What happens when a city goes bankrupt?

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Oct. 14 2005 6:33 PM

What Happens When a City Goes Bankrupt?

You stay solvent, San Diego.

San Diego: city on the brink
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San Diego: city on the brink

Federal corruption investigations, bottomed-out bond ratings, and a history of poor fiscal management have brought San Diego to the brink of financial ruin. Two mayoral candidates have said the city might have to file for bankruptcy in the face of its $1.4 billion pension deficit. How does a city go bankrupt?

Daniel Engber Daniel Engber

Daniel Engber is a columnist for Slate

It asks a judge's permission. Under Chapter 9 of the bankruptcy code, a municipality (i.e., a city, county, town, or public authority) can file for protection from its creditors if it meets certain eligibility criteria. First, it must get approval from the state legislature. (About half the states have laws on the books that allow their cities to go bankrupt. The others would have to give permission on a case-by-case basis.) Second, it must be demonstrably insolvent—the city needs to prove that it can't make future debt payments or that it has already missed debt payments for lack of funds. Third, the city must want to get out of financial trouble, and it must have made a good-faith effort to negotiate with its creditors before filing for bankruptcy.

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Bankruptcy for cities didn't exist until the 1930s. As tax revenues fell during the Great Depression, thousands of municipalities failed to make their debt payments. In 1934, Congress drafted emergency legislation to give cities a way out. In its early years, the new law ran afoul of the Supreme Court, since the 10th Amendment prohibits the federal government from meddling too much in state affairs.

As a result, modern Chapter 9 fillings don't work quite like other bankruptcies. When a city goes bankrupt, the judge's primary job is to make sure that it's eligible to file and to approve its plan for paying off the debt. But federal bankruptcy judges have less control over cities than they do over other kinds of debtors. In particular, the judge can't order a city to liquidate its assets to pay off creditors. (As one Chapter 9 lawyer said when Miami faced bankruptcy in 1996, "They can't come pick up the fire engine.") In addition, the city can borrow money without the oversight of the judge or her appointed trustee. (In conventional bankruptcies, a debtor would need approval from the judge for certain financial transactions.)

Since the 1930s, fewer than 500 municipalities have gone through bankruptcy. Cash-strapped cities that would benefit from Chapter 9 might be reluctant to file because the recovery process often involves unpopular service cuts and tax hikes; the political fallout also tends to be grave.

New York City came close to filing during its mid-1970s financial crisis. At the time it was almost impossible for a large metropolis to meet Chapter 9's eligibility requirements. For one, New York would have had considerable trouble negotiating with all of its many creditors before filing.

Congress changed the bankruptcy law in the late 1970s to make it easier for big cities to file. The new rules allowed for Orange County's huge municipal bankruptcy in 1994. A local official had put the county's money in high-risk investments that ended up losing almost $2 billion. After a year and a half, the O.C. emerged from bankruptcy and paid off $900 million of its debt with new financing.

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Explainer thanks Alex Laughlin of Wiley Rein & Fielding LLP.