In 2013, Detroit became the largest city in U.S. history to file bankruptcy, bringing new scrutiny to the role that different stakeholders play when a municipality is unable to cover its debts.
In a new working paper, “The Legislative Structure of Municipal Bankruptcy,” Vincent Buccola , a Wharton professor of legal studies and business ethics, focuses on whose rights are most likely to take precedence in such cases, noting that unlike corporate or consumer bankruptcy filings, municipal Chapter 9 bankruptcy “is riddled with substantive uncertainty.” Buccola discussed his findings — and stressed the importance of imposing some measure of predictability into the system — during a recent interview on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111.
An edited transcript of the conversation appears below.
Knowledge at Wharton: Let’s start with municipal bankruptcy. Explain a little bit about what you were delving into with the paper that you put together.
Buccola: What I’m exploring in the paper really comes from two puzzles that we see when we look at the municipal bankruptcy terrain. One is that there don’t seem to have been many municipal bankruptcies, and it’s a little bit of a puzzle why. The second puzzle to explain is, why is it that in some of the plans we’re seeing — such as what’s happening in San Bernardino, California now, what’s happened in Detroit, what’s happening in Stockton, California — you have creditors who have formally equal rights to payments of debts — bondholders and pensioners, typically — who are in fact being treated under these plans in very different ways.
So, the paper tries to address those two puzzles by giving us a theory of what it is that’s going on in Chapter 9, which is the Federal Bankruptcy Chapter regulating municipal bankruptcy.
Knowledge at Wharton: We were just reading up on the case in San Bernardino, where pensioners are receiving 100% and the bond holders are receiving a penny on the dollar at this point. It should be a level playing field, but it is not. How is that happening?
Buccola: As a formal matter under existing law, pension holders and employees who are going to have pension rights in the future and bond holders have equal priority, which is to say that under the formal law, at least, they ought to be sharing losses. If their rights against the city government are going to be impaired, they ought to be impaired equally. This is typically the case. What’s interesting is that in a corporate bankruptcy setting under Chapter 11, various creditors who have equal priority do in fact get paid out roughly equally. And that’s been the long-standing practice.
The question to figure out is, why is it that in municipal bankruptcy that doesn’t seem to be what’s happening? What I argue in the paper is that there really are two features that are very different between Chapter 11, the corporate bankruptcy code, and Chapter 9.
The first has to do with the fixed nature of priorities and rights against assets. In a corporate bankruptcy, all the assets of the corporation are up for grabs to be distributed to creditors, and everyone can identify beforehand what those assets are. And the priorities are fairly structured. People with the highest priority take until they’re satisfied. Then people at the next level take until they’re satisfied, and so on, until a point where there’s not enough money to go around. At which point people at that given level of priorities split roughly equally.
“The question becomes, to what extent, if at all, can creditors force tax hikes, which is sort of a way to liquidate the value of that taxing power?”
In a municipal bankruptcy, on the other hand, there is no fixed set of assets in the same way.
Knowledge at Wharton: You can’t have it. It’s a municipal government.
Buccola: Yeah. Are you going to take the roads? Are you going take the city hall? The real asset that a municipal government has typically is the power to tax its residents.
The question becomes, to what extent, if at all, can creditors force tax hikes, which is sort of a way to liquidate the value of that taxing power? And the answer is, we don’t really know.
Now, the second feature, which I think is maybe even more interesting and maybe even more important, has to do with the mandatory place of these different bankruptcy provisions. In the corporate context, when a business can’t pay its debts or it’s getting low in its ability to pay, it can be forced into bankruptcy whether it likes it or not. And creditors can’t hold out. They have to join into the bankruptcy process themselves. If they take money out early, it’ll get clawed back through what’s called preference law. So everyone gets forced into the bankruptcy process, and there’s no real ability to opt out.
In the municipal context, on the other hand, the city can’t be forced into municipal bankruptcy. It has to elect to go in. Even more interesting, there are a bunch of actors who can keep the city from going in — the state legislature, often the governor, the city government structure itself. And I argue in the paper, sometimes the bankruptcy judge as well.
So, there are these veto players who can prevent the bankruptcy from happening, even if it would be good for the group as a whole. In the corporate context, no one person can choose to sit out the game, if you want to call it that. These are fundamental differences that drive a lot of different outcomes in the two settings, even though the structure of the law formally seems to be quite similar.
Knowledge at Wharton: In San Bernardino, California, the city council voted for an exit plan they had put together, which said that the pensioners are going to receive 100% of their funding and the bond holders are going to receive 1% of their holding. When you hear that, it brings up a lot of questions as to why this is happening, and maybe why the bondholders are not receiving their fair share.
Buccola: Yeah, I think that’s right. What I think this really underlines as an important foundational or structural matter, is the uncertainty of how it works in bankruptcy. Because you’re right to point out that in San Bernardino, the pensioners are getting paid 100 cents on the dollar, compared to one cent on the dollar for the bondholders. But in a bankruptcy a handful of years ago in Rhode Island, in a town called Central Falls, something very different happened. A lien was slapped on the bondholders’ rights after the fact of the city not being able to pay. And the bondholders got paid 100 cents on the dollar, and it was the city employees and residents who got stiffed there.
In a sense, what we want from the system is some kind of predictability, at least, which will then allow employees, lenders and residents all to be able to plan effectively.
“There are these veto players who can prevent the bankruptcy from happening, even if it would be good for the group as a whole.”
Knowledge at Wharton: What is the need then to try and get that to be a more uniform decision at the municipal level across the United States?
Buccola: My view is that this would probably require some kind of legislative changes, probably at the federal level, probably in the federal bankruptcy code. And the way to do it is essentially to construct a more explicit priority structure. The law frankly — without getting into too many of the details — the law is just basically a bit uncertain over who gets how much rights to what assets.
I think that probably, the best step would be to just state it more explicitly. Then everyone can adjust their behavior going forward and plan. If the answer’s going to be that bondholders always lose out to employees, that’s fine as a rule, but it would be good for people to know that so that the bondholders can price that into the interest rates that they charge.
Knowledge at Wharton: How did Detroit’s bankruptcy play out along this spectrum?
Buccola: There were a number of different classes there. I think on average — and I don’t have the numbers right in front of me — the pension claims ended up getting something around the order of 80 cents on the dollar, depending on which classification. And various creditors got anywhere between, I think the average was around 20 cents, 25 cents on the dollar. Although I don’t have those numbers in front of me right now.
Knowledge at Wharton: In some respects then, you’re talking about a situation in which you could have a case like San Bernardino, where the creditors don’t have much recourse once the decision is made, and likewise, a case like Rhode Island, where the pensioners don’t have much recourse.
Buccola: That’s exactly right. We need a more structured set of priorities, including maybe some rules about how far the taxing power can be pushed for municipalities…. The other thing I think is very important is this question of who can prevent the bankruptcy from happening. In the current setup, as long as some stakeholder group, some coalition, whether it’s the bondholders or whether it’s the pensioners or so on, has strong enough allies either in city government, in the state government, sometimes in the governor’s office — it depends on the state — they can prevent the bankruptcy from happening at all by vetoing the ability of the city to get into bankruptcy in the first place. I think that’s equally important, because right now we have fights going on essentially on these two fronts: whether an adjustment plan can go forward at all on one hand, and then what the terms of that adjustment will be if indeed it goes forward. That’s going to depend on who happens to have friends in the governor’s mansion at that time, and that’s not a good, stable way to run a credit system.
Knowledge at Wharton: That’s something that obviously won’t sit well with the constituents of that particular area — the fact that it’s basically a political process that’s being played out.
“Look, if the Democrats had won the governorship in Michigan in the last election, Detroit would not have gone into bankruptcy.”
Buccola: Look, if the Democrats had won the governorship in Michigan in the last election, Detroit would not have gone into bankruptcy. I think you can say that with some confidence. I’m obviously not privy to any inside information, but that certainly appears to be the structure of what happened there.
Knowledge at Wharton: For municipal bankruptcy, you mentioned that reform is something that would really have to happen at the federal level. Is it even realistic to think that we could see something change like that in the near term?
Buccola: I think that as typically happens, it’s crisis points that tend to push legislation. Now, [Rep. John] Conyers from Michigan did put forward an amendment to the bankruptcy code that didn’t end up being enacted, but with respect to what he was seeing going on in Detroit before the bankruptcy actually happened. My aim is to set out some principles of what I think would be an effective way to change the law if and when Congress ever gets around to it. Obviously, right now, we don’t see a whole lot of legislative action on this front.
Knowledge at Wharton: Illinois apparently has five municipalities that are staring Chapter 9 in the face right now. Detroit just went through this. I’d say we’re getting a little bit closer to a crisis point, although you can’t ever tell when these incidents are going to pop up.
Buccola: It’s difficult, because so much does turn on the macro-economy. If the investments held by the state of Illinois and by Chicago and by Cook County start performing really well, then all of a sudden it looks like we’re not really at a crisis. It’s always difficult to predict when you’re looking at long-term budgetary problems.
The problem in Illinois is it’s not just the municipalities. The state government itself is in a hot mess. In some states that have troubled municipalities, it may be the case that the state government can help bail out or ease some of the pressure by taking on some of the services … that the municipality would have owned. In Illinois, it’s not even clear that that can happen.
