Over the past few months, even the most confident municipal bond investors have seen fit to revisit the basics of municipal insolvency law. Municipal governments are in a period of once-in-a-lifetime fiscal stress, and negative headlines have stoked fears that even the sturdiest municipal issuers might go the way of Lehman Brothers.

However, until recently, few investors had considered that municipal insolvency laws can change. Rhode Island revamped its municipal insolvency system in June. California is considering its own revisions.

The municipal bond community ought to weigh in on these reforms. Changes that promote clarity for investors and speedy reorganization for municipalities would be welcome.

Clearer insolvency rules could help sustain an orderly market during a period of fiscal distress, and rules that promote swift restructuring could help end the long-standing practice of propping up chronically distressed municipalities.

In particular, investors should support changes that reaffirm the seniority of general obligation bondholders, allow for proactive and standing municipal monitoring agencies, permit judges to impose tough-love decisions on distressed municipalities, and insulate state receivers and control boards from political influence.

These reforms would dovetail with municipal restructuring efforts underway in the states. They would also keep at bay unwanted federal interference in the municipal bond market.

Lacks Clarity, Slows Progress

In the broadest terms, U.S. municipal insolvency law works as follows: in roughly half of the states, insolvency is a joint state and federal affair. In these states, insolvent municipalities may take advantage of state-based rules and-or file for protection under Chapter 9 of the federal bankruptcy code. States must authorize municipalities to file for Chapter 9, but once “in” the federal bankruptcy court, federal judges are (at least nominally) in control. In the rest of the country, municipal insolvency is entirely a state process. States often appoint control boards, receivers, or extend credit to struggling municipalities in dire financial situations.

Under the current framework, key municipal insolvency rules provide limited clarity for investors.

For example, under Chapter 9, courts recognize the seniority of general obligation creditors’ inconsistently, and state approaches to municipal fiscal distress are reactive and ad hoc. Receivers and control boards are often appointed only after financial distress metastasizes and on a case-by-case basis.

Current rules also ensure that municipal insolvency proceedings advance at a glacial pace. Chapter 9 judges have limited ability to force hard decisions in bankruptcy proceedings, and state-appointed receivers or control boards often lack the political will or proper tools to impose painful decisions on municipal debtors. The result is stagnant municipal recovery, sometimes characterized by decades-long fiscal distress.

Reform efforts in Rhode Island and California are, unfortunately, traditional approaches. Rhode Island’s new receivership law provides for an uncertain, case-by-case determination of fiscal stress whereby insolvent municipalities migrate slowly to federal bankruptcy court. California’s proposed law would similarly delay the inevitable, requiring municipalities to gain approval from the California Debt and Investment Advisory Commission before filing for Chapter 9.

Under both regimes, bondholders might be forced to live with years of uncertainty and illiquid securities. It is worth asking: Will Rhode Island’s new rules really stabilize the market for Rhode Island municipal bonds if four of its 39 municipalities seek help under the new receivership law? Will CDIAC help California’s municipalities re-boot quickly and efficiently?

Insolvency law changes are needed given the market’s current condition. Municipal defaults have traditionally been rare, one-off events that have little impact on the broader market, but today there is a risk that defaults could occur more frequently, and this could negatively impact market liquidity.

Likewise, policies that prolong the municipal insolvency process are designed for an environment of infrequent defaults. Old-fashioned approaches may be less workable today. State budgets are tight, borrowing and spending is highly scrutinized, and policymakers have less interest in keeping afloat “zombie municipalities.”

The market needs new insolvency rules that enhance clarity and empower municipalities to quickly clean up their balance sheets. Clearer rules can ensure that capital continues to flow efficiently to creditworthy communities during a period of fiscal distress, and laws that enable quick restarts can help prevent the accumulation of capital in overly indebted local governments.

Improving the System

There are at least two steps lawmakers can take to clarify insolvency rules for investors: make plain the seniority of general obligation bondholders, and replace states’ reflexive and improvised fiscal monitoring systems with proactive, standing commissions.

Reaffirming the seniority of general obligation bond investors in insolvency proceedings would add stability to the municipal market. General obligation bonds comprise roughly 34% of annual issuance, and for more than 200 years, the municipal market has understood the general obligation covenant to be the “gold standard” in municipal finance. Among other things, general obligation bonds generally come with an unlimited tax pledge and are typically issued only with voter approval. While most legal scholars believe federal courts should recognize the seniority of the general obligation covenant in insolvency proceedings, there is little case law to rely on.

States would also benefit from proactive, standing municipal monitoring agencies. North Carolina may provide a ­template.

In North Carolina, a monitoring commission acts before financial disaster strikes and is omnipresent in the financial lives of the state’s municipalities. The commission brings added clarity for investors and has been directly linked to lower borrowing costs by Moody’s Investors Service and Fitch Ratings.

Lawmakers can also take steps to promote rapid municipal reorganization. Policy options include empowering Chapter 9 judges to “get tough” with municipal debtors and enacting laws to insulate receivers and control boards from the political process.

Allowing Chapter 9 judges to compel municipal assets sales, tax hikes, and spending cuts in bankruptcy proceedings would be very helpful. Such a change would incent speedier municipal-creditor settlements, whether outside of the bankruptcy process or within it. It could also prevent capital from perpetuating unsustainable and unhealthy public finance endeavors.

Curtailing political influence is also a good idea. Research suggests that independent receivers and control boards are more likely than political actors to make the unpopular decisions that speed along the municipal insolvency process. Independence vests receivers and control boards with the will to act and often comes with a grant of extraordinary powers such as the ability to negotiate union contracts outside of the collective bargaining process.

Changes that promote clarity and speedy reorganization would complement local government restructuring efforts underway in the states. The National Governors Association has called the post-Great Recession fiscal environment “The Big Reset,” and as part of this effort has prioritized streamlining local government.

In Pennsylvania, the governor has proposed redistricting 80% of the states’ school systems. In Nebraska, lawmakers are considering a bill that would consolidate the state’s 93 counties into 30. Insolvency law reforms that enable muscular approaches to municipal distress would buttress these efforts.

Clearer laws and faster municipal recoveries could also help prevent the worst possible outcome: a federal bailout of ­municipalities.

Though the overwhelming majority of U.S. municipalities have manageable debt levels and will persevere through today’s fiscal stress, a few will not. Propping up these governments invites the federal government to act just like it did with issuers in other markets (Fannie Mae, Freddie Mac, GM, AIG, Citigroup, etc.). Such a bailout could ultimately threaten the country’s two-century-old system of local control over prioritizing capital spending and debt issuance. Better rules could help ensure that never happens.

The Consequences

Reform is unlikely to clarify every aspect of municipal insolvency rules or ensure a “reboot” for every struggling local government. Nor will reform enable reorganization at speeds found in the private sector. Settled constitutional principles underpin municipal insolvency law, and municipal deterioration is rarely due to poor management, alone. Likewise, local governments are not designed to restore budget balance via swift, unilateral decision making as in the private sector.

Nonetheless, bond investors ought to seek an upgrade to the existing insolvency laws. There is much to gain from a clearer and speedier framework. The current rules are opaque at a time when investors crave certainty, and they prevent the most indebted governments from pressing the financial “reset” button. Investors should get behind reforms that strengthen municipal market liquidity and give struggling municipalities a path to financial recovery.

Adam Stern is a lawyer and a senior analyst with Boston-based Breckinridge Capital Advisors.