Bankruptcy laws exist for good reason—three, in fact. They provide an orderly way for filers to acknowledge they can’t pay everything they owe, they provide creditors with the best chance of getting at least some of their money back, and they help provide closure to everyone involved.
Stricter isn't necessarily better, however: Countries with far more stringent bankruptcy laws than the U.S. tend to have lower rates of entrepreneurship and innovation. But just because it provides us some societal benefits doesn’t mean there isn’t a great deal of pain associated with declaring bankruptcy in the United States. And that pain is about to become far worse.
That's because bankruptcy isn't just an option for individuals or companies that declare it under Chapter 7, 11 or 13. Since the 1930s, our laws have also offered the option of Chapter 9 bankruptcy, which is the section of the bankruptcy code that allows municipal governments to file for bankruptcy. Every state except Georgia legally permits their municipalities to take advantage of the U.S. bankruptcy code should they need it. And in July, the latest municipality—the city of Detroit—announced it was insolvent and filed for bankruptcy under Chapter 9. With nearly $20 billion in liabilities owed to more than 100,000 creditors, it is the largest municipal bankruptcy in U.S. history.
How It Works
Since the municipal bankruptcy laws were written nearly 80 years ago, there have been nearly 650 filings, with the last few years accounting for several dozen of them. A municipal bankruptcy differs in many respects from an individual or corporate one. Although it's a legal process handled by the courts, the judge presiding over the case doesn’t have as much flexibility or control as in other, non-Chapter 9 bankruptcy cases. In effect, the filing municipality is still in charge of the process of negotiating with creditors and presents its plan for achieving solvency to the judge for approval. This greater control also means that the municipality has greater leverage over its creditors.
Even though the number of Chapter 9 filings is small when compared to the number of corporate and individual bankruptcy filings, the impact on small businesses can be devastating because of the consequences:
- If your business serves as a supplier to a municipality, it’s likely you have grown reliant on the steady flow of payments from your contract. A municipal bankruptcy could disrupt those payments for months or even years.
- As the municipality prepares its financial plan to become solvent again, higher taxes are likely to form part of the solution. That means you can expect local taxes, especially those accessed to businesses, to increase significantly.
- Most municipalities exiting a bankruptcy will also need to cut back on expenditures, which means smaller budgets for services like sanitation, police and fire departments. This hurts the quality of life in that city, which can drive out existing residents and make it a less likely destination for new ones.
- The combined effect of these consequences tends to lower property values, which negatively impacts your capital and could cause problems or violations with your bank’s loan covenants.
Steps To Take
As a business owner, you need to take proactive steps to ensure that a municipal bankruptcy won’t also lead to the bankruptcy of your business:
- Evaluate the concentration of your revenues. No client should represent more than 10 percent of your revenue in a given year. If you just landed a huge contract, then congratulations are in order, but be sure to find other clients to help balance out that growth.
- Monitor the municipal bond market. Most municipalities borrow money for working capital or for special projects. General Revenue Bonds are issued by municipalities and are secured by the revenues they earn from taxes and fees. The price of these bonds provides an indicator as to how risky it is to lend money to a particular municipality. If you plan to do business with a city, town or water utility and offer payment terms that extend beyond 30 days, it would be helpful for you to understand how professional investors perceive the riskiness of lending money to those particular institutions.
- Pay attention to your municipality's finances. The finances of a municipality are public information, so do your homework. It’s important to look at how much the municipality borrows for working capital. If this is increasing, it could be a troubling sign. Also review how the municipality adjusts its spending in the face of lower tax revenues. If it spends more even as its taking in less money, that's a red flag. Finally, learn how the municipality is dealing with union contracts and retiree benefits. Municipalities across the country offer some of the most generous retirement benefits in the nation. Even smaller cities and towns have hundreds of millions or even billions of dollars in liabilities to current and future retirees. This last problem will likely lead to more filings, as bankruptcy is one method cities can use to legally renegotiate contracts.
Detroit’s filing is particularly sad because it illustrates how far this former titan of industry has fallen. Your city or town doesn’t need to experience the extreme problems Detroit is currently facing to find itself insolvent. And you don't need to get caught in the mess, so stay on top of it and keep your business protected.
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