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What’s So Special About Special Districts?

Recently, I’ve become fascinated by special districts, independent government units created for a specific, limited purpose. These districts act like a part of local government. They can collect property taxes and issue tax-exempt bonds. And they often provide basic services that we’ve come to expect from local government—things like fire protection or mosquito control.

Yet, these entities also look like businesses. Special districts can come and go – they can be created or dissolved, depending on needs within the state. And some special districts, such as hospital districts, provide services akin to those provided by private entities.

These entities are so varied in type, purpose, and structure that it is difficult to generalize about them. But special districts are everywhere, and they provide so many basic services without most of us even thinking about them (readers of and writers for this blog excluded). And, as a person who studies bankruptcy, I am fascinated by the possibilities that exist when these entities experience distress.

Although municipal bankruptcy is rare, the bankruptcies that tend to get the most attention are those of cities, towns, and counties. Yet, these general-purpose municipalities file for bankruptcy at a much lower rate than their special-purpose counterparts. And when special districts do file for bankruptcy, they can face significant challenges, including a question as to whether they belong in municipal bankruptcy at all.

The Bankruptcy Code draws a rigid line between government and non-government entities. Under bankruptcy law, there is no recognition that an entity might be quasi-governmental—in other words, bankruptcy law doesn’t account for the possibility that an entity might have both public and private aspects. So, if a special district or other quasi-governmental entity seeks bankruptcy protection, as sometimes occurs, bankruptcy law requires that the entity be fit into either a business or a municipal box.

Bankruptcy draws this rigid line because there is a special chapter of the Bankruptcy Code that is only for municipalities. Chapter 9 of the Bankruptcy Code was developed to provide a federal process for municipal entities to adjust their debts while recognizing that the Tenth Amendment places limits on what the federal government can do in this area. Thus, if an entity qualifies as a “municipality” under the Bankruptcy Code, it must file for chapter 9. If, by contrast, an entity does not qualify as a municipality, it may not file for chapter 9 and must instead use the Bankruptcy Code’s other chapters, primarily chapters 7 or 11, to achieve its debt-related goals.

There is a twist, however. In a nod to the Tenth Amendment, the Bankruptcy Code requires specific state authorization before a municipality of any type may file for bankruptcy. In practice, state authorization for municipal bankruptcy varies widely: about half the states allow at least some of their local governments to declare bankruptcy, but even those states may place restrictions on when and how a local government can file, as well as which specific local governments are authorized. Thus, it is entirely possible, and perhaps even likely, that a special-purpose district will not be eligible for bankruptcy relief at all. If the entity is classified as a municipality, and the state in which the entity is located does not permit municipalities (or the specific type of municipal entity at issue) to file for bankruptcy, the entity will be out of luck as far as access to federal bankruptcy relief is concerned.

However, this assumes that someone will object to the entity’s eligibility for bankruptcy in the first place. As Diane Dick has pointed out, at least in the case of hospital districts, “[i]n most cases, the debtor chooses a chapter and there are no objections.” This raises the question: if no one is objecting, in practice, to these entities filing for bankruptcy under whatever chapter they choose—chapter 9 or chapter 11—what role are federalism concerns actually playing in these bankruptcies? In other words, it’s entirely possible that a governmental entity could file for chapter 11, and no one would care enough to raise an objection that the entity is in the wrong chapter.

Even more puzzling is what happens when special-purpose entities do get into chapter 9. Because many of them function more like businesses than local governments, some judges have essentially imported principles from chapter 11 bankruptcy practice and have allowed special districts to do things they normally wouldn’t be able to do in a chapter 9. While this approach might recognize the realities of the way these entities operate, it risks ignoring or downplaying the federalism concerns that drove the creation of a separate bankruptcy chapter for local governments in the first place.

In short, special district bankruptcies on the whole do not get a lot of scholarly—or practical—attention, but they are worth paying attention to because of these and other quirks. There are numerous entities that don’t fit neatly into either a government box or a business box. If our legal system, and our bankruptcy system in particular, draws a firm line between government and business out of concerns of federal government overreach, we should be concerned if and when, in practice, the line becomes blurred.


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