INTRODUCTION: STATE REDUCTION OF MUNICIPAL ASSETS
States faced with fiscally distressed municipalities typically must confront creditor demands for payment, the satisfaction of which would threaten the provision of local public services. A state that attempts to strike the delicate balance between assisting its local governments and maintaining relationships with creditors has substantial options. The state can, of course, simply provide funding to municipalities, perhaps conditioned on municipal reforms that address the problem of moral hazard. (1) Alternatively, states may assert authority over the municipality either in concert with or in substitution of municipal officials (2) and attempt to negotiate solutions with creditors or grant creditors priority in municipal revenues. (3) The state may also authorize and encourage the municipality to adjust its debts, primarily by entering Chapter 9 of the federal Bankruptcy Code. Each of these efforts may bring some relief to municipal budgets. But they have very different effects on creditors, and thus on the potential incentives that future creditors may have to invest in municipalities of the state.
Providing direct relief to the distressed municipalities or dictating priorities in revenues may permit payment of creditors in full. States may exercise that option in order to signal future creditors that debts will be paid. The importance of such signals to maintain the creditworthiness of municipalities is embodied in provisions such as the New York State Constitution's requirement that cities pledge their faith and credit to debts and exceed real estate tax limits if necessary to pay those debts. (4) Another example is a provision in the General Laws of Rhode Island that requires cities grant creditors "first liens" on tax revenues and thus requires payment of debts prior to other municipal expenses. (5)
Other jurisdictions have been less solicitous of creditors and have embraced some form of the third alternative. States that permit their municipalities to enter bankruptcy essentially signal the possibility that creditor claims will be adjusted in those proceedings. (6) Current law prohibits states from enacting their own version of unilaterally compromising debts of their municipalities. But states may also attempt to shift the costs of municipal fiscal distress from residents to creditors by altering the nature of the underlying debt obligation rather than directly reducing the amount of indebtedness. That may take the form of shifting assets initially used to support debt to a new set of creditors. Those efforts were prominent in the late nineteenth century, as states altered debtor municipalities' boundaries and taxing authority on which existing creditors had relied. More recently, states have attempted to assist distressed municipalities through more subtle means of shifting assets. (8)...