What happens when a city declares bankruptcy?
Eileen St. Pierre, The Everyday Financial Planner
On June 17, the city of Detroit announced it would default on $2.5 billion in debt in an effort to avoid bankruptcy. Avoid bankruptcy? Isn’t Detroit bankrupt already? In all practical terms, Detroit is bankrupt, but not in a legal sense. Detroit Emergency Manager Kevyn Orr is currently negotiating with creditors, including pension trustees and union representatives, to reorganize the city’s debt obligations in order to free up cash to maintain basic city services. But Detroit has not officially filed for bankruptcy protection.
Update: Detroit officially filed for bankruptcy protection on Thursday, July 18.
Chapter 9 Bankruptcy
While individuals who have trouble paying their debts can file either Chapter 7 (liquidation) or Chapter 13 (reorganization) bankruptcy, municipalities may be able to file Chapter 9 bankruptcy. In addition to cities, municipalities include towns, villages, counties, taxing districts, municipal utilities, and school districts. Chapter 9 allows the city to stop paying its debts while it proposes and implements a restructuring plan.
- However, unlike individuals and corporations, cities are sovereign entities so it can be difficult for the courts to force the city to do anything.
- Likewise, cities have the power to tax so it may be difficult for the courts to believe the city has no means to pay its debts.
- No one wants a massive tax increase so this explains why Detroit is trying so hard now to negotiate with its creditors.
Cities are permitted to file bankruptcy if allowed under state law. According to Governing, 23 states do not allow bankruptcy. Michigan does allow its cities to file for bankruptcy protection if specific conditions are met. Twelve states, including Oklahoma and Texas, allow Chapter 9 bankruptcy with no specific conditions.
It is rare for cities to file for bankruptcy. According to Governing, only 7 cities, towns, and counties have filed for bankruptcy since January 2010 and 3 of these cases have been dismissed. With over $4 billion in debt, Jefferson County, Alabama (Birmingham) became the largest civic bankruptcy in U.S. history; earlier this month, a bankruptcy deal was reached according to The NY Times. In June 2012, Stockton, California became the largest U.S. city (population 300,000) to declare bankruptcy.
Before the housing market collapse and resulting recession, municipal bankruptcies tended to be triggered by lawsuit settlements, catastrophes, and risky investments. But now the poor economy appears to be the trigger, when combined with years (even decades) of poor financial decisions.
Consequences of Bankruptcy
It is hard to find any city or town that has not felt the impact of the Great Recession. When families face tough times, they re-examine their budgets and make tough choices. Cities have had to do the same thing. Local leaders, businesses, and residents face real consequences if their city declares bankruptcy, including:
- Further reductions in city services
- The need to raise taxes to increase tax revenue, which may not work if residents start to leave
- Drops in property values
- Increases in fees and utility rates
- The layoff or furlough of city employees
- Reductions in pension and other benefits for both current and retired employees
- A shifting of the burden of providing services to the county and/or state, passing on costs indirectly to taxpayers who do not live in the city
- An increase in future borrowing costs, if the city is able to borrow money at all, hurting future growth
Financial problems rarely happen overnight. They build over time due to poor decision making. If there is a silver lining for the residents of Detroit and other troubled cities, it’s the hope that their leaders will finally get their financial house in order.
Visit my Basic Financial Management page for more information on how to get your financial house in order.