Beyond the Great Divide: Federalism Concerns in Municipal Insolvency

Abstract

A growing number of municipalities are experiencing extreme financial distress, a problem which states have sought to address either under state law or with the aid of federal bankruptcy relief. There is an unresolved tension in how these two options interact. If a state chooses the bankruptcy option, do state laws nonetheless operate to protect the interests of certain classes of creditors? If a state does not use bankruptcy, might bankruptcy law nonetheless limit the state’s ability to adjust the municipality’s debts?

These questions raise important federalism concerns that have frequently been analyzed under what this article calls the Great Divide Model of municipal bankruptcy federalism. This model formalistically allocates to Congress the exclusive power to adjust debts and to states the exclusive power to address local governance.

This article challenges this model as inconsistent with the practical realities of municipal financial distress and its resolutions. Debt and governance often go hand in hand, both in causing and resolving financial distress. The federalism questions in municipal insolvency are better framed within a functionalist model of municipal bankruptcy, which involves analyzing the limits of the bankruptcy power in this realm and the state interests in local governance.

Keywords: municipal bankruptcy, insolvency, federalism