Saving Cities or Exploiting Creditors?: State Diversion of Municipal Assets

Abstract

States that seek to resolve fiscal distress within their political subdivisions face both political and economic pressures to balance residents’ and creditors’ interests. States have occasionally engaged in strategies that subordinate the rights of creditors, frequently by removing from debtor municipalities assets on which creditors may have relied for payment. Constitutional constraints, and the Contracts Clause in particular, created a bulwark against favoritism that arguably exploited creditors through the diversion of assets in the 19th Century. In those cases, states appeared to use asset diversion to impose a holdup “compromise” on creditors. More recently, states have adopted strategies that also divert assets away from creditors. Although the initial magnitude of the diversion differs from that in the earlier cases, the ultimate effect cannot be known at the time the strategy is implemented. Thus, the more recent strategies potentially have effects similar to those that caused earlier courts to invalidate the state’s action. Nevertheless, the more recent strategies appear to be deployed to provide distressed cities with needed capital to finance the services they were created to provide rather than to limit creditor recoveries after default. The inevitable difficulty of predicting the long-term consequences of current diversion of revenues complicates the ability to distinguish contemporary from 19th Century versions of the strategy. But history suggests that judicial reactions to state-approved asset stripping depend on the court’s conception of what the state was attempting to accomplish more than on a desire to achieve doctrinal consistency or coherence.