By James Spiotto

United States Senate Committee on the Judiciary Hearing on Puerto Rico’s Fiscal Problems: Examining the Source and Exploring the Solution

Is Chapter 9 Bankruptcy the Ultimate Remedy for Financially Distressed Territories and Sovereigns Such as Puerto Rico: Are there Better Resolution Mechanisms?

(originally written December 1, 2015)

James E. Spiotto

© 2015 by James E. Spiotto. All rights reserved. As of January 1, 2014, Mr. Spiotto retired as a Partner of Chapman and Cutler LLP. He has been a Managing Director of Chapman Strategic Advisors LLC, a consultancy providing educational and strategic insights to market participants concerning municipal finance topics of interest. He also is co-owner and co-publisher of, an online resource specializing in municipal-related research and information concerning State and local government, including public finance, infrastructure, job market data and economic statistics and analysis. The statements expressed in this material are solely those of the author and do not reflect the position, views or opinions of Chapman and Cutler LLP or Chapman Strategic Advisors LLC.


Table of Contents

Heading                                                                                                             Page

Introduction………………………………………………………………………………… 1

Executive Summary……………………………………………………………………… 2

Need for Congressional Action Now ………………………………………………. 2

Chapter 9 is Not a Universal or Desired Solution……………………………. 3

Chapter 9 is Not Designed for the Commonwealth of Puerto Rico……. 3

Puerto Rico Can Be Authorized to Allows its Municipalities and Public Corporations to Use Chapter 9 as a Last Resort with a “Second Look”………………………………………… 3

The Need for Financial Oversight and a Recovery Plan for the Commonwealth of Puerto Rico……….. 4

Benefits of Financial Oversight and Recovery Plan………… 4

Discussion……………………………………………………………………………………. 5

Is Chapter 9 the Desired Solution for the Commonwealth of Puerto Rico or its Municipalities, Public Corporations or other Governmental Bodies?………………………………………………………………… 9

The Municipal Bankruptcy Experience…………………………………….. 10

The Lessons Learned from Constitutional Challenges to Municipal Bankruptcy Provisions……………………………………………. 10

Legislation by the State to Authorize Chapter 9…………………….. 14

The Traditional Role of States in Assisting Financially Troubled Municipalities…………………………………………………………… 20

Financial Cycles Require That State and Local Governments Prepare for Economic Downturns…………………………………………….. 20

How States Have Attempted to Supervise State and Local Government Financing and Volatility in Times of Economic Distress………………………………………………………………………………………. 21

Debt Limitations………………………………………………………………………… 21

Debt Limitation for Puerto Rico Municipalities………………………. 22

Tax Limitations for Puerto Rico Municipalities………………………. 22

Refunding Bonds……………………………………………………………………….. 22

The Use of Various Mechanisms by States to Provide Financial Oversight and Assistance to Municipalities in Distress to Avoid the Use of Chapter 9…………………………………………………………………… 23

State-Implemented Programs to Assist in Time of Financial Crisis……………………………………………………………………………………………………. 24

States Recognizing Municipal Receivers: Rhode Island and Texas………………………………………………………………………………………….. 26

Financial Control Boards and Their Progeny………………………… 26

Development of the Financial Oversight and Recovery Authority for Territories including the Commonwealth of Puerto Rico and Its Municipalities, Public Corporations and Related Governmental Bodies………………………………………………….. 31

The Structure for Oversight and Emergency Financing………… 34

Respecting Traditions and Principles of Government Financing is Essential to a Successful Recovery Plan…………………………….. 38

Municipal Operations and Creditor Protections…………………….. 40

Lengthy Litigation on the Competing Rights of Creditors May Not Be in Their Best Interest……………………………………………………… 41

Conclusion…………………………………………………………………………………. 42



The United States Congress and, in particular, the United States Senate Committee on the Judiciary are considering whether and how best to assist Puerto Rico and its related municipalities and public corporations now facing severe financial challenges or economic distress. You may find instructive how other countries or sovereigns as well as States in the United States of America have addressed these problems and the alternatives and opportunities available in the form of legislation including authorization to file for Chapter 9, municipal bankruptcy, under Federal Bankruptcy Law 11 U.S.C. § 901, et seq. I am submitting this discussion at the request of this Committee. I previously testified before the House Judiciary Committee with respect to the Municipal Bankruptcy Amendments of 1988 that corrected some of the inconsistencies between then existing bankruptcy law and municipal law and financing practices. Following the adoption of the Bankruptcy Reform Act of 1994, which clarified the split that had developed in case decisions and provided that municipalities must be specifically authorized by the State in order to be eligible to file for bankruptcy, I testified regarding the Orange County Bankruptcy and municipal investments before a Subcommittee of the Committee on Banking and Financial Services. More recently, I testified in 2011 before a House subcommittee regarding the role of public employee pensions in contributing to State’s insolvency and the possibility of a State bankruptcy chapter.

Dealing with the financial distress of a government requires not merely short-term actions to reduce debt obligations, increase tax revenues and lower costs, but also the long-term reinvestment in the government, its economy and its people. As a parade of over 600 sovereign debt defaults since 1950 involving 95 countries have demonstrated, there are too many repetitive problems because of a limited focus on reducing external debt without addressing the systemic problem that caused the economic distress. We in the United States, with a few exceptions, have been blessed with our State and local governments during this period weathering the storm of 11 economic downturns since 1950.[1]

The missing and needed ingredient in these failed sovereign restructuring of debt is the long-term reinvestment in the government and its people to improve and expand governmental services and infrastructure and stimulate business opportunities. This creates growth of new businesses and new jobs resulting in new taxpayers to increase tax revenues that brings about the recovery for the health, safety and welfare of citizens. Such an approach is likely in the best interests of not only the government but also its citizens and taxpayers, and its creditors, including employees and retirees. It is only through a robust recovery plan that creditors, including employees and retirees, will be paid to the fullest extent possible.

As you consider Puerto Rico’s fiscal problems and as you examine the reason why they developed and explore possible solutions, you will desire to know the answer to the following questions:

(1)       What is the extent of financial distress of Puerto Rico and its municipalities and related governmental entities?

(2)       Does Puerto Rico’s fiscal distress require action by Congress?

(3)       Is Congress authorized to act?

(4)       How can Puerto Rico’s sovereignty be respected?

(5)       Is the ability to use Chapter 9 municipal debt adjustment necessary and appropriate for Puerto Rico and its municipalities and other governmental entities in dealing with their financial obligations?

(6)       Has past history shown there are better alternatives for governmental financial recovery and debt resolution mechanisms?

Executive Summary

The brief answer to these basic questions concerning Puerto Rico’s fiscal distress and the needed solution is as follows:

Need for Congressional Action Now

The financial challenges, loss of business and jobs resulting in many not being meaningfully employed, the need for economic stimulus and business development, the demands for social programs and governmental services, the level of poverty and financial strain on programs to address human distress have been well documented by Puerto Rico, its community leaders, its creditors and the financial markets. There should be no debate over whether assistance is needed now, only by whom and what form the assistance will take need to be answered. Congress, under the Territorial Clause and Bankruptcy Clause of the U.S. Constitution, has the mandate, mission and ability to provide needed rules and regulations. The federal government is the governmental parent of Puerto Rico. It is a Commonwealth and still a territory and therefore the federal government is not a mere spectator but an interested party with the ability to effect and play a role in the solution.

Chapter 9 is Not a Universal or Desired Solution

Chapter 9 bankruptcy is a process not a solution. Chapter 9 bankruptcy is expensive, time consuming, unpredictable and seldom accomplishes the desired results. For that reason, Chapter 9 is rarely used. Only 664 Chapter 9s have been filed since 1937, of which almost two-thirds are municipal utilities and special tax districts. Use of Chapter 9 by cities, towns, villages and counties is less than 20% of the total Chapter 9 filings. There have been only a handful of large municipal Chapter 9s (Orange County, Jefferson County, Stockton, San Bernardino and Detroit). Chapter 9 is a difficult process, especially for larger governmental bodies and complex economies and services. Chapter 9 was drafted and intended to be used by a sub-sovereign of a State where there are established constitutional and statutory laws which are to be honored and which act as a point of reference for governmental action going forward and the legal premise of a recovery plan. Chapter 9 was not constructed for use by States as sovereigns given the Tenth Amendment and the required respect by the federal government for the States as co-sovereigns. Under the controls and limitations a State imposes under its laws and constitutional mandates on a municipality’s exercise of governmental powers, revenue and property cannot be interfered with or impaired by the Federal Bankruptcy Court. This has been acknowledged from the very birth of Chapter 9 in the United States Supreme Court decisions in Ashton and Bekins.[2]

Chapter 9 is Not Designed for the Commonwealth of Puerto Rico

Puerto Rico as a Commonwealth desires to be treated as a State, and some federal legislation and the definition of “State” in the Bankruptcy Code at times recognize Puerto Rico’s unique sovereignty subject to the principles of the U.S. Constitution and in particular its Supremacy and Territorial Clauses. Therefore, Chapter 9 does not work for the Commonwealth of Puerto Rico.

Puerto Rico Can Be Authorized to Allows its Municipalities and Public Corporations to Use Chapter 9 as a Last Resort with a “Second Look”

However, like a State, the Commonwealth should be authorized if needed to allow its sub-sovereign municipalities, public corporations and related governmental entities to file Chapter 9 as the absolute last resort. The stigma and cost of Chapter 9 require that any authorization for a municipality to file should be after a “second look” effort by the sovereign to ensure every effort at consensual resolution has been explored. This “second look” historically has been shown to have statistical and practical merit. Municipalities in States that require a “second look” approval by a State elected official or agency were six times less likely to use Chapter 9. Many municipalities have found the ability to use Chapter 9 as benefit without actually filing. As the threatened use of Chapter 9 from its very beginning in the late 1930’s has demonstrated Chapter 9 is more effective as an “or else” threat rather than as actually used.

The Need for Financial Oversight and a Recovery Plan for the Commonwealth of Puerto Rico

The inappropriateness of Chapter 9 for the Commonwealth of Puerto Rico does not mean there is nothing for the Federal Government and Congress to do to assist Puerto Rico. The Commonwealth and others have pointed out a needed review of federal law, rules, regulations and policy to ensure appropriate fairness compared to the treatment of States and others. The lack of a stimulus for economic and business development in Puerto Rico following the repeal of Section 936 tax exemption for U.S. companies, the claimed disproportionate burden of Medicaid and social programs, the need for effective tax reform and efficient collections method mandate the consideration of review and, where needed, assistance. Further, the extent and duration of the economic and financial distress of Puerto Rico and past failed efforts by it to find the appropriation solution have resulted in increasing the erosion of its financial credibility and doubt about its ability to effectively and fully address these issues without additional assistance. Many of the 600 sovereign debt restructuring in 95 countries have been band-aids and not permanent fixes. That is because they have merely addressed external debt issues and did not address the systemic problems that brought the financial crisis to a boil. The failure to address the systemic problem is fatal to successful recovery. What is needed is a detailed Recovery Plan that takes a holistic approach, which: (a) determines what is sustainable and affordable and what is not, (b) allows for development of accurate, transparent and mutually agreed-upon financial statements and projections, (c) provides appropriate funds for needed governmental services and infrastructure improvements, (d) permits, if necessary, consistent with the traditions and principles  of government finance (best demonstrated by U.S. States and local governments) restructuring of debt and (e) provides for economic stimulus and motivates business development in order to expand business and attract new business activities that create good new jobs for a high percentage of those meaningfully employed.

Benefits of Financial Oversight and Recovery Plan

This Recovery Plan will foster financial credibility and create increased revenues due to increased business activity and new, better compensated employees and better services and infrastructure to attract and encourage business activity and a healthier, safer and more prosperous future for its citizens. This needed Recovery Plan can only be developed with financial credibility buy-in and participation by the affected governmental bodies, elected officials, citizens and taxpayers, vendors, bondholders and other creditors as well as the international markets and community. This needed financial credibility has been obtained in the past by the use of financial oversight and recovery assistance provided by a higher governmental or recognized entity. This is well demonstrated by: (a) the use of the Municipal Assistance Corporation for New York City in 1975, (b) the Pennsylvania Intergovernmental Cooperation Authority for Philadelphia in 1991, (c) the District of Columbia Financial Responsibility and Management Assistance Authority for Washington, D.C. in 1995 and (d) the use by the majority of States of various forms of financial oversight, technical assistance aimed at addressing the financial distress of their municipalities to avoid financial meltdown and Chapter 9. In the past, sovereign restructuring have used the Paris Club (for government debt), the London Club (for commercial bank debt) and the International Monetary Fund attempting to achieve the same result. The evolving diversity of financial creditors with differing investment motivations demonstrates the need for financial oversight and recovery assistance from a higher or agreed-upon supervising adult.

Accordingly, for the Commonwealth of Puerto Rico, Congress should consider establishing a Financial Oversight and Recovery Assistance Authority to (a) help Puerto Rico help itself to develop the necessary Recovery Plan, (b) provide necessary oversight of financial information, operation and credibility, (c) encourage and foster buy-in and constructive participation by creditors and others through an impartial and fair process that will bring all required parties to the table and provide all the best results possible, (d) if necessary, determine what is sustainable and affordable and resolve issues with the input from all parties, with impartial and fair respect for their respective rights for the best interest of all. The Treasury Report defined below should be helpful to Congress in its consideration of what is the appropriate legislation for Puerto Rico to help itself successfully address its financial distress. The general conclusions in the Treasury Report find support in the discussion herein of the issues and the experience of past sovereign debt crises and the best practices to be followed to obtain an effective and expedited resolution that is a permanent fix and not one of the many band-aids. The following will further discuss, explain and support these statements.


The Extent of Financial Distress?

There have been numerous financial analyses of the economic plight of Puerto Rico and its public corporations and municipalities and government agencies. Puerto Rico itself has set forth its financial challenges and efforts to attempt to address them in various reports, legislation and analysis including: Anne O. Krueger, Ranjit Teja and Andrew Wolfe, Puerto Rico – A Way Forward (“Krueger Report”); Conway MacKenzie, Commonwealth of Puerto Rico – Liquidity Update, August 25, 2015 (“Conway MacKenzie Report”); Working Group for Fiscal and Economic Recovery of Puerto Rico, Puerto Rico Fiscal and Economic Growth Plan, pursuant to Executive Order 2015-022, September 9, 2015 (“Working Group Report”). Recently the U.S. Treasury Department released a Joint Statement by Treasury Secretary Jacob J. Lew, National Economic Council Director Jeff Zients, and Health and Human Services Secretary Sylvia Mathews Burwell on the Obama Administration’s Legislative Proposal to Address Puerto Rico’s Urgent Fiscal Situation including an analysis of Puerto Rico’s Economic and Fiscal Crisis and Roadways for Congressional Action (“Treasury Report”). While debates may continue as to the degree and ability of Puerto Rico to pay certain of its debt obligations, and there may be disputes on the finer points of accounting and ability to pay in the long run, at this time, the financial illiquidity and impending possible financial meltdown if these challenges are not promptly and adequately addressed cannot be rationally or in good faith denied. Accordingly, the answer to the first question appears to be there is fiscal distress that needs to be addressed now in the best interests of all.[3] The exact extent and ability to pay must be deferred pending further analysis and effort. The inquiry then turns to the who and the what of a practical resolution mechanism.

Is Congress Authorized to Act?

As you know all too well in considering any type of legislative relief, there is the question of whether there is jurisdiction and power for the legislature to so act. Many times the journey to finding an answer to this question takes a tortuous and winding road. This answer appears simple. The Commonwealth of Puerto Rico is and remains a territory of the United States albeit with its own Constitution of 1952 as approved to by Congress and the President.[4]

Puerto Rico is a Commonwealth of the United States. The Puerto Rico Constitution is bound to the principles of the United States Constitution under the Supremacy Clause and relevant Federal legislation under the Territorial Clause. The Territorial Clause provides “Congress shall have power to dispose of and make all needful rules and regulations respecting the territory or other property belonging to the United States”. (U.S. Constitution Article IV, Section 3).

Accordingly, if needed, Congress has the power and authority to make rules and regulations for the Commonwealth of Puerto Rico. This could include providing financial oversight and technical assistance to the Commonwealth of Puerto Rico with creation of a process and mechanism to assist and facilitate Puerto Rico in developing a Recovery Plan that provides to the people of Puerto Rico and their governments as well as to their creditors assurances and credibility that the financial challenge can be addressed and resolved with (a) appropriate funding of needed and vital essential services and infrastructure, (b) required stimulus of business expansion and economic development creating new good jobs for its underemployed work force, (c) “buy in” and cooperation as to the transparent financial statements and need for appropriate debt resolution that is sustainable and affordable, that pays creditors as much as can be paid as soon as reasonable without jeopardizing the economic recovery and growth that is vital to all. Any questions relating to facilitating debt resolution or adjustment through such an oversight and technical assistance mechanism or process can be authorized by creating the uniform process of mechanisms for all territories and protectorates under the Bankruptcy Clause of the U.S. Constitution. This does not necessarily have to be under Chapter 9 of the Bankruptcy Code. This could be a separate provision for territories that the Commonwealth may avail itself if enacted as a uniform law on the subject of bankruptcy for territories under Article I, Section 8, Clause 4 of the United States Constitution.

Does Puerto Rico Fiscal Distress Require Action by Congress?

It cannot seriously be disputed that Puerto Rico has in good faith over the recent years struggled to address its financial challenges and find a financially sound path forward with its governmental obligation of essential services and infrastructure, economic stimulus and business development as well as dealing with ever increasing debt and rising costs of borrowing. Sometimes despite good faith efforts a successful result is not easily attained. See Exhibit I, slides 8-10 and the analysis of the Greece failed bailout efforts (slides 69-74). At the same time, one of the ugly and unfortunate facts of economic distress is that it adversely affects your financial credibility in the market so that access to needed liquidity and cost of borrowing become more expensive exactly when you least can afford the increased cost and burden.[5]

This loss of financial credibility had led to Puerto Rico paying a yield of over 10% while most sovereigns enjoy rates are experiencing currently low bond annual yields of 2.27% for U.S.A., 1.52% for Canada, .74% for Germany and 1.03% for France (10 year bond October 2015) (compare to Puerto Rico’s recent ten year G.O. bond with a yield exceeding 10% in February 2014).[6]

The price of a lack of financial credibility to a sovereign cannot be underestimated. Just 2% more on a 20 year bullet maturity debt financing of $1 billion has a present value cost of approximately $250 million (at a 5% discount) or 25% of the original principal amount. The use of financial oversight has a proven record for provided needed financial credibility to citizens and creditors alike. It is not interference or intrusion into sovereign affairs of a government; it is technical assistance and guidance that provides reaffirmation of good decisions and a second chance to prevent bad decisions from being implemented. As will be discussed below and as you may well recall, the Municipal Assistance Corporation (“MAC”) in 1975 for New York City, the Pennsylvania Intergovernmental Cooperation Authority (“PICA”) in 1991 for Philadelphia and the District of Columbia Financial Responsibility and Management Assistance Authority in 1995 for Washington, D.C. all provided this financial supervision and technical assistance that helps the local government help itself. Congress has to do the same here to avoid the continuing loss of financial credibility and increased costs of funding essential and vital services and to prevent the lack of credibility being the obstacle to a successful recovery.

As noted in Exhibit I, sovereign debt resolutions that have succeeded have benefited from external bodies that are independent and provided verification of financial statements and projections, technical assistance as to past best practices to be considered and coordination of creditors with assurances that the vetted proposal will not be subject to a death of a thousand bites but will be one sustainable recovery program. The past case of the London Club (for commercial bank debt), the Paris Club (for external government debt) and the IMF (International Monetary Fund) have played an important role of verification, confirmation, support, recommendation and coordination that lead to creditor, international commerce and local “buy in”.[7] As will be noted below, the times and participants have been evolving and new mechanisms need to be developed for the new challenges present.

The current gridlock between certain financial creditors and the Commonwealth of Puerto Rico can be relieved by an independent and credible vehicle that can restore financial credibility to the current crisis and encourage participation, coordination and consensual agreement between financial creditors and Puerto Rico and its municipalities and agencies. Puerto Rico’s effort to address this by the enactment of the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (“DERA”) was met with vigorous creditor litigation and ruling by the United States District Court and the United States Court of Appeals for the First Circuit that DERA was preempted by Section 903 of the Federal Bankruptcy Code and the Bankruptcy Clause of the U.S. Constitution and therefore void pursuant to the Supremacy Clause of the United States Constitution. See Franklin California Tax Free Trust et al. v. Commonwealth of Puerto Rico et al., 85 F.Supp 3d 577 (D.P.R. 2015) affirmed by the Court of Appeals, 2015 WL 40794 22 (1st Cir. July 6, 2015), petition for cert. docketed August 31, 2015.

This litigation and dispute did not help the growing issue of financial credibility. Recently, Puerto Rico in attempting to address the issue has proposed its own oversight mechanism. This raises the old question of whether you can successfully provide oversight and recommendations to yourself and have external credibility. No matter how well intended the effort, the question remains, so that external, independent oversight, supervision and technical assistance results in increased credibility from others.

Accordingly, just like New York City in 1975, Philadelphia in 1991 and Washington, D.C. in 1995, there is a clear and sufficient reason for Congress to consider and, if appropriate, pass legislation that provides the needed financial credibility through financial oversight and technical assistance to the degree necessary to reduce creditors’ reluctance to reach consensual resolution on a recovery plan that Puerto Rico and its governmental bodies and citizens believe will put them on the path of recovery, economic stimulus, business development and address the employment, Medicaid, social programs and other identified issues that have been the obstacle to successful recovery.

There is the question of whether any action by Congress would interfere with the “sovereignty” of Puerto Rico and its governmental bodies. Help and assistance from Congress and the U.S. Government is not inference but enhancement to the overall possibility of a successful resolution. To stand by and watch the continued struggles of Puerto Rico and its people to lift the situation out of the current morass would be failing to recognize what the Territorial Clause provides and mandates, namely, needful rules and regulations that provide for the overall sovereign technical assistance and oversight to help Puerto Rico help itself. This is similar to what the State of New York provided to New York City in MAC, what the Commonwealth of Pennsylvania provided to Philadelphia in PICA and what Congress provided to Washington, D.C. in 1995 (“DCFRMA”). Representatives of Puerto Rico have long advocated the need for federal legislation to remedy injustices from past adverse treatment of Puerto Rico such as exempting Puerto Rico from the adverse affects of the Merchant Marine Act of 1920, and requesting parallel treatment with States as to Medicaid, Medicare, the federally-subsidized health insurance exchanges established by the Affordable Care Act, the earned income tax credit, the child tax credit, Supplemental Nutrition Assistance Program (SNAP), and the Low Income Home Energy Assistance Program (LIHEAP).[8]

Accordingly, the final set of questions posed relate to the use of Chapter 9. The answers are there better alternatives.

Is Chapter 9 the Desired Solution for the Commonwealth of Puerto Rico or its Municipalities, Public Corporations or other Governmental Bodies?

In connection with any analysis of the advisability of permitting Puerto Rico or its municipalities to file for Chapter 9, consideration should be given to an unexpected consequence of the availability of such a remedy. As will be discussed further, Chapter 9 typically is recognized as a last resort, a step to be taken if all else fails in attempts to rescue the financially troubled municipality. Certainly, given historic costs, expense and disruption resulting from Chapter 9, Chapter 9 is not a step to be undertaken lightly. However, the very existence of the availability of Chapter 9 may have a salutary effect on efforts to resolve municipal difficulties outside of a Chapter 9 proceeding. This was recognized in hearings before the United States House of Representatives Committee on the Judiciary as early as 1942.[9] The legislative history for hearings on the extension of the Municipal Debt Composition Act reported that the passage of the Municipal Bankruptcy Act in 1934 permitted the City of Detroit to restructure its outstanding municipal debt outside of bankruptcy through a composition of creditors requiring 100% approval of affected creditors. Since 8% of bondholders were holdouts with 92% approval of creditors, the Mayor and Civic Leaders of Detroit were major supporters of municipal bankruptcy in the passage of 1930’s Chapter IX not because they were clairvoyant that in 2013 they would use it. Rather, they supported the bankruptcy option realizing that a more drastic alternative would convince the holdouts to accept the plan approved by the 92% given the fear of alternative municipal bankruptcy treatment was perceived to be far worse. The legislative history also refers to the refunding and refinancing of the significant amount of outstanding indebtedness of the City of Chicago at that time because of the favorable psychology of having the provisions of the Bankruptcy Act available. Thus, any exploration of the advisability of the passage of authorizing legislation ought not be viewed as necessarily leading to a rush to file Chapter 9.

The Municipal Bankruptcy Experience

As you may be aware, there have been only 664 municipal bankruptcies (see Charts, Appendix 1 and 2) filed in the United States since the adoption of the authorizing legislation in 1937. Few debtors have been governments of any major size. Orange County, California in 1994, Bridgeport, Connecticut in 1991, Jefferson County, Alabama in 2011, Stockton, California and San Bernardino, California in 2012 and Detroit in 2013 are recent notable exceptions. For the most part, the 664 Chapter 9 filings have been small municipalities or special tax districts or utilities (about 60%).  In fact, since 1954, less than 20% of all Chapter 9 filings have been cities, towns, villages and counties (64 of 320). Further, in the municipal bankruptcy, even determining eligibility can take significant time and delay such as in Vallejo, California, which was filed in 2008. Disputes with municipal unions over pensions and benefits bogged down the proceeding and delayed that City’s emergence from bankruptcy. The issue of the relative treatment of pension and debt payments took center stage in Chapter 9 cases of Detroit, Stockton and San Bernardino. The decision on the eligibility of Stockton alone took almost ten months. After more than a year in bankruptcy, the issue of the eligibility of San Bernardino was finally determined, paving the way for a battle between the competing interests. The Detroit bankruptcy was long and expensive. It is safe to say that the availability of a bankruptcy option has not proven to be a “quick or easy fix” to municipalities.[10] This is particularly true where there has been contention between the major players in the case. Historically and practically, Chapter 9 debt adjustments should be the last resort after all other alternatives have been unsuccessful. Many States have provided assistance, refinancing, oversight and other mechanisms to help local government avoid Chapter 9 if it is at all possible. The authorization of a government to file should not be interpreted as precluding such efforts such as financial oversight, technical assistance and guidance.

The Lessons Learned from Constitutional Challenges to Municipal Bankruptcy Provisions

The Tenth Amendment to the Constitution explicitly articulates the Constitution’s principle of Federalism by providing that powers not granted to the Federal Government nor prohibited to the States by the Constitution of the United States are reserved to the States respectively or to the people. Accordingly, while Article I, Section 8 of the Constitution gives Congress the power to “establish uniform laws on the subject of bankruptcies throughout the United States,” that power may not interfere with the power reserved to the States by the Tenth Amendment. While there may be precedent for the Federal preemption of bankruptcy law for corporations and individuals, there was, at our Nation’s founding, no precedent for a dual sovereign passing a law regulating the bankruptcy of the other. This remains the case today. The earliest iterations of statutes providing for municipal debt adjustment (Chapter IX) not unexpectedly resulted in a review of the constitutionality of municipal bankruptcy by the U.S. Supreme Court.

As you know, the current version of Chapter 9 of the Bankruptcy Code attempts to embrace the concept of sovereignty of States and the limitations imposed by the Tenth Amendment. Section 903 of the Bankruptcy Code specifically reserves a State’s power to control municipalities.[11] In addition, § 904 of the Bankruptcy Code specifically limits the jurisdiction and powers of the Court over the municipality.[12] As a result, the power of a Bankruptcy Court presiding over a Chapter 9 case is limited and cannot interfere with the property, revenue, politics, government and affairs of the municipality unless the municipality consents, and municipality can only consent to that which is authorized or permitted under State law. The jurisdiction of the Bankruptcy Court over the municipality flows from the specific authorization of the State in question to allow the municipality to file. Most States have chosen not to specifically authorize their municipalities to file.[13]

Earlier versions of municipal bankruptcy legislation attempted to deal with these concepts as well. Prior to 1934, Federal bankruptcy legislation did not provide a mechanism for municipal bankruptcy, insolvency, or debt adjustment.[14] During the period 1929 through 1937, there were 4,700 defaults by governmental bodies in the payment of their obligations.[15] In 1934, the House and Senate Judiciary Committees estimated that there were over 1,000 municipalities in default on their bonds.[16] That was obviously a different stage of financial distress than presently exists today with no State in default of any its general obligation bonds.

Until World War II, units of local government were very heavily dependent upon property tax. During the Depression, there was widespread nonpayment of such taxes. Bondholders brought suits for accountings, secured judgments and obtained writs of mandamus for levies of further taxes. The first municipal debt provisions of the Bankruptcy Act of 1898 as amended from time to time (hereinafter the “Bankruptcy Act”) were enacted as emergency legislation for the relief of such municipalities. The municipal provisions became effective on January 24, 1934.[17] These provisions were to be operative for a two-year period from that date, but this period was later extended to January 1, 1940.[18] This legislation reflected a recognition that municipalities required a mechanism that would stay the annihilating litigation arising from defaults and provide a fresh start through the allowance of municipal debt adjustment to what is sustainable and affordable. In this way, creditors of the distressed municipality could be paid as much as possible without crowding out essential governmental services.

The municipal debt adjustment provisions of the Bankruptcy Act enacted in 1934 thus reflected an attempt to protect municipalities from debilitating disputes with creditors.[19] The 1934 legislation provided a procedure whereby a local governmental unit, if it could obtain acceptances from two-thirds of its creditors, could have a plan of readjustment enforced by the Federal courts. The 1934 legislation contained language similar to the policy expressed in the current § 904:

The Judge… shall not by any order or decree, in the proceeding or otherwise, interfere with (a) any of the political or governmental powers of the taxing district or (b) any of the property or revenues of the taxing district necessary in the opinion of the Judge for essential governmental purposes or (c) any income producing property, unless the plan of adjustment so provides.

Nevertheless, the Supreme Court determined that, under the 1934 legislation, the court, and to some extent, the creditors through the court, had certain control over the municipality’s revenues and governmental affairs. In 1936, the Supreme Court of the United States held, in the case of Ashton v. Cameron County Water Improvement Dist., No. 1,[20] that the 1934 municipal bankruptcy legislation was unconstitutional because it infringed upon the sovereign powers of the States and potentially permitted too much control by a Federal court and by Federal legislation over municipalities, sub-sovereigns of the sovereign States.

In 1937, new legislation was passed attempting to cure the defects outlined by the Court in Ashton and to protect municipalities from the injurious protracted litigation that some were enduring. The 1937 municipal bankruptcy legislation, enacted in response to the Ashton decision, required:

(l)      no interference with the fiscal or governmental affairs of political subdivisions;

(2)      a restriction on the protection of bankruptcy to the taxing agency itself;

(3)      no involuntary proceedings;

(4)      no judicial control or jurisdiction over property and those revenues of the petitioning agency necessary for essential governmental purposes; and

(5)      no impairment of contractual obligations by the States.

This legislation was upheld by the Supreme Court in United States v. Bekins,[21] where the Supreme Court noted that the statute was carefully drawn so as not to impinge upon the sovereignty of the States. Like the 1934 legislation, language similar to the § 904 concept was included, although references to “the opinion of the Judge” were deleted.

Chapter IX then, while part of the Bankruptcy Act, provided a forum in which a municipality could voluntarily seek an adjustment of indebtedness if authorized by the State to file. A Chapter IX proceeding was not a proceeding to adjudge the city a bankrupt. The court’s jurisdiction did not extend to declaring the city bankrupt or to administering its affairs as a bankrupt. The court was limited to approving as a matter of law or carrying out a proposed plan for reorganization of a municipality’s debt.[22]

The principles enumerated in Ashton and the 1937 legislation are important in understanding the role of a Bankruptcy Court in a Chapter 9 proceeding today.[23] The Court cannot constitutionally interfere with the revenue, politics, or day-to-day operations of the municipality. The Bankruptcy Court cannot replace, by its rulings or appointments, the City Council or any other elected or appointed official. The limited, but vital, role of the Bankruptcy Court is to supervise the effective and appropriate adjustment of municipal debt in accordance with applicable law. (Obviously, the special limitations on the power of the Bankruptcy Court in a Chapter 9 case would not be applicable if the city consented to the stay or order of the court which affected its political or governmental powers.)[24] Historically, Chapter IX and its successor Chapter 9 were intended to facilitate rather than mandate voluntary municipal debt adjustment, not municipal debt elimination. States have in their legislation provided mechanisms to assist local governments in distress ranging from needed technical assistance to an emergency manager or receiver who takes charge of governmental operations and financing under State law.

Legislation by the State to Authorize Chapter 9

Only a municipality may be a debtor under Chapter 9 of the Bankruptcy Code.[25] Only a municipality can initiate a Chapter 9 proceeding. There can be no involuntary Chapter 9 proceeding. Not only are involuntary proceedings constitutionally prohibited, as set forth in Ashton, but also there is no statutory basis for such an involuntary action. Only § 301 of the Bankruptcy Code, providing for voluntary cases, is incorporated into Chapter 9. A municipality is a political subdivision, or public agency, or instrumentality of a State.[26] A municipality is not eligible to be a debtor pursuant to any other Chapter of the Bankruptcy Code.[27]

Moreover, under the 1994 Act, in order to proceed under Chapter 9, State law must have specifically authorized the entity to be a debtor under Chapter 9.[28] As noted, twelve States have specifically authorized a municipality to so proceed.[29] Two States have specifically prohibited municipalities from filing for relief under the Bankruptcy Code.[30] Another twelve States authorize a filing under certain conditions such as approval of the Governor, Treasurer, some legislative committee or authority or use of an additional review process such as the neutral evaluator in California. Three States authorize only a specific municipality or type of municipality to file. (Illinois currently only authorizes the Illinois Power Authority to file Chapter 9.) The remaining twenty-one States have no specific authorization so their municipalities cannot file Chapter 9 in California.  See Charts, Appendix 3 and 4.

Prior to 1994, a number of States had been silent on the issue of whether local governmental bodies were authorized to file under Chapter 9. The power of a municipality “to do all acts necessary, proper or convenient” including the right to sue and be sued had been held sufficient to authorize a municipality to file.[31] Given the judicial and legislative history surrounding municipal debt adjustments and State authorization to file a Chapter 9, it was important to note there could have been an overlooked problem in this regard. Commentators cited the reported decisions in North and South Shenango Joint Municipal Authority as a statement of law.[32] This case as reported could stand for the proposition that home rule power granted to a municipality is sufficient authority for it to be eligible to institute a Chapter 9 proceeding even though there is no expressed statutory power to file. However, such was not the final result in North and South Shenango, in which the Bankruptcy Court was reversed by the district court in an unreported decision.

In a decision arising out of the filing by a Colorado special purpose district before the 1994 legislation, the bankruptcy court revisited the same issue. The special purpose district had, under applicable statute, the ability to be a party to suits, actions and proceedings, to borrow money, incur indebtedness and issue bonds, to refund any bond indebtedness, to manage, control and supervise all of the business and affairs of the district and to exercise all rights and powers necessary or incidental to or implied from the special powers granted by the statute. The statute further provided that the specific powers granted should not be considered as limitations upon any power necessary or appropriate to carry out the purposes and intent of the statute. The court found that the express and specific authorization to file a Chapter 9 is not required by 11 U.S.C. § 109(c)(2) and the aforementioned general powers were sufficient to constitute a general authorization for a Chapter 9 filing. The court held that the ability to file a Chapter 9 was necessary or incidental to the power to refund bond indebtedness and the District’s ability to manage, control or supervise its business and affairs.[33] However, a Philadelphia bankruptcy court decision,[34] citing the North and South Shenango case, held that the right to sue and be sued did not constitute the requisite affirmative action required by the Bankruptcy Code. In the bankruptcy of the City of Bridgeport, the court also concluded that specific authorization to file a Chapter 9 petition was not required.[35] The legislative history behind the 1994 Act specifically noted the controversy and the purpose of the amendment to clarify the matter. The State law must specifically authorize the filing.[36] The court in the Orange County bankruptcy ruled that the Orange County Investment Pool was not specifically authorized to file a Chapter 9 petition by a statute which referenced a laundry list of public entities that are authorized to file but which did not refer to an investment fund.[37]

Should Congress Authorize the Commonwealth of Puerto Rico to File Chapter 9?

Given the history of Chapter 9 that is to be available to States a co-sovereign of the Federal Government to be used by States’ sub-sovereigns, municipalities, only if the State so authorizes raises questions of the “sovereignty” and autonomy of Puerto Rico. Even though Puerto Rico is a territory and a Commonwealth of the United States and could be viewed as a sub-sovereign of the Federal Government, it has enjoyed, and Congress has recognized, its unique status and its request to be treated like a State. States cannot file for protection under Chapter 9 due to their co-sovereign status and the Tenth Amendment.[38] As noted above, a Federal Bankruptcy Court cannot interfere with or stay, order or decree anything that would limit or impair a State’s control over its municipalities’ exercise of governmental powers including expenditure (§ 903 of the Bankruptcy Code) or authorize without the municipality’s consent interference with the municipality’s exercise of political or governmental powers, property, revenues or affairs of the municipality. Further, the municipality and the Court cannot violate such State law or constitutionally mandated actions to be taken by the municipality or authorize actions in the Plan of Adjustment that would do so. Accordingly, to the extent Congress desires to treat Puerto Rico like a State, allowing it to file under Chapter 9 would create a conflict with its unique “sovereignty” and raise constitutional questions regarding its statutory laws and constitution and whether the action could be taken under the Territorial Clause or the Bankruptcy Clause.

Further, if Chapter 9 were to apply to the Commonwealth of Puerto Rico, as opposed to its municipalities, such  would require significant redraft of Chapter 9 since it was never intended to apply to an entity like a State or “quasi state” like the Commonwealth of Puerto Rico with respect for its autonomy subject to the principles of the U.S. Constitution the Supremacy Clause and Territorial Clause inter alia. In addition, any such legislation should consider the unique “sovereignty” the Commonwealth of Puerto Rico and a sub-sovereign of a State such as:

  1. What is the Controlling Law for the Debtor? Municipalities are restricted to be in compliance with State law. A Federal Bankruptcy Court may not interfere with the political or governmental powers of the debtor or the revenues or property of the debtor without debtor consent (Section 904). What is the control over the debtor as to priorities of expenditures and actions (Section 903). State law provides guidance as to what the municipality can and cannot do. If the debtor is a Sovereign like Puerto Rico and more like a State as opposed to a sub-sovereign of a State, how is this determined and controlled?
  2. How is interim liquidity provided? If there is question as to the effectiveness of financing provided post petition you can go to the State and have it grant a statutory lien on the pledged revenues or source of payment as was done for the exit financing in Detroit to gain market acceptance.
  3. Post confirmation what are the guiding rules on ability to issue debt, debt limits, tax limits, financial controls supervision etc? Perhaps an interim financial review board can be established post confirmation but it may be helpful to have such a board in place during the case and after confirmation of a plan. What will be the role of the Governor and the legislature and who will be in control of the negotiations and plan development and what is subject to open meetings and freedom of information act provisions and what is not?
  4. What supervision will be provided post confirmation and by whom? Again a supervisory board to provide guidance to plan implementation would be necessary and provide some political cover. Would the same supervision help in the Chapter 9? Probably yes, for the same reason.
  5. As noted above, what law will Puerto Rico be governed by in proposing the plan of debt adjustment and implementation?
  6. Does Puerto Rico need supervision during the implementation phase of the plan and what is the legal basis to provide it and how will non-compliance be enforced?
  7. What will be the effect of future borrowing cost to Puerto Rico given the stigma of bankruptcy and a 200 to 300 basis point swing in the interest cost per annum for good and bad credits in the market today and far greater swing for Puerto Rico and other sovereign debtors as noted above. This could be a greater cost than the benefits of Chapter 9. We know part of the recovery of Puerto Rico will be borrowing for needed infrastructure or services so the economy can be stimulated and good new jobs created.

While Congress may have the power to authorize the Commonwealth to file a modified Chapter 9, that may not be the wisest approach. Chapter 9 is not preferable to establishing a financial oversight authority to provide oversight, financial rules of the road for reinvestment in Puerto Rico and best financial practices to be followed along with economic stimulus and development that would be the basis of a Recovery Plan for Puerto Rico. In addition the oversight authority should have the ability to refinancing the outstanding debt with the backing of the credit worthy authority credit enhancement (good as gold structure) that allows the refinancing to be at a borrowing cost of 200 to 400 basis points per annum lower than the debt refinanced.

As you may know in the hearings on HB 870 (Puerto Rico Chapter 9 Authority), I submitted a letter, at the request of the House Judiciary Committee (See Exhibit I, slides 134-138) which specifically referenced the fact that any legislation should not prevent the Federal Government from exercising its authority to provide oversight and to aid in the refinancing of the debt, as was done with MAC in New York City in 1975 with the use of PICA for Philadelphia and the DC Financial Control Board Congress provided in 1995.

Accordingly, Chapter 9 was not drafted to deal with the unique sovereignty of the Commonwealth of Puerto Rico and a significant redraft or redo of Chapter 9 is not practical or advisable. As will be discussed below, other alternatives are available that appear more effective and better designed to provide the technical assistance and financial oversight that build the credibility and consensus that lead to a successful Recovery Plan.

Should the Ability to Use Chapter 9 be Provided to Puerto Rico’s Municipalities including Public Corporation and Related Governmental Bodies?

As noted above, in conjunction with the House Judiciary Committee hearing on HB 870 earlier this year, the letter I submitted notes that the grant of authority to Puerto Rico to authorize, if it chooses, its municipalities including public corporations and related governmental bodies to be able to file Chapter 9 as a last resort when all other alternatives have not been successful would be consistent with Puerto Rico’s express desire to be considered more like a State than a sub-sovereign and, as noted above, is consistent with respecting the Constitution and statutory law of Puerto Rico. As you know, the term “State” as defined in § 101(52) of the Bankruptcy Code includes Puerto Rico and the District of Columbia except for the purpose of defining who may be a debtor under Chapter 9. Accordingly, there is a simple change of deleting the exception for Puerto Rico in the definition of State. Again, even if Puerto Rico is authorized to allow its municipalities to file Chapter 9, it should not exclude financial oversight and supervision by Puerto Rico or by an oversight authority created by Congress and should encourage consensual resolution through other alternatives.

If the Commonwealth of Puerto Rico is to be authorized to allow its municipalities to file Chapter 9, consideration by Congress and Puerto Rico should be given to providing technical assistance, financial oversight like a number of States have done to promote consensual resolution, financial credibility and a process with a proven record of success. As you know, only 12 States[39] allow a municipality solely on its own decision to file a Chapter 9 bankruptcy without a “second look,” either the approval of the governor, treasurer, some State agency or authority or a last effort at negotiation like the neutral evaluator in California (adopted in 2011) and 12 more require a second look. Since 1980, those municipalities with no second look are more than six times more likely to file Chapter 9 than in the State where a second look is required (200 versus 32). Accordingly, a review of a mechanism and procedure for a second look or oversight and assistance used by States in connection with consideration of the authorization of use of Chapter 9 municipalities seems prudent. Further, Congress’ consideration of the appropriate alternative recovery and resolution mechanism for the Commonwealth of Puerto Rico may be assisted by a review of how States have so provided oversight and help to their fiscally distressed municipalities when needed.

The Traditional Role of States in Assisting Financially Troubled Municipalities

States typically play an important role in assisting municipalities in times of financial distress. It is unusual that the largest city in the State has filed Chapter 9 bankruptcy as the best solution in face only one in over 70 years has done so namely Detroit in 2013. States traditionally have enacted legislation designed to protect their cities from financial distress or to aid cities should financial distress befall them.

Traditionally, States have attempted to supervise local government financing and limit volatility through the enactment of debt limitations and laws that permit the refunding of municipal obligations. Over time, States have developed more sophisticated mechanisms of assisting and providing oversight to their municipalities through the use of receivers, financial managers, and oversight and refinance authorities. Each State has its own, unique approach to these mechanisms. Various States have adopted different vehicles to provide supervision, oversight, and assistance to their municipalities on an ongoing basis and especially in times of financial distress. At their most basic, these methods, which may be found in legislation or constitutional provisions, include limitations on debt and taxes and on the authority to refinance outstanding debt. More hands‑on involvement by the States arises in the event of financial distress. Procedures devised for such situations generally start with the requirement to balance the budget and progress to review, assistance and oversight by the States of municipal budgets and financial issues.

In addition, States have developed unique approaches to the oversight, supervision, and assistance of local governments in times of emergency. These include advisory commissions that review the financials, the budgeting and financing done by municipalities, receiverships, financial managers, financial control boards, refinance authorities, oversight commissions, and others. These mechanisms will be briefly reviewed in this material and are discussed in more detail in Municipalities in Distress? referenced in footnote 10.

Financial Cycles Require That State and Local Governments Prepare for Economic Downturns

The impact of economic cycles has been demonstrated throughout the history of State and local government debt financing.[40] Unfortunately, we all recognize an adverse effect of downturns, namely, lower State and local government revenues. Nevertheless, economic downturns provide no holiday from the threat of higher State and local government expenses, which are highlighted by the ever-increasing need for improvement in infrastructure, education, health care, and public safety. Puerto Rico’s fiscal distress has demonstrated this all too well. Over time, various new mechanisms have been introduced by States to provide supervision and assistance to those local governments that are experiencing financial distress. There does not appear to be a reason any local government should have to endure, without supervision or assistance, the devastating effects of a financial meltdown and possibly to resort to the filing of municipal bankruptcy under Chapter 9 of the U.S. Bankruptcy Code. Traditionally, States have worked with their local governments to avoid financial meltdowns and bankruptcy, and there is no reason to believe that tradition will not continue.

How States Have Attempted to Supervise State and Local Government Financing and Volatility in Times of Economic Distress

Historically, States have adopted various mechanisms to provide supervision, oversight, and assistance to their municipalities on an ongoing basis and especially in times of financial distress. In the past, these mechanisms primarily have started with basic limitations on debt and taxes and authorization to issue refunding bonds.

At the front lines of protecting the financial status of local government are constitutional and statutory limitations on the debt municipalities may have outstanding at any time. In addition to debt limitations, all States include provisions in their statutory law for the issuance of refunding bonds.

Debt Limitations

One of the most important protections for municipalities and their creditors is the limitation that the various States have imposed on the amount of debt a municipality may issue and hold at any one time—in fact, all States with the exceptions of Alaska, Florida, and Tennessee impose some sort of limit.[41] Municipalities in 27 States and Puerto Rico are restricted by limits imposed by their respective constitutions. Twenty States and the District of Columbia that impose debt limitations on their municipalities do so via statutory provisions. These municipal debt limits range from a percentage of a valuation of assessed property in the local unit of government to a set monetary amount.[42]

Debt Limitation for Puerto Rico Municipalities

Under the Puerto Rican Constitution, the Puerto Rican legislature may fix municipal debt limitations, but the debt limitation shall not be less than 5 percent or more than 10 percent of the aggregate tax valuation of the property within the municipality. The Puerto Rican legislature has limited municipal general obligation bonds or notes to a total principal sum that, together with the principal to be paid for all other general obligations of the municipality, may not exceed 10 percent of the total appraised value of the property within the municipality. In addition, the municipality may not incur debt from notes in advance of municipal general obligation bonds exceeding 10 percent of the total appraised value of the property in the municipality and may not issue special obligation bonds exceeding 10 percent of the average recurrent operating income of the municipality in the two fiscal years immediately preceding the current fiscal year. Further, no municipality may issue notes or instruments in advance of taxes and revenues exceeding 10 percent of the average recurrent operating income of the municipality in the two fiscal years immediately preceding the current fiscal year.[43]

Tax Limitations for Puerto Rico Municipalities

The laws of the Commonwealth of Puerto Rico allow its municipalities to levy real property tax of up to 6 percent of the appraised value of the real property and a personal property tax of up to 4 percent of appraised value of personal property.[44]

Refunding Bonds

The most common way that municipalities restructure their debt is through the issuance of refunding bonds. Refunding bonds, as the name implies, are bonds that are issued to redeem the principal of outstanding bonds. Every State provides some sort of refunding bond provision for its municipalities. By issuing refunding bonds, a municipality may be able to refinance its debt at a more favorable interest rate or restructure its outstanding obligations to mature at a time when the municipality believes it will be more flush with money. Refunding bonds also may help a municipality to push off its debt troubles for another day. In most cases, the issuance of refunding bonds does not result in an increase in outstanding debt, because the refunded bonds no longer count toward the legal limits. By setting debt limits and taxing limits and allowing for the issuance of refunding bonds some States have attempted to curb the number of municipal financial crises and defaults. In certain situations, a municipalities’ entities may issue refunding bonds to refund and refinance outstanding debt. In addition to these provisions, some States have gone a step further to help beleaguered municipalities resolve their financial issues at the initial signs of a problem by providing financial oversight and technical assistance. Puerto Rico has refunding bond legislation.[45]

There is some truth to the old adage “while doctors bury their mistakes, governments refinance them.” As you probably know, China is concerned about the over $3 trillion of sub-sovereign debt of its provinces. China’s cities and local governments have amassed debt with the high interest rate thereon of about 400 to 500 basis points above treasury yield (3.5% on ten years). China is presently exchanging (refinancing) some of the sub-sovereign debt and hopes to achieve interest rate savings of 300 basis points or more per year. As noted above, the present value of saving 2% interest charge per year on a bullet maturity of 20 years at a 5% discount on a $1 billion of debt is approximately $250 million. Even greater savings might be able to be obtained from refinancing through financial credibility support of an oversight authority in refinancing Puerto Rico’s related debt. In some respects perhaps more could be obtained from such refinancing than could be obtained by Puerto Rico from any of the proposed debt restructuring that they have discussed. Certainly refinancing savings would be better for the ability of Puerto Rico to obtain financing from the capital markets in the future.

The Use of Various Mechanisms by States to Provide Financial Oversight and Assistance to Municipalities in Distress to Avoid the Use of Chapter 9

The limitation on indebtedness and authorization to issue refunding bonds are the basic tools in the States’ arsenal to assist municipalities and Puerto Rico has likewise provided for its municipalities. However, in times of financial distress, these basic approaches have been enhanced by additional mechanisms. These methods have started with reaffirming statutory requirements to balance budgets and progressed to greater State assistance and oversight of municipal budgets and finances in times of financial emergency as well as the use of refinance authorities, receivers, financial managers and financial oversight authorities. States have approached the task of supervising and assisting their municipalities in a variety of ways. Although these mechanisms vary by type and degree of supervision and assistance, the widespread development of these mechanisms indicates the growing trend of more active oversight and supervision of municipalities by States in order to build better credibility with citizens and creditors, including the municipal bond market. A review of these mechanisms may be helpful to Congress in considering what alternative oversight and assistance can be provided to the Commonwealth and its municipalities.

State-Implemented Programs to Assist in Time of Financial Crisis

As discussed below, over half of States have implemented municipal debt supervision or restructuring mechanisms to aid municipalities. These programs, many of which are identified in the Table below and which are described in detail in Municipalities in Distress?, range from the California Debt and Investment Advisory Commission and the Florida Local Government Financial Technical Assistance Program, which provide guidance for and keep records of the issuance of municipal bonds in those States, to the layered approach of Rhode Island to aid municipalities depending on a municipality’s level of financial instability. Other States with these provisions have effectively used these mechanisms to control the restructuring of their municipalities.


Table:             State-Implemented Programs to Aid Municipalities
State Intervention Provision
Arizona School District Receivership
California Debt and Investment Advisory Commission
Connecticut Ad hoc State Intervention
District of Columbia Financial Responsibility and Management Assistance Authority
Florida Bond Financial Emergencies Act and Division of Bond Finance and Local Government Financial Technical Assistance Program
Georgia Government Monitoring
Idaho Debt Readjustment Plans
Illinois Local Government Financial Planning and Supervision Act and Illinois Financially Distressed City Law
Indiana Distressed Political Subdivision Protections and Township Assistance and Emergency Manager
Kentucky County Restructuring Provisions
Maine Board of Emergency Municipal Finance
Massachusetts Ad hoc State Intervention and State Bond Intervention
Michigan Emergency Financial Management and Local Government and School District Fiscal Accountability Act and Local Financial Stability and Choice Act
Minnesota Back-Up Payment Procedures for Municipalities and School Districts
Nevada Local Government Financial Assistance and Audit Enforcement Act and Severe Financial Emergency
New Hampshire Emergency Financial Assistance
New Jersey Local Government Supervision Act and Municipal Rehabilitation and Economic Recovery Act of 2002 and Special Municipal Aid Act
New York Emergency Financial Control Board; Municipal Assistance Corporation; New York Financial Control Board and State Comptroller’s Fiscal Stress Monitoring System
North Carolina Local Government Finance Act and the Local Government Commission
Ohio State Auditor’s Fiscal Caution and Fiscal Watch; Fiscal Emergency; and the Fiscal Emergencies and Financial Planning and Supervision Commission
Oregon County Public Safety Emergency and Fiscal Control Board and Municipal Debt Advisory Commission
Pennsylvania Financially Distressed Municipalities Act; Intergovernmental Cooperation Act
Rhode Island Fiscal Overseer; Municipal Receiver; Budget Commission
Tennessee Emergency Financial Aid to Local Government Financially Distressed Municipal Procedures
Texas Municipal Receivership
Wisconsin Deficiency Protection for Public Improvement Bonds

In Puerto Rico, the Municipal Revenues Collection Center collects proceeds of a special surtax and any other property tax. The center then deposits the special surtax in the municipality’s account in the Redemption Fund. If the Government Bank determines the deposits in the municipality’s account are not sufficient to cover the principal and interest payment on any existing general obligation bonds, the Government Bank must notify the center, and the center must deposit into the municipality’s account an amount sufficient to cover the bond payments from other income subject to the first lien created by this provision. Although this provision has never been used, on its face it would require the deposit of an amount sufficient to cover bond payments pre-default.[46]

States Recognizing Municipal Receivers: Rhode Island and Texas

Some States provide for the appointment of a receiver for troubled municipalities. For example, in June 2010, Rhode Island enacted a law providing a process of progressive State intervention for municipalities in financial distress. The new law created a three-step process for distressed government, in what was possibly an attempt by Rhode Island to prevent ad hoc efforts by municipalities to restructure with tactics that could be unfriendly to the municipal markets.[47]

In addition to the recent Rhode Island law and a law in Texas allowing for a judicially appointed municipal receiver, other States have chosen to allow for a financial control board, emergency managers, coordinators, overseers, or a financial commission to aid troubled municipalities.

Financial Control Boards and Their Progeny

Today, the laws of Florida, Indiana, Michigan, Nevada, New Jersey, New York, North Carolina, Pennsylvania, and Rhode Island include a variation on a provision allowing for the appointment of a financial control board or commission, emergency managers, receivers, coordinators, or overseers over a troubled unit of local government. The intent of many of these provisions is to identify early signs of financial distress for a city or municipality so that the State may intervene before the city or municipality reaches the level of a municipal crisis. Importantly, such provisions are not just a web of buried State laws never to be used but, rather, are applied where situations call for intervention.

The New York Experience. Perhaps the most well‑known appointment of a financial commission was the implementation of the New York City Financial Control Board in 1975. In the spring of 1975, New York City was unable to market its debt because the bond market had discovered that, for more than ten years, New York City had been using questionable accounting and borrowing practices to eliminate its annual budget deficits.[48] Banks refused to renew short‑term loans that were maturing or to loan additional cash to the city, and only State cash advances were keeping the city afloat. The city’s spending for operating purposes exceeded operating revenues over several years, and the accumulated fund deficit could be resolved only by increasing amounts of short‑term borrowing. New York City itself had no funds to meet its short-term obligations. New York City nearly defaulted on the payment of its notes in October 1975, and it was predicted that a default was likely in December absent federal aid.[49] In response, the State Municipal Assistance Corporation issued a series of securities on behalf of the city and a financial control board was appointed.

The New York City Financial Control Board was given the power and responsibility to review and provide oversight with respect to the financial management of New York City’s government. Among other things, the act establishing the board required the city to prepare and submit a “rolling” four‑year financial plan to the Financial Control Board prior to the beginning of each city fiscal year.

The Pennsylvania Experience. Similar to the New York experience, Pennsylvania has implemented a series of provisions to aid ailing cities. Pennsylvania law contains the Financially Distressed Municipalities Act, which applies to any county, borough, incorporated town, township, or home‑rule municipality (Act 47).[50] Under these provisions, if the State’s Department of Community Affairs determines that a municipality is financially distressed based on certain triggering events, the department may appoint a coordinator to guide the municipality in getting its financial affairs in order. Since 1987, there have been only 29 municipalities that have chosen to involve the Act 47 declaration of and determination of financial distress and only 10 so far have had the determination rescinded.

In addition to the Financially Distressed Municipalities Act, Pennsylvania law contains the Intergovernmental Cooperation Authority Act, which was created in 1991 to deal with insolvency issues faced by Philadelphia. The act created a five-member authority with authorization to enter into intergovernmental cooperation agreements with cities, and these agreements were preconditions to the issuance of any obligations by the authority. Among other things, the authority could issue bonds and the city and the authority were required to work together to develop a five-year recovery financial plan.

The Michigan Experience. Likewise, the State of Michigan, under its former Local Government Fiscal Responsibility Act, has taken over the Detroit Public Schools, the City of Pontiac, the City of Ecorse, the Village of Three Oaks, the City of Hamtramck, the City of Highland Park, and the City of Flint.[51] These provisions were subsequently replaced by the Local Government and School District Fiscal Accountability Act.[52] Under this act, if a school district or municipality was in a perilous financial situation, the governor of Michigan could declare a financial emergency. Should the municipality or school district enter into a financial emergency and an emergency manager be appointed, the emergency manager had broad powers to operate and restructure the municipality, including the ability to reject, modify, or renegotiate contractual obligations.[53] As a last resort, this emergency manager could file a Chapter 9 municipal bankruptcy petition on behalf of the municipality.[54] This Public Act 4 of 2011 provided for a Michigan emergency manager with extraordinary power. The act was very controversial, especially to local government bodies and elected officials. A referendum placed on the November 6, 2012, ballot defeated Public Act 4 of 2011, the Michigan Emergency Manager Law.

On December 27, 2012, the governor of Michigan signed into law the Local Financial Stability and Choice Act,[55] which replaced the defeated Public Act 4. Also, in 2012, Indiana passed legislation allowing its Distressed Political Subdivisions Appeal Board to appoint an emergency manager for its distressed subdivisions on grounds and with powers similar to the Michigan emergency manager.[56]

The Massachusetts Ad Hoc Experience. Similar to the laws of States establishing specific authority for financial control boards or similar commissions, Massachusetts has typically employed a system of implementing legislation on an ad hoc basis to create a financial control board or overseers for municipalities in severe financial distress.

The California Experience: Neutral Evaluator. California also has experimented with the concept of introducing a third party to assist in the resolution of municipal financial difficulties. California recently enacted a provision restricting the ability of its municipalities to file petitions to institute Chapter 9 proceedings.[57] The thrust of the legislation is to provide a period of objective and dedicated negotiation and resolution of issues affecting major creditors or financial problems. The legislation provides for a neutral evaluation process, otherwise known as mediation, for major creditors and parties to the financial problems. The neutral evaluator process provides a professional, independent, neutral advisor to serve as the supervising adult, which is the essence of a neutral evaluator. The neutral evaluator can foster negotiations among the municipality and representatives of major creditor constituencies, including workers and union representatives, vendors, contract suppliers, holders of major claims including bondholders, judgment creditors, or others whose interests could affect the financial fate of the municipality. The neutral evaluator process may not last more than 60 days from the date the evaluator is chosen unless the municipality or a majority of participating interested parties elect to extend the process up to an additional 30 days. The neutral evaluator procedure is intended to be an expedited process and cannot last more than 90 days from the date of the selection of the neutral evaluator. In Municipalities in Distress?, referenced in footnote 10, there is a discussion of questions arising from the California neutral evaluator process that may be worthy of review and consideration in connection with oversight and assistance for the Commonwealth of Puerto Rico and its municipalities:

There have been in use of the neutral evaluator process in the Stockton case in particular implementation questions such as (1) how do you ensure participation by all affected creditor representatives; (2) how do you motivate the municipality and creditors to drop public posturing, adopt realistic demands and explore realistic alternatives; (3) who determines what is sustainable and affordable; (4) where do needed additional revenues come from; (5) what rights under State laws and constitutional provisions are protected from change, if any, including recognition that statutory liens and special revenues cannot be altered by a municipality or impaired; (6) are constitutional and statutory laws against impairment of pension benefits a bar to changing labor costs and pension benefits which in Chapter 9 can be modified; (7) what should be allowed to be public about the neutral evaluation process and what should be kept confidential for the sake of honest negotiation, such as whether exceptions from open meetings and freedom of information laws should apply and how confidentiality will be protected; and (8) what if more than 90 days is required to reach agreement?

North Carolina Experience. Due to a significant number of local government defaults during the Great Depression, North Carolina created the Local Government Finance Commission as part of the North Carolina Department of the State Treasurer. The Commission provides oversight and assistance to North Carolina local governments. No debt can be incurred by any local government in North Carolina without the supervision and assistance of that Commission and the oversight continues as to annual financial reporting and accounting of the fiscal health of the local governmental offering broad assistance in financial administration. This is supervision of debt incurrence from cradle to payment in full.

The passage of legislation permitting the Commonwealth of Puerto Rico to allow its municipalities to be able to file Chapter 9 should not preclude Congress from providing financial oversight and technical assistance to the Commonwealth and its governmental bodies similar to what States have provided to hopefully avoid financial meltdown and use of a Chapter 9 filing to rescue their financially challenged municipalities.[58] These alternatives to Chapter 9 that certain States have provided to avoid the cost and stigma of Chapter 9 have been well-accepted and appreciated by the municipal market. For this reason, every State provides for some form of refinancing of municipal obligations and some States provide various forms of oversight, supervision and financial support to the distressed municipality. The ability to file Chapter 9 does not prevent as an alternative the oversight, supervision and refinancing of the debt of a financially challenged municipality as was done with New York City in 1975 and the formation by New York State legislation of a Municipal Assistance Corporation that helped supervise the financial recovery of the City and refinance its debt or similar assistance by Ohio to Cleveland in 1978 or by Pennsylvania to Philadelphia in 1991 with the passage of the Pennsylvania Inter-Governmental Cooperation Act or by Congress to Washington, D.C. in 1995 with the passage of the District of Columbia Financial Responsibility and Management Assistance Authority. Further, the passage of the Bill would not preclude the oversight and supervision, budget commission or determination of what is sustainable and affordable and what is not such as authorized by recent legislation in Rhode Island or the use of an emergency manager as permitted by legislation in Michigan and Indiana or financial control boards in New York State or Act 47 used in Pennsylvania.

Development of the Financial Oversight and Recovery Authority for Territories including the Commonwealth of Puerto Rico and Its Municipalities, Public Corporations and Related Governmental Bodies

The experience of the New York Financial Control Board, Detroit with the emergency manager, the Rhode Island receiver approach, and the mediator of the California statutory scheme have coalesced in the concept of a government protection authority. An outline of the proposal for other sovereigns is set forth in Exhibit I, slides 75-93. The principles set forth herein can be detailed in proposed legislation that would create acceptance and “buy in” by the Commonwealth and its governmental bodies, its citizens, its creditors as well as the international community as providing needed financial oversight and credibility while respecting the rights of the Commonwealth and its creditors. Under consideration by some States is the use of a government protection authority utilizing some of the best aspects from the mediation process of the neutral evaluator and the oversight and supervision of financial control boards and financial management. Under this government debt resolution mechanism, Congress under the Territorial Clause and Bankruptcy Clause would establish an entity that would have a quasi-judicial function and power similar to a commission or special master appointed by a court. The members of the authority would be independent, experienced experts in governmental operation or finance as well as in mediation and debt resolution techniques, including bankruptcy. The authority would start with legislation for the authority that would encourage the Commonwealth and its governmental bodies to accept and join in as well as its creditors as an opportunity for an integrated holistic approach to addressing their concerns. The structure of the authority would assure all parties of a fair, impartial process designed to foster consensual resolution of issues. The procedures of the authority would require transparent financial information that is vetted and determined to be accurate and the basis of sustainable and affordable budgets and financial proposals. Consideration must be given of financial goals and triggers to ensure balanced budgets, oversight and assistance to prevent further financial erosion. Such oversight and assistance would address the financial and operational problems as well as social programs to ensure adequate funding of essential services, infrastructure, stimulate economic development and promote financial credibility in dealing with creditors and citizens.

The first step is to make sure that accurate financial information is available to all so that interim and long term budgets and any necessary financing to ensure liquidity and funding is available during the process so that human suffering from inadequate services and infrastructure is reduced or eliminated and dealing with creditors is not complicated with financial illiquidity so there is no time for rational thought and discussion. The more expedited the agreement of the Commonwealth and its creditors on the basic financial numbers and the extent of the financial crisis, the quicker and better the resolution for all. Without this process, the past obstacles of dueling financial numbers and debate over whether payment can be made or not will lead to financial meltdown. This process is aimed at reducing or eliminating unprofitable debate by either having everyone agree to the financial numbers or have the authority, through a vetting process with the input from all parties, determine what is sustainable and affordable what is not.

Once the critical budgeting and financial transparency is accomplished, the concurrent steps of discussion, mediation and resolution of financial issues and creditor dispute can be effectively addressed and resolved. Resolution is more probable and more constructive when everyone is on the same financial statement page. The goal is consensual agreement by the Commonwealth and the affected creditor constituencies. However, participation by the authority may be voluntary by acceptance by the Commonwealth and other affected constituencies or otherwise necessary mandated by the financial emergency. Negotiation, mediation and discussion of positions are strictly confidential. Laws establishing the authority may have an exception to any open meetings law and its freedom of information law to allow for open discussion of any sensitive and confidential topics. If additional tax revenues or loans or grants from the Commonwealth or financing are needed, recommendations to the Commonwealth by the authority may be made. The authority may be empowered to recommend increased taxes or other actions. Specified time periods for resolution will be set forth and, if the voluntary process is not successful, the second phase may be requested or may be required if the authority so determines.

In the second phase if consensual agreement is not reached, the authority and its designated members turn into a quasi-judicial panel, and the Commonwealth is required to set forth the steps to be taken to address its specific financial problems (recovery plan). Creditors, workers, and taxpayers will have the ability to comment and to attempt, through negotiation, to modify the recovery plan within a set period of time. Then, the recovery plan is presented to the members of the authority for determination of the plan’s feasibility and whether it is reasonably fair to creditors’ interests in relation to the requirement that, under all circumstances, essential governmental services, at least at an established necessary level, must be maintained for the reasonable future. One of the triggers for the authority’s action is the petition of the Commonwealth, its workers, taxpayers or creditors that a governmental function emergency exists or creditor litigation or action threaten a fair resolution for all creditors and the Commonwealth and its citizens of the open issues. The petition should state what essential services as to the health, safety, and welfare of its residents are being threatened or threatened creditor action and that the forced reduction in services, given the government’s financial condition and its revenues, impairs the health, safety, and general welfare of its residents. The authority, after hearing all sides (government, workers, taxpayers, affected creditors), will determine:

  • What is sustainable and affordable;
  • What the government can afford; and
  • What adjustments must be made to the recovery plan to allow the Commonwealth to continue to provide essential governmental services to its residents at established mandated levels to preserve the health, safety, and welfare of its residents and to pay what is feasible to its creditors, including workers’ wages and pensions.

The authority would act as an “honest broker” to review budgets, operation efficiency and financial plan and to approve or make recommendations so that good decisions are recognized and supported and questionable ones are vetted so that bad decisions are avoided. To the extent justified by financial analysis, the authority may recommend increases in taxes, where necessary; increases in contributions or concessions by the various interested parties who agree, if necessary; or reduction, delay, or stretching out of payments to creditors if legally permitted and necessary. Further, if necessary to preserve the public health, safety, and welfare of the Commonwealth’s residents, the authority will have the power to recommend adjustments to workers’ wages, pensions, or other benefits.

Under this process a government that underestimates in its recovery plan its ability to pay creditors or for services will have necessary increases recommended and found by the authority to be required for the benefits of the workers, citizens and the creditors. A government that overestimates its ability to pay or makes promises that are not sustainable and affordable will be subject to the recommendation of the authority that payments available to creditors be reduced or taxes possibly increased. The findings of the authority will specify if they are final and enforceable by the parties or if further negotiations or proceedings are necessary. The authority will be charged to make sure that the Commonwealth and its governmental bodies maintain access to the financial markets, and the ability to borrow will be protected to the fullest extent possible. This authority process should help protect all parties, workers, vendors, and creditors and the taxpayers and the government so they will have needed means of continued financing credibility that can be accomplished based upon maintaining market credibility. The authority can authorize the municipality to enforce its findings in a Federal District Court as an exercise of the Bankruptcy Clause power. Likewise, the Authority may enforce its jurisdiction in the Federal District Court under the Bankruptcy Clause including a stay similar to an automatic stay in a bankruptcy proceeding if needed to prevent precipitous creditors action that would be adverse to the interests of other creditors and the Commonwealth. As noted above, this process of using a Financial Oversight and Recovery Assistance Authority would be available to all territories as approved by Congress as a uniform law for territories under the Bankruptcy Clause and an exercise of the Territorial Clause. The findings, determinations, and rulings of the authority can have the force of law as a final court order by providing that the Federal District Court reaffirms them. Such means of reinforcement can including have the recovery plan as approved or revised by the Authority approved by the Federal Court like a pre-negotiated or “pre-packaged” Chapter 9 plan. The authority could be allowed to authorize municipalities, public corporations and related governmental bodies to file for a Chapter 9 proceeding but only after the “second look” by the Commonwealth and authority as noted above and every effort to use the mediation and determination of what is sustainable and affordable available through the authority to avoid any unnecessary use of Chapter 9. The use of Chapter 9 by a municipality could be based on the recovery plan as a pre-packaged plan. Such a pre-packaged Chapter 9 plan can significantly reduce costs, expenses, uncertainty, and financial market risk of a free‑fall Chapter 9 proceeding. In the corporate world, for instance, pre‑packaged Chapter 11 plans (corporate plans of reorganization) have been confirmed in weeks rather than months or years with reduced costs, risks, and uncertainties.

This Financial Oversight and Recovery Assistance Authority concept could be the means of providing the Commonwealth and its related governments with cooperation and oversight while allowing the Commonwealth and its related governments their elected officials, workers and unions, creditors and bondholders to have a means of participation with a definitive end result. Further, the resolution for affected workers and creditors can be hard-wired for a payment source of dedicated taxes for assured payment of wages, benefits, and creditor claims rather than the speculative hope of future payment at the willingness of future legislative actions.

The Structure for Oversight and Emergency Financing

Local governments that have encountered financial distress have resorted to financing and oversight authorities (such as New York City and Philadelphia). This approach can involve various degrees of formal oversight and control. In the beginning, it can be as simple and benign as a “commission” or “authority” that reviews the city budget and makes recommendations based on new revenue sources. If necessary, the authority can develop into a refinancing authority with full power to refinance existing debt of the local government and to authorize collection of new revenue sources or withdraw use of new revenue sources if budget recommendations are not followed or met. There are two basic advantages to this approach:

  • The new independent conduit issuer can have financial credibility and, therefore, access to borrowing in the capital marketplace if it has an assured source of revenue to pay debt service that is isolated from the bankruptcy and other legal risks; and
  • An independent authority can use various tools to enforce fiscal discipline on the government because it can be removed from political pressures.

The basic idea is that the Commonwealth requests needed financing that is approved by the authority. Congress in its legislation may authorize the authority to be a conduit borrower with the ability to structure financial assurance to creditors by means of a revenue source that is irrevocable and dedicated to be used to pay the debt. The Authority then borrows and assigns the revenue source to pay debt service on the debt to creditors. The authority makes the bond proceeds available to the Commonwealth to refinance expensive debt, pay its expenses, retire its deficit and to provide funds for necessary infrastructure enhancement to foster improved economic growth. A basic legislative choice is whether the local government levies the new taxes and pledges the proceeds to the authority or the authority is the taxing body authorized to levy taxes. In addition, the government’s ability to levy new taxes may be conditioned on a balanced budget or approval of the authority. The New York Times has favorably reported on this concept of an authority as a structure to assist troubled cities deal with their problems, including issues of pension and debt obligations.  See Walsh, Mary Williams. “Stepping Up with a Plan to Save American Cities.” New York Times, 12 Nov. 2013, NY ed: F16.

Financing through the authority can be used both for a long‑term amortization of the cumulative deficit and, if necessary, for an interim period, to accomplish the annual revenue anticipation note borrowings that are necessary for the government to operate. Different revenue sources might be used for each type of borrowing. The disciplinary tools are important and a wide range of tools can be constructed, including the following:

Loans from the Federal Government or Capital Market Sources. Rather than a grant from the federal government, the federal, government or capital market sources can make loans that require ultimate repayment. The loan becomes a tool if the Authority imposes performance conditions as a precondition to any loan. The repayment terms can be varied depending upon the government’s compliance with an approved financial plan and the achievement of goals over time. That is, interest rates can be increased or decreased as needed; in a worst‑case scenario, principal payment can be accelerated for a default. There can also be in certain States the assumption of the obligations by the State.

Intercepts. Part of the discussion in structuring grants and loans should consider “intercepting” the payments to the local government. Legislation can be written that permits the Authority or the Commonwealth to withhold these payments if the government (Commonwealth or local) acts inappropriately or fails to act, or may provide those revenues to be pledged (e.g., paid directly) to lenders or bondholders. In the implementation stage, there is an issue of whether special interest groups, such as unions, local financial institutions, or pension funds might have the ability and willingness to invest in such financing. New York City had support from unions in purchasing significant positions of its refinancing debt.

Budget Process Involvement. Having a financial plan to work out of the deficit, following that plan, and changing the plan as experience dictates are the keys to a successful workout. The first step is to identify the problems and to stop the financial bleeding to the degree possible. The Financial Oversight and Recovery Assistance Authority, as noted above, can provide such oversight.

Required Financial Performance. The authority can legislatively be given powers to participate in and monitor the government’s budget process across a broad spectrum. Ultimately, the teeth in the program are that bond proceeds or new tax revenue sources are not made available to the local government until it complies with the plan, and that continued compliance is required for a continuing revenue flow. The legislation itself can contain the requirements, or it can authorize the authority to develop and establish the requirements.

Legislative Assistance. A financially distressed government comes as a somewhat recalcitrant beggar to the legislature.  An authority that is monitoring (and actively participating in) the government’s recovery can give it credibility with the legislature or, alternatively, if the government fails to make progress, can assist the legislature in developing new criteria and programs.

Appointment of Authority Members. The makeup of the governing body of the Financial Oversight and Recovery Assistance Authority is critical to its success. Payment of its staff is important. It is conceivable that some community leaders may be willing to serve without compensation if they believe the authority and its tools are capable of success. Representation by members nominated or acceptable to the Commonwealth, it’s creditors and citizens is important for credibility with all. The extent of the interested parties’ participation and ability to appoint or be represented on the authority is a question for the drafters of the legislation.

Acceleration of Loans. If the authority makes loans to the government, the loan could include the right to accelerate repayment of the obligations if the government fails to comply with the recovery plan.

Publicity. By participating in the government recovery process, the authority can become a mechanism for disseminating both good and bad information about the progress of the local government’s recovery efforts. Such information flow and disclosure will be helpful in building credibility with the investment community. The experiences of New York City, Cleveland, and Philadelphia stress the importance of accurate and clear communication with the financial market.

Powers. The authority can have as many or as few powers as the legislature may require, including but not limited to:

  1. Authorizing filing of a judicial action for debt adjustment by the local government;
  2. Granting, after hearing and notice, a stay against litigation and debt enforcement;
  3. Approving or withdrawing future use of increased tax revenues;
  4. Rejecting or approving budget, financial plans, and future financing;
  5. Determining financial emergency or recovery;
  6. Approving, expediting, or withholding tax revenues or aid and entitlement to taxes distributed to the government;
  7. Approving or issuing bonds for refinancing debt or paying government deficit or extraordinary operating expenses;
  8. Reporting to the Congress or the Commonwealth regarding the need for further legislative or disciplinary tools; and
  9. Transferring certain governmental services to other governmental bodies or consolidating governmental services on a regional basis or with other municipalities.

Consolidation of Regional Essential Governmental Services. One interesting proposition for States and to a degree for the Commonwealth and territories is whether certain essential governmental services such as public safety (police and fire) or public health or education should be consolidated and combined on a regional basis to gain the benefits of the efficiencies and elimination of duplicative and overlapping services and administration.

Legislation can be written so that some or all of the above-described tools are available to the authority. These tools can be designed and enacted so that they are mandatory or discretionary. The choices and variations can be further delineated. A variation of the intercept and periodic financial reporting has been used in connection with troubled debt securities issued by local government as a mechanism to ensure the flow of payments from taxes or fees to the bondholders.

Any Financial Oversight and Recovery Assistance Authority should have sufficient power and authority under law to effectively supervise a distressed government namely the Commonwealth or territory. Accordingly, any such oversight and reference authority should be authorized to be able to:

  1. Require balanced budgets and provide economic discipline and reporting;
  2. Issue debt in the government’s name or as a separate entity to obtain market credibility and access;
  3. Have the power to negotiate debt restructuring if all efforts by the government fail and quasi-judicial jurisdiction;
  4. Review services or costs and whether they should be transferred to other governmental bodies;
  5. Have the right to intercept tax revenue and ensure payment for essential services and necessary operating costs;
  6. Have the power to authorize a judicial action if needed;
  7. Obtain bridge financing of, or refinance, troubled debt;
  8. Transfer certain services to other governmental agencies to reduce expenditures;
  9. Grant funds to the government to bridge the financial crisis;
  10. Provide funds to the government by means of a loan with terms that are realistic or payable from out-of-state tax sources that can be offset;
  11. Use an intercept of taxes payable to the government to ensure essential municipal service;
  12. Create private-public partnerships to lease and sell municipal properties to provide bridge financing and cash-flow relief;
  13. Develop a vendor assistance program to provide vendor payments through financing by purchase of vendor claims at a discount (fixed discount) and secured by payment from dedicated tax revenues over time or provide current cash flow relief from current or future vendor payments;
  14. Explore the consolidation on a regional basis of certain governmental services; and
  15. Monitor compliance with any restructuring plan to ensure compliance and prevent financial erosion.

Respecting Traditions and Principles of Government Financing is Essential to a Successful Recovery Plan

Our Founding Fathers recognized the importance of financial credibility to a country long term and success as a government that provides for the health, safety, welfare and prosperity of its citizens. As George Washington stated over 220 years ago in his State of the Union Address of December 3, 1793:

“No pecuniary consideration is more urgent than the regular redemption and discharge of public debt. On none can delay be more injurious or economy of time more valuable.”

These words were referencing the debts of the Revolutionary War incurred by the States that were assumed by the federal government to insure continued market credibility for the newborn nation and its States. Washington and Hamilton were instrumental in having the federal government assume the former colonies’ (States’) debt from the Revolutionary War since some States were balking at paying such debt which they believed was a financial game, and they feared their taxes would go to pay northern speculators or debt or States who incurred large war debts like Massachusetts and South Carolina. Washington and Hamilton knew the progress of a new nation could be no swifter than its financial credibility. For this reason, the assured payment of the revolutionary war debt through assumption by the federal government began the long, proud history of payment of State and local government debt to insure market credibility. Hamilton at the same time announced his principle of the “immortality of public debt”[59] namely a government, federal, State or local, should not incur debt unless at the same time it dedicates a revenue source sufficient to pay and thereby assuring payment without fear of change of circumstances, means or payment of the debt.

As recognized in the 1988 Amendments to the Bankruptcy Code and the Senate Report on that legislation traditions of government financing must be recognized and protected in any bankruptcy or restructuring law. “Special Revenues” are tax revenues that the government specifically pledged and dedicated to the payment of the associated financing debt and must be paid as bargained for without impairment to the creditors contractual rights. This respect for Special Revenues is so that government can continue to have access to the capital markets and be able to borrow at a low cost. (See §§ 902(2), 922(d) and 928 of the Bankruptcy Code).[60] Accordingly, Special Revenues should be so respected in any oversight or financial restructuring of the Commonwealth and its related governments and public corporation debts. Likewise statutory liens that are created and arise from a governmental statute or constitutional provisions must be honored and not impaired, delayed or interfered with. This follows from the principles articulated by Ashton and Bekins as to State control over a municipalities’ exercise of governmental powers cannot be impaired or limited as required by Sections 903 and 904 of the Bankruptcy Code.[61]

Failure to follow these principles will only make the restructuring process and recovery more difficult if not impossible but also may cause future necessary borrowing cost to be too expensive for long term financial survival. The lessons learned from past and recent sovereign debt crises is that any adverse effect to the government’s financial credibility going forward increases its future cost of borrowing and frustrates economic recovery and future governmental services. As noted above, Greece has defaulted on its sovereign debt at least five times since 1826 and prior to its recent saga (1826, 1843, 1860, 1894 and 1932) and Greece’s ten year bonds in March 2012 had an annual yield of 37.1% even after its recent bailout its annual yield is over 10.5% with a 52 week range of 5.5% and 19.5%. Brazil has a large economy and has defaulted at least eleven times since 1826, that time in 1990 and still has an average ten year bond annual yield between 2006 and 2015 of approximately 12.3% with an all time high of 17.91% in October 2008. Puerto Rico is presently experience annual bond yield in excess of 10% if financing is available (see yield on ten year Puerto Rico General Obligation Bonds in February 2014). At the same time the bond yield for U.S.A., Germany, France and Canada are around 2% or less. The consequences of not following the principles of government finance are clear and painful.

Government Operations and Creditor Protections

While in an oversight, restructuring process or a Chapter 9 proceeding, the government will still have to function as a government. Depending upon the constitutional or statutory mission of the government, there are certain necessary and basic government services that must be provided, such as public safety (police and fire), public health and welfare (education and health, transportation, building and zoning and, under certain instances, sewer, water and electrical services). History has shown that governments in financial distress need a recovery plan that stimulates economic activity in the government and encourages business to locate or expand there. This business expansion typically creates new, good jobs that increase tax revenues that lead to the recovery and the solution of financial distress. Also, in order to effectuate a recovery plan, which is necessary for a turnaround, and to prevent future financial distress, there must be funding of essential government services. This will produce a stimulation of the economy and encourage growth of the municipality which will attract new businesses and new citizens. This economic growth will create needed jobs, especially for younger workers who will in turn become taxpayers and which will result in increased tax revenues. In order to accomplish the recovery plan, improved infrastructure is required in order to ensure the required movement of goods, services and workers. In addition, enhanced education programs are important to train young workers for the specific jobs created. Further, improved public safety and welfare programs that will lead to a constructive environment fostering economic growth and recovery.

Defining these necessary governmental services is a question of constitutional or statutory law and local choice and may by itself be a complex issue. However, the economic benefits of reinvesting in the government are real and essential to a successful recovery. This is demonstrated by an economic study that show that for each $1 invested in hard infrastructure expense there is an economic impact of $3.21 over twenty years.[62] For each new job created, there is a job multiplier from 2 to 4 jobs or more depending on the ancillary services necessary and the material services or goods required to be purchased for the job and jobs salary or benefits.

Lengthy Litigation on the Competing Rights of Creditors
May Not Be in Their Best Interest

Governments cannot pay that which they have no revenues to fund. Further, when obligations become so overwhelming to a government as to crowd out necessary expenses for essential governmental services and infrastructure, the consequences can be devastating and can lead to the meltdown of the government and the economy.

Without a successful recovery plan, there will not be enough funds to employ workers, provide essential services, programs and fund necessary infrastructure improvements. In reality, the future of paying creditors including pension funding, workers continued employment and a recovery plan is dependent upon determining what costs and expenses are sustainable and affordable. This would include determining what amount of current expense can be paid that is reasonable, prudent and feasible. Such determination must take into account the necessity of sufficient funding for a recovery plan whereby essential governmental services can be raised to an acceptable level and infrastructure provided to encourage, stimulate and insure business growth and expansion with its accompanying creation of good new jobs, especially for the young citizens. This will insure not only short-term recovery, but long-term success.

The “second look” and oversight mechanisms described herein would help the Commonwealth and its municipalities as well as all concerned parties in developing an effective recovery plan rather than litigate over payment issues, which will not be efficient or cost effective.

Fortunately, the answer to all of this is simple. Rather than positioning and fighting as to what can be paid, what cannot be paid and what must be paid, it is in the best interests of all parties striving for the recovery and success of the government to recognize and determine what is sustainable and affordable acknowledging the resulting increase in the revenues or adjustments are simply a recognition of reality. This can be accompanied through a consensual process prior to Chapter 9 through the financial oversight and recovery assistance of the authority as well as, the last resort, in a Chapter 9 proceeding. In the long term, this will pay more than the best litigation strategy.

Obligations of the government can be appropriately adjusted to what is sustainable and affordable, allowing the government to invest in that which will help it recover and grow. There would be the determined affordable fixed payments and contingent payments that would only be paid if there are increased revenues from the success of the recovery.If the government does better, there will be more funding. Obligations are not impaired or diminished because realistically all that can be paid is being paid. Creditors have improved expectations that the government operating under a realistic recovery plan which they participated in the development of will make future payments to fund their obligations based on anticipated recovery and success of the municipality. Also, there could be periodic adjustments to the fixed and contingent payments based on actual results of the recovery and what is affordable.

There should be a periodic review of the progress in the recovery plan. If there is a need to adjust available revenues or payment obligations so that what is paid is sustainable and affordable, those adjustments should be made.


As the Commonwealth of Puerto Rico in the various reports it and its representatives have issued and as the Treasury Report confirms, Puerto Rico’s financial distress must be addressed now and its economic recovery must be efficiently and effectively implemented. This is beyond any reasonable dispute. Chapter 9 was not created to deal with sovereign like States and is not presently drafted to be helpful to the Commonwealth of Puerto Rico for the reasons we have discussed and because Chapter 9 does not work for States. The Commonwealth of Puerto Rico may be authorized by Congress to allow its municipalities and related governments to file Chapter 9 but only if all other efforts to reach consensual resolution fail. This would include the efforts of a Financial Oversight and Recovery Assistance Authority and where a “second look” cannot suggest a better alternative to Chapter 9. Since the stigma and cost of Chapter 9 is so high every effort at reaching a consensual resolution should be expended. There is a better alternative for the Commonwealth of Puerto Rico and its related governments such as the Financial Oversight and Recovery Assistance mechanics that has coalesced from the experience of MAC for New York City, PICA for Philadelphia, DCFRMA for Washington, D.C. and use by various States of financial control boards and oversight authorities. Congress has the authority to enact such legislation under the Territorial Clause and the Bankruptcy Clause of the U.S. Constitution and Puerto Rico clearly has the need for such legislation.

As discussed above, Chapter 9 is not a solution to the problems of a financially-troubled governments. Rather, Chapter 9 is a process. As a result, debt adjustment without a recovery plan does not create an economic turnaround and raises the question of the futility of the process of not addressing the systemic cause of the problem. Essential governmental services must be funded. As noted above, the use of a Financial Oversight and Recovery Assistance Authority for Puerto Rico will prove an ingredient of increased financial credibility, opportunity for consensual agreement and ultimate resolution. Such an authority can help develop transparent financial statements and budget that will have input and review by all those concerned. The vetting by an independent, impartial authority with all parties on the same financial page avoids futile arguments over whether and when payment can be made and sustainability and affordability of budgets and proposals.

This consensual foundation will assist the Commonwealth in developing is recovery plan. This would be a recovery plan that stimulates the economy while providing adequate funds for the payment of essential governmental services which will lead to economic opportunities and resulting job opportunities for the citizens of a financially distressed government, especially for the young workers. This recovery plan can only be accomplished by assuring participants that the process through the Authority is fair and impartial and that essential governmental services will be provided, including improved infrastructure and essential services so the blighted areas are transformed into areas where businesses and citizens will desire to reside and flourish and good jobs are available for all. Such a process will lead to new and expanded business and job opportunities, which result is in the best interest of all creditors.

If there is the need for further federal legislation to address issues of fairness to Puerto Rico versus other State or social programs, the views of all concerned will be provided and can be channeled through the Authority. The recovery plan necessarily must be based upon the payment of what is sustainable and affordable. The increased revenues that flow from the creation of new jobs and new taxpayers under the recovery plan should permit the additional funds to ensure payment of these obligations that should be paid, including continued employment of public workers and appropriate funding of services. Without a successful recovery plan, the repayment of obligations will not only be difficult but practically impossible. However, restructuring of the obligations in a manner that pays what is feasible is in the best interest of all. Chapter 9 has been and should continue to be used as a last resort when all other alternatives fail. Consideration of interim processes and procedures to encourage prompt and effective resolution of the causes of the financial distress should be considered such as a Federal Financial Oversight and Recovery Assistance Authority for all territories that need and deserve it. In the long run, we all are benefitted by effective laws and procedures to address and detect as early as possible the existence of government financial distress so that the governmental services provided to citizens of the government and the infrastructure are at a level that will allow both citizens and the government to best assure the bright future for all concerned.


Appendix 1


Appendix 2


Appendix 3


Appendix 4


Appendix 5

Key Differences Between Chapter 9 and Chapter 11

Chapter 9 Chapter 11
§  Only the municipality can initiate a Chapter 9 if authorized by State law. §  The corporation (voluntary) or its creditors (involuntary) can initiate a Chapter 11 case if the corporation is a moneyed entity (not a non-for-profit) and insolvent.
§  Only the municipality can file a Plan of Debt Adjustment. §  The corporate debtor (during the exclusive period) or any creditor (after the exclusive period) may file a Plan of Reorganization or Liquidation.
§  The Plan of Debt Adjustment can only adjust debt.  It cannot liquidate the municipality. §  A corporate plan can be for reorganization or liquidation.
§  A Labor Agreement can be rejected in a Chapter 9 if the Labor Agreement burdens the municipality and the equities balance in favor of rejection.  This is a lower standard than a Chapter 11. §  Section 1113 of the Bankruptcy Code sets forth the requirements for sharing information with employee representatives and workers and the process of information sharing, and the proposal by the debtor prior to the rejection of the Labor Agreement.  It is a higher standard than Chapter 9.
§  There is no limitation on damages on real estate leases held by a Trustee or Municipal Building Authority for a lease financing and the lease financing will be treated as a secured debt financing. §  There is a limitation of the greater of one year’s rent or 15% of the remaining terms of the lease not to exceed three years for lease damages in a corporate Chapter 11.  It is not treated as secured debt of the corporate debtor if it is a true lease.
§  Payments to defease or pay current interest or principal on bonds or notes within the 90 day preference period before a Chapter 9 filing are not capable of being voided or deemed a preference. §  Payment of principal or interest not secured by collateral could be voided or deemed a preference during the 90 day period prior to filing a Chapter 11 if the holder would receive more than what it would be entitled to in a Chapter 7 liquidation.
§  There are no priorities ahead of unsecured claims for prepetition claims due to employee wages, pensions, accrued vacations, healthcare and other employment benefits. §  There is a priority ahead of unsecured claims of up to $11,725 per employee for pre-petition wages, benefits, accrued vacation and healthcare benefits.
§  “Special Revenues” and “Statutory Liens” are not limited or terminated by a Chapter 9 filing and are intended to continue to be paid to secured creditor and are unimpaired by the Chapter 9 filing (there is no Chapter 11 provisions comparable). §  Accounts receivable and inventory created post petition are not covered by the pre-petition lien of a secured lender and the pre-petition lien is terminated except for “proceeds” of the pre-petition lien.
§  A Bankruptcy Court cannot interfere with any restrictions or requirements of State law regarding a municipality’s exercise of its governmental powers (including payment of statutory liens).  The Bankruptcy Court cannot interfere with the property, revenue and affairs of the municipality. §  The corporate debtor cannot take any action outside the ordinary course of business without Bankruptcy Court approval.
§  The municipality can sell its assets, incur debt, borrow money and engage in governmental affairs without the necessity of having to obtain the approval of the Bankruptcy Court. §  The corporate debtor cannot borrow money, sell assets or expand or contract its business without Bankruptcy Court approval.




[1]             There is attached as Exhibit I a detailed presentation on “Lessons Learned from Financially Distressed Governments and a Resulting Sovereign Recovery Debt Adjustment Mechanism”. This presentation reviews the history of sovereign debt defaults (slides 4-11), causes and resolution mechanisms (slides 11-17) that have worked and not worked (slides 75-83). It analyzed why past factors that motivated financial health have lost their potency (slides 21-29). What has worked and not worked over the last 60 years (slides 75-83 and 95-128). It reviews the sagas of Puerto Rico (slides 30-68) and Greece (slides 69-74). It contrasts this to the U.S. experience (slides 94-113) with limited municipal bankruptcies (Chapter 9) of 320 over the last 60 years of which only 64 have been counties, cities, towns and villages (most notably the recent filings of Detroit, Stockton, San Bernardino and Jefferson County). It ends with outlining a new proposal resolution mechanism that is intended to avoid the problems and obstacles of the past (slides 75-93).

[2]Ashton v. Cameron County Water Improvement Dist. No. 1, 298 U.S. 513, 80 L. Ed. 1309, 56 S. Ct. 892 (1936), reh’g denied 299 U.S. 619, 81 L. Ed. 457, 57 S. Ct. 5 (1936) (“Ashton”); United States v. Bekins, 304 U.S. 27, 82 L. Ed. 1137, 58 S. Ct. 811 (1938), reh’g denied 304 U.S. 589, 82 L. Ed. 1549, 8 S. Ct. 1043 (1938) (“Bekins”).

[3]             For further detail on the efforts of Puerto and the severity of the situation, see Exhibit I, slides 30-68.

[4]             Pub. L. 82-447, 66 Stat. 327, enacted July 3, 1952.

[5]             On March 2, 2012, Greece had a ten year bond annual yield of 37.1% and in July, 2015, after the third attempted bailout and austerity package being implemented, Greece annual yield is still over 10.5% with a 52 week range of 5.5% and 19.5%.

Greece has defaulted on its sovereign debt since 1826 at least five times prior to its recent financial crisis (1826, 1843, 1860, 1894 and 1932).

Brazil, a large developing economy which defaulted or restructured its sovereign debt eleven times since 1826, the last time 1990, had an average ten year bond annual yield between 2006 and 2015 of approximately 12.3% with all time high of 17.91% in October, 2008.

[6]             One of the reasons why states and territories since the late 1800’s have not any significant defaults on their debt obligation has been the historically high price paid as demonstrated in the 1840’s experience of repudiating or defaulting by state and territory. The repudiation of debt by eight states and one territory in the 1840s provides a lesson to be learned. Between 1841 and 1843, eight states and one territory (now a state) repudiated their debt, and seven states between 1843 and 1848 resumed payment. Some attribute the repudiation to pay for needed transportation improvements given the success of the Erie Canal or for needed banking services in the state. By 1844, nineteen states and two territories had borrowed money for needed economic growth. The inflationary boon of 1834-39 with the accompanying Panic of 1837 came to end by 1841, and there was a tightening of credit that put pressure on incomplete construction projects for transportation improvements in the North (Pennsylvania, Maryland, Indiana, Illinois and Michigan) and lack of credit for banks in the South (Arkansas, Louisiana, Mississippi and Florida Territory). All but the Florida Territory and Mississippi resumed payment by 1848. The reason was the cost of default including denial to the market of access or experienced borrowing yields to complete projects of 32% until they resumed payment and then paid 4% above market to borrow. Mississippi and Florida Territory lacked access to then public market for almost over a decade. Florida as a territory had its access to the market practically restricted until it became a state.

[7]             See Exhibit I, slides 12-17.

[8]See e.g. Written Testimony of The Hon. Pedro R. Pierluisi, “Puerto Rico: Economy, Debt, and Options for Congress” to the Senate Committee on Energy and Natural Resources on October 22, 2015, p. 3.

[9]             Municipal Bankruptcy Composition Law: Hearing on H.R. 6912 Before the Special Subcommittee on Bankruptcy and Reorganization of the Committee on Judiciary, 77th Cong., 2d Sess. (1942).

[10]           In fact, not all fifty States permit their municipalities to file for Chapter 9. Only twelve States specifically authorize municipal bankruptcies. For more detail, see the book by the author entitled Municipalities in Distress? published by Chapman and Cutler LLP (“Municipalities in Distress”), which is a 50 state survey of State laws dealing with financial emergencies of local governments, rights and remedies provided by States and State authorization of municipalities to file for Chapter 9 bankruptcy.

[11]           “This Chapter does not limit or impair the power of a State to control, by legislation or otherwise, a municipality of or in such State in the exercise of the political or governmental powers of such municipality, including expenditures for such exercise…” 11 U.S.C. § 903.

[12]           “Notwithstanding any power of the court, unless the debtor consents or the plan so provides, the court may not, by any stay, order, or decree, in the case or otherwise, interfere with – (1) any of the political or governmental powers of the debtor; (2) any of the property or revenues of the debtor; or (3) the debtor’s use or enjoyment of any income producing property.” 11 U.S.C. § 904.

[13]See States listed in Note 29 for those that currently authorize municipalities to file.

[14]See The Bankruptcy Act of 1800, 2 Stat. 19 (1800); The Bankruptcy Act of 1841, 5 Stat. 440 (1841); The Bankruptcy Act of 1867, 14 Stat. 517 (1867); The Bankruptcy Act of 1898, 30 Stat. 544 (1898). That is not to say that there were no defaults in government obligations in the nineteenth century. Indeed, the 1842 default by the State of Pennsylvania on its bonded debt inspired William Wordsworth to pen the sonnet “To the Pennsylvanians” in which he spoke of “won confidence, now ruthlessly betrayed.” It was the defaults of local utility districts and municipalities in the 1800s that tarnished the integrity of the “new frontier’s” obligations. George Peabody, an eminent financier, sought to be admitted to polite English Society only to be rebuffed, not due to his lack of social grace, but because his countrymen did not pay their debts. It was the defaults by State governments in the early nineteenth century and municipalities in the late nineteenth century that brought about the procedures which are now taken for granted, including debt limitations on municipal issues, bond counsel, and clearly defined bondholders’ rights and State statutory provisions relating thereto.

[15]See A Commission Report, City Financial Emergencies: The Intergovernmental Dimension (Advisory Commission on Intergovernmental Relations, Washington, D.C., July 1973) (“ACIR Report”).

[16]           S. Rep. No. 407, 73rd Cong., 2d Sess. (1934).

[17]           48 Stat. 798 (1934).

[18]           49 Stat. 1198 (1936).

[19]See generally H.R. Rep. No. 207, 73rd Cong., 1st Sess. 103 (1933); H.R. Rep No. 517, 75th Cong., 1st Sess. 3-4 (1937); H.R. Rep. No. 686, 94th Cong., 1st Sess. 541, 542 (1975); H.R. Rep. No. 595, 95th Cong., 1st Sess. 397-398 (1977); S. Rep. No. 95-989, 95th Cong., 2nd Sess. 110 (1978), reprinted in 1978 U.S.C.C.A.N. 5787.

[20]Ashton, fn. 2 supra.

[21]Bekins, fn. 2 supra.

[22]Leco Properties, Inc. v. R.E. Crummer & Co., 128 F.2d 110 (5th Cir. 1942). Further, the court had no jurisdiction to determine the existence the city or boundary disputes in the nature of quo warrantoGreen v. City of Stuart, 135 F.2d 33 (5th Cir. 1943), cert. denied 320 U.S. 769, reh’g denied 320 U.S. 813, 88 L. Ed. 491, 64 S. Ct. 157 (1943).

[23]           Upon the adoption of the Bankruptcy Reform Act of 1978, the roman numerals which had previously been used to identify chapters of the Bankruptcy Act were abandoned in favor of Arabic numbers. Hence, since the effective date of the Bankruptcy Code, “Chapter IX” has become Chapter 9.

[24]See, In re Richmond Unified School District, 133 B.R. 221 (Bankr. N.D. Cal. 1991), (a Chapter 9 debtor may voluntarily divest itself by consent of its autonomy rights under § 904 of the Bankruptcy Code.

[25]           11 U.S.C. § 109(c). Claims by holders of industrial revenue bonds are not governed by Chapter 9, and amounts owed by private companies to the holders of industrial development bonds are not to be included among the assets of the municipality. S Rep No 95989, 95th Cong, 2d Sess. 109 (1978). The determination of whether or not an entity is a “municipality” can be difficult. Although originally Chapter 11 relief was sought and denied because of the debtor’s status as a municipality, the Court in In re Jersey City Medical Center, 817 F.2d 1055 (CA3, 1987), ruled that a public municipal hospital was a proper debtor under Chapter 9. Conversely, the cases American Milling Research and Development, Inc., No. 7400129 and Fort Cobb Irrigation District, No. 7600679, were initially filed under Chapter 9 but were converted to Chapter 11 bankruptcies.

[26]           11 U.S.C. § 101(29).

[27]           Only a “person” is eligible for relief under Chapters 7 and 11 of the Code. “Governmental unit” is excluded from the definition of “person.” 11 U.S.C. § 101(33).

[28]           11 U.S.C. § 109(c)(2).


Ala. Code § 11-81-3

Ariz. Rev. Stat. Ann. § 35-603

Ark. Code Ann. § 14-74-103

Idaho Code Ann. § 67-3903

Minn. Stat. Ann. § 471.831

Mo. Ann. Stat. § 427.100

Mont. Code Ann. § 7-7-132

Neb. Rev. St. § 13-402

Okla. Stat. Ann. Tit. 62 §§ 281, 283

S.C. Code Ann. § 6-1-10

Tex. Loc. Gov’t Code § 140.001

Wash. Rev. Code § 39.64.040

Colorado has enacted legislation specifically authorizing its beleaguered special taxing districts to file a petition under Chapter 9. Section 32‑1‑1402 of the Colorado revised statutes states that “any insolvent taxing district is hereby authorized to file a petition authorized by federal bankruptcy law and to take any and all action necessary or proper to carry out the plan filed with said petition ….”


[30]See, e.g., Ga. Code Ann §§ 36‑80‑5.

[31]           In re Pleasant View Utility Dist. of Cheatham County, Tenn., 24 BR 632 (BR MD Tenn., 1982). The court concluded that the term “generally authorized” as used in § 109(c) mans only that the state should give some indication that the municipality has the necessary power to seek relief under the federal bankruptcy law. The court so held despite legislative history of the section which indicated that the Senate rejected the House’s proposal that a municipality would be eligible to file a Chapter 9 petition unless such filing was prohibited by state law. See HR Rep No 595, 95th Cong, 1st Sess. 263264, 318319, reprinted in [1978] US Code Cong & Admin News 5963, 62206222. The Senate’s position was a departure from the earlier notion that a municipality’s authority to file a municipal bankruptcy was an inherent element of existence. See In re South Beardstown Drainage & Levee Dist., 125 F.2d 13 (CA7, 1941). See also In re City of Wellston, 43 BR 348 (BR ED Mo, 9184), in which the court held that a grant of powers to act for the preservation of peace and good order and for the benefit of trade and commerce was sufficient to authorize the filing of a Chapter 9 petition.

But see In re North & South Shenango Joint Municipal Authority, No. 8100408 in the United States Bankruptcy Court for the Western District of Pennsylvania. There, the bankruptcy court found that a joint municipal authority which had been created under Pennsylvania law to construct and operate sewer systems, had been “generally authorized” to file a petition under Chapter 9. The court relied on the distinction in Pennsylvania law between municipal authorities like the debtor authorized to do all acts “necessary or convenient for the promotion of their business,” and political subdivisions, which were required to obtain the approval of the state Department of Community Affairs before they could file a petition for relief under the federal bankruptcy law. The court found that the decision to restrict political subdivisions’ resort to bankruptcy evidenced a contrary intent regarding municipal authorities. 14 BR 414 (BR WD Pa, 1981). The Third Circuit declined to exercise jurisdiction over the appeal. Pennbank v. Washbaugh, 673 F.2d 1301 (CA3, 1981). However, the District Court, to which an appeal was also taken, reversed the Bankruptcy Court and held that there was no sufficient showing of state authorization. 80 BR 57 (BR WD Pa, 1982). The case was then handled in a state court proceeding. (Letter of Kirkpatrick, Lockhart, Johnson & Hutchinson, Pittsburgh, Pennsylvania to author dated August 8, 1984).

[32]See e.g., 4 Collier on Bankruptcy, § 900.03 n 12.

[33]           Villages at Castle Rock Metropolitan District No. 4, No. 89 B 16240 (D Colo., May 11, 1990).

[34]In re Carroll Township Authority, 119 BR 61 (BR WD Pa, 1990).

[35]In re City of Bridgeport, 128 BR 688 (D Conn 1991).

[36]See Bankruptcy Reform Act of 1994 Section by Section Description appearing at 140 Cong. Rec. H 10771 (daily ed 10/4/94).

[37]In re County of Orange, 183 BR 594 (BC CD Cal. 1995). See also in Alleghany Highlands Economic Development Authority, 720 BR. 647 (BC WD Va. 2001).

[38]See testimony by the author, Hearing Before the Subcommittee on Courts, Commercial and Administrative Law of the Committee on Judiciary, House of Representatives, 112 Congress, First Session, Feb. 14, 2011, Serial 112-25.

[39]           The number was thirteen states before 2011 and California’s adoption of the neutral evaluator process before municipalities are able to file a Chapter 9.

[40]           As noted above, since 1949, there have been 11 economic downturns in the United States, and the states and their local governments not only have weathered those financial storms but have provided substantial support to the eventual economic recovery by expenditures for infrastructure and other purposes that have increased employment and GDP growth. In each of these economic downturns, increased government debt financing for needed essential infrastructure and improvements was what helped provide the stimulus for recovery. These bond-funded projects have stimulated the economy by providing increased employment for construction, purchase of goods, and the ripple effect that such increases in salaries and purchases have on tax revenues, employment, and GDP. See “The Role of the State in Supervising and Assisting Municipalities, Especially in Times of Financial Distress,” by James E. Spiotto in the Municipal Finance Journal, Winter/Spring 2013.

[41]           Even Alaska and Florida have some indirect control on debt. Alaska has a limitation on taxes and a municipality may not levy ad valorem taxes for any purpose in excess of 3% assessed value of the property in the municipality. However, these limitations do not apply to taxes levied for payment of principal and interest on bonds. Alaska Stat. §§ 29.45.090, 29.45.100 and 29.47.200 (2012). Florida has a limitation on ad valorem taxes to finance or refund capital projects only if approved by the voters.

[42]           Compare Alabama—Ala. Const. Art. XII, § 225 and Ark. Const. § 342 (2012) (debt may not exceed a particular percentage of valuation) with Washington, DC—D.C. Code § 47‑102 (setting debt limit at 1878 levels). Alabama is somewhat unique in providing that any tax to be levied must be levied by the state legislature and does not grant the local government the power to levy taxes on its own.

[43]           P.R. Const. art. VI, § 2; P.R. Laws Ann. tit. 21, § 6015.

[44]           P.R. Laws Ann. tit. 21 § 5001.

[45]See, e.g., P.R. Laws Ann. tit. 12, § 1265 (refunding bonds of Puerto Rico Industrial, Tourist, Educational, medical, and Environmental Control Facilities Financing Authority); P.R. Laws Ann. tit. 23, § 6445 (authorizing refunding bonds for Puerto Rico Convention Center District Authority); and P.R. Laws Ann. tit. 3, § 1908 (authorizing refunding bonds for Puerto Rico Infrastructure Financing Authority).  Puerto Rico’s code may be more expansive and an attorney should be consulted to examine any specific situation involving a default.

[46]           P.R. Laws Ann. tit. 21, § 6016.  According to the Government Development Bank for Puerto Rico, this provision has never been used.  See “Puerto Rico Municipal Finance Agency (MFA),” (last visited July 18, 2011).

[47]See “Assembly and Governor OK Measure to Prevent Municipal Receivership”; Available at

[48]           For a detailed study of the New York City fiscal crisis see Donna Shalala and Carol Bellamy, “A State Saves a City: The New York Case,” Duke Law Journal, 1976(6) (January 1977); United States Congress, House of Representatives Committee on Banking, Finance and Urban Affairs, Subcommittee on Economic Stabilization, Securities and Exchange Commission Staff Report on Transactions in Securities of the City of New York (95th Cong. 1st Sess., August 1977).

[49]New York Times, October 19, 1975, Section 4 at 1.

[50]           53 Pa. Stat. §§ 11701.101-11701.501.

[51]           Former Mich. Comp. Laws. § 141.2802 (this provision has been replaced by the Local Government and School District Fiscal Accountability Act). See also Eric Scorsone, Local Government Financial Emergencies and Municipal Bankruptcy, Michigan Senate Fiscal Agency Issue Paper; Available at

[52]           Mich. Comp. Laws §§ 141.1501‑141.1531 (2011).

[53]           Mich. Comp. Laws. § 141.1519 (2011).

[54]           Mich. Comp. Laws. § 141.1523 (2011).

[55]           Local Financial Stability and Choice Act, Mich. Pub. Act 436 of 2012, Mich. Comp. Laws, § 141.1541 et seq. The new act contains 19 different possibilities that would allow for the state financial authority to conduct a preliminary review of a local government’s finances to determine the existence of probable stress. The state financing board is required to complete a final report and then to submit that report to the local emergency financial assistance loan board to determine if probable financial stress exists for the local government.

If probable stress is found, the governor is then required to appoint a review team for that local government, and that review team, after investigating the circumstances and meeting with the local government, must submit a written report to the governor within 60 days following its appointment, although it may be granted one extension of 30 days to conduct its analysis. In its report, the review team must conclude either that a financial emergency exists or that one does not exist, and within 10 days of receiving the report, the governor must also make a determination as to the existence or not of a financial emergency. The decision is appealable to the Michigan Court of Claims within 10 business days by a resolution approved by two‑thirds of the members of the local government’s governing body.

Should a financial emergency be found, the local government must either (1) enter into a consent decree with the state, (2) agree to the appointment of an emergency manager, (3) enter into a neutral evaluation process or (4) file a Chapter 9 bankruptcy petition if so approved by the governor. If it does not choose an option, the local government must proceed under a neutral evaluation process. Each of the options provides a process for resolving the causes of financial distress.

If the neutral evaluation process or other options do not result in a resolution, the governing body of the local government must adopt a resolution recommending that it proceed under Chapter 9 and submit that resolution to the governor and state treasurer for consideration and approval by the governor.

[56]           Ind. Code § 6.1.1-20.3 et seq. (2012).

[57]           Cal. Gov’t Code §§ 53760; 53760.1; 53760.3; 53760.5; and 53760.7 (as amended and added by Cal. A.B. 506; signed into law on October 9, 2011). This provision was first put to the test by the City of Stockton, California, which filed a Chapter 9 petition in June 2011 after going through a neutral evaluator process. San Bernardino in August 2012 avoided the neutral evaluator process by declaring a fiscal emergency, as discussed below.

[58]           These alternative debt resolution mechanisms consistent with Section 903 of the Bankruptcy Code are described in detail in Chapter IV of Municipalities in Distress. See also James E. Spiotto, “The Role of the State in Supervising and Assisting Municipalities in Times of Financial Distress,” 33 Municipal Finance Journal, (2013); The Pew Charitable Trusts, The State Role in Local Government Financial Distress, July 2013.

[59]See, The Papers of Alexander Hamilton (Columbia University Press ed. 1979).

[60]           The Senate Report for the 1988 Amendments, Senate Report No. 100-506, 100th Cong., 2d Session (1988) (the “Senate Report”), made it clear that the intention of the 1988 Amendments was to address the real worry in the marketplace that revenues dedicated to the repayment of municipal revenue obligations would be diverted to other purposes once a local government entered bankruptcy; that his worry rendered clarification of the law a necessity; and that revenue debt could not be impaired in a Chapter 9. The same concern was reflected in the House Report for the 1988 Amendments, which noted that the bill “remedies the inconsistencies between bankruptcy law and principles of municipal finance to remove the potential for problems that now exist.”

Examples of the “special revenues” mentioned in clause (A) include receipts derived from or received in connection with the ownership, financing, operation or disposition of a municipal water, electric or transportation system. An excise tax on hotel and motel rooms or the sale of alcoholic beverages would be a special excise tax under clause (B). “Special excise taxes” are taxes specifically identified and pledged in the bond financing documents and are not generally available to all creditors under state law. General state sales, general income or general property taxes would not be special excise taxes without specific language deemed levied to finance a specific project or system. In a typical tax increment financing referred to in clause (C), public improvements are financed by bonds payable solely from and secured by a lien on incremental tax receipts resulting from increased valuations in the benefited area. Although these receipts may be part of the general tax levy, they are considered to be attributable to the improvements so financed and are not part of the preexisting tax base of the community. Examples of revenues from particular functions under clause (D) would include regulatory fees and stamp taxes imposed for the recording of deeds or any identified function and related revenues identified in the municipality’s financing documents, such as tolls or fees related to a particular service or benefit. Under clause (E), an incremental sales or property tax specifically levied to pay indebtedness incurred for a capital improvement and not for the operating expenses or general purposes of the debtor would be considered “special revenues.” Likewise, any special tax or portion of a general tax specifically levied to pay for a municipal financing should be treated as “special revenues.”

[61]           In certain situations, a bondholder may continue to receive payment in the wake of a Chapter 9 filing if the underlying statute authorizing the issuance contains a statutory lien, which lien comes into existence by virtue of the statute and arises by force of the statute on specific circumstances or conditions and not requiring further action by the municipality. A statutory lien cannot be canceled on the filing of a bankruptcy petition or by the bankruptcy court. This approach was recognized by the district court on appeal in the Orange County bankruptcy. There, the court found that the lien securing tax and revenue anticipation notes pursuant to a California statute authorizing the county to pledge assets to secure notes was a statutory lien. Since the statute imposed the pledge, not a security agreement, it survived the filing of a Chapter 9 petition. At least thirty-two States recognize some form of a statutory lien in relation to their bond obligations.

In 2011, the State of Rhode Island was faced with issues of financial distress of its municipalities and, in particular, the City of Central Falls, an old manufacturing town of 19,000, which that had lost its industrial base and had fallen on hard times. The bond rating agencies had reacted to efforts of Central Falls to have a court appointed received place as new management of the City. The state adopted a new law in 2010 that provided that with state supervisions, depending on the degree of distress, there could be use of a state appointed overseer, a budget commission of state and local appointed members to approve budgets going forward or a receiver who would replace local government with the power to file Chapter 9. The governor and others had fears that the new law that allowed Chapter 9 filings might cause a restriction in access to the financial market or increase in borrowing costs by all municipalities in Rhode Island as a contagion of a municipal bankruptcy filing. Accordingly, Rhode Island passed a law granting a first statutory lien on all ad valorem taxes and general funds assessments for payment of all public debt (bonds and notes). This was well received by rating agencies and the municipal market so that, when Central Falls filed a Chapter 9 bankruptcy later in 2011, there was no real contagion to other Rhode Island municipalities as to restriction of access to or increase in the cost of borrowing. This is unlike the experience in Michigan where other municipalities claimed as much as 100 basis points or more (1% or more per annum) increase in borrowing costs for unlimited ad valorem tax general obligation bonds (“ULTGOs”) due to Detroit’s filing in 2013 and the emergency manager’s unfounded claim they were unsecured. Even though ultimately, the ULTGOs bondholders were to receive 100% recovery under Detroit Plan of Debt Adjustment the contagion and cloud on ULTGOs continues.

[62]           Isabelle Cohen, Thomas Freiling & Eric Roberson, The Economic Impact and Financing of Infrastructure Spending 1 (2012), available at