Local Government Bankruptcy

Court-appointed receivership is not a typical remedy for local government financial emergencies. More common in the rest of the country (though prohibited in many states) are Chapter 9 federal bankruptcy proceedings. Still, governments entering bankruptcy are fairly rare, and there have been none in Michigan.

Under Chapter 9, a federal bankruptcy judge has the power to alter or negate the government’s debts to vendors and bondholders. In addition, the bankruptcy judge has the power to alter collective bargaining agreements with the government’s union workers, as well as the power to modify retiree insurance coverage and accrued pension benefits payable to retired city employees.[20]

The power to amend workers’ and retirees accrued pension benefits is prohibited to Michigan governments and state courts by the Michigan Constitution.[21] This power is thus outside the domain of a state-appointed emergency manager or emergency financial manager. In contrast, it is clearly within the purview of federal bankruptcy judges, one of whom recently made substantial cuts to the pension benefits of municipal retirees in the bankrupt city of Central Falls, Rhode Island.[22]

A state can refuse to allow its local governments to participate in Chapter 9.[23] Alternatively, a state can stipulate how a local government can enter bankruptcy and otherwise regulate the municipal bankruptcy process. This is to protect a state’s authority to manage its internal affairs free from federal involvement.[24]

In Michigan, Public Act 4 was, as a last resort, the official avenue to a local government bankruptcy, stating “If, in the judgment of the emergency manager, no reasonable alternative to rectifying the financial emergency … exists, then the emergency manager may recommend to the governor and the state treasurer that the local government be authorized to proceed under [federal bankruptcy law]. …”[25]  With the suspension of Public Act 4 pending the outcome of Proposal 1, Public Act 72 (Public Act 4’s predecessor) is now the avenue to bankruptcy. [*] [26] Note that the legal costs to a government unit of filing and proceeding through federal bankruptcy can be substantial.

While governmental bankruptcy gives a federal judge important powers to limit the government’s debt, the court does not assume full control over the local government’s affairs. Chapter 9 protects the local government’s powers for constitutional reasons, and the law allows the local government to continue to manage its operations during the bankruptcy.[27] Chapter 9 also prevents federal bankruptcy courts from selling the local government’s assets.[28]

In contrast, an emergency manager under Public Act 4 or an emergency financial manager under Public Act 72 would expressly be allowed to manage the city’s operations and sell assets.[29] If an emergency manager under Public Act 4 were to file for bankruptcy, however, he or she would be empowered by state law to “act exclusively on the local government’s behalf.”[30] Thus, under Public Act 4, filing for bankruptcy would not return the management of the bankrupt local government back to its elected officials. Under Public Act 72, it is unclear whether the emergency financial manager would be appointed to act on behalf of the local government during Chapter 9 proceedings.[†]

Graphic 1 shows the major unilateral powers available to emergency managers, emergency financial managers, court-appointed receivers and bankruptcy judges in different instances. The unilateral powers available to emergency financial managers under Public Act 72 are similar to those of receivers under a court-appointed receivership (assuming powers like those granted in Ecorse). This is not surprising, since the powers of Public Act 72 and its predecessor, Public Act 101, were fashioned after the powers available to court-appointed receiver in Ecorse.

As noted above, a bankruptcy judge’s powers under Chapter 9 are substantially different from those of court-appointed receivers and those of the various managers appointed under state legislation. Also as noted above, the major difference between managers in Public Act 4 and Public Act 72 — the two alternatives available under Proposal 1 — is the power under Public Act 4 to unilaterally modify the terms of a municipality’s or school district’s collective bargaining agreements with its employee unions. (See Appendix A for a extended list of the differences between the powers available under these two public acts.)

Graphic 1: Major Unilateral Powers Available to Receivers, Bankruptcy Judges and State-Appointed Managers Under Various Authorities

Graphic 1: Major Unilateral Powers Available to Receivers, Bankruptcy Judges and State-Appointed Managers Under Various Authorities - click to enlarge

Sources: Robert Daddow, “Ecorse: The Fall and Rise of a Michigan City,”(Mackinac Center for Public Policy, 1992) http://goo.gl/0MkET; Michael W. McConnell and Randal C. Picker, “When Cities Go Broke: A Conceptual Introduction to Municipal Bankruptcy,” University of Chicago Law Review, Spring 1993;Public Act 4 of 2011; Public Act 72 of 1990.

Local units of government in Michigan have in the past petitioned the state for permission to file for bankruptcy under Chapter 9 on their own, outside of Public Act 72 or Public Act 4. None of these has been approved. The most recent example came in 2010, when Hamtramck’s request for permission to file for bankruptcy without entering emergency financial management was rejected.[31]

Readier access to bankruptcy has been argued as a possible way to remedy local government fiscal stress in Michigan while avoiding the loss of local control that would occur when the state appointed an emergency manager. Bankruptcy is viewed as a wild card in Michigan policy, however, especially for the government’s creditors. There is a belief that allowing a local government bankruptcy would spill over into the rest of Michigan’s municipal finance, making it more difficult for governments to borrow at low interest rates or even to borrow at all. Moody’s — one of the major bond rating agencies — issued a report stating that the removal of the emergency manager law “would be credit negative for distressed local governments.”[32]

The overall impact of bankruptcy on local government’s ability to borrow from the private market is somewhat theoretical, though. No government in Michigan has ever filed for bankruptcy.

In any event, altering the rules for entering bankruptcy is not part of Proposal 1.[‡] The only possible difference is whether the manager will act on behalf of the local government when it enters federal bankruptcy — the emergency manager clearly would under Public Act 4, while the emergency financial manager’s role is unclear under Public Act 72.  

[*] While some local governments have asked the state for permission to enter federal bankruptcy proceedings without invoking Public Act 4 or Public Act 72, not one of these requests has been granted.

[†] The relevant provisions, MCL § 141.1222(1) and MCL § 141.1241(3), empower the emergency financial manager to recommend bankruptcy, but say nothing about the government’s representative in bankruptcy.

[‡] Note that while the defeat of Proposal 1 would appear to reinstate Public Act 72 of 1990, there has been a legal challenge to this argument. If this challenge succeeds and Public Act 72 is not reinstated, then government units in Michigan would appear to no longer have an avenue to bankruptcy, since that avenue has been provided in the past by Public Act 4 of 2011 and Public Act 72 of 1990.