A confluence of factors, including high debt, spiraling pension obligations, and lower sales and property tax revenues, has forced more municipalities to face insolvency than any time since the 1930s. The two largest municipal bankruptcies in history — Jefferson County, Ala., and Detroit, Mich. — recently ended. With the economy improving, we may never see the wave of municipal bankruptcies some commentators predicted. However, major cases are still pending, many municipalities are struggling with depleted tax bases, and few state and local governments have come to grips with unfunded pension obligations.

Municipalities have several reasons not to file bankruptcy:

  • Many lack the option. The federal bankruptcy code requires state authorization for municipal filings, and about half the states do not allow municipalities to file. Other states impose limits and conditions.
  • Unlike commercial debtors, a municipality faces strict eligibility requirements. Bankruptcy is limited to municipalities that can prove they are insolvent, and that have tried to settle with creditors outside bankruptcy, if possible. Municipalities that do not comply get kicked out of court.
  • Bankruptcy is disruptive to the public and to the local economy, diverts resources from normal government functions, and costs a lot of money. Bankruptcy may harm a municipality’s reputation and limit access to the credit markets, even if the case is successful.

In contrast, a municipality has only one reason to file bankruptcy: it cannot pay its debts and state law remedies are not adequate.

Accordingly, no municipality files bankruptcy lightly. When the municipality acts in good faith, other parties should respond in kind.

For example, ratings agencies should recognize that bankruptcy is not the cause of municipal default. Checking into the hospital does not cause a patient’s illness. Bankruptcy allows a municipality to fix its balance sheet and enhance its credit. Ratings agencies should not penalize debtors for seeking the cure of bankruptcy, but focus on the underlying economics of the debt, which bankruptcy may improve.

Similarly, creditors should consider whether bankruptcy presents a positive opportunity. To be in bankruptcy, a municipality must prove it is unable to pay its debts when due. In these circumstances, trying to block or opt out of the bankruptcy is not constructive. In recent cases, creditors have challenged the debtor’s right to file bankruptcy and have argued that state law prevents their debt from being impaired in bankruptcy — unsuccessfully and at enormous expense. After litigating, creditors in Detroit and Jefferson County took up the hard work of settlement. Each case resulted in confirmation of a consensual plan.

Because municipal defaults are rare, creditors often assume municipal debt cannot be impaired. State law does not allow the impairment of a bond, a collective bargaining agreement, or a pension. But state law does not allow impairment of any contract — a commercial debtor cannot impair a promissory note any more than a municipal debtor can impair a bond or a pension obligation. Bankruptcy is different. All debtors can impair contracts under federal bankruptcy jurisdiction. Municipal creditors have advanced various arguments why the impairment of contracts in bankruptcy should not apply to them, but the courts generally have rejected these arguments.

Efforts to exempt debts from bankruptcy miss the larger point. Although no creditor wants its rights affected, restructuring debt sometimes is necessary to achieve a global settlement and maximize returns to the whole. When the municipality does not have enough money to pay its debts, denying access to bankruptcy is no answer. Creditors should accept reality and take advantage of the process to restructure claims on terms the debtor can perform.

The commercial lending industry learned this lesson decades ago. Commercial creditors generally do not oppose bankruptcy filings and rarely argue that state law prevents impairment in bankruptcy. The parties do not waste time and money litigating fundamental issues. Commercial bankruptcy has become an efficient means of maximizing enterprise value, often through the sale of the debtor’s assets. Although liquidation is not an option for a city or county, healthcare authorities and other single purpose instrumentalities may sell themselves as going concerns.

Another feature of bankruptcy is that restructuring plans can be confirmed without the agreement of all creditors. Most indentures, for example, require 100 percent bondholder approval of any modification, which means workouts often are not feasible out of court. Commercial lenders understand the benefits of being able to bind recalcitrant or absent minorities with a majority vote. Impossible deals become possible, and creditors can negotiate the best solution available under the circumstances.

Municipalities that can pay their debts should. When there is not enough money, however, bankruptcy may present the best alternative. Creditors should take a page from their commercial counterparts and embrace the process.

This article first appeared in American City & County on February 11, 2015.