Just days after becoming controller of financially strapped Harrisburg, Pa., in January, Daniel Miller began uttering an obscure term that baffled most people who had never heard it and chilled those who had: Chapter 9.The seldom-used part of U.S. bankruptcy law gives municipalities protection from creditors while developing a plan to pay off debts. Created in the wake of the Great Depression, Chapter 9 is widely considered a last resort and filings under it are more taboo than other parts of bankruptcy code because of the resulting uncertainty for everyone from municipal employees to bondholders.
Since Chapter 9 was enacted in 1934, just 600 cases have been filed under the code, partly because they require state approval. Some municipalities have found escape hatches, such as raising taxes. The largest Chapter 9 case was filed in 1994, when Orange County, Calif., lost $1.6 billion on wrong-way bets on interest rates.
But many experts fear that a surge in municipal bankruptcy filings is unavoidable. "The day of reckoning is coming," says Michael Pagano, dean of the University of Illinois at Chicago's College of Urban Planning and Public Affairs.
To keep cities and towns from toppling into Chapter 9, more states are likely to make use of state laws to assume oversight of financially distressed municipalities, he predicts. Pittsburgh, for one, has been operating under such a law since 2004.
Vallejo, Calif., a city of about 116,000 people near San Francisco, has been trying to rejigger worker contracts in bankruptcy court since it filed for Chapter 9 in 2008, after buckling under declining real-estate values. Some union contracts expire later this year, and Vallejo is attempting to scrap them and start over.