Central Coast councillors have pleaded with the government not to suspend them, arguing the organisation's "serious" accounting failures are not their fault.
The state agreed to a $6.2 million bailout last week to ensure the council's staff and suppliers would get paid.
Local Government Minister Shelley Hancock issued the 15 councillors, including mayor Lisa Matthews, with a show-cause notice, giving them a week to show why they should not be suspended.
The council has forecast an $89 million deficit for 2019-20 and cannot pay its debts.
Ms Hancock's show-cause notice said the council had illegally spent restricted funds for the wrong purposes and had not taken action to address the looming deficit.
She was "sufficiently concerned that the decisions of the elected body" had contributed to the problems. But the councillors said in their reply on Wednesday that they had been unaware of the scale of the deficit and "serious liquidity issues" until early October.
They said they had taken urgent action to address the council's financial position, including formulating a 100-day rescue plan.
The council had appointed consultants Grant Thornton Australia for interim financial support in August, DMB Consulting to review its accounts in September, law firm Clayton Utz in October to investigate what went wrong and a new chief financial officer who started work this week. It was also engaging KPMG to complete a forensic audit.
The council said the spending of restricted funds had "apparently gone undetected" despite Audit Office audits, oversight from its audit and risk committee and financial planning from professional services specialists.
"Whilst there has clearly been a failure in Council's accounting systems which must be urgently addressed, in the circumstances of multiple levels of audit and accounting oversight, this is not a failure that would warrant suspension of the elected representatives," the councillors wrote.
"Councillors are of the view that they have not knowingly passed a resolution to allow the use of restricted funds for non-approved purposes. This accounting practice is not a matter councillors directed, to their knowledge."
Central Coast Council, among the state's biggest, was formed two years ago after a merger of Wyong and Gosford councils.
The councillors blamed the "ongoing costs arising from the merger", decreased rates income and COVID-19 for this year's deficit.
Ms Hancock is expected to review the council submission over the next week.
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