Over the past several years, especially since the financial crisis, there has been considerable discussion about municipal bankruptcies and their effects. The most notable recent municipal bankruptcy was Detroit’s due to its large size and longstanding reliance on the auto industry. When conducting a bankruptcy that is applicable to a municipality, such a bankruptcy falls under Chapter 9 of the United States Bankruptcy Code.

The impact of a municipal bankruptcy can be far-reaching. Its scope is often the largest of any bankruptcy because it affects so many people and industries. In general, an employer-employee relationship is, in effect, a creditor-debtor relationship. That is to say, suppose a municipality pays its employees every two weeks. The employee works for the employer and, based on the work performed, receives a paycheck. Until the employee is paid, the employer owes the employee money, though it is not due until the pay date. Thus, upon a municipal bankruptcy, municipal employees are creditors and may have to go through the bankruptcy process to get paid for amounts owed prior to the municipality filing a bankruptcy petition.

Chapter 9 Bankruptcy

For a municipality to be eligible for Chapter 9 bankruptcy, the following four conditions must be met:

• The municipality must be “specifically authorized” to file for bankruptcy: Specific authorization occurs when state law specifically allows for a municipality in that state to file for Chapter 9 bankruptcy. This can be either via a state law stating that Chapter 9 is applicable or via a government agency that is authorized to permit a Chapter 9 bankruptcy,
• The municipality is “insolvent”: The definition of insolvent in a Chapter 9 context contrasts with insolvent for Chapters 7 and 13 debtors. Chapters 7 and 13 define insolvency as balance sheet insolvency based on liabilities versus assets whereas Chapter 9 insolvency applies when a municipality is generally not or unable to make payments as they become due.
• The municipality presents a plan to “adjust” its debt: This is generally accomplished where a municipality presents a plan or reorganization.
• The municipality had proper dealings with its creditors: This can be demonstrated by a good faith showing of dealing with creditors regarding the debt. Often, a municipality will claim that it tried to negotiate with creditors but was unable to reach a deal. Unilaterally filing for Chapter 9 bankruptcy without prior negotiation with creditors will result in the dismissal of the bankruptcy petition. This contrasts with other Chapters of the Bankruptcy Code that generally require notice to the creditors but does not require a pre-bankruptcy attempt at negotiation.

Ripple Effect

When a municipality files for bankruptcy, this usually signals significant trouble. These troubles may cause many other people, especially municipal employees, to also file for bankruptcy. While a struggling city already has its share of corporate bankruptcies and corporate relocations long before the bankruptcy, it is usually the employees who will suffer the most.

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