How Cities Fail: Service Delivery Insolvency and Municipal Bankruptcy
by | posted in: Bankruptcy Roundtable Updates, Municipal Bankruptcy | 0

By Clayton Gillette (New York University School of Law)

Clayton Gillette

Courts in municipal bankruptcy cases have confronted the inherent vagueness in the statutory tests for municipal “insolvency” by embracing a test of “service delivery insolvency.” That test is typically evaluated in terms of a significant reduction in the availability of city services. Focus on a municipality’s failure to deliver services certainly serves as a plausible proxy for fiscal health, since provision of services is a primary function of local governments and thus a function that a financially healthy municipality would satisfy. Initially, such a test appears to be viable, since it invites both temporal and interlocal comparison service levels as a measure of fiscal health. Nevertheless, this article indicates severe limitations of a service delivery insolvency test. Reductions in service may indicate efforts to recover fiscal health rather than indicating fiscal distress, because that distress was generated by overspending on services. In addition, focus on particular service reductions as a measure of insolvency creates perverse incentives for local officials who desire to obtain debt relief to diminish those services most susceptible to measurement. When determining eligibility for Chapter 9, two potential measures other than service delivery insolvency may serve as alternative or complementary proxies for the need to adjust municipal debt: population outflows and loss of agglomeration benefits.

Population outflows may serve as an alternative indicator of fiscal distress. A city that fails to provide services at a level commensurate with its tax prices may lose mobile residents, and population declines imply that the per capita debt of the municipality is increasing. But that measure does not necessarily distinguish among emigrants. If those who exit consumed more services than they paid for, then exit will not necessarily betoken fiscal distress.

Local fiscal health is often dependent on the capacity of the locality to obtain the benefits of agglomeration. As a result, and notwithstanding measurement difficulties, one promising proxy for fiscal distress entails identifying whether those who have exited would otherwise have contributed agglomeration benefits to the locality. Agglomeration effects are related to the benefits that individuals or firms receive from being located within a network of other individuals or firms, such as sharing of knowledge and information, reducing spatial mismatches between jobs and places of residence, and neighborhood effects which are necessary for the development of social capital. Agglomeration may affect decision making by prompting residents to remain when they might otherwise emigrate because they would lose network benefits in excess of the gains they would obtain from exit. Demonstrable declines in agglomeration benefits could, more than population declines or rough measures of service delivery insolvency alone, inform judgments about the potential sources of fiscal distress and the likelihood that debt adjustment would be appropriate. If population decline is largely attributable to exit by firms that tend to generate local agglomeration benefits, then continued and declining fiscal distress is more likely to occur without intervention than if population decline results from exit that creates less of a reduction of those benefits.

The full article is available here.

Gatekeepers Gone Wrong: Reforming the Chapter 9 Eligibility Rules
by | posted in: Municipal Bankruptcy | 0

By Laura N. Coordes (Arizona State University Law School)

In order to gain access to chapter 9 bankruptcy, municipalities must demonstrate that they meet several eligibility requirements. These requirements were put in place to prevent municipalities from making rash decisions about filing for bankruptcy. Too often, however, these requirements impede municipalities from attaining desperately needed relief. This Article demonstrates that as currently utilized, the chapter 9 eligibility rules overemphasize deterrence and are not rationally connected to the reasons the chapter 9 bankruptcy system was developed. This Article, therefore, posits that the chapter 9 eligibility requirements should be relaxed.

To support this claim, the Article conducts a detailed analysis of the history and theory of chapter 9 to determine the primary reasons for the eligibility rules and the core functions of a municipal bankruptcy solution. It then demonstrates how many of the concerns driving the eligibility rules’ existence are addressed in other chapter 9 mechanisms, and it proposes sweeping revisions to the eligibility rules to facilitate appropriate access to chapter 9. Specifically, municipalities in fiscal distress should be able to access bankruptcy when they demonstrate a need for the primary types of assistance that bankruptcy can best provide: nonconsensual debt adjustment, elimination of the holdout creditor problem, and breathing space. Through its analysis, this Article brings needed attention to the broader questions of who should have access to bankruptcy and when that access should be granted.

The full article is available here.

For more Roundtable posts on municipal bankruptcy, see Parikh & He, “Falling Cities and the Red Queen Phenomenon”; Skeel, “From Chrysler and General Motors to Detroit”; and Roundtable updates on Puerto Rico’s debt crisis (covering a call for congressional action and Puerto Rico’s Public Corporation Debt Enforcement and Recovery Act).

Falling Cities and the Red Queen Phenomenon
by | posted in: Municipal Bankruptcy | 0

By Samir D. Parikh (Lewis and Clark Law School) and Zhaochen He (Lewis and Clark College)

Cities and counties are failing.  Unfunded liabilities for retirees’ healthcare benefits aggregate to more than $1 trillion.  Pension systems are underfunded by as much as $4.4 trillion.  Many local government capital structures ensure rising costs and declining revenues, the precursors to service-delivery insolvency.  These governments are experiencing the Red Queen phenomenon.   They have tried a dizzying number of remedies but their dire situation persists unchanged.  Structural changes are necessary, but state legislatures have failed to respond.  More specifically, many states have refused to implement meaningful debt restructuring mechanisms for local governments. They argue that giving cities and counties the power to potentially impair bond obligations will lead to a doomsday scenario: credit markets will respond by dramatically raising interest rates on new municipal and state bond issuances. This argument – which we term the paralysis justification – has been employed widely to support state inaction.  But the paralysis justification is anecdotal and untested.

This article attempts to fill a significant gap in the literature by reporting the results of an unprecedented empirical study. Our study aggregates data for every general obligation, fixed-rate municipal bond issued in the U.S. from January 1, 2004 to December 31, 2014, over 800,000 issuances in total.  By employing multivariate regression analysis, we are able to conclude that the paralysis justification is a false narrative.  Municipalities located in states that offer meaningful debt restructuring options enjoy the lowest borrowing costs, all other things equal.  This article removes one of the largest obstacles to financial relief for many cities and counties. We hope to encourage recalcitrant state legislatures to enact the structural changes their local governments need desperately.

The full article is available here.

Municipal Borrowing Costs and State Policies for Distressed Municipalities
by | posted in: Bankruptcy Roundtable Updates, Municipal Bankruptcy | 0

By Pengjie Gao (University of Notre Dame), Chang Lee (University of Illinois at Chicago), and Dermot Murphy (University of Illinois at Chicago)

Recent high-profile municipal default cases in Detroit, Puerto Rico, and various cities in California have underscored the importance of state laws for dealing with default proceedings, or even preventing default from occurring in the first place. However, the effects of these laws, or lack thereof, on municipal borrowing costs remain unclear. Does unconditional state support for distressed local municipalities lead to lower local borrowing costs? If so, are there tradeoffs?

The authors address these questions by examining differences in distress-related laws and statutes across states. Some states have proactive policies in place that activate when their local municipality is exhibiting signs of fiscal distress (“Proactive states”). Meanwhile, other states allow unconditional access to the Chapter 9 bankruptcy procedure, with no laws in place for dealing with distressed municipalities (“Chapter 9 states”).

The authors find that these differences significantly affect local borrowing costs. In particular, Proactive states have lower borrowing costs and significantly lower yield reactions following default. Furthermore, Proactive state yields are less sensitive to economic conditions because of the implicit insurance that becomes particularly valuable when economic conditions are weak. There is also a significant contagion effect in Chapter 9 states that does not exist in Proactive states, in that a default in a Chapter 9 state is more likely to lead to higher yields for other bonds located in that state. However, the authors also provide evidence that borrowing costs at the state level are somewhat higher in Proactive states because of the partial transfer of local credit risk to the state.

The full article is available here.

Fair and Unfair Discrimination in Municipal Bankruptcy
by | posted in: Municipal Bankruptcy | 0

By Richard M. Hynes and Steven D. Walt, University of Virginia School of Law

hynes_0915 walt_lowresSome bankrupt municipalities have proposed plans of reorganization that offer substantially greater recoveries to their active workers and retirees than those offered to other creditors.  Because these greater recoveries are not mandated by a priority enjoyed by the active workers and retirees, a judge can only approve such a plan if it does not “discriminate unfairly” against a class of disfavored creditors that votes against the plan.  This Article describes the law defining the unfair discrimination standard, identifies the categories of circumstances in which discrimination between co-equal classes is permitted, and argues that the claims of retirees and active workers do not fall into any of these categories.  The Article concludes that current law does not allow a judge to approve a reorganization plan that provides retirees and active workers with a greater recovery.

The full version of the article can be found here.