Until this year, I have never really heard of a school district going bankrupt. It's an extremely rare event. But, Detroit may be left no other option and several schools in California (2) are telling the state they simply cannot pay their bills anymore.
We don't hear about school bankruptcy normally for several reasons. Schools usually have rainy day funds, they usually compensate for lower budgets with cuts, and if everything else goes wrong the state may well bail them out. But, rainy day funds are exhausted. Staff and programs have already been cut to bare minimums. And, some states (California, Nevada, Florida, etc.) are in worse shape than the schools. In effect, there are no more fallback plans. Bankruptcy is real option.
So ... can schools, as public entities, go bankrupt? Yes - and here are some details:
Chapter 9 of the Bankruptcy Code provides for municipality bankruptcy, which under the definition expressly includes school districts. Not surprisingly, this provision was put in place during the Great Depression. But, use of this provision is very rare. Since its passage, it has been used less than 500 times. Compare that to the over a million Chapter 7 and 13 filings that are going to happen this year alone.
Here's the deal with Chapter 9, though. There are serious federalism problems when a federal court, acting under federal statutes, seeks to tell a state entity how to restructure its debt. There is far less flexibility than in personal or corporate bankruptcies for restructuring. For instance, schools can't just stop offering math. They can't sell off a division, like GM with Saturn. The federal bankruptcy judge can't tell the state to sell property. There is some flexibility with union contracts, but those are more procedural than substantive. In short, there is not a heck of a lot a court can do in these situations other than provide protection and negotiating power to municipal debtors against creditors - who, together, sort of have to work it out. If they don't, though, there is less protection for creditors against public debtors than against private debtors.
What happens is that after failure of good faith negotiations between the creditor and debtor, the debtor (school) must offer a restructuring plan to the court. Unlike other bankruptcies, the creditor is not permitted to offer a counter-restructuring plan (because we don't allow private entities to dictate public financial choices). The judge then reviews it for legality on several aspects and, if legal and not overly unfair to the creditor, will confirm it and the school district's debt will be discharged as articulated in their restructuring plan.
Really, what schools get here is time because bonds and other general debt do not have to be paid during the court proceedings, which could last a long time. And, while they probably can't just write off debt like under Chapter 7, the restructuring can put off payment of that debt for a while. The beauty is that schools don't really have to change all that much as long as they propose a plan that conforms with all the bankruptcy laws. If they do, federal judges and creditors are not in a strong position to deny that plan. So, there are certainly short-term financial benefits to filing.
The downside, though, is that school districts have credit ratings just like individuals (instead of numbers they use letters). This is for the bonds that schools get for buildings and repairs and whatnot. Of course, bankruptcy will absolutely destroy a credit rating and these schools will have serious trouble getting acceptable loans in the future. For instance, the damage was so bad to the 1991 bankruptcy of Richmond Unified School District in California that it was forced to change its name and it is still trying to get out from under millions of dollars of debt nearly 20 years later. Going down to a default credit rating will absolutely destroy a district's ability to obtain money.
So, as we see more and more school districts start to consider the nuclear option of bankruptcy, keep in mind the far reaching implications it will have on the kid's kids in that district. I would hate to have to be the school leader that pulls the trigger on one of these filings.