Insolvency Rule Enforcement Could Have Saved Detroit

Published September 4, 2014

Earlier this year, the city of Detroit concluded negotiations with the holders of its liabilities, regarding who is will take cuts on their debt, and how much of a cut they will accept. Starting in September, the city will need to convince the courts of its plan, in order to certify its plan.

Throughout the saga of Detroit’s bankruptcy, the lesson drawn from these proceedings is simple: it is far better to take steps to prevent a situation, than to actually go through it.

Much of the commentary regarding the city revolves around whether one type of creditor or another will be given preferential treatment in bankruptcy. However, this is the wrong question to answer, because governments should pay all of their debts.

Bankruptcy, on the other hand, is about negating debts. If municipalities stay out of trouble, their creditors will not have to worry about whether  a court will rule that some obligation is more sacred than another obligation.

Michigan is a national leader in working to prevent insolvency. State law requires local governments balance their budgets. If they overspend, the entity’s managers must submit a plan to eliminate this deficit. For these struggling governments, the state can help the city obtain bonds secured with state assistance to the local government, and can also provide direct emergency loans.

If these measures do not work and the city remains non-compliant with fiscal solvency rules, the state can declare a financial emergency, becoming more active in addressing the local government’s situation. Agreements can be signed with local officials to detail how the municipality will proceed until the emergency is resolved.

One of those options is the appointment of an emergency manager. The emergency manager is entrusted with the care of the local government until the crisis is resolved, effectively stripping elected officials of their responsibility. Given that these local governments are creatures of the state, entrusted with powers that the state assigns to them, it is appropriate for the state to intervene when local entities fail to meet state requirements.

Failing this, though, the emergency manager can take the local unit of government into bankruptcy court, with the approval of the governor.

According to the Pew Charitable Trusts, 19 other states have insolvency prevention and intervention programs, but none have been more aggressive than Michigan.

Yet this did not save Detroit from bankruptcy. The state waited too long, and was not strict enough with the city. Detroit’s problems were not new, and the city did follow some of the state’s insolvency-prevention policies. The city developed deficit elimination plans, but did not abide by them. The state helped loan the city money, but that only delayed the inevitable.

Ideally, the State of Michigan should have stepped in when Detroit first began showing financial instability, in 2000.

Between 2000 and the present day, the city’s financial situation continued to deteriorate, systems of financial information fell into disarray, and Detroit policymakers were charged with corruption.

The Motor City’s situation had deteriorated to the point that one expert in the bankruptcy proceedings observed, “the lack of accounting and financial information systems confounds virtually every City operation and makes it difficult to perform even basic analysis or performance monitoring.”

When the lack of information makes financial management impossible, it is only a matter of time before a government is unable to pay its bills.

Now that the city is in bankruptcy, a number of creditors are attempting everything in their power to ensure that their payments are satisfied.

The conclusion of Detroit’s bankruptcy case may find that the city should have sold more of its artistic holdings to satisfy debt, or it may certify the city’s plan to lower liabilities. However, these are win-lose questions that could have been prevented with better management.

As Michigan shows, state officials can do a lot to prevent these tough questions from having to be answered, if they enforce the insolvency prevention policies already on the books.

James M. Hohman ([email protected]) is Assistant Director of Fiscal Policy at the Mackinac Center for Public Policy.