Bankruptcy appears to be the word of the day here in Oakland. Chip Johnson’s column yesterday about how we might declare bankruptcy sparked a flurry of media coverage on local TV stations, the radio, blogs, and newspapers. It even caught the attention of Rush Limbaugh. The story also made some kind of national news that I haven’t been able to locate online, but know exists because my parents in Houston called last night all concerned about it.
At the moment, the word from City Hall (PDF) is that although the option of bankruptcy has been looked into, it isn’t being seriously considered at the moment because, one, it’s a last resort, and two, it’s not terribly helpful in our situation. This is completely unchanged from the response to the same question provided at a town hall meeting in April.
Anyway, before we all rush into debating whether we will or we won’t, or whether we should or we shouldn’t, I think it would probably be helpful to make sure we actually understand what a bankrupt Oakland would even mean. So here’s a little bit of background.
First, let’s be very clear. Bankruptcy is not some perfect solution that magically makes all your problems go away. In fact, it does not magically make any of your problems go away. It does not eliminate your debt. And it creates new, long term problems that could potentially be even worse than the ones you already have.
Most of you probably have at least some familiarity with bankruptcy in general. You’ve probably read some article or another at some point about Chapter 7 (liquidation) or Chapter 11 (reorganization). Very briefly, if you find yourself in a situation where you have a lot of debt you can’t pay, the government provides a method for you to either liquidate your assets to pay as much as you can, and then dismiss the rest of the debt, or, for businesses that don’t want to shut down, to shield you from collection efforts from creditors while you reorganize and figure out how you’re going to either pay while at the same time giving you an opportunity to modify your obligations to your creditors. Oakland would not be filing for either of these types of bankruptcy.
The United States Bankruptcy Code has a special section reserved for municipal bankruptcies, Chapter 9. Chapter 9 is only for government entities, and it is the only type of bankruptcy available for municipalities.
The reason you’re probably not familiar with Chapter 9 is because it is hardly ever used – there have been fewer than 600 filings ever, and less than 200 in the last twenty years. Even then, it’s almost always some miniscule town where their total debt is like, less than Oakland spends on bottled water in a year. Well, maybe not quite, but generally there are not huge amounts of money at stake. Most of the filings aren’t even a city, they’re like, a hospital or a water board or a housing authority or an amusement park or something.
There are, of course, two big exceptions to that. First, Orange County declared bankruptcy in 1994, due to massive losses in the financial markets after the County treasurer made a series of staggeringly poor (PDF) investment choices. Orange County was faced with over a billion dollars in debt in couldn’t pay, more than quadruple the combined total of all other municipal bankruptcies before it.
Then there’s the more recent one everybody knows about, Vallejo. Vallejo signed some unbelievably stupid collective bargaining agreements, which, among other things, committed them to public safety salary increases of 24% over a three year period (PDF). Unable to pay, they voted to declare bankruptcy last May.
So what happens when a city is bankrupt? Chapter 9 is a reorganizational bankruptcy, intended for the adjustment, not elimination of debt, but it differs from the more familiar Chapter 11 in several key ways (PDF). Here’s how it works.
If a municipality can establish itself as insolvent (meaning that it simply cannot pay its obligations, a different standard than the balance sheet test for Chapter 11), and can satisfy the court that they’ve met all the required conditions, they can file a petition for bankruptcy. They then get something called an automatic stay, which is historically the primary benefit of chapter 9 (although this may change depending on what happens in Vallejo). This means that the city is now protected from any collection actions against it by its creditors, which offers a little breathing room where the city can step back, re-evaluate their financial situation, and figure out a way to pay.
During the bankruptcy, the city does not have to make payments on its general obligation bonds, either principal or interest, but that does not mean the bonds just go away. The city is expected to use the bankruptcy period to either adjust its revenues and spending or restructure the debt or, more likely, do a combination of both, such that when it emerges from bankruptcy, it will be able to resume payment. Not all debt payments are suspended, however. Mortgages, liens, and special revenue bonds (like those paid by, say, leases) must still be paid during bankruptcy, as long as the revenue that’s supposed to be paying those bonds exists.
In chapter 11, the court has a great deal of power over the debtor, and will generally appoint a trustee to liquidate assets, supervise financial decisions, and the like. Municipal bankruptcy does not work that way, thanks to the Tenth Amendment, which prohibits Federal interference into local affairs. As such, chapter 9 does not give the court any authority over the city’s property, revenue, or decision-making. The court does not monitor the city’s day to day financial decisions and cannot dictate or interfere with spending or operations. In municipal bankruptcy, the debtor itself is responsible for figuring out what it’s going to have to do to become solvent again, which may entail selling property, raising taxes, cutting services, or any number of other things.
But the protections of bankruptcy are not limited to suspending and restructuring bond debt. Chapter 9 also lets you reopen burdensome contracts for adjustment, such as (in Vallejo’s case) contracts with employee unions and retiree benefit plans. Again, bankruptcy does not magically void these obligations. It simply opens them up for renegotiation. Whether or not contracts with employee unions can be outright rejected (canceled) under Chapter 9 has been a matter of dispute in the Vallejo case. The judge in that case ruled recently (PDF) that yes, the agreements may be rejected, although that does not necessarily mean that they will be. Despite the city asking repeatedly for the contracts to be voided, the judge has made it clear that he is not eager to do so, has ordered Vallejo and the two remaining unions to mediation (PDF) in the hopes that a settlement can be reached. If no settlement can be reached, and the judge does approve the rejection of the contract, the union will definitely appeal the ruling that allowed it. They will might not win that one, or they might. Nobody knows. But it will drag the case out even longer.
Anyway, the court gives the bankrupt city a timeline for creating a restructuring plan that will restore them to solvency, and can either confirm or refuse to confirm whatever plan the city submits, but neither the court nor the creditors can provide a plan of their own (again, the 10th Amendment). If the city cannot come up with a satisfactory plan within a reasonable time period, the court does have the option of dismissing the petition and revoking the bankruptcy protections. Whatever plan the city ends up submitting is supposed to be agreed to by any creditors (creditors include groups like retirees owed benefits) who would be impaired by the proposal, although if they do not agree, the court can force their agreement and confirm the plan anyway, but only if certain conditions are met.
So is Oakland going to declare bankruptcy? Probably not. Well, not for now, anyway. As I noted above, municipal bankruptcy is very rare, and almost every large city that’s come near the brink of it (Washington, Philadelphia, Cleveland, New York) has figured out a way to avoid it by hook or by crook. Even in those cases, the flirtation with the idea of bankruptcy and financial uncertainty that caused it meant those cities lost completely their ability to borrow money for years. Oakland’s bond rating is in danger of downgrade as is, and if we were to declare bankruptcy, we could basically expect to entirely lose our ability to bond for the foreseeable future. That’s disastrous.
But it isn’t just the bond rating we have to worry about. The stigma attached to being a bankrupt city cannot be underestimated. All those new businesses and private investment we’re so desperate to attract? If we declare bankruptcy, we can just forget about it. Those new office buildings we’re hoping to get built downtown? They will never happen. Bankruptcy (even talk of bankruptcy) leads to huge flight of investment and tax base, something Oakland may be even more ill-positioned to afford than our enormous pension obligations.
It’s also important to remember than bankruptcy is not a way to avoid drastic service cuts. Our problem at the moment is that we don’t bring in enough revenue to pay for the services we provide. Bankruptcy doesn’t change that (and in fact, would likely reduce our revenue base even further). It has the potential to help us avoid future burdensome obligations, but does nothing to ease the day-to-day pains of trying to operate the city. Also, it costs a fortune in legal fees.
What bankruptcy might be able help with is our post-employment benefit obligations, which are not an immediate problem, but will start being a big problem in not so many years. For the reasons outlined above, bankruptcy is definitely not an ideal option for dealing with these, and there is no precedent to indicate that it is necessarily a feasible option for dealing with these. Although if the city can’t get its finances in order and find a way to attract new revenues over the next few years, it may be forced to consider it.
In any case, what Oakland (and every other city in similarly dire financial straits) is most likely to do is wait and see how things play out in Vallejo. If Vallejo is successful in using bankruptcy to void some of their post-employment benefit obligations, we can expect to see many cities follow their path. If bankruptcy becomes a common method of dealing with these types of unfunded liabilities, it is possible that Chapter 9 will lose some of its stigma.
Of course, there’s a bill pending in Sacramento that would make all this irrelevant. But that’s an issue for another day.