using Chapter 9 in times of Fiscal Stress, John Know and Marc Levinson, Orrick, 2009
Campbell Robertson, Mary Williams Walsh and Michael Cooper, “Bankruptcy Rarely Offers Easy Answer for Counties,” New York Times,
November 10, 2011
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