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With Detroit’s recent filing for bankruptcy, there has been a lot of attention on municipal bankruptcy. It’s a type of bankruptcy that many people have never even heard of. But it stands to reason that just as some people experience financial hardships and aren’t able to repay their debts, entire cities can end up in the same place. And like people who turn to bankruptcy, cities like Detroit need to have an option to discharge debts and start over. Because Chapter 9 (municipal) bankruptcies are relatively rare, many are unfamiliar with how they work. Here’s a look at the rules behind a Chapter 9 bankruptcy.

What is a Chapter 9 bankruptcy?

The ninth chapter of the bankruptcy code was added in 1937. It was created by congress to give cities court protection in the event of a financial crisis. This court protection allows the city’s essential government functions to continue while government officials work to restructure and repay debts.

Only cities can file for a Chapter 9 bankruptcy, not states. In order to be considered eligible for municipal bankruptcy, a city must be declared insolvent, in other words their debts exceed their assets. Municipalities seeking a Chapter 9 bankruptcy must also have made a good-faith effort to repay debt and reach an agreement with creditors and they must also have created a plan to get out of debt. Finally, most cities must seek permission from their state before filing for bankruptcy. Only 15 states grant cities the right to file on their own. Of the remaining 35, 34 want to be a part of the process and 1, Georgia, will not allow cities to file for bankruptcy regardless of the circumstances.

How does municipal bankruptcy work?

Like other bankruptcy cases, municipal bankruptcies are resolved in court. There are, however, some key differences. Creditors can’t foreclose government buildings and sell them to pay off debt, and the court can’t make any spending decisions for the municipality. A city filing for bankruptcy must make its own plan to get out of debt and the court merely approves it or rejects it based on input from stakeholders in the bankruptcy. The reason municipalities file for bankruptcy is because it grants them court protection and time to get the financial situation under control.

If granted bankruptcy, municipalities have a hard road ahead. Just like individuals and businesses that file for bankruptcy, cities will have a lower credit rating and will have a much harder time borrowing money in the future. When they do borrow, interest rates will be higher. Many businesses and individuals will leave the city which results in less tax revenue. Public employees could see lower salaries and loss of retiree benefits. Citizens who remain will probably see higher taxes.

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