Governance Reform and the Judicial Role in Municipal Bankruptcy

Abstract

Recent proceedings involving large municipalities such as Detroit, Stockton, and Vallejo illustrate both the utility and the limitations of using the Bankruptcy Code to adjust municipal debt. In this article, we contend that, to truly resolve the distress of a substantial city, municipal bankruptcy needs to do more than simply provide immediate debt relief. Debt adjustment alone does nothing to remedy the fragmented decision-making and incentives for expanding municipal budgets that underlie municipal distress. Unless bankruptcy also addresses governance dysfunction, the city may slide right back into financial crisis. Governance restructuring has long been an essential element of corporate bankruptcy. Given the monopoly position of local governments as providers of local public goods, governance reform is even more important in the municipal bankruptcy context.

Some might argue that reducing a city’s debt is the best bankruptcy courts can do, because a more comprehensive approach would, among other things, interfere with state sovereignty. In our view, these concerns do not withstand inspection. Based on a careful analysis of the historical origins of the current municipal bankruptcy provisions, as well as an assessment of recent Supreme Court jurisprudence, we argue that governance reform is permitted even under existing law. To be sure, the states themselves, rather than a bankruptcy court, ideally should be the ones to effect municipal governance reform. But political factors and the salience of the fiscal crisis make state intervention unlikely, thus underscoring the need for a more comprehensive approach to municipal bankruptcy.

Keywords: Chapter 9, section 904, Chapter 11, reorganization, municipal budget policy, judicial intervention in local governance, local government debt, separation of powers, federalism, state constitutions, National Federation of Independent Businesses v. Sebelius

JEL Classification: G33, H12, H74, H77, K39