History

• Municipalities have only been able to declare bankruptcy since 1937. Congress passed the first modification of bankruptcy code to allow for municipal bankruptcy in 1934, but the Supreme Court case "Ashton v. Cameron County Water Improvement Dist. No. 1" declared state bankruptcy unconstitutional under the guise that bankruptcy code infringed on the sovereignty of the states. Between 1980 and 2008, only 32 towns and cities have used Chapter 9, according to Weiner.
  
  

Features

• Bankruptcy for a municipality works in much the same way as bankruptcy for a citizen. The municipality must prove to the court that it is insolvent -- holding more debts than assets -- and must make a good faith effort to pay creditors. Half of all creditors must agree to the bankruptcy unless doing so would be impractical, such as when a municipality has thousands of individuals holding its debts. The municipality receives the power of automatic stay during bankruptcy, which means creditors cannot sue to recover their debt.
  
  

Considerations

• Municipalities usually try everything possible to avoid bankruptcy, because a bankrupt town has an extremely difficult time raising money because of low confidence from investors. Bankruptcy also makes it harder for neighboring towns to raise money. Meeting the conditions of bankruptcy are nearly impossible for most towns. The bankruptcy court won't approve a case, for instance, just because a town does not want to raise taxes or make other politically unenviable decisions. Processing a Chapter 9 case requires millions of dollars, but the town does not have to liquidate assets like in a normal bankruptcy case.
  
  

Effects on the Individual

• Investors should factor in the risk of bankruptcy by diversifying their municipal bond holdings. States cannot declare bankruptcy -- only default on payments to creditors, which has an effect like bankruptcy. However, the default and bankruptcy rate of municipalities is much smaller than that of any other debt. The low risk and tax-preferred status of municipal bonds means most investors should put up to 50 percent of their investment funds into bonds, according to Charles Schwab.