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State-sanctioned Federal Bankruptcy

posted by Katie Porter

If Credit Slips had a category for "Beyond the Comfort Zone," I'd put this blog post here. But I'm curious about the pending California legislation, Assembly Bill 155, that would restrict municipal (Chapter 9) bankruptcy filings. The bill would require municipalities to obtain approval from the state-run California Debt and Investment Advisory Commission before filing bankruptcy. The political story is easy; this is the fall-out of the bankruptcy of Vallejo, CA last year. Among other concerns, unions whose members had their pay or benefits reduced want to restrict access of local governments to chapter 9. Cash-strapped cities, facing a double-whammy of lower taxes and higher claims on social services, feel differently.

Now my bankruptcy teacher was pretty decent but I never learned that the Bankruptcy Code gives states the power to limit their municipalities' ability to file a chapter 9 case. But it's right there in 11 USC 109(c)(2). (Of course, this means that I also didn't know that municipalities must be "insolvent" to file chapter 9, a requirement that is notably absent for debtors in other chapters.) Apparently, states take a variety of approaches to this--some prohibiting chapter 9, some remaining silent leaving things unclear, and some conditioning chapter 9 on some thing, as California's proposed legislation would do. I'm  struck by the remarkably different approach in chapter 9 than in chapter 11, where the doors are really wide open to bankruptcy relief. Are the public harms that different? The bankruptcy of a company, including the rewriting of its union contracts and the devaluation/cancellation of its stock, can have similar harms on communities. I'd be very grateful to Credit Slips readers who will share their thoughts about these issues; I have a feeling the future will bring more chapter 9 filings.


Ignoring the distributional issues among citizens, creditors and unions, and the rent seeking motives of the unions, I think the legal issue analogizes to shareholders and corporations. The municipalities are creations of the states, as corporations are creations of their shareholders. As shareholders can establish voting hurdles to the corporation filing bankruptcy, so a state can establish a voting requirement before a municipal unit files. The Supreme Court said sometime ago that a corporate bankruptcy petition must be dismissed if not properly authorized so I would think the same would apply to a municipality's. This does not trigger a preemption question as the bankruptcy code says nothing about how an entity decides to file a voluntary case.

mt is right; it's a federalism issue. Municipalities are creatures of the state, and the state determines how much or how little power they have (See, e.g. Kelo.). It would be politically unpopular, to say the least, for Congress to invade that sphere, not least because states are frequently co-debtors with their municipalities, and a Chapter 9 filing would be a liability trigger.

I think the second comment is close to my view -- Congress wants to avoid a fight over control of subsidiary state entities. But unlike the first commentator, I would suggest that Congress could, if it wanted to, preempt the authorization question.

The reasons for insolvency requirement are less clear to me, especially given that the definition of insolvency largely puts the question under the municipality's control.

Of course, corporations too are "creatures of the state." They exist under state law, and their powers and duties are defined by the state legislature. And states too are often deeply entangled in the financial affairs of corporations, including being creditors of bankrupt/insolvent corporations for taxes.

One of the differences between CH9 and CH11 is that the latter contemplates possible asset sales and CH7 conversion. These steps are impossible for municipalities--are you going to do a Section 363 sale of the local fire trucks, or Town Hall? The public harms really are that different. CH7 conversion implies a federal dissolution of a state creature.

And I'm afraid that corporations haven't been creatures of the state for awhile, at least in the eyes of our Supreme Court. If so, they wouldn't have First Amendment rights notwithstanding reserved powers clauses in their charters. Or look at Atherton v. FDIC, where the Supremes applied state law to a federally-chartered corporation.

Please note that my preemption statement simply described what the bankruptcy code currently provides, i.e., nothing. Obviously Congress could create a law that pre-empts state law as to the steps an entity created by a state must take to file a case.

Another way to think of the subject is that the municipalities are off balance sheet vehicles, or special purpose subsidiaries, of the state and the code provision referenced by Prof. Porter recognizes the interest of the state in assessing the impact on its credit as well as its functions from a bankruptcy filing of such subsidiaries.

The Supreme Court said sometime ago that a corporate bankruptcy petition must be dismissed if not properly authorized so I would think the same would apply to a municipality's.

Interesting reading the post and the comments. It stands to logic that if congress wants to take corrective measure it would so if they are not then it simply means that they do not want to step in.

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