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Is Municipal Bankruptcy
in New Jersey's Future?

Edward J. McMamimon
By Edward J. McManimon
NJLM Associate Councel, Partner
McManimon & Scotland, LLC

While defaults and bankruptcy for local governments in New Jersey are subjects that nobody wants to talk about (or even whisper for fear of credit implications), they are, nevertheless, creeping into conversations more and more.

Municipalities are subject to the annual review of their budgets and audits by the Division of Local Government Services. In addition, the Local Finance Board has certain financial triggers (e.g. two years of a deficit of more than 4 percent, etc.) that require the municipality to present a financial recovery plan to the Local Finance Board for approval or have one imposed by the Local Finance Board if those triggers indicate a sustained financial problem. This is supposed to be a preemptive process to keep municipalities from slipping into financial chaos and ultimately insolvency or bankruptcy. The perceived problem now is that the state’s policies in drastically cutting aid to the very municipalities facing the most difficult financial challenges, coupled with the lack of state resources to help those municipalities avoid insolvency, may lead to the inevitable and practical consideration of bankruptcy.

The state seems to believe that urban New Jersey’s problems are of their own making due to years of expenditures on social programs and blind largess in negotiating labor contracts. Therefore, the state assumes that urban municipalities can absorb the drastic and continuing drop in state aid by changing the policies that put them in this position. Clearly, the cities are being forced to make drastic budget cuts to balance their budgets. The reality is that in the short time they have to do it, they really can’t. It is certainly time for local and state leaders to recognize the financial reality and at least understand the options, limitations and consequences of bankruptcy.

To some municipalities, the uncertainty of short term and long term state aid further raises questions about their ability to continue to exist at all; as funds for libraries, recreation, public safety and community services that have existed for decades face drastic cuts. Continued and precipitous drops in state aid coupled with caps and limits on expenditures and tax levies, when balanced with the realization of the legal limitation to actually raise taxes, have caused legitimate fears in many communities. For elected officials, who can not simply “cut” their way to a balanced budget and “self-sufficiency” overnight, balancing the budget may seem impossible.

The ability to raise taxes to pay for these services, generally without limit, has always kept any thought of default or bankruptcy off the table from any serious discussion involving municipal finance. Different credit ratings are assigned by the major credit rating agencies based on the quality and diversity of the community’s tax base, tax collection history, management practices and other related economic and financial considerations. However, the idea that even the lower rated credits would default or consider bankruptcy was just not an issue. In fact, the various protections or limits built into the financial structure of New Jersey local governments actually provided secure and ready access to the bond markets at the highest levels, even for those communities at the lower levels of credit.

So why now, after all these years, would the issue of default or bankruptcy become a serious one for discussion? There are many reasons:

• The urgent and drastic nature of the financial policies imposed at the state level have alerted communities across the board that they may no longer be able to afford the level of services that have been provided for decades. The impact is immediate.

• The state is struggling to balance its own budget. The financial condition of the state, which has always been viewed as the umbrella protecting local governments against financial troubles, is uncertain and problematic. It is even viewed as the catalyst (if not the cause) of the projected financial chaos of many local governments. Concern exists over whether the state’s resources would be available to catch and solve a local government financial problem early or prevent default on any number of contractual obligations. The recent drop by Moody’s in the state’s credit rating from Aa2 to Aa3 and similar drops by Standard and Poor’s and Fitch only highlight this concern. Not only does that affect the debt service costs to the state but also to local governments, which rely on the state’s credit on bonds issued under the Qualified Bond Act and other similar programs.

• Communities have become aware of the size of the unfunded pension and other long-term, post employment obligations for its employees for health care and other benefits that in many cases were blindly negotiated into labor contracts with little regard or understanding of how large that obligation would become. Although some recent changes to the contribution levels by employees have softened some of the impact, the overall drastic increases in these costs have begun to hit budgets.

• Massive contractual obligations for accrued sick and vacation time for retiring employees have surfaced as employees fearing changes in state and local policies have filed for early retirement to avoid losing such benefits.

• Communities have been hit with significant tax appeal judgments challenging the very foundation of the local property tax structure and have been forced to borrow to pay the judgments.

• There seems to be a lack of critical awareness and political will to recognize the severe financial obligations municipalities face. Few have considered the necessary and, in many instances, immediate and drastic cuts in services and costs needed in view of the legal and financial limits to raising taxes and other revenues.

• The public seems inconsistent in demanding tax decreases but insisting at the same time that the services and programs it can’t afford should, nevertheless, be maintained.

So, is it better to continue to not “talk about it” or should we all have a better understanding of what the process and rules are in bankruptcy and whether they even work? For some there is a slowly developing view or attitude that bankruptcy may provide the “solution” to the conflict between economics and cost. For those there is a sense that this choice is easier and thus provides a convenient substitute for the hard decisions needed to reign in the policies, costs and priorities of the choices that need to be made. The debate can no longer be about “freezing costs.” It will be about cutting them across the board. Otherwise, the downward spiral will continue.

Here are a few basics for initial thought, leaving a full discussion of the process, options, limitations and consequences of municipal bankruptcy for another more detailed article:

• The state itself cannot file for bankruptcy under the U.S. Bankruptcy Code.

• Municipalities cannot file for bankruptcy under the U.S. Bankruptcy Code without approval of the state (See N.J.S.A. 52:27-40).

• The state has in the past made it clear that they would not approve such a filing by a municipality. As noted above, there are red flags under state law that identify when a municipality is experiencing financial difficulty. Such a municipality must appear before the Local Finance Board with a financial recovery plan.

These steps have worked in the past, but the state seems to be as challenged financially as the local governments, so it is unclear whether the state can continue in this role.

• It is unclear, at best, whether the major costs affecting municipalities for unionized contractual obligations can effectively be terminated, changed or even renegotiated by virtue of Chapter 9 of the U.S. Bankruptcy Code. These obligations seem to be the driving force behind bankruptcy filings by local governments in other states, but they do not appear to have been successful in creating leverage in such contractual negotiations. The lack of ability to reorganize or dissolve that enables private corporations to bring their creditors to the table for serious negotiations as leverage may not exist under Chapter 9.

• The ability to restructure and spread out a municipality’s long term debt over a longer period may be limited and may have to be done on a taxable basis depending on whether it has previously been refinanced. It also requires the approval of the Local Finance Board which generally has viewed this negatively because of the increased costs of spreading such debt out over longer periods, particularly for a period that is longer than the useful lives of the projects financed.

There is certainly much to consider before taking any such action. A better understanding of the benefits, options, limits and consequences of bankruptcy will enable governments and the electorate to consider bankruptcy, but only as a last resort; and not as false hope that takes the place of direct but difficult decisions on the priorities and costs incurred to serve its constituents.

These circumstances as they unfold over the next few years will likely lead to more significant discussions of consolidation to reduce the number of governments, but this may too serve as false hope and a substitute for the difficult decisions on the real issues and costs that are causing the problems. These are not likely to go away with consolidation.

Interesting times ahead.



Originally published in New Jersey Municipalities, Volume 88, Number 7, October 2011


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