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ARTICLES
Fiscal Federalism, Political Will, and Strategic Use of Municipal Bankruptcy
Clayton P. Gillette
Municipalities in fiscal distress may seek to adjust debts under Chapter 9 of the
Bankruptcy Code either because they are truly destitute or because they lack the political
will to adopt difficult resource adjustments. Local officials of municipalities that enter
bankruptcy proceedings nevertheless retain political authority over municipal fiscal
affairs. The decision to enter bankruptcy, however, may have significant financial
consequences for other municipalities or for more centralized levels of government.
Those externalities induce central governments to consider bailouts for distressed
municipalities. In order to avoid moral hazard problems, central governments typically
impose harsh restrictions on local officials as a condition of bailout. This dual system of
rescue for distressed municipalities—bailouts and bankruptcy—permits local officials to
threaten to file under Chapter 9 and thus to impose costs on central governments, unless
the latter modify the conditions of bailouts. In this Article, I suggest that allowing
bankruptcy courts to impose resource adjustments serves to neutralize the strategic
behavior of local officials and thus encourages localities to internalize the costs of their
activities in a manner more consistent with the tenets of fiscal federalism.
INTRODUCTION .................................................. .................................................. ................. 284
I. THE DOCTRINAL BACKGROUND .................................................. ................................. 290
II. MUNICIPAL FINANCE AND MUNICIPAL EXTERNALITIES ......................................... 299
A. Federal Relief and the Federal Fiscal Commons ................................... 299
B. Centralized Relief and the Risk of Contagion ........................................ 303
C. The Primacy of State Intervention .................................................. .......... 309
D. The Consequences for Central Governments of Potential Bailouts ... 311
III. THE STRATEGIC USE OF MUNICIPAL BANKRUPTCY ............................................... 320
A. Local Incentives to Exploit Bankruptcy .................................................. . 320
B. State Self-Help against Municipal Opportunism .................................... 326
C. Limitations on the Judicial Power to Impose Resource
Adjustments .................................................. ................................................. 327
IV. A NOTE ON STRATEGIC USE OF BANKRUPTCY BY THE STATES ............................ 329
CONCLUSION........................................ .................................................. ............................... 331
† Max E. Greenberg Professor of Contract Law, New York University School of Law.
Thanks to Ken Ayotte, Barry Adler, Oren Bar-Gill, G. Allen Bass, Ed DeSeve, Lee
Fennell, Rick Hills, Omer Kimhi, Daryl Levinson, Julie Roin, David Skeel, and participants in
workshops at New York University School of Law and the University of Chicago Law School.
284 The University of Chicago Law Review [79:283
INTRODUCTION
After an unfortunate investment in derivatives in the 1990s
caused substantial losses to the treasury of Orange County,
California, residents had the opportunity to facilitate exit from
bankruptcy by enacting a ten-year, half-cent increase in the county
sales tax.1 They declined. They apparently preferred that losses be
borne by holders of debt secured by Orange County revenues,
which, in the absence of a tax increase, could prove insufficient to
pay debt service.2 In 2008, the city of Vallejo, California, filed for
bankruptcy in order to reject collective bargaining agreements, the
costs of which constituted $79.4 million of its $95 million budget.3
The district court noted that the city council had consistently refused
to seek electoral approval for tax increases, even though Vallejo had
the lowest sales tax in its geographic area.4 In the summer of 2010,
the mayor of Harrisburg, Pennsylvania, declared that the city would
default on a scheduled $3.3 million bond payment.5 To the argument
that the city could instead have cut services, the mayor responded,
“To disrupt [services] because we can’t make a bond payment would
just be unconscionable. And as a leader I couldn’t do it.”6
Harrisburg’s city council subsequently rejected a proposed financial
recovery plan proffered under a state plan for distressed localities on
the grounds that it imposed too great a burden on taxpayers.7 When
the mayor and the state persisted in pursuing a bailout plan that
required the sale or lease of city assets, the city council voted to file
for bankruptcy.8
1 Mark Baldassare, When Government Fails: The Orange County Bankruptcy 151–60
(California 1998).
2 Id at 159–60.
3 In re City of Vallejo, 408 BR 280, 287 (BAP 9th Cir 2009). The city has recently
proposed a plan under which it would pay unsecured creditors between 5 and 20 percent of
their claims. See Randall Jensen, Vallejo Offers 5–20 Cents on the Dollar, Bond Buyer 1, 6 (Jan
20, 2011).
4 In re City of Vallejo, 2008 WL 4146015, *10, 12 (Bankr ED Cal).
5 Romy Varghese, Harrisburg Surrender: Why Pennsylvania’s Capital Skipped Its Debt
Payment, Wall St J C1 (Sept 8, 2010).
6 Id (alteration in original).
7 See Paul Burton, Harrisburg Rips Up Its Blueprint for Recovery: Council Backtracks;
Mayor Eyes Moves, Bond Buyer 1, 6 (July 21, 2011).
8 See Michael Corkery and Kris Maher, Capital Files for Bankruptcy: In Fight with State,
Harrisburg, Pa., Rejects Governor-Backed Plan to Sell Assets, Wall St J A3 (Oct 13, 2011). The
bankruptcy court subsequently dismissed the bankruptcy petition on the grounds that the city
council lacked authority to commence the case and the city had not been specifically
authorized under state law to be a debtor under the Bankruptcy Code. In re City of Harrisburg,
2011 WL 6026287, *15 (Bankr MD Pa).
2012] Fiscal Federalism and Municipal Bankruptcy 285
These refusals of fiscally distressed municipalities to accept
higher taxes or reduced services (I will refer to these options
collectively as “resource adjustments”) to satisfy obligations that
they have come to regret have multiple plausible explanations.9 They
may reflect actual fiscal incapacity to pay existing obligations.
Resource adjustments, that is, could be self-defeating because any
such effort will generate sufficient exit by current firms and residents
that net revenues will actually decline.10 Alternatively, failure to fund
obligations could be the consequence of an absence of political will
rather than of fiscal incapacity. Refusal to accept resource
adjustments may result from residents’ justifiable indignation that
political officials incurred obligations in the locality’s name
notwithstanding reasonable expectations that costs would ultimately
exceed municipal benefits. Both debts incurred to fund capital
projects that have proven burdensome (an incinerator in the case of
Harrisburg) and agreements to provide generous pensions to public
employees arguably fall within this category. Mark Baldassare
reports that substantial opposition to the Orange County sales tax
increase came from residents who viewed it as a means of paying for
the “mistakes” of county officials.11 While turning the responsible
officials out of office may provide a more highly targeted means of
chastisement, the binary nature of voting, the low likelihood that the
officials of distressed cities will run for reelection, and the common
perception that officials betrayed the trust of the electorate suggest
that residents believe repudiation of onerous obligations is
appropriate.
Perhaps less benignly, municipalities that could bear resource
adjustments may refuse to fund obligations because residents regret
having taken a risk that subsequently materialized and believe that
relief from another source—a more centralized government or the
creditors themselves—is plausible. Bailout or bankruptcy, that is,
may be seen as a viable alternative to resource adjustments. Eric
Monkkonen’s study of late nineteenth-century municipal defaults,
largely precipitated by overinvestment in railroad aid and other
“internal improvements,” concluded that localities systematically
could afford to avoid default but preferred to impose the costs of
9 The examples above are not exhaustive of recent efforts to avoid debt. Residents of
Mount Clemens, Michigan, defeated a proposal to increase tax rates in November 2010,
notwithstanding the city’s $1 million deficit. See Nick Bunkley, Debt Rising, a City Seeks
Donations in Michigan, NY Times A10 (Nov 20, 2010).
10 See Andrew Haughwout, et al, Local Revenue Hills: Evidence from Four U.S. Cities,
86 Rev Econ & Stat 570, 582–83 (2004).
11 See Baldassare, When Government Fails at 147–48 (cited in note 1).
286 The University of Chicago Law Review [79:283
imprudently incurred obligations on creditors rather than to require
that residents bear them.12
If municipal distress implicated little more than the relationships
between municipalities and their creditors, we might address the
issue as a variation on fiscal difficulties suffered by individuals or
firms. Indeed, that has been the approach of most of the literature
that has considered the provisions for municipal debt adjustment
under Chapter 9 of the Bankruptcy Code.13 In this Article, however, I
contend that the options available to fiscally distressed municipalities
are properly examined under the lens of fiscal federalism, as well as
under standard perspectives on debtor insolvency, because the
conduct of municipalities necessarily affects the fiscal stability of
more centralized governments. Whether default on municipal debt
arises from fiscal incapacity or the absence of political will may
therefore have implications for the proper role of federal law and
federal actors in the face of threatened or actual default.
Specifically, fiscal federalism and the motivation for municipal
default have implications for the vexing issue of whether bankruptcy
courts can or should require resource adjustments for residents of
municipalities that seek to adjust their debts under Chapter 9.
Several years ago, Michael McConnell and Randal Picker proposed
that bankruptcy courts do indirectly what they could not do directly
by using the authority to reject or confirm a municipal debt
adjustment plan in order to induce the debtor municipality to levy
taxes on its residents, even if the same court had no authority to
order the same increase.14 The McConnell-Picker suggestion was part
of their broader claim that municipal bankruptcy proceedings should
more closely resemble bankruptcy proceedings that relate to firms,
and that, in particular, they should include grants of power “to force
politically unpopular, but sensible, decisions such as elimination of
municipal functions, privatization, and changes in tax law,”15 or to
force more efficient forms of municipal organization.16 Others
subsequently disagreed, though primarily with the proposed solution
rather than with the problem of constraining municipalities from
12 Eric H. Monkkonen, The Local State: Public Money and American Cities 69–77
(Stanford 1995).
13 11 USC § 901 et seq (2008).
14 Michael W. McConnell and Randal C. Picker, When Cities Go Broke: A Conceptual
Introduction to Municipal Bankruptcy, 60 U Chi L Rev 425, 474 (1993).
15 Id at 472.
16 Id at 470.
2012] Fiscal Federalism and Municipal Bankruptcy 287
strategically using bankruptcy to avoid the claims of creditors.17
Omer Kimhi, for instance, would restrict the scope of bankruptcy to
avoid holdout problems and would leave rehabilitation efforts to
state political and financial processes,18 while Kevin Kordana would
allow municipalities relatively free rein, within the confines of state
law, to make decisions about the propriety and costs of default,
constrained only by marketplace sanctions.19
Because these analyses treat the potential federal and state
means of redress for municipal distress as independent alternatives,
they ignore the interactions between them. Federal bankruptcy and
federal or state bailouts allocate losses from municipal fiscal distress
differently. If debts are adjusted under federal bankruptcy law,
creditors bear much of the cost of fiscal distress, while municipalities
bear no obligation to alter the policies that generated the crisis. If
bailouts occur, creditors are more likely to recover their expected
payments; the loss will initially fall on the government that provides
funds, although the terms of the bailout may require repayment of
funds, reorganization of municipal functions, or both. Even within
the realm of bailouts, federal and state governments occupy very
different positions with respect to their capacity to dictate terms of
relief to distressed municipalities. States exercise plenary authority
over their political subdivisions and thus have broad legal authority
to create mechanisms to address fiscal distress.20 Both institutional
capacity and principles of federalism suggest that the federal
government is less able to monitor or dictate the performance of
municipalities.
But the fact that different avenues for dealing with municipal
distress impose different costs does not mean that the choice among
them in any particular situation will be optimal. To the contrary, the
availability of multiple options plausibly allows local officials to act
strategically in using or threatening to exploit alternative means of
relief. To the extent that they can select among alternatives, those
localities that lack political will rather than fiscal capacity may be
able to avoid affordable, if painful, resource adjustments. That
possibility arises from the likelihood that the preferences of local
officials over the source and terms of relief differ from the
17 See, for example, Kevin A. Kordana, Tax Increases in Municipal Bankruptcies, 83 Va
L Rev 1035, 1106–07 (1997). See also Omer Kimhi, Reviving Cities: Legal Remedies to
Municipal Financial Crises, 88 BU L Rev 633, 653 (2008).
18 See Omer Kimhi, Chapter 9 of the Bankruptcy Code: A Solution in Search of a
Problem, 27 Yale J Reg 351, 362–65, 385–89 (2010).
19 See Kordana, 83 Va L Rev at 1106–07 (cited in note 17).
20 See Lynn A. Baker and Clayton P. Gillette, Local Government Law: Cases and
Materials 237–48 (Foundation 4th ed 2010).
288 The University of Chicago Law Review [79:283
preferences of more centralized governments. For instance, if states
are relatively well positioned to deal with local fiscal distress, albeit
at some cost to local officials, it may be preferable to push localities
away from federal bankruptcy and into state programs. But if
bankruptcy is a plausible option for distressed municipalities, and a
more attractive one than centralized bailouts that constrain local
political authority, then local officials may use the threat of
bankruptcy to reduce the conditions that states place on a proposed
bailout. Indeed, local officials may be imperfect agents of their own
constituents and make decisions that serve personal political
objectives rather than the interests of either residents or the broader
public.
The strength of the municipal threat to act strategically depends
on the motivations of centralized officials to resolve municipal fiscal
distress. Those motivations emanate from numerous sources.
Centralized governments (both the state of which the municipality is
a subdivision and, in some cases, the federal government) may fear
that municipal default will implicate the budgets of other
municipalities or of the centralized governments themselves, either
because those other governments will be required to expend
resources to relieve the distressed locality or because distress of one
locality is perceived as a signal of imminent distress elsewhere.
Ideally, markets would distinguish between distressed and
nondistressed entities; nevertheless, there appears to be substantial
evidence of contagion that flows from distressed to healthy debtors.21
Alternatively, centralized governments may intervene out of fear
that municipal distress is sufficiently correlated with other economic
risks such that otherwise unproblematic municipal defaults would
trigger more systemic risks. Thus, for some localities and under some
circumstances, markets may perceive municipal obligations as
including an implicit guarantee that centralized governments will
take measures necessary to provide rescue in the event of fiscal
distress. Any implicit guarantee obviously assists the debtor
municipality in the form of lower interest rates for debt issuance. But
it simultaneously induces risk taking by municipalities, the downside
of which is borne by the guarantor. Failure of the centralized
government to satisfy expectations of rescue could then be viewed as
21 See, for example, Mardi Dungey, et al, Contagion in International Bond Markets
during the Russian and the LTCM Crises, 2 J Fin Stability 1, 19 (2006); John M. Halstead,
Shantaram Hegde, and Linda Schmid Klein, Orange County Bankruptcy: Financial Contagion
in the Municipal Bond and Bank Equity Markets, 39 Fin Rev 293, 295–99, 313 (2004).
2012] Fiscal Federalism and Municipal Bankruptcy 289
further evidence of widespread crisis.22 Indeed, the problem creates
somewhat of an infinite regress, because the very likelihood of
centralized intervention induces localities to incur more and riskier
debts than would otherwise be the case, hence increasing the
likelihood that fiscal distress, and the need for centralized
intervention, will emerge. The result, however, is that central
governments that need to avoid “fiscal pollution”23 or systemic risks
can be vulnerable to the opportunism of local officials.
It is in this sense that fiscal federalism becomes an important
consideration in the resolution of municipal financial distress. As a
general proposition, fiscal federalism requires each level of
government to internalize both the costs and the benefits of its
activities.24 Centralized governments should, therefore, subsidize
decentralized governments only to control negative spillovers of
local activity or to induce activities that generate positive spillovers.
Concomitantly, decentralized governments should be discouraged
from engaging in activities that impose adverse external effects. In at
least some cases of fiscal distress, however—primarily those
involving localities that have substantial state or national
importance—municipalities can externalize some costs of
idiosyncratic choices or local public goods onto more centralized
levels of government or creditors. As a result, municipalities have
tendencies both to overgraze on the commons of more centralized
budgets and to avoid the exercise of political will to satisfy the debts
they incur. The current legal structure for addressing municipal fiscal
distress may interfere with, rather than advance, the objectives of
fiscal federalism insofar as it insulates local decisions from
centralized influence and reduces the need for distressed localities to
internalize the consequences of fiscal decisions. The result is that
while theories of federalism typically focus on the security that
decentralization confers against an onerous centralized government,25
the capacity of subnational governments to exploit the financial
strength of more central governments raises the possibility that the
22 See Bethany McLean and Joe Nocera, All the Devils Are Here: The Hidden History of
the Financial Crisis 47–51 (Penguin 2010) (discussing how the market’s treatment of privately
held, but federally chartered, government-sponsored enterprises allowed them to issue debt as
if it were supported by an implicit federal guarantee and induced the government ultimately to
intervene as if actual guarantees existed).
23 I thank Eric Posner for the felicitous phrase.
24 See Wallace E. Oates, Toward a Second-Generation Theory of Fiscal Federalism,
12 Intl Tax & Pub Fin 349, 350–54 (2005); David A. Super, Rethinking Fiscal Federalism,
118 Harv L Rev 2544, 2571–79 (2005); Clayton P. Gillette, Fiscal Federalism and the Use of
Municipal Bond Proceeds, 58 NYU L Rev 1030, 1065–66 (1983).
25 See Oates, 12 Intl Tax & Pub Fin at 352–53 (cited in note 24). See also Super, 118 Harv
L Rev at 2556–58 (cited in note 24).
290 The University of Chicago Law Review [79:283
latter require protection from the former. The claim of this Article is
that judicially imposed resource adjustments may be used as a means
of providing such protection by reducing the incentives of
municipalities to exploit bankruptcy proceedings strategically.
The next Part of this Article discusses the doctrinal background
for municipal bankruptcy. Part II introduces the nature of the fiscal
commons, the risk of financial contagion, and the interests of state
and federal governments in responding to fiscal distress in
decentralized jurisdictions. Part III develops the claim concerning
the incentives of distressed localities strategically to exploit
centralized jurisdictions and the capacity of federal bankruptcy
courts to neutralize that behavior. Part IV adds a brief note on the
application of the analysis to the current debate about permitting
states to file for bankruptcy under federal law.
I. THE DOCTRINAL BACKGROUND
It is tempting to treat the refusal of distressed municipalities to
adjust resources as little more than the implementation of an implicit
risk allocation in the original bargain between localities and their
creditors. Municipal governments, like other borrowers, receive
extensions of credit in return for a promise to repay principal with
interest. Typically, municipal bankruptcy is precipitated by actual or
imminent default on general obligation debts, in which that promise
is secured by the general tax revenues of the debtor municipality.26
But promises to repay are subject to background legal rules and
contractual limitations. Even municipalities that have the capacity to
pay debts may be able to deploy those terms to avoid repayment.
Outside bankruptcy, some municipal debtors have successfully
contended that, under state law, a contractual pledge of their faith
and credit, which is typically incorporated into municipal promises to
repay debts payable from general taxes, means little more than an
obligation to exercise good faith in making payments.27 On this
26 See Robert S. Amdursky and Clayton P. Gillette, Municipal Debt Finance Law:
Theory and Practice 25–29 (Little, Brown 1992). See also Daniel Bergstresser and Randolph
Cohen, Why Fears about Municipal Credit Are Overblown *17–18 (unpublished manuscript,
June 2011), online at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836678 (visited Nov
15, 2011).
27 See State v City of Lakeland, 16 S2d 924, 925 (Fla 1944) (en banc) (holding that a city’s
pledge of “‘full faith, funds, property, credit, and resources’ did “no more, in legal effect, than
express an undertaking by the city to be irrevocably obligated, in good faith, to use such of its
resources and taxing power as may be authorized or required by law for the full and prompt
payment of the principal and interest of the obligation”). The court’s conception of an
“undertaking,” especially modified by the “good faith” limitation, arguably falls short of an
absolute promise of payment. Id at 925–26.
2012] Fiscal Federalism and Municipal Bankruptcy 291
understanding, if the locality can make payments only by reducing
essential services below a level of “public necessity,” then residents
arguably prevail over creditors.28
Other jurisdictions have proven harsher. The New York Court
of Appeals rejected a state-authorized moratorium on payments of
New York City notes on the grounds that it conflicted with state
constitutional provisions that required debt service to be paid even if
constitutional tax limits had to be exceeded.29 But in an era in which
mortgagors on underwater properties are encouraged to mail their
keys back to the mortgagee rather than continue to make payments,30
and distressed corporations obtain federal bailouts, there initially
seems little reason to distinguish cities that have been overly
optimistic about future revenues when investing in credit default
swaps, economic development, or collective bargaining agreements.31
If the background rules or contractual terms against which creditors
extended credit do not obligate the debtor to impose resource
adjustments, then no impropriety attaches to a decision to forgo
them; instead, that decision only constitutes an exercise of the option
created by the bargain, and one for which creditors were presumably
paid at the time that the bargain was struck.
A locality might avoid resource adjustments notwithstanding
default, for instance, where it has pledged to use tax revenues for
debt service only on satisfaction of certain conditions, even where
fulfillment of the conditions lies entirely within the its own
discretion. That has been the history of so-called “subject to
appropriation” debt, in which municipalities agree to pay debt
service for capital projects only if the local legislature makes the
necessary annual appropriation for that purpose.32 It might seem
28 See, for example, DeFoe v Town of Rutherfordton, 122 F2d 342, 345 (4th Cir 1941).
29 See Flushing National Bank v Municipal Assistance Corp, 358 NE2d 848, 851–52 (NY 1976).
30 See Brent T. White, The Morality of Strategic Default, 58 UCLA L Rev Discourse 155,
156 (2010), online at http://uclalawreview.org/pdf/discourse/58-8.pdf (visited Nov 13, 2011).
31 See Gretchen Morgenson, The Swaps that Swallowed Your Town, NY Times BU1
(Mar 7, 2010). See also Michael Cooper and Mary Williams Walsh, Mounting Debts by States
Stoke Fears of Crisis, NY Times A1 (Dec 5, 2010); Leslie Wayne, Localities Want U.S. to
Support Muni Bonds, NY Times B1 (May 26, 2009).
32 See, for example, Colleton County Taxpayers Association v School District of Colleton
County, 638 SE2d 685, 690 (SC 2006) (holding that a school district may incur general
obligation debt “provided the school district remains within the constitutional and statutory
limits”); Moschenross v St. Louis County, 188 SW3d 13, 20 (Mo App 2006):
The agreement in the present case was merely to request annual appropriations for
repayment of the bonds, subject to the approval of the county council. Therefore, the
performance of the contract depends upon action by the county council before any
unconditional indebtedness arises. This is distinguishable from an absolute agreement to
incur debt, which has been determined to violate the debt-limitation provisions of Article
VI, section 26 of the constitution.
292 The University of Chicago Law Review [79:283
peculiar for creditors to grant such latitude to the debtor
municipality, unless the market perceives the promise to consider
appropriating funds as tantamount to a commitment to make the
necessary appropriations. Investors might view the form of the
transaction as necessary to satisfy legal requirements unrelated to
the payment obligation, such as the desire to circumvent state
constitutional debt limitations by removing a legal but not a practical
obligation to make payment. Investors could reasonably conclude
that a locality that initially financed capital projects in this manner
would continue to finance the debt primarily out of concern that it
would otherwise jeopardize its return to the capital markets.33 But if
no such obligation exists as a legal matter, it is also plausible that
localities would lack the political will to incur resource adjustments
for projects that turned out to be inopportune.34 In the absence of a
legal obligation to pay the debt, there would be little reason for a
court to alter the bargain by requiring a distressed locality to make
such appropriations. The situation for municipalities’ lenders would
be no different than that of a mortgagee who discovers that a
mortgagor in a nonrecourse jurisdiction, that is, one that disallows
personal actions against the mortgagor to recover any deficit
between the outstanding indebtedness and the value of the
foreclosed home, has decided to cease payments and pay the
statutorily designated liquidated damages of the value of the home,
Drury v City of Cape Girardeau, 66 SW3d 733, 740 (Mo 2002) (en banc). The New Jersey
Supreme Court initially expressed skepticism about the propriety of the practice, noting that
the market treated “subject to appropriation” as the equivalent of general obligation debt to
which issuers have pledged their faith and credit. See Lonegan v State, 809 A2d 91, 101, 107–09
(NJ 2002). But the court subsequently determined that the constitutional debt limitation
applied only when the state is legally obligated to make payments. Lonegan v State, 819 A2d 395,
402–03 (NJ 2003).
33 See, for example, Lonegan, 809 A2d at 128 (Stein concurring in part and dissenting in
part), quoting Revised Lease and Appropriation-Backed Debt Rating Criteria 1 (Standard & Poor’s
June 12, 2001):
Finally, while appropriation-backed bonds are not considered debt under a strict legal
definition, Standard & Poor's considers all appropriation-backed bonds of an issuer to be
an obligation of that issuer and a failure to appropriate will result in a significant credit
deterioration for all types of debt issued by the defaulting government.
34 Indeed, that appears to be the issue in current litigation involving a default by the city
of Menasha, Wisconsin, on bond anticipation notes issued to finance a steam plant. The notes
were secured in part by the city’s promise to appropriate funds out of its annual general tax
levy to pay any deficiency that resulted if the steam plant generated insufficient revenues for
debt service. But that promise was subject to annual appropriation from the budget, and the
city refused to make the requisite appropriation. The market presumably considers such debts
as mechanisms for avoiding constitutional debt limitations, but not a limitation on a general
obligation to pay debts, since any locality refusing to make payments would have difficulty in
subsequent borrowings. Nevertheless, Menasha apparently called the market’s bluff. See
Yvette Shields, Investors: All Eyes on Menasha, Wis., Steam-Plant Lawsuit, Bond Buyer 5
(Sept 9, 2010).
2012] Fiscal Federalism and Municipal Bankruptcy 293
notwithstanding financial ability to continue making payments. The
perceived failure of political will might cause consternation to future
residents when the locality sought to reenter the credit markets, but
fiscal prudence is not the measure of legal obligation.
The defaults that give rise to a municipality filing for debt
adjustment under Chapter 9, however, typically involve obligations
that allegedly cannot be paid as a financial matter, rather than
because of any contractual defense.35 Where municipalities have
pledged their faith and credit to repay the defaulted debts, creditors
are likely to insist that resource adjustments be imposed to permit
payments.36 In the face of municipal recalcitrance, creditor success
depends in large part on the background rules of the bankruptcy
regime. In theory, a municipal bankruptcy regime could permit
judges to overcome any failure of political will and require localities
to adjust resources to pay affordable, if unpopular, obligations. As a
doctrinal matter, however, the existing bankruptcy regime appears to
preclude any such intervention. Section 904 of Chapter 9 explicitly
bars the court, without the consent of the debtor, from interfering
with the political or governmental powers of the debtor municipality,
any of its property or revenues, or its use or enjoyment of any
income-producing properties.37 No court approval is necessary for the
municipality to continue to operate as its political leaders determine,
or even to borrow additional funds.
This noninterference principle implies that the objective of
Chapter 9 is simply to allow a financially distressed city to
restructure its monetary obligations, not to restructure the city
government or to liquidate its assets for the benefit of creditors.
More implicit signals exist to the same effect. Omer Kimhi has noted
that the absolute priority rule, which precludes junior creditors from
obtaining any payout in bankruptcy before senior creditors have
been fully satisfied, acts as a substantial check on shareholder
35 Jonas Elmerraji, What Happens When Cities Go Broke? In a Tough Economy,
Bankruptcy Has Become a Dreaded—Yet Not Uncommon—Phenomenon, Even for Cities and
Municipalities, Forbes (July 2, 2010), online at http://www.forbes.com/2010/07/02/when-citiesgo-
broke-personal-finance-municipal.html (visited Nov 13, 2011).
36 See, for example, In re City of Vallejo, 2008 WL 4146015, *6–7, 12, 16–18, 29–30
(Bankr ED Cal).
37 The relevant provision, 11 USC § 904, reads as follows:
Notwithstanding any power of the court, unless the debtor consents or the plan so
provides, the court may not, by any stay, order, or decree, in the case or otherwise,
interfere with—
(1) any of the political or governmental powers of the debtor;
(2) any of the property or revenues of the debtor; or
(3) the debtor’s use or enjoyment of any income-producing property.
294 The University of Chicago Law Review [79:283
reluctance to pay creditors in corporate bankruptcy.38 The absolute
priority rule requires that shareholders pay the debts of both secured
and unsecured creditors in full before they can retain any of their
own interest in the firm. Although the absolute priority rule applies
in municipal bankruptcy as a formal matter,39 its application in that
setting has little of the constraining effect that it creates in corporate
bankruptcies. As Kimhi argues, since municipal residents are not
considered shareholders or creditors of the locality, their demands
for municipal services can be satisfied prior to creditors’ demands for
payment without violating the priority of the latter.40 Residents,
therefore, can demand continued operation of fire, police, school,
and waste-disposal services before any municipal funds are dedicated
to creditors. Indeed, the likelihood that judges would refuse to
subordinate residents’ interests in public services to the demands of
creditors may increase localities’ ability to obtain concessions from
the latter.41 The effect is that municipal bankruptcy serves as a
mechanism by which localities can obtain the equivalent of the fresh
start available to individuals in bankruptcy, rather than the “efficient
reconfiguration of assets” characteristic of corporate bankruptcy.42
The underlying assumption appears to be that localities should be
preserved in their current form, free from judicial reorganization,
notwithstanding that they thereby became financially overextended.
Perhaps the underlying rationale is that the alternative of dedicating
tax revenues to creditors, rather than to municipal activities, will
dilute residents’ incentives to engage in municipally productive
behavior and will interfere with municipal officials’ efforts to provide
the local public goods that justify municipal incorporation in the first
instance.43 More doctrinally, some suggest that the noninterference
principle preserves the constitutionality of a federal bankruptcy law
directed at municipalities by minimizing the role of federal actors in
matters best left to state consideration.44
But the apparently clear rule that the court may not require
resource adjustments becomes more opaque once one considers the
38 See Kimhi, 88 BU L Rev at 652 (cited in note 17).
39 See 11 USC § 901 (incorporating into Chapter 9 the absolute priority rule of 11 USC
§ 1129(b)(2)).
40 See Kimhi, 88 BU L Rev at 652 (cited in note 17).
41 See, for example, Martin Shefter, Political Crisis Fiscal Crisis: The Collapse and
Revival of New York City 106–07 (Columbia 1992).
42 McConnell and Picker, 60 U Chi L Rev at 468–70 (cited in note 14).
43 See Kimhi, 88 BU L Rev at 653–54 (cited in note 17) (explaining that both the court
and creditors are subject to the tax rates submitted by the municipality in its proposed
bankruptcy plan).
44 See, for example, In re New York City Off-Track Betting Corp, 427 BR 256, 264–65
(Bankr SDNY 2010); In re City of Vallejo, 403 BR 72, 75–76 (Bankr ED Cal 2009).
2012] Fiscal Federalism and Municipal Bankruptcy 295
discretion that a court does have to condition the grant of relief in
Chapter 9 on the political will of residents to accept them. Judicial
discretion is apparent at various stages of the bankruptcy inquiry.
First, only municipalities that are “insolvent” can file for adjustment
of their debts.45 Chapter 9 (unlike the rest of the Bankruptcy Code)
involves a cash-flow test under which a municipality is “insolvent” if
it is unable currently or prospectively to pay its bills as they become
due.46 The prospective element of the inquiry allows courts discretion
over the extent to which a municipality must deploy revenue-raising
capacity before it can claim inability to pay its debts as they become
due. For instance, the city of Bridgeport, Connecticut, failed the
“insolvency” test, even though it faced a $16 million deficit for its
current budget year, because it had access to a fund containing bond
proceeds sufficient to eliminate the deficit.47 Any withdrawals that
Bridgeport made from that fund, however, would have had to have
been repaid in future years,48 so that current withdrawals implied
subsequent use of the municipal taxing power to fund repayments.
The court might have agreed with Bridgeport that failure to provide
immediate relief simply deferred to the near future the city’s
inability to generate revenues sufficient to meet all its obligations.49
The court thus could have concluded that the prospective test was
satisfied. But the court instead required the prospective default to be
“imminent and certain,” and concluded that the current availability
of assets precluded satisfaction of that test.50
The second point at which judicial intervention is plausible
involves the statutory provision requiring that a municipality seeking
the protection of Chapter 9 first engage in good faith negotiations
with creditors.51 At least one court has considered it appropriate to
take into account willingness to increase taxes when evaluating the
municipality’s satisfaction of the good faith standard. In In re
Sullivan County Regional Refuse Disposal District,52 the court
concluded that districts composed of multiple municipal members
had not entered into good faith negotiations because the districts
failed to exercise their ability to assess their member municipalities
45 11 USC § 109(c)(3).
46 11 USC § 101(32)(C)(ii). See also In re City of Vallejo, 408 BR 280, 289–90 (BAP 9th
Cir 2009).
47 See In re City of Bridgeport, 129 BR 332, 337–39 (Bankr D Conn 1991).
48 Id at 337.
49 See id at 339.
50 Id at 337–38. For further discussion of the imminence requirement, see In re Hamilton
Creek Metropolitan District, 143 F3d 1381, 1386–87 (10th Cir 1998).
51 11 USC § 109(c)(5)(B).
52 165 BR 60 (Bankr D NH 1994).
296 The University of Chicago Law Review [79:283
for unpaid service fees owed to creditors.53 Those assessments would
have been paid from taxes assessed by the member municipalities on
their residents. While the court concluded that Chapter 9 did not
require municipal debtors “to demonstrate that they have fully
exercised their taxing powers to the maximum extent possible,”
failure to exercise their assessment authority at all precluded their
assertion of good faith.54
The third point at which judicial discretion can be exercised, and
the focal point of the McConnell-Picker argument, is at the stage of
confirming a plan for adjusting municipal debts. Confirmation is
permitted only if it serves the “best interests of creditors.”55 Even if
all classes of creditors do not accept the municipality’s proposal, a
court can confirm a plan that is “fair and equitable.”56 The “best
interests” and “fair and equitable” standards arguably are satisfied
only if the amount to be received by creditors under the plan is all
they can reasonably expect given the municipality’s circumstances.
The relevant circumstances, however, arguably include the fiscal
capacity of the debtor to bear additional resource adjustments. The
classic case cited for judicial supervision of the “best interests”
standard in the municipal context is Fano v Newport Heights
Irrigation District.57 In that case, a bondholder of a bankrupt
irrigation district appealed from a decree confirming a proposed
composition of indebtedness. The court concluded that even though
the district was insolvent in the sense that it did not have cash on
hand to pay interest, it was not insolvent “in the bankruptcy sense,”
as it owned “debt free” assets with a value that exceeded the
outstanding indebtedness.58 Those assets took the form of
improvements that the district had purchased with current funds that
could otherwise have been dedicated to the payment of debt service.
53 Id at 78–79.
54 Id.
55 11 USC § 943(b)(7). For an analysis of the “best interests” requirement and its
potential for use as a judicial tool, see McConnell and Picker, 60 U Chi L Rev at 465–67, 474–75
(cited in note 14). Other commentators have also noted the judicial discretion over municipal
resource adjustments inherent in determining whether the standard for confirmation has been
satisfied. See, for example, David L. Dubrow, Chapter 9 of the Bankruptcy Code: A Viable
Option for Municipalities in Fiscal Crisis?, 24 Urban Law 539, 582 (1992).
56 11 USC § 1129(b)(1). This provision is incorporated into Chapter 9 by 11 USC
§ 901(a).
57 114 F2d 563 (9th Cir 1940). Fano was cited, along with Kelley v Everglades Drainage
District, 319 US 415 (1943) (per curiam), in the legislative history of Chapter 9 to elucidate the
meaning of the “best interests” of creditors. See 124 Cong Rec 32403 (Sept 28, 1978) (Rep
Edwards). Commentators disagree on the extent to which those citations should control
application of the standard. Compare McConnell and Picker, 60 U Chi L Rev at 465–66 (cited
in note 14), with Kordana, 83 Va L Rev at 1060–66 (cited in note 17).
58 Fano, 114 F2d at 565–66.
2012] Fiscal Federalism and Municipal Bankruptcy 297
Fiscal Federalism, Political Will, and Strategic Use of Municipal Bankruptcy
Clayton P. Gillette
Municipalities in fiscal distress may seek to adjust debts under Chapter 9 of the
Bankruptcy Code either because they are truly destitute or because they lack the political
will to adopt difficult resource adjustments. Local officials of municipalities that enter
bankruptcy proceedings nevertheless retain political authority over municipal fiscal
affairs. The decision to enter bankruptcy, however, may have significant financial
consequences for other municipalities or for more centralized levels of government.
Those externalities induce central governments to consider bailouts for distressed
municipalities. In order to avoid moral hazard problems, central governments typically
impose harsh restrictions on local officials as a condition of bailout. This dual system of
rescue for distressed municipalities—bailouts and bankruptcy—permits local officials to
threaten to file under Chapter 9 and thus to impose costs on central governments, unless
the latter modify the conditions of bailouts. In this Article, I suggest that allowing
bankruptcy courts to impose resource adjustments serves to neutralize the strategic
behavior of local officials and thus encourages localities to internalize the costs of their
activities in a manner more consistent with the tenets of fiscal federalism.
INTRODUCTION .................................................. .................................................. ................. 284
I. THE DOCTRINAL BACKGROUND .................................................. ................................. 290
II. MUNICIPAL FINANCE AND MUNICIPAL EXTERNALITIES ......................................... 299
A. Federal Relief and the Federal Fiscal Commons ................................... 299
B. Centralized Relief and the Risk of Contagion ........................................ 303
C. The Primacy of State Intervention .................................................. .......... 309
D. The Consequences for Central Governments of Potential Bailouts ... 311
III. THE STRATEGIC USE OF MUNICIPAL BANKRUPTCY ............................................... 320
A. Local Incentives to Exploit Bankruptcy .................................................. . 320
B. State Self-Help against Municipal Opportunism .................................... 326
C. Limitations on the Judicial Power to Impose Resource
Adjustments .................................................. ................................................. 327
IV. A NOTE ON STRATEGIC USE OF BANKRUPTCY BY THE STATES ............................ 329
CONCLUSION........................................ .................................................. ............................... 331
† Max E. Greenberg Professor of Contract Law, New York University School of Law.
Thanks to Ken Ayotte, Barry Adler, Oren Bar-Gill, G. Allen Bass, Ed DeSeve, Lee
Fennell, Rick Hills, Omer Kimhi, Daryl Levinson, Julie Roin, David Skeel, and participants in
workshops at New York University School of Law and the University of Chicago Law School.
284 The University of Chicago Law Review [79:283
INTRODUCTION
After an unfortunate investment in derivatives in the 1990s
caused substantial losses to the treasury of Orange County,
California, residents had the opportunity to facilitate exit from
bankruptcy by enacting a ten-year, half-cent increase in the county
sales tax.1 They declined. They apparently preferred that losses be
borne by holders of debt secured by Orange County revenues,
which, in the absence of a tax increase, could prove insufficient to
pay debt service.2 In 2008, the city of Vallejo, California, filed for
bankruptcy in order to reject collective bargaining agreements, the
costs of which constituted $79.4 million of its $95 million budget.3
The district court noted that the city council had consistently refused
to seek electoral approval for tax increases, even though Vallejo had
the lowest sales tax in its geographic area.4 In the summer of 2010,
the mayor of Harrisburg, Pennsylvania, declared that the city would
default on a scheduled $3.3 million bond payment.5 To the argument
that the city could instead have cut services, the mayor responded,
“To disrupt [services] because we can’t make a bond payment would
just be unconscionable. And as a leader I couldn’t do it.”6
Harrisburg’s city council subsequently rejected a proposed financial
recovery plan proffered under a state plan for distressed localities on
the grounds that it imposed too great a burden on taxpayers.7 When
the mayor and the state persisted in pursuing a bailout plan that
required the sale or lease of city assets, the city council voted to file
for bankruptcy.8
1 Mark Baldassare, When Government Fails: The Orange County Bankruptcy 151–60
(California 1998).
2 Id at 159–60.
3 In re City of Vallejo, 408 BR 280, 287 (BAP 9th Cir 2009). The city has recently
proposed a plan under which it would pay unsecured creditors between 5 and 20 percent of
their claims. See Randall Jensen, Vallejo Offers 5–20 Cents on the Dollar, Bond Buyer 1, 6 (Jan
20, 2011).
4 In re City of Vallejo, 2008 WL 4146015, *10, 12 (Bankr ED Cal).
5 Romy Varghese, Harrisburg Surrender: Why Pennsylvania’s Capital Skipped Its Debt
Payment, Wall St J C1 (Sept 8, 2010).
6 Id (alteration in original).
7 See Paul Burton, Harrisburg Rips Up Its Blueprint for Recovery: Council Backtracks;
Mayor Eyes Moves, Bond Buyer 1, 6 (July 21, 2011).
8 See Michael Corkery and Kris Maher, Capital Files for Bankruptcy: In Fight with State,
Harrisburg, Pa., Rejects Governor-Backed Plan to Sell Assets, Wall St J A3 (Oct 13, 2011). The
bankruptcy court subsequently dismissed the bankruptcy petition on the grounds that the city
council lacked authority to commence the case and the city had not been specifically
authorized under state law to be a debtor under the Bankruptcy Code. In re City of Harrisburg,
2011 WL 6026287, *15 (Bankr MD Pa).
2012] Fiscal Federalism and Municipal Bankruptcy 285
These refusals of fiscally distressed municipalities to accept
higher taxes or reduced services (I will refer to these options
collectively as “resource adjustments”) to satisfy obligations that
they have come to regret have multiple plausible explanations.9 They
may reflect actual fiscal incapacity to pay existing obligations.
Resource adjustments, that is, could be self-defeating because any
such effort will generate sufficient exit by current firms and residents
that net revenues will actually decline.10 Alternatively, failure to fund
obligations could be the consequence of an absence of political will
rather than of fiscal incapacity. Refusal to accept resource
adjustments may result from residents’ justifiable indignation that
political officials incurred obligations in the locality’s name
notwithstanding reasonable expectations that costs would ultimately
exceed municipal benefits. Both debts incurred to fund capital
projects that have proven burdensome (an incinerator in the case of
Harrisburg) and agreements to provide generous pensions to public
employees arguably fall within this category. Mark Baldassare
reports that substantial opposition to the Orange County sales tax
increase came from residents who viewed it as a means of paying for
the “mistakes” of county officials.11 While turning the responsible
officials out of office may provide a more highly targeted means of
chastisement, the binary nature of voting, the low likelihood that the
officials of distressed cities will run for reelection, and the common
perception that officials betrayed the trust of the electorate suggest
that residents believe repudiation of onerous obligations is
appropriate.
Perhaps less benignly, municipalities that could bear resource
adjustments may refuse to fund obligations because residents regret
having taken a risk that subsequently materialized and believe that
relief from another source—a more centralized government or the
creditors themselves—is plausible. Bailout or bankruptcy, that is,
may be seen as a viable alternative to resource adjustments. Eric
Monkkonen’s study of late nineteenth-century municipal defaults,
largely precipitated by overinvestment in railroad aid and other
“internal improvements,” concluded that localities systematically
could afford to avoid default but preferred to impose the costs of
9 The examples above are not exhaustive of recent efforts to avoid debt. Residents of
Mount Clemens, Michigan, defeated a proposal to increase tax rates in November 2010,
notwithstanding the city’s $1 million deficit. See Nick Bunkley, Debt Rising, a City Seeks
Donations in Michigan, NY Times A10 (Nov 20, 2010).
10 See Andrew Haughwout, et al, Local Revenue Hills: Evidence from Four U.S. Cities,
86 Rev Econ & Stat 570, 582–83 (2004).
11 See Baldassare, When Government Fails at 147–48 (cited in note 1).
286 The University of Chicago Law Review [79:283
imprudently incurred obligations on creditors rather than to require
that residents bear them.12
If municipal distress implicated little more than the relationships
between municipalities and their creditors, we might address the
issue as a variation on fiscal difficulties suffered by individuals or
firms. Indeed, that has been the approach of most of the literature
that has considered the provisions for municipal debt adjustment
under Chapter 9 of the Bankruptcy Code.13 In this Article, however, I
contend that the options available to fiscally distressed municipalities
are properly examined under the lens of fiscal federalism, as well as
under standard perspectives on debtor insolvency, because the
conduct of municipalities necessarily affects the fiscal stability of
more centralized governments. Whether default on municipal debt
arises from fiscal incapacity or the absence of political will may
therefore have implications for the proper role of federal law and
federal actors in the face of threatened or actual default.
Specifically, fiscal federalism and the motivation for municipal
default have implications for the vexing issue of whether bankruptcy
courts can or should require resource adjustments for residents of
municipalities that seek to adjust their debts under Chapter 9.
Several years ago, Michael McConnell and Randal Picker proposed
that bankruptcy courts do indirectly what they could not do directly
by using the authority to reject or confirm a municipal debt
adjustment plan in order to induce the debtor municipality to levy
taxes on its residents, even if the same court had no authority to
order the same increase.14 The McConnell-Picker suggestion was part
of their broader claim that municipal bankruptcy proceedings should
more closely resemble bankruptcy proceedings that relate to firms,
and that, in particular, they should include grants of power “to force
politically unpopular, but sensible, decisions such as elimination of
municipal functions, privatization, and changes in tax law,”15 or to
force more efficient forms of municipal organization.16 Others
subsequently disagreed, though primarily with the proposed solution
rather than with the problem of constraining municipalities from
12 Eric H. Monkkonen, The Local State: Public Money and American Cities 69–77
(Stanford 1995).
13 11 USC § 901 et seq (2008).
14 Michael W. McConnell and Randal C. Picker, When Cities Go Broke: A Conceptual
Introduction to Municipal Bankruptcy, 60 U Chi L Rev 425, 474 (1993).
15 Id at 472.
16 Id at 470.
2012] Fiscal Federalism and Municipal Bankruptcy 287
strategically using bankruptcy to avoid the claims of creditors.17
Omer Kimhi, for instance, would restrict the scope of bankruptcy to
avoid holdout problems and would leave rehabilitation efforts to
state political and financial processes,18 while Kevin Kordana would
allow municipalities relatively free rein, within the confines of state
law, to make decisions about the propriety and costs of default,
constrained only by marketplace sanctions.19
Because these analyses treat the potential federal and state
means of redress for municipal distress as independent alternatives,
they ignore the interactions between them. Federal bankruptcy and
federal or state bailouts allocate losses from municipal fiscal distress
differently. If debts are adjusted under federal bankruptcy law,
creditors bear much of the cost of fiscal distress, while municipalities
bear no obligation to alter the policies that generated the crisis. If
bailouts occur, creditors are more likely to recover their expected
payments; the loss will initially fall on the government that provides
funds, although the terms of the bailout may require repayment of
funds, reorganization of municipal functions, or both. Even within
the realm of bailouts, federal and state governments occupy very
different positions with respect to their capacity to dictate terms of
relief to distressed municipalities. States exercise plenary authority
over their political subdivisions and thus have broad legal authority
to create mechanisms to address fiscal distress.20 Both institutional
capacity and principles of federalism suggest that the federal
government is less able to monitor or dictate the performance of
municipalities.
But the fact that different avenues for dealing with municipal
distress impose different costs does not mean that the choice among
them in any particular situation will be optimal. To the contrary, the
availability of multiple options plausibly allows local officials to act
strategically in using or threatening to exploit alternative means of
relief. To the extent that they can select among alternatives, those
localities that lack political will rather than fiscal capacity may be
able to avoid affordable, if painful, resource adjustments. That
possibility arises from the likelihood that the preferences of local
officials over the source and terms of relief differ from the
17 See, for example, Kevin A. Kordana, Tax Increases in Municipal Bankruptcies, 83 Va
L Rev 1035, 1106–07 (1997). See also Omer Kimhi, Reviving Cities: Legal Remedies to
Municipal Financial Crises, 88 BU L Rev 633, 653 (2008).
18 See Omer Kimhi, Chapter 9 of the Bankruptcy Code: A Solution in Search of a
Problem, 27 Yale J Reg 351, 362–65, 385–89 (2010).
19 See Kordana, 83 Va L Rev at 1106–07 (cited in note 17).
20 See Lynn A. Baker and Clayton P. Gillette, Local Government Law: Cases and
Materials 237–48 (Foundation 4th ed 2010).
288 The University of Chicago Law Review [79:283
preferences of more centralized governments. For instance, if states
are relatively well positioned to deal with local fiscal distress, albeit
at some cost to local officials, it may be preferable to push localities
away from federal bankruptcy and into state programs. But if
bankruptcy is a plausible option for distressed municipalities, and a
more attractive one than centralized bailouts that constrain local
political authority, then local officials may use the threat of
bankruptcy to reduce the conditions that states place on a proposed
bailout. Indeed, local officials may be imperfect agents of their own
constituents and make decisions that serve personal political
objectives rather than the interests of either residents or the broader
public.
The strength of the municipal threat to act strategically depends
on the motivations of centralized officials to resolve municipal fiscal
distress. Those motivations emanate from numerous sources.
Centralized governments (both the state of which the municipality is
a subdivision and, in some cases, the federal government) may fear
that municipal default will implicate the budgets of other
municipalities or of the centralized governments themselves, either
because those other governments will be required to expend
resources to relieve the distressed locality or because distress of one
locality is perceived as a signal of imminent distress elsewhere.
Ideally, markets would distinguish between distressed and
nondistressed entities; nevertheless, there appears to be substantial
evidence of contagion that flows from distressed to healthy debtors.21
Alternatively, centralized governments may intervene out of fear
that municipal distress is sufficiently correlated with other economic
risks such that otherwise unproblematic municipal defaults would
trigger more systemic risks. Thus, for some localities and under some
circumstances, markets may perceive municipal obligations as
including an implicit guarantee that centralized governments will
take measures necessary to provide rescue in the event of fiscal
distress. Any implicit guarantee obviously assists the debtor
municipality in the form of lower interest rates for debt issuance. But
it simultaneously induces risk taking by municipalities, the downside
of which is borne by the guarantor. Failure of the centralized
government to satisfy expectations of rescue could then be viewed as
21 See, for example, Mardi Dungey, et al, Contagion in International Bond Markets
during the Russian and the LTCM Crises, 2 J Fin Stability 1, 19 (2006); John M. Halstead,
Shantaram Hegde, and Linda Schmid Klein, Orange County Bankruptcy: Financial Contagion
in the Municipal Bond and Bank Equity Markets, 39 Fin Rev 293, 295–99, 313 (2004).
2012] Fiscal Federalism and Municipal Bankruptcy 289
further evidence of widespread crisis.22 Indeed, the problem creates
somewhat of an infinite regress, because the very likelihood of
centralized intervention induces localities to incur more and riskier
debts than would otherwise be the case, hence increasing the
likelihood that fiscal distress, and the need for centralized
intervention, will emerge. The result, however, is that central
governments that need to avoid “fiscal pollution”23 or systemic risks
can be vulnerable to the opportunism of local officials.
It is in this sense that fiscal federalism becomes an important
consideration in the resolution of municipal financial distress. As a
general proposition, fiscal federalism requires each level of
government to internalize both the costs and the benefits of its
activities.24 Centralized governments should, therefore, subsidize
decentralized governments only to control negative spillovers of
local activity or to induce activities that generate positive spillovers.
Concomitantly, decentralized governments should be discouraged
from engaging in activities that impose adverse external effects. In at
least some cases of fiscal distress, however—primarily those
involving localities that have substantial state or national
importance—municipalities can externalize some costs of
idiosyncratic choices or local public goods onto more centralized
levels of government or creditors. As a result, municipalities have
tendencies both to overgraze on the commons of more centralized
budgets and to avoid the exercise of political will to satisfy the debts
they incur. The current legal structure for addressing municipal fiscal
distress may interfere with, rather than advance, the objectives of
fiscal federalism insofar as it insulates local decisions from
centralized influence and reduces the need for distressed localities to
internalize the consequences of fiscal decisions. The result is that
while theories of federalism typically focus on the security that
decentralization confers against an onerous centralized government,25
the capacity of subnational governments to exploit the financial
strength of more central governments raises the possibility that the
22 See Bethany McLean and Joe Nocera, All the Devils Are Here: The Hidden History of
the Financial Crisis 47–51 (Penguin 2010) (discussing how the market’s treatment of privately
held, but federally chartered, government-sponsored enterprises allowed them to issue debt as
if it were supported by an implicit federal guarantee and induced the government ultimately to
intervene as if actual guarantees existed).
23 I thank Eric Posner for the felicitous phrase.
24 See Wallace E. Oates, Toward a Second-Generation Theory of Fiscal Federalism,
12 Intl Tax & Pub Fin 349, 350–54 (2005); David A. Super, Rethinking Fiscal Federalism,
118 Harv L Rev 2544, 2571–79 (2005); Clayton P. Gillette, Fiscal Federalism and the Use of
Municipal Bond Proceeds, 58 NYU L Rev 1030, 1065–66 (1983).
25 See Oates, 12 Intl Tax & Pub Fin at 352–53 (cited in note 24). See also Super, 118 Harv
L Rev at 2556–58 (cited in note 24).
290 The University of Chicago Law Review [79:283
latter require protection from the former. The claim of this Article is
that judicially imposed resource adjustments may be used as a means
of providing such protection by reducing the incentives of
municipalities to exploit bankruptcy proceedings strategically.
The next Part of this Article discusses the doctrinal background
for municipal bankruptcy. Part II introduces the nature of the fiscal
commons, the risk of financial contagion, and the interests of state
and federal governments in responding to fiscal distress in
decentralized jurisdictions. Part III develops the claim concerning
the incentives of distressed localities strategically to exploit
centralized jurisdictions and the capacity of federal bankruptcy
courts to neutralize that behavior. Part IV adds a brief note on the
application of the analysis to the current debate about permitting
states to file for bankruptcy under federal law.
I. THE DOCTRINAL BACKGROUND
It is tempting to treat the refusal of distressed municipalities to
adjust resources as little more than the implementation of an implicit
risk allocation in the original bargain between localities and their
creditors. Municipal governments, like other borrowers, receive
extensions of credit in return for a promise to repay principal with
interest. Typically, municipal bankruptcy is precipitated by actual or
imminent default on general obligation debts, in which that promise
is secured by the general tax revenues of the debtor municipality.26
But promises to repay are subject to background legal rules and
contractual limitations. Even municipalities that have the capacity to
pay debts may be able to deploy those terms to avoid repayment.
Outside bankruptcy, some municipal debtors have successfully
contended that, under state law, a contractual pledge of their faith
and credit, which is typically incorporated into municipal promises to
repay debts payable from general taxes, means little more than an
obligation to exercise good faith in making payments.27 On this
26 See Robert S. Amdursky and Clayton P. Gillette, Municipal Debt Finance Law:
Theory and Practice 25–29 (Little, Brown 1992). See also Daniel Bergstresser and Randolph
Cohen, Why Fears about Municipal Credit Are Overblown *17–18 (unpublished manuscript,
June 2011), online at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836678 (visited Nov
15, 2011).
27 See State v City of Lakeland, 16 S2d 924, 925 (Fla 1944) (en banc) (holding that a city’s
pledge of “‘full faith, funds, property, credit, and resources’ did “no more, in legal effect, than
express an undertaking by the city to be irrevocably obligated, in good faith, to use such of its
resources and taxing power as may be authorized or required by law for the full and prompt
payment of the principal and interest of the obligation”). The court’s conception of an
“undertaking,” especially modified by the “good faith” limitation, arguably falls short of an
absolute promise of payment. Id at 925–26.
2012] Fiscal Federalism and Municipal Bankruptcy 291
understanding, if the locality can make payments only by reducing
essential services below a level of “public necessity,” then residents
arguably prevail over creditors.28
Other jurisdictions have proven harsher. The New York Court
of Appeals rejected a state-authorized moratorium on payments of
New York City notes on the grounds that it conflicted with state
constitutional provisions that required debt service to be paid even if
constitutional tax limits had to be exceeded.29 But in an era in which
mortgagors on underwater properties are encouraged to mail their
keys back to the mortgagee rather than continue to make payments,30
and distressed corporations obtain federal bailouts, there initially
seems little reason to distinguish cities that have been overly
optimistic about future revenues when investing in credit default
swaps, economic development, or collective bargaining agreements.31
If the background rules or contractual terms against which creditors
extended credit do not obligate the debtor to impose resource
adjustments, then no impropriety attaches to a decision to forgo
them; instead, that decision only constitutes an exercise of the option
created by the bargain, and one for which creditors were presumably
paid at the time that the bargain was struck.
A locality might avoid resource adjustments notwithstanding
default, for instance, where it has pledged to use tax revenues for
debt service only on satisfaction of certain conditions, even where
fulfillment of the conditions lies entirely within the its own
discretion. That has been the history of so-called “subject to
appropriation” debt, in which municipalities agree to pay debt
service for capital projects only if the local legislature makes the
necessary annual appropriation for that purpose.32 It might seem
28 See, for example, DeFoe v Town of Rutherfordton, 122 F2d 342, 345 (4th Cir 1941).
29 See Flushing National Bank v Municipal Assistance Corp, 358 NE2d 848, 851–52 (NY 1976).
30 See Brent T. White, The Morality of Strategic Default, 58 UCLA L Rev Discourse 155,
156 (2010), online at http://uclalawreview.org/pdf/discourse/58-8.pdf (visited Nov 13, 2011).
31 See Gretchen Morgenson, The Swaps that Swallowed Your Town, NY Times BU1
(Mar 7, 2010). See also Michael Cooper and Mary Williams Walsh, Mounting Debts by States
Stoke Fears of Crisis, NY Times A1 (Dec 5, 2010); Leslie Wayne, Localities Want U.S. to
Support Muni Bonds, NY Times B1 (May 26, 2009).
32 See, for example, Colleton County Taxpayers Association v School District of Colleton
County, 638 SE2d 685, 690 (SC 2006) (holding that a school district may incur general
obligation debt “provided the school district remains within the constitutional and statutory
limits”); Moschenross v St. Louis County, 188 SW3d 13, 20 (Mo App 2006):
The agreement in the present case was merely to request annual appropriations for
repayment of the bonds, subject to the approval of the county council. Therefore, the
performance of the contract depends upon action by the county council before any
unconditional indebtedness arises. This is distinguishable from an absolute agreement to
incur debt, which has been determined to violate the debt-limitation provisions of Article
VI, section 26 of the constitution.
292 The University of Chicago Law Review [79:283
peculiar for creditors to grant such latitude to the debtor
municipality, unless the market perceives the promise to consider
appropriating funds as tantamount to a commitment to make the
necessary appropriations. Investors might view the form of the
transaction as necessary to satisfy legal requirements unrelated to
the payment obligation, such as the desire to circumvent state
constitutional debt limitations by removing a legal but not a practical
obligation to make payment. Investors could reasonably conclude
that a locality that initially financed capital projects in this manner
would continue to finance the debt primarily out of concern that it
would otherwise jeopardize its return to the capital markets.33 But if
no such obligation exists as a legal matter, it is also plausible that
localities would lack the political will to incur resource adjustments
for projects that turned out to be inopportune.34 In the absence of a
legal obligation to pay the debt, there would be little reason for a
court to alter the bargain by requiring a distressed locality to make
such appropriations. The situation for municipalities’ lenders would
be no different than that of a mortgagee who discovers that a
mortgagor in a nonrecourse jurisdiction, that is, one that disallows
personal actions against the mortgagor to recover any deficit
between the outstanding indebtedness and the value of the
foreclosed home, has decided to cease payments and pay the
statutorily designated liquidated damages of the value of the home,
Drury v City of Cape Girardeau, 66 SW3d 733, 740 (Mo 2002) (en banc). The New Jersey
Supreme Court initially expressed skepticism about the propriety of the practice, noting that
the market treated “subject to appropriation” as the equivalent of general obligation debt to
which issuers have pledged their faith and credit. See Lonegan v State, 809 A2d 91, 101, 107–09
(NJ 2002). But the court subsequently determined that the constitutional debt limitation
applied only when the state is legally obligated to make payments. Lonegan v State, 819 A2d 395,
402–03 (NJ 2003).
33 See, for example, Lonegan, 809 A2d at 128 (Stein concurring in part and dissenting in
part), quoting Revised Lease and Appropriation-Backed Debt Rating Criteria 1 (Standard & Poor’s
June 12, 2001):
Finally, while appropriation-backed bonds are not considered debt under a strict legal
definition, Standard & Poor's considers all appropriation-backed bonds of an issuer to be
an obligation of that issuer and a failure to appropriate will result in a significant credit
deterioration for all types of debt issued by the defaulting government.
34 Indeed, that appears to be the issue in current litigation involving a default by the city
of Menasha, Wisconsin, on bond anticipation notes issued to finance a steam plant. The notes
were secured in part by the city’s promise to appropriate funds out of its annual general tax
levy to pay any deficiency that resulted if the steam plant generated insufficient revenues for
debt service. But that promise was subject to annual appropriation from the budget, and the
city refused to make the requisite appropriation. The market presumably considers such debts
as mechanisms for avoiding constitutional debt limitations, but not a limitation on a general
obligation to pay debts, since any locality refusing to make payments would have difficulty in
subsequent borrowings. Nevertheless, Menasha apparently called the market’s bluff. See
Yvette Shields, Investors: All Eyes on Menasha, Wis., Steam-Plant Lawsuit, Bond Buyer 5
(Sept 9, 2010).
2012] Fiscal Federalism and Municipal Bankruptcy 293
notwithstanding financial ability to continue making payments. The
perceived failure of political will might cause consternation to future
residents when the locality sought to reenter the credit markets, but
fiscal prudence is not the measure of legal obligation.
The defaults that give rise to a municipality filing for debt
adjustment under Chapter 9, however, typically involve obligations
that allegedly cannot be paid as a financial matter, rather than
because of any contractual defense.35 Where municipalities have
pledged their faith and credit to repay the defaulted debts, creditors
are likely to insist that resource adjustments be imposed to permit
payments.36 In the face of municipal recalcitrance, creditor success
depends in large part on the background rules of the bankruptcy
regime. In theory, a municipal bankruptcy regime could permit
judges to overcome any failure of political will and require localities
to adjust resources to pay affordable, if unpopular, obligations. As a
doctrinal matter, however, the existing bankruptcy regime appears to
preclude any such intervention. Section 904 of Chapter 9 explicitly
bars the court, without the consent of the debtor, from interfering
with the political or governmental powers of the debtor municipality,
any of its property or revenues, or its use or enjoyment of any
income-producing properties.37 No court approval is necessary for the
municipality to continue to operate as its political leaders determine,
or even to borrow additional funds.
This noninterference principle implies that the objective of
Chapter 9 is simply to allow a financially distressed city to
restructure its monetary obligations, not to restructure the city
government or to liquidate its assets for the benefit of creditors.
More implicit signals exist to the same effect. Omer Kimhi has noted
that the absolute priority rule, which precludes junior creditors from
obtaining any payout in bankruptcy before senior creditors have
been fully satisfied, acts as a substantial check on shareholder
35 Jonas Elmerraji, What Happens When Cities Go Broke? In a Tough Economy,
Bankruptcy Has Become a Dreaded—Yet Not Uncommon—Phenomenon, Even for Cities and
Municipalities, Forbes (July 2, 2010), online at http://www.forbes.com/2010/07/02/when-citiesgo-
broke-personal-finance-municipal.html (visited Nov 13, 2011).
36 See, for example, In re City of Vallejo, 2008 WL 4146015, *6–7, 12, 16–18, 29–30
(Bankr ED Cal).
37 The relevant provision, 11 USC § 904, reads as follows:
Notwithstanding any power of the court, unless the debtor consents or the plan so
provides, the court may not, by any stay, order, or decree, in the case or otherwise,
interfere with—
(1) any of the political or governmental powers of the debtor;
(2) any of the property or revenues of the debtor; or
(3) the debtor’s use or enjoyment of any income-producing property.
294 The University of Chicago Law Review [79:283
reluctance to pay creditors in corporate bankruptcy.38 The absolute
priority rule requires that shareholders pay the debts of both secured
and unsecured creditors in full before they can retain any of their
own interest in the firm. Although the absolute priority rule applies
in municipal bankruptcy as a formal matter,39 its application in that
setting has little of the constraining effect that it creates in corporate
bankruptcies. As Kimhi argues, since municipal residents are not
considered shareholders or creditors of the locality, their demands
for municipal services can be satisfied prior to creditors’ demands for
payment without violating the priority of the latter.40 Residents,
therefore, can demand continued operation of fire, police, school,
and waste-disposal services before any municipal funds are dedicated
to creditors. Indeed, the likelihood that judges would refuse to
subordinate residents’ interests in public services to the demands of
creditors may increase localities’ ability to obtain concessions from
the latter.41 The effect is that municipal bankruptcy serves as a
mechanism by which localities can obtain the equivalent of the fresh
start available to individuals in bankruptcy, rather than the “efficient
reconfiguration of assets” characteristic of corporate bankruptcy.42
The underlying assumption appears to be that localities should be
preserved in their current form, free from judicial reorganization,
notwithstanding that they thereby became financially overextended.
Perhaps the underlying rationale is that the alternative of dedicating
tax revenues to creditors, rather than to municipal activities, will
dilute residents’ incentives to engage in municipally productive
behavior and will interfere with municipal officials’ efforts to provide
the local public goods that justify municipal incorporation in the first
instance.43 More doctrinally, some suggest that the noninterference
principle preserves the constitutionality of a federal bankruptcy law
directed at municipalities by minimizing the role of federal actors in
matters best left to state consideration.44
But the apparently clear rule that the court may not require
resource adjustments becomes more opaque once one considers the
38 See Kimhi, 88 BU L Rev at 652 (cited in note 17).
39 See 11 USC § 901 (incorporating into Chapter 9 the absolute priority rule of 11 USC
§ 1129(b)(2)).
40 See Kimhi, 88 BU L Rev at 652 (cited in note 17).
41 See, for example, Martin Shefter, Political Crisis Fiscal Crisis: The Collapse and
Revival of New York City 106–07 (Columbia 1992).
42 McConnell and Picker, 60 U Chi L Rev at 468–70 (cited in note 14).
43 See Kimhi, 88 BU L Rev at 653–54 (cited in note 17) (explaining that both the court
and creditors are subject to the tax rates submitted by the municipality in its proposed
bankruptcy plan).
44 See, for example, In re New York City Off-Track Betting Corp, 427 BR 256, 264–65
(Bankr SDNY 2010); In re City of Vallejo, 403 BR 72, 75–76 (Bankr ED Cal 2009).
2012] Fiscal Federalism and Municipal Bankruptcy 295
discretion that a court does have to condition the grant of relief in
Chapter 9 on the political will of residents to accept them. Judicial
discretion is apparent at various stages of the bankruptcy inquiry.
First, only municipalities that are “insolvent” can file for adjustment
of their debts.45 Chapter 9 (unlike the rest of the Bankruptcy Code)
involves a cash-flow test under which a municipality is “insolvent” if
it is unable currently or prospectively to pay its bills as they become
due.46 The prospective element of the inquiry allows courts discretion
over the extent to which a municipality must deploy revenue-raising
capacity before it can claim inability to pay its debts as they become
due. For instance, the city of Bridgeport, Connecticut, failed the
“insolvency” test, even though it faced a $16 million deficit for its
current budget year, because it had access to a fund containing bond
proceeds sufficient to eliminate the deficit.47 Any withdrawals that
Bridgeport made from that fund, however, would have had to have
been repaid in future years,48 so that current withdrawals implied
subsequent use of the municipal taxing power to fund repayments.
The court might have agreed with Bridgeport that failure to provide
immediate relief simply deferred to the near future the city’s
inability to generate revenues sufficient to meet all its obligations.49
The court thus could have concluded that the prospective test was
satisfied. But the court instead required the prospective default to be
“imminent and certain,” and concluded that the current availability
of assets precluded satisfaction of that test.50
The second point at which judicial intervention is plausible
involves the statutory provision requiring that a municipality seeking
the protection of Chapter 9 first engage in good faith negotiations
with creditors.51 At least one court has considered it appropriate to
take into account willingness to increase taxes when evaluating the
municipality’s satisfaction of the good faith standard. In In re
Sullivan County Regional Refuse Disposal District,52 the court
concluded that districts composed of multiple municipal members
had not entered into good faith negotiations because the districts
failed to exercise their ability to assess their member municipalities
45 11 USC § 109(c)(3).
46 11 USC § 101(32)(C)(ii). See also In re City of Vallejo, 408 BR 280, 289–90 (BAP 9th
Cir 2009).
47 See In re City of Bridgeport, 129 BR 332, 337–39 (Bankr D Conn 1991).
48 Id at 337.
49 See id at 339.
50 Id at 337–38. For further discussion of the imminence requirement, see In re Hamilton
Creek Metropolitan District, 143 F3d 1381, 1386–87 (10th Cir 1998).
51 11 USC § 109(c)(5)(B).
52 165 BR 60 (Bankr D NH 1994).
296 The University of Chicago Law Review [79:283
for unpaid service fees owed to creditors.53 Those assessments would
have been paid from taxes assessed by the member municipalities on
their residents. While the court concluded that Chapter 9 did not
require municipal debtors “to demonstrate that they have fully
exercised their taxing powers to the maximum extent possible,”
failure to exercise their assessment authority at all precluded their
assertion of good faith.54
The third point at which judicial discretion can be exercised, and
the focal point of the McConnell-Picker argument, is at the stage of
confirming a plan for adjusting municipal debts. Confirmation is
permitted only if it serves the “best interests of creditors.”55 Even if
all classes of creditors do not accept the municipality’s proposal, a
court can confirm a plan that is “fair and equitable.”56 The “best
interests” and “fair and equitable” standards arguably are satisfied
only if the amount to be received by creditors under the plan is all
they can reasonably expect given the municipality’s circumstances.
The relevant circumstances, however, arguably include the fiscal
capacity of the debtor to bear additional resource adjustments. The
classic case cited for judicial supervision of the “best interests”
standard in the municipal context is Fano v Newport Heights
Irrigation District.57 In that case, a bondholder of a bankrupt
irrigation district appealed from a decree confirming a proposed
composition of indebtedness. The court concluded that even though
the district was insolvent in the sense that it did not have cash on
hand to pay interest, it was not insolvent “in the bankruptcy sense,”
as it owned “debt free” assets with a value that exceeded the
outstanding indebtedness.58 Those assets took the form of
improvements that the district had purchased with current funds that
could otherwise have been dedicated to the payment of debt service.
53 Id at 78–79.
54 Id.
55 11 USC § 943(b)(7). For an analysis of the “best interests” requirement and its
potential for use as a judicial tool, see McConnell and Picker, 60 U Chi L Rev at 465–67, 474–75
(cited in note 14). Other commentators have also noted the judicial discretion over municipal
resource adjustments inherent in determining whether the standard for confirmation has been
satisfied. See, for example, David L. Dubrow, Chapter 9 of the Bankruptcy Code: A Viable
Option for Municipalities in Fiscal Crisis?, 24 Urban Law 539, 582 (1992).
56 11 USC § 1129(b)(1). This provision is incorporated into Chapter 9 by 11 USC
§ 901(a).
57 114 F2d 563 (9th Cir 1940). Fano was cited, along with Kelley v Everglades Drainage
District, 319 US 415 (1943) (per curiam), in the legislative history of Chapter 9 to elucidate the
meaning of the “best interests” of creditors. See 124 Cong Rec 32403 (Sept 28, 1978) (Rep
Edwards). Commentators disagree on the extent to which those citations should control
application of the standard. Compare McConnell and Picker, 60 U Chi L Rev at 465–66 (cited
in note 14), with Kordana, 83 Va L Rev at 1060–66 (cited in note 17).
58 Fano, 114 F2d at 565–66.
2012] Fiscal Federalism and Municipal Bankruptcy 297