Bankruptcy rights may go to states

January 7, 2011
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According to a report filed by Reuters a few weeks ago, Congressional Republicans will try to pass legislation in this session that would allow a state government to file for bankruptcy protection — an action cities and counties can take but states currently can’t.

The potential bill would reportedly either amend the Chapter 9 bankruptcy law, which allows cities and counties to file, or create a new law. Either would extend the financial option that municipalities have to state governments.

A recent report from the nation’s capital said the 50 state budgets have a collective deficit of $140 billion for the fiscal year. The Michigan 2012 general budget, which right now has a projected total of roughly $8.3 billion, is facing an estimated shortfall of $1.5 billion that will have to be dealt with before Oct. 1.

“I think the whole idea that the Republican Party is putting forth is, it’s trying to provide some fiscal rectitude for the states that are currently facing all kinds of problems, including Michigan,” said Tim Weed, a partner at accounting firm Plante and Moran, from his office in Southfield.

“What the Republicans are suggesting is actually a new law that would allow a state to file bankruptcy. The Chapter 9 bankruptcy code is written primarily for units of state government, whether it’s a city or a county or some type of special revenue district,” he added.

The idea behind any bankruptcy, of course, is to allow the filer time to get its financial affairs in order and to develop a fiscal plan that would accomplish that task through some sort of restructuring. Should Republicans get the bill through Congress and past President Barack Obama, that process for a state would be overseen by a federal bankruptcy judge.

Weed pointed out, though, that when a city files this action, the federal judge handling the case has less leeway to make decisions than if he or she were overseeing a bankruptcy petition from an individual or a corporation.

“With a corporate entity, it would decide how it wanted to continue in business and where it wanted the revenue to come from. It could decide to enter into a new line of business and start selling widgets of a different kind.

“But with a municipality, most of its revenue is raised through taxes. And it cannot file bankruptcy and decide to start raising taxes outside the normal process of how its taxing authority is currently written. So there are some constraints of what it can do on the revenue side,” said Weed.

“Probably more to the point, on the expenditure side, the amount of money that is typically devoted to employee salaries and benefits in any municipality that has got governmental unions involved, it can’t just sort of overturn bargaining agreements.”

Weed said there probably is an impression among various segments of the public that when a city files for bankruptcy, it can simply tear up employment contracts that were negotiated with bargaining units and then force those union members to accept lower wages, benefits and changes to pension plans.

“There is a requirement in the bankruptcy code that a municipality needs to bargain with the unions. Bankruptcy is not a panacea that gets you around the fact that you need to work through those issues. A municipality would have to go through a pretty rigorous negotiation process, and most judges would want them to do that,” he said.

“Most judges typically are going to be living somewhere near or in the district that is going through bankruptcy, and they might also feel there is a need from a due-process standpoint to allow both sides to come up with a compromise.

“I think many judges would use judicial restraint and not think that they should impose their will either way on either party.”

Weed said it was difficult for him to imagine a state taking a bankruptcy route for two reasons. The first is that most states, like cities and counties, use the public markets to borrow money at a lower interest rate than a typical company can because it has the ability to tax the public to raise funds to pay for debt. The market, in turn, often views this type of borrowing as a fairly low risk.

“But if one were to file for bankruptcy and not pay its debts in full, the thought is the public markets would no longer allow it to borrow at a very low rate. They’d be paying much closer to market rates like a company, or even higher. There would be this future penalty for that enterprise — in this case, a state,” he said.

One example is in Vallejo, Calif., a city with a population of 117,000 near San Francisco. Vallejo filed for bankruptcy in 2008. After the city filed but before the matter went to court, ratings agency Standard and Poor’s lowered the city’s bond rating from A to B and also downgraded its financing authority bonds from A- to B.

“Then you’d also have the issue of the stigma on the citizens and the businesses that might decide that they don’t want to be involved with that state.

“I don’t know if that stigma is as great as some people think it is,” he added. “But I think the future cost to the state would be such that it would make it a costlier place to do business, and it would be a higher-tax state for the citizens and the community to live in. People and businesses have some mobility, so it could actually make things worse if people leave the state and leave a smaller tax base for a state to try to pay things back.”

Still, Weed felt that having Republicans in Congress suggest giving states the right to file for bankruptcy protection is an interesting concept, one that is sending a message to governors and state legislators across the country. 

“I think it’s really just trying to support their overall attitude toward the need for government to shore up its own house, similar to what individuals and companies have had to do through the Great Recession,” he said. “They need to try to impose a similar discipline on all of the governments, and picking out the states is a target for this proposed law.”

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