What happens when your local council goes bankrupt

Local government fulfils an essential role in society. It provides fundamental services – from social care and transport to education, water and waste collection. And when it no longer can, when a council goes bankrupt, it is the most vulnerable citizens who bear the brunt of that failure.

In the UK, this has been deftly illustrated by the situation facing the town of Slough, in Berkshire. In 2021, the council issued a section 114 notice, effectively declaring itself bankrupt. The recovery and renewal plan subsequently drawn up laid out how services would be downsized and staffing numbers cut. So far, five care services have been closed and local transport has been reduced, with more measures likely to be introduced. The council has also been pressured to sell most of its real estate holdings. These cuts will continue to have a significant impact on the lives of local residents for years to come.

Our research shows that when a local authority has strict accounting and reporting rules in place, it is less likely to experience financial problems. The national government, in turn, is less likely to have to use taxpayers’ money to rescue it.

Strict fiscal accounting measures are helpful

Since 2018, several other local authorities across England, from Northumberland county council to Croydon, Nottingham and Northamptonshire, have followed Slough in running out of cash. The Public Accounts parliamentary committee in the House of Commons has cautioned that more councils will be forced to issue Section 114 notices, thereby restricting all non-essential spending because of a lack of funds.

Experts have long warned that councils would be facing financial difficulties. But rampant inflation and rising costs related to social care, transport and utility have meant this has happened much earlier than anticipated.

To study how local governments across the world deal with financial difficulties, since 2018, we have gathered evidence from cases and legal systems from 20 jurisdictions, including the UK and the US, at times conducting qualitative interviews with managers and politicians. We recently presented a working paper from this research project at the INSOL London Academic Colloquium Programme.

We have found that local councils in those countrieswhich have strict accounting rules – including Belgium, Canada, France, Germany, Japan, the Netherlands and the Russian Federation – are less likely to experience financial difficulties. In Japan, strict fiscal accounting measures were introduced in 2007 with the Local Financial Soundness Act. This led to a reduction – from 40 to 0 – in the number of cities facing early restructuring procedures to save costs and avoid bankruptcy. Only one city (down from three per year in 2007), Yubari, is still working to become solvent. After filing for bankruptcy in 2007 due to the collapse of the local coal industry, Yubari council is following a complex multi-rehabilitation process, which has involved increasing taxation and reducing staffing and services.

Implementing rules is where problems arise

Having a legal mechanism in place to ensure that money is well spent is another key safeguard. In Belgium, among other countries, the government has developed an online tool for tracking local councils’ financial health. If they deviate from their financial targets, the government can force them to revise their budget allocations, among other coercive measures.

However, this is not enough. In South Africa, despite constitutional mandates on municipal budgeting and financial accountability, the way these rules are implemented has resulted in extraordinarily high number of local authorities in distress. In 2020 alone, about one in five South African municipalities was under administration.

Research shows that in Canada, despite strict accounting and lending rules, during the 1930s several municipalities, including the cities of Windsor, York and Burnaby, defaulted on payments. Today, Canadian local authorities are still intrinsically vulnerable to unforeseen events – a sudden spike in commodity prices, natural disasters, conflicts in neighbouring countries, significant drops in the population and influxes of refugees and migrants – which can cause the most financially sound municipality to go bankrupt.

Detroit, in the US, offers an instructive case study. In the 1930s, the Michigan city was a major centre for commercial trade due to its location in the Great Lakes region. It became the automotive capital of the world and one of the largest and most prosperous cities in North America. However, the gradual collapse of the automotive industry since the 1970s combined with population decline heightened social and racial issues. Chronic corruption and mismanagement meant that the city which had been famously known as the “Arsenal of Democracy” for its contribution to the Allies in the second world war went bankrupt.

The US is the only country in our study to have a comprehensive set of insolvency rules applicable only to local entities in distress. This ensures that when cities like Detroit run out of cash, there is a sufficiently tried-and-tested approach to negotiate a way out. In these procedures, creditors must adhere to whatever plan the local government proposes. In this instance, in the so-called “Grand Bargain” negotiated during Detroit’s Chapter 9 bankruptcy, some philanthropic organisations were allowed to protect pensioners’ claims.

Most European countries – from Italy and France to Belgium – opt for special administrative rules. They believe that public law mechanisms, rather than insolvency laws, are better suited to protecting vulnerable citizens. The need to ensure the continuity of essential services justifies departing from more traditional insolvency rules on distribution of assets. This forces creditors to waive a more significant portion of their claims or to accept much longer repayment terms than if these traditional rules applied.

The UK adopts a much less structured approach. Rather than intervening early to minimise disruptions to essential services, our research shows that British councils indirectly support mergers between local councils, and their laws only intervene by replacing local councillors when no money is left in the council.

At that point, the only option left on the table is a government’s bailout with taxpayers’ money, as has happened in Slough and in Croydon. This over-reliance on government assistance is due to a lack of rules that encourage councils to act at the first signs of crisis, as well as to inadequate financial supervision. As the Japanese and American cases demonstrate, last-minute bailouts of this kind are inefficient and ineffective.

Authors: Eugenio Vaccari – Lecturer, Royal Holloway University of London | Laura Coordes – Professor of Law, Arizona State University | Yseult Marique – Senior lecturer, University of Essex