Cities in Crisis: How States Can Help Municipalities Facing Bankruptcy & Fiscal Distress
While local governments typically manage their own budgets, states can play a role in helping to ensure cities and towns are in good fiscal health. Well-defined systems for regularly monitoring local governments’ finances allow a state to identify signs of trouble early and proactively intervene before the situation reaches a crisis level. The state can also provide expert guidance, technical assistance, loans, and other support to help a city tackle fiscal challenges. If the city is reluctant, the state may need the authority to force change by withholding approval for bonds or other funding or appointing a receiver to manage a city’s finances.
An early warning system to detect trouble and strong state intervention when problems do arise can help keep municipalities in good financial health. The alternative is for states to step in when a city is already facing fiscal crisis or even potential bankruptcy. This happened in Rhode Island in the wake of the Great Recession of 2008, when Central Falls became the first city in the state’s history to declare bankruptcy.1 Rapid and forceful action by the state stabilized the city’s fiscal situation and fostered a quick and ongoing recovery.
Through its response to the situation in Central Falls, Rhode Island created a framework for dealing with future fiscal crises. This framework might be further strengthened by examining how other states have dealt with similar issues and implemented preventative measures to stop fiscal crisis before it starts.
This article explores the approaches taken by Rhode Island and three other states in response to municipalities in fiscal distress. Massachusetts’ intervention in Springfield highlights the value of a strong state response tailored to the needs of each city. Pennsylvania’s system for monitoring local fiscal health allows it to identify trouble early and help develop plans for recovery when cities are facing problems, although until recently the state had little authority to force change. North Carolina has perhaps the strongest approach to addressing local fiscal health, combining a robust early-warning system with powerful mechanisms for pressuring cities to stay on track. Though there is no one-size-fits-all approach to municipal fiscal stress, lessons from these states may help Rhode Island in its efforts to keep its cities and towns in good financial health.
Financial Trouble in Central Falls
A wide range of factors can contribute to municipal financial stress. Some are internal and related to municipal governance: corruption, poor accounting practices (such as underfunding pension funds), and political fragmentation that diffuses responsibility and accountability.2 Other issues are rooted in broad socioeconomic forces beyond a city’s control, including global recession, demographic shifts, and state and federal policy changes such as cuts in state aid or policies that cap tax rates.
The Great Recession of 2008 brought several municipalities to the brink of fiscal crisis. The collapse of the housing market tanked the municipal property tax base, instability in the stock market hurt pension funds, and states significantly cut aid to local governments. Central Falls was one of the cities hit hard by the recession, and its recent history demonstrates how multiple external and internal factors can intersect to create fiscal crisis.
After years of job loss and industrial decline in Central Falls, the housing market collapsed in the wake of the recession. The city’s already small property tax base shrank 44% in four years (from 2006 to 2010), creating a decline in property tax revenues that led to immediate and growing operating deficits.3
Central Falls’ access to state revenue dwindled as the Rhode Island government, also reeling from the financial crisis, first cut its revenue sharing program in half and then eliminated it all together. This program passed a portion of state tax revenue to every municipality according to a formula based on per capita income and local tax burden. When the $25 million program was eliminated in Rhode Island’s FY 2010 budget, Central Falls saw a loss of $649,611.4
Adding to these strains were financially burdensome labor contracts negotiated with Central Falls’ police and fire departments, which left Central Falls with overtime and early-retirement benefits that ate up a quarter of its annual budget.5 Even more problematic is that, by 2011, the local government had an unfunded pension liability of $80 million.6 According to experts at the Pew Charitable Trust, the city’s deteriorating financial situation was hidden from view by a combination of one-time fixes, weak accounting practices, and failure of oversight. When state receivers finally took over in 2011, they found a budget in disarray, unpaid bills stuffed in desk drawers, and an annual operating deficit of $6 million. Ultimately, Central Falls was a victim of internal mismanagement as well as broader economic forces and state policy.5
FIg. 1 Timeline of Central Falls' Bankruptcy & Recovery
Rhode Island’s Response to the Crisis in Central Falls
The fiscal situation in Central Falls reached crisis levels in May 2010 and the City Council declared the municipality insolvent. With a population of 19,400 and an annual operating budget of $17 million, the city was facing an annual budget deficit of $6 million and an unfunded pension liability of $80 million.6
To help manage the situation, the mayor requested and was granted a receiver by the Rhode Island Superior Court.(a) In an effort to maintain political control over the situation, the state government passed legislation in June 2010 that retroactively prohibited court-appointed receivers and replaced them with three levels of potential state oversight: a fiscal overseer, a budget commission, and a state-appointed receiver. The dire case of Central Falls was assigned to the third option.
In July, the state replaced the court-appointed receiver with its own receiver, Mark Pfeiffer. Pfeiffer took over as mayor and, in November 2010, replaced the City Council with his own “Receivers’ Council.” In February 2011, Pfeiffer was replaced by Robert G. Flanders, Jr., who continued a hands-on approach to dealing with the situation in Central Falls. He shut down the city’s library and community center, raised property taxes to the maximum level allowed by state law, and reduced the number of city employees from 174 to 121.7
With the pension fund nearing depletion, Flanders sought concessions from city unions and retirees in July 2011. When these were rejected, he filed for Chapter 9 bankruptcy on behalf of the city in August 2011, immediately voided all collective bargaining agreements, and replaced them with new contracts that cut nearly $2.5 million in annual pension and benefit payments.7
The state did not provide any financial assistance to the city. It did, however, enact a statute — the first of its kind in the nation — that put bondholders first in line for payments during municipal bankruptcies, thus immunizing them against the effects of the city’s fiscal disaster.8 Any tax revenues went first to pay off debt, while other municipal expenditures, like payroll and services, made do with what was left over. The justification for this approach is that it avoids the spread of lender uncertainty to the state and other municipalities by guaranteeing that bonds will be paid before all other bills, thus eliminating risk to lenders regardless of the financial distress of the city. Typically in a municipal bankruptcy, all creditors – city employees, vendors, pensioners, and lenders – share the risk and take a shared hit. This action immunized lenders from that “hit.” It ended up being a hallmark of the Central Falls approach and was widely praised in the business press for allowing the city to make use of Chapter 9 bankruptcy without further endangering its ability to borrow.9
Rhode Island’s first municipal bankruptcy became the shortest in United State history when the court approved the receiver’s six-year Debt Adjustment Plan in October 2012.10 The plan cut pensions and other benefits for retirees and employees, increased property taxes, and maintained a reduced city workforce. It guaranteed bondholders 100% payment of their obligations and other creditors 45%.9 City officials are required to comply with the six-year plan and conduct annual status conferences with the court. Until 2018, the city is under strict supervision of an Administrative and Financial Officer (AFO) who must sign off on all spending, personnel, and budget decisions. The AFO is appointed by Central Falls Mayor James Diossa in accordance with state requirements.11
As of March 2017, Central Falls continues to meet and even exceed the terms of the Debt Adjustment Plan. Expenditures are below what the plan projected, the city has been able to create a general reserve account, and the city has contributed 50% more to the pension fund than required by the plan.12 The city has also undertaken cost-saving consolidation measures, new economic development initiatives, and infrastructure enhancements. The bond market, which had dropped Central Falls’ rating to junk status when the city declared insolvency, has now raised its rating back to a level just shy of investment grade (BB).12
(a) A receiver is appointed by the court or the legislature to manage the financial affairs of an entity that is in fiscal distress or facing bankruptcy.
Fig. 2 Central Falls Budget, 2010-2016
Source: Budget data provided by Len Morganis, Administrative and Financial Officer for Central Falls. Bond ratings from Moody’s.
How Other States Manage Municipal Fiscal Crises
Because the federal government has shown little willingness to help cities in crisis – from New York City in 1975 to Detroit in 2013 – the responsibility has generally fallen to state governments.(b) State approaches vary widely according to politics, ideology, custom, available resources, and past practices. Some states choose not to intervene at all, while others have formal or informal systems for helping get cities back on track.
For states that do intervene, experts in the field agree on certain best practices.13 Intensive, ongoing state monitoring of local governments’ financial situations is important to provide warning signs if trouble is on the way, allowing states to proactively intervene before a situation reaches crisis levels. States should provide active assistance, in the form of loans, grants, and technical support, as soon as symptoms of fiscal stress appear. States are advised to play a constructive, not punitive, role, but there must be a willingness to make hard choices. Municipalities will need strong leadership to take aggressive measures, such as tax increases and spending cuts, to restore fiscal order. Transparency in decision making and record keeping can help maintain public support, particularly from unionized public sector workers, for those hard choices.
State approaches to municipal financial crises vary widely. A 2013 review found that 19 states have some kind of statutory program for intervening in situations of municipal fiscal distress.14 These range from early warning and oversight systems, like those in North Carolina and New York, to state takeovers of local government in places such as Pennsylvania, Rhode Island, and Massachusetts. Below we explore the systems used in Massachusetts, Pennsylvania, and North Carolina.
Massachusetts: A Case-by-Case Response When Crisis Hits
As in Rhode Island prior to the Central Falls crisis, Massachusetts has no codified approach for dealing with municipalities in fiscal distress.5 Each town is assessed individually as crisis arises, and different remedies are applied depending on the severity of the situation. There is no centralized monitoring of municipal fiscal health or fixed set of criteria that trigger state intervention. On request, the state’s Department of Revenue will provide municipalities with a financial management review that analyzes their fiscal strengths and weaknesses and makes recommendations for improvement.15
The case of Springfield demonstrates Massachusetts’ ad hoc approach to responding to municipal fiscal distress. Over the past several decades, Springfield struggled to adapt economically in the face of declining manufacturing and demographic shifts. Shrinking property values, reduced state aid, poor city management, and increasing demand for services pushed the city towards insolvency in 2004.16 The Mayor and City Council asked the state to review the city’s finances, and the state determined a takeover was needed.
Unlike Rhode Island, which responded to the crisis in Central Falls with general legislation covering all cases of municipal fiscal distress, Massachusetts passed legislation that specifically addressed the case at hand: “An Act Relative to the Financial Stability in the City of Springfield.” The act created a five-member Financial Control Board made up of state and local appointees to take over the day-to-day operations of the city. The board was granted extensive authority to take actions such as hiring and firing city employees, reorganizing city government, and raising service fees.5
(b) American federalism provides state governments with tremendous flexibility in how they manage their relationships with the towns, cities, and counties within their borders. There is neither a constitutional nor legal obligation for states to help out, nor are there federal guidelines to assist states in this regard.
Text Box 1. Authority Granted to Springfield’s Financial Control Board
Source: Pew Charitable Trusts (2013).14
A $52 million interest-free state loan was used to pay the city’s immediate bills. The Financial Control Board conducted management reviews of all city departments and evaluated economic development possibilities for the city. Ultimately, the board implemented a number of reforms, including long-term budgeting and a requirement that all pay increases be tied to these budget plans. Back taxes and unpaid fees were collected, additional fees were imposed, and some municipal services were privatized. All union contracts were resolved and a new teachers’ contract was put in place.5
After five years of direct management by the Financial Control Board, Springfield recovered from a $41 million budget deficit in 2005 to $40 million in reserves in 2009.5 The heavy hand of the state-appointed board permitted the reforms necessary to bring the city budget into balance without bankruptcy or the kinds of dramatic cuts in services and personnel required in other cities like Central Falls and Pittsburgh. However, the approach was tailored to Springfield and did not push Massachusetts toward a larger framework for handling municipal fiscal distress.
Pennsylvania: Gentle Monitoring & Guidance
While Rhode Island had to move quickly to pass legislation to address the unfolding crisis in Central Falls, Pennsylvania has had a framework for anticipating and responding to municipal financial distress since 1987. The Municipalities Financial Recovery Act, known as Act 47, created a monitoring system that requires all cities to submit annual financial reports to the state Department of Community and Economic Development (DCED).5 Those cities that score poorly may seek state intervention. The state will propose a plan for the city to address its financial problems and, if the city accepts the plan, it becomes eligible for state loans and grants. If the city rejects the proposed state plan, it must develop its own plan and submit it for DCED approval. Since Act 47’s inception, 28 Pennsylvania municipalities have entered the program,17 including Pittsburgh, Scranton, Reading, and Harrisburg.(c)
(c) Philadelphia qualifies for Act 47 intervention as well, but is handled by a special commission created by the state.5
Text Box 2. Indicators of Municipal Fiscal Distress in Pennsylvania’s Monitoring System
Source: Pew Charitable Trusts (2013).14
Pittsburgh requested state intervention under Act 47 in 2003. Despite cutting programs and services and laying off almost 500 city workers, the city was facing a $42 million deficit on a total budget of $398 million.17 Its credit rating had been downgraded to junk bond status. The Pennsylvania DCED assigned a team of lawyers and fiscal consultants to develop a plan for Pittsburgh, which the city adopted in June of 2004.18 The plan contained two hundred initiatives that cut costs, raised taxes, and promoted efficiencies in program design and in administrative and accounting procedures.
While Pittsburgh has made a number of gains since 2003, it continues to struggle with operating deficits and underfunded pension liabilities. As a result, the city has yet to exit the Act 47 program, and in this it is not alone. Since Act 47’s inception, only nine of the 28 municipalities that have entered the program have been judged healthy enough to be released from state oversight.17 Virtually all of the communities that have emerged from Act 47 oversight are small in population and size, unlike Pittsburgh.
The failure of Act 47 to move more cities along to financial independence and stability may be because the approach was, until recently, fairly hands-off.(d) It provided cities with a recovery plan but with weak incentives to meet targets. In 2013, the act was amended so that if cities fail to meet their requirements within five years, they are subject to either receivership or disincorporation.19 This change gives Pennsylvania’s approach more muscle by allowing the state to take control away from local officials and put it in the hands of a receiver if progress is not made. The 2013 amendment also provided municipalities with greater taxing options.19 It is still too soon to determine if these measures will facilitate more cities exiting Act 47 oversight, but they do provide the state with more direct control.
North Carolina: Strong Central Oversight & Control
North Carolina has one of the nation’s oldest and most well-regarded programs for proactively addressing municipal fiscal distress.20 It was established in 1931 to resolve a series of municipal bond defaults that swept through the state during the Great Depression. These defaults were resolved in the 1940s and, since then, no North Carolina jurisdiction has failed to meet its debt obligations. The state’s municipalities receive the top bond grade from rating agencies, which point to the state’s strong “influence and oversight” of local financial health as key to their economic success.20
North Carolina’s system is managed by a Local Government Commission that provides centralized fiscal oversight of all counties, cities, and special districts. Financial reports for each jurisdiction are generated by an online management tool that analyzes the data and provides a five-year projection and comparison to other municipalities.21 If problems are observed, the Commission provides recommendations for solutions. If these are not followed, it can step in and run the daily operations of a municipality. This has happened only four times in the 70-year history of the Commission, including in the town of East Spencer in 2001. The town temporarily lost control of its finances after it failed to meet the Commission’s requirement that it eliminate its budget deficit and fix its accounting and tax collection systems.20
One of the main ways the Commission exerts control is by overseeing local debt – it must approve and sell all bonds issued by local jurisdictions for capital projects. It will only allow a city to take on more debt if the city is in good fiscal health and has reserve funds that are at least 8% of its annual operating expenses.5 A number of municipalities, including Chowan County and Scotland County, have been prohibited from borrowing money when this key indicator dropped below 8%.5,20 As a result, these counties increased taxes and cut jobs and spending in order to get their reserve funds back up and become eligible to issue bonds again. North Carolina also keeps municipalities out of fiscal trouble by maintaining a single, well-funded public-sector pension system managed by the state.5
North Carolina’s aggressive oversight and control ensures that municipalities keep their fiscal health in order. By giving the state control over municipal bonds, the system forces municipalities to be fiscally disciplined before they can take on additional debt. This system of strong oversight and control has keep North Carolina’s municipalities out of bankruptcy for decades.
Promising Strategies for Helping Municipalities in Fiscal Distress
(d) External factors beyond the scope of Act 47 may also play a role in the failure of cities like Pittsburgh to exit state supervision. State law limits the ability of municipalities to change their pension systems, to tax certain businesses, and to impose “commuter taxes” on individuals who work in a city but live elsewhere. More broadly, Pennsylvania’s economy continues to struggle to attract new industries and adjust to the decline of manufacturing jobs.
The four states profiled in this report demonstrate the variety of intervention strategies available to states for addressing municipal fiscal crises. Two key lessons emerge about which strategies appear to be most successful: an early warning system and strong state action when necessary.
North Carolina’s early warning system and clear metrics for evaluating municipal fiscal health have been widely praised by academics and practitioners.5,22 The success of their system is also demonstrated by the high ratings the state and its municipalities receive in the bond market.23 While the other three states profiled in this article have intervention programs, they all require some kind of request by the municipality before intervention occurs. Because Massachusetts and Rhode Island have no central monitoring systems, it is up to municipalities to determine when a crisis has hit. By the time these requests come, cities are usually so deeply distressed – as in the cases of Central Falls, Springfield, and Pittsburgh – that only painful spending and service cuts, tax increases, large injections of state aid, and/or bankruptcy can address the problem. North Carolina’s early warning system, on the other hand, identifies problems and provides recommendations before situations become dire.
An early warning and oversight system appears to be most successful if coupled with forceful action from the state when intervention is necessary. While Pennsylvania has a strong system for monitoring municipal fiscal health, it cannot require municipalities to take specific steps to restore fiscal stability. Even if cities seek state intervention, they have five years to meet requirements before being subject to receivership. Rhode Island, in contrast, acted rapidly in Central Falls to appoint a receiver empowered to take aggressive action to restore the city to fiscal health. North Carolina’s system combines both proactive oversight and state control. By prohibiting municipalities from issuing bonds unless they meet key fiscal indicators, particularly the fund balance, the state provides a strong incentive for cities to keep their financial houses in order.
While states can learn from these successful strategies, particularly the model of North Carolina, the diversity inherent in American federalism makes a one-size-fits-all approach to municipal fiscal stress impossible. As states strive to implement best practices, they should consider variations in responsibility for service provision, collective bargaining requirements, pension arrangements, levels of state aid, specific patterns of municipal tax bases, and the availability of revenue sources, including taxes and bonds.21 A willingness to learn from other states and adapt promising approaches to their own context may help states prevent future cases of municipal fiscal crisis, from Detroit to Pittsburgh to Central Falls.
1. MacDonald, Mary (2016) “City leaders cringe at the thought, but is bankruptcy Providence’s way out?” Providence Business News, March 4.
2. Kimhi, Omer (2008) “Reviving cities: Legal remedies to municipal financial crises,” Boston University Law Review, 88.
3. Pfeiffer, Mark A. (2010) “Report of the State Receiver,” Providence, RI.
4. House Fiscal Advisory Staff (2010) “Budget as Enacted FY 2010,” Providence, RI.
5. Fehr, Stephen (2012) “Pennsylvania Struggles to help its weakest Cities,” Stateline, July 12.
6. Malone, Scott (2011) “Rhode Island’s Central Falls files for bankruptcy,” Reuters, August 1.
7. Russ, Hilary (2012) “Bankruptcy saves tiny Rhode Island City but leaves scars,” Reuters, September 3.
8. McGee, Patrick and Taylor Riggs (2011) “Central Falls aims to protect GOs,” BondBuyer, August 1.
9. Corkery, Michael (2011) “Bondholders win in Rhode Island,” The Wall Street Journal, August 4.
10. Bidgood, Jess (2012) “Plan to End Bankruptcy in Rhode Island City Gains Approval,” The New York Times, September 16.
11. Malinowski, W. Zachary (2013) “Central Falls Mayor names administrative and financial officer,” The Providence Journal, April 2.
12. City of Central Falls (2015) “Adopted Budget Fiscal Year 2015-2016,” Central Falls, RI.
13. American Bankruptcy Institute (2013) “Lessons to be Learned from Detroit and Other Municipalities in Distress,” American Bankruptcy Institute podcast, Episode 140, November 14. Coe, Charles R. (2008) “Preventing Local Government Fiscal Crises: Emerging Best Practices,” Public Administration Review, 68:4.
14. Pew Charitable Trusts (2013) The State Role in Local Government Financial Stress, Philadelphia, PA.
15. See http://www.mass.gov/dor/local-officials/technical-assistance-bureau/technical-assistance-published-reports.html for a sampling of these reports.
16. Forrant, Robert (2013) “Grinding Decline in Springfield,” New England Journal of Public Policy, 20:2.
17. Pennsylvania Department of Economic and Community Development (2017) “Act 47 Distress Determinations,” Harrisburg, PA.
18. City of Pittsburgh (2004) Municipalities Financial Recovery Act Recovery Plan, Pittsburgh, PA.
19. Magrini, Kimberly D. and William C. Rhodes (2014) “Act 47: Pennsylvania says enough is enough. Or is it?” JDSupra, November 3.
20. Fehr, Stephen (2012) “Local Governments in North Carolina Better Off Because of Unique State Agencies,” Governing.com, June 6.
21. Public Finance Management (2011) State Programs for Municipal Financial Recovery: An Overview, Philadelphia, PA.
22. Spiotto, James E., Ann E. Acker, and Laura E. Appleby (2014) Municipalities in Distress? How States and Investors Deal with Local Government Financial Emergencies, New York: Chapman and Cutler, LLC.
23. Duhring, Nicole (2013) “States with AAA bond ratings from all three major rating agencies,” Washington Business Journal, February 27.
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