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After Detroit's filing: A look at bankruptcy laws in the Midwest and state oversight, help for local governments in financial distress

by Tim Anderson ~ October 2013~ PDF of Stateline Midwest article »
When his hometown of Detroit filed for bankruptcy this summer, Michigan Rep. David Nathan had two reactions. One, it was unfortunate. Two, it had to be done.
“My perspective is that it can help our citizens who have been sticking it out here, through thick and thin,” Nathan says.
From the trash that is no longer picked up in a timely manner to the slow response times of police and fire departments, Nathan says, city services have deteriorated to unacceptable levels.
“It is all related to a financial situation that the city is in,” Nathan says, “and it didn’t look like the creditors were going to help unless they were forced to.”
Detroit’s bankruptcy filing was a milestone in the 79-year history of Chapter 9. Municipal filings have been rare and, for the most part, inconsequential because they have involved small taxing bodies.
Some states, in fact, do not even authorize municipal bankruptcies in statute and, in the case of Iowa, prohibit them (see map).
In the Midwest, not a single municipal bankruptcy filing occurred between 1980 and 2011 in seven states.. And only Nebraska had a large number of filings during that period (55, most in the nation), but those all involved specially designated sanitary and sewer tax districts.
Detroit’s case is much different — and consequential.
“The tradition has been that any city of size viewed Chapter 9 as an option to be avoided at all costs, because the city did not want to interfere with its ability to borrow and access markets at a low interest rate,” says James Spiotto, a partner with the firm Chapman and Cutler LLP and a leading national expert on bankruptcy law.
He believes the stigma and negative consequences of bankruptcy will keep municipalities from viewing Chapter 9 as anything but a “last, last resort.”
Spiotto adds that bankruptcy is a messy process; in Detroit, there will be a fight between workers, retirees, creditors and public officials over “a piece of a pie that isn’t much to begin with.” That process, Spiotto says, keeps the parties involved from focusing on the most important goal — finding a path to long-term economic recovery and fiscal health.
“You can adjust the debt without solving the systematic problems, and then you just repeat the problems,” he warns.
State policies critical, and evolving
Nathan says a long list of factors led Detroit down the road to bankruptcy, and he includes policy decisions made by the state in that list.
In the late 1990s, for example, the city agreed to reduce income tax rates in exchange for more revenue-sharing dollars from the state. But subsequent crises in Michigan’s fiscal conditions meant those dollars never came in at expected levels.
“Detroit was counting on that revenue to help pay the debt and provide its services,” Nathan says.
In fact, one reason for today’s heightened concerns about municipal bankruptcy is tight state budget conditions. States are an important source of revenue for local governments, and either because of fiscal choice or necessity, cuts have been made in recent years.
Ohio Rep. Lou Terhar points to recent reductions in local government funding as one cause of difficult financial conditions for some of his state’s political subdivisions. He also cites the impact of the recent recession, elimination of Ohio’s estate tax and “questionable financial decisions made at the local government level.”
Partly in response to Detroit’s bankruptcy, and his subsequent research into the financial health of Ohio’s local governments, Terhar crafted legislation — set to be ready for General Assembly consideration in the fall — that places new fiscal restraints on the state’s political subdivisions. The measure would require jurisdictions to maintain balanced budgets, adhere to stricter debt limits and meet new standards for funding locally administered pension systems.
“Municipal bankruptcies hurt not only the political entity going through bankruptcy and its local residents,” Terhar said in a statement announcing the new legislation, “they also negatively affect the economic health of the region.”
As Spiotto notes, too, the financial credibility of local governments — and their ability to access low interest rates in capital markets — “is at the heart of our system of federalism.”
“It’s essential to allowing decisions to be made locally on what local officials believe is right,” he says."Imagine if you had to go to the federal government and ask permission to build a road or school. Our infrastructure would be in the dark ages.”
States have long recognized the vested interest they have in maintaining the financial stability and health of their political subdivisions.
One traditional policy approach has been to set debt limits on municipal entities — either a set monetary amount or, more common in the Midwest, a percentage of assessed property values in the local taxing body.
Every state in the region has statutory or constitutional debt limits. The efficacy of these state laws can be limited, however. Michigan, for example, sets a debt limit of 10 percent for its cities, but as a recent Wall Street Journal article points out, exceptions to the law allowed Detroit to accumulate a “mountain of debt,” with the city spending more than 40 percent of its revenue on borrowing costs and retirement benefits.
When push comes to shove, too, states might not see any other choice than to raise the debt limit. In recent years (including with passage of HB 2420 in 2012), Kansas lawmakers have established a higher debt limit for the town of Junction City because of concerns that the local government would otherwise not be able to pay its bills.
Beyond debt limits, Spiotto says, many states have been taking a more hands-on approach to local governments in financial distress — and even those simply at risk of falling into distress.
“The earlier states can detect potential problems and start to help, the better off they are and the more constructive their help can be,” he notes.
Two years ago in Ohio, lawmakers passed HB 153, which includes a “fiscal caution” provision that gives the state auditor authority to provide technical assistance to a local entity found with problematic fiscal practices and budgetary conditions.
This recently enacted legislation added a third layer to Ohio’s plan for dealing with local governments in distress. After “fiscal caution” comes “fiscal watch,” when jurisdictions are required to come up with a financial plan reviewed and approved by the auditor.
The last layer is “financial emergency,” when a local entity is overseen by a state financial planning and supervision commission. There currently are 24 local governments in fiscal emergency.
Like Ohio, other states in the Midwest have plans to manage or oversee financially strapped municipalities (see table). In Illinois, state legislators two decades ago passed a law to help the town of East St. Louis. The city gets special state assistance in the form of loans and state bonding authority, while a five-member state board oversees the city’s finances.

Illinois also has a separate statute for towns in “fiscal emergency”; its provisions include intervention by a state commission to change local budgeting and debt issuance.
In 2012, Indiana lawmakers added a provision to its law establishing the position of a state-appointed emergency financial manager to oversee the finances of a local government in distress. Under HB 1192, this emergency manager cannot raise taxes, but he or she does have the power to cut spending, including through a renegotiation of labor contracts. (In contrast, the Illinois commission does not have the power to change existing labor agreements.)
Michigan’s 2011 change in its law became the subject of a statewide vote in 2012, in large part because of the broad powers granted to a state-appointed emergency manager (including the power to redo labor contracts). Michigan residents voted to repeal that law. The next month, the Legislature passed a new law (SB 865) that took effect earlier this year.
Under the statute now in place, a state review team and the governor decide if a financial emergency exists in a local unit of government. If such an emergency is determined, the local government is given one of four alternatives:
• enter into a consent agreement that addresses the emergency;
• have a state-appointed emergency financial manager act in place of the local governing body;
• agree to move forward with a “neutral evaluation process” involving negotiations between local government officials, creditors and other interested parties; or
• file for Chapter 9 bankruptcy.
Spiotto says the most effective state laws and programs find the right middle ground between adequate state oversight and local autonomy. On the issue of debt limits, for example, limits that are too high are useless, while those that are too restrictive can impede local control.
State intervention into local financial affairs works best, he adds, with buy-in from the community and its elected leaders.
“They don’t want someone coming in who doesn’t know the neighborhood, so to speak,” Spiotto says. “They want somebody to give them the technical advice, and then they can make the policy decision.”
For state legislatures, he has proposed creation of a Municipal Protection Commission to deal with financial emergencies in local government. This independent state commission would start by offering recommendations on how to resolve a fiscal emergency.
The recommendations would be voluntary and based on input from financial experts, local leaders, creditors, workers and other affected parties. If that first step didn’t work, the commission would then have the power to adopt a financial recovery plan, which could include a “pre-packaged” Chapter 9 plan.
“This recent economic downturn helped crystallize the necessity of dealing with these problems early and the importance of having a recovery plan,” Spiotto says. “It’s not only, how do you control your budget and expenditures, but how do you stimulate your tax revenues and create jobs?”