Why Filing Bankruptcy Would Be No Quick Fix for States

COMMENTARY Budget and Spending

Why Filing Bankruptcy Would Be No Quick Fix for States

May 1, 2020 6 min read
Zack Smith

Senior Legal Fellow, Meese Center for Legal Studies

Zack is a Senior Legal Fellow and Manager of the Supreme Court and Appellate Advocacy Program in Heritage’s Meese Center.
Our nation was born during a time of great economic upheaval, in which many of the new states found themselves deeply indebted immediately after the American Revolution.   photo_smart/Getty Images

Key Takeaways

Fiscally troubled states are nothing new.  

Government bankruptcies are the result of decades of fiscal mismanagement and not a temporary crisis.  

States do face an impediment in restructuring their own debts—one put in place by the Framers themselves.

Fiscally troubled states are nothing new.  

In fact, our nation was born during a time of great economic upheaval, in which many of the new states found themselves deeply indebted immediately after the American Revolution.  

The residents of those states paid a high price—literally and figuratively—for their freedom from King George III.

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Unfortunately, that wasn’t the end of financial struggles for the states. In fact, less than half a century later, in a painful episode, almost one-third of U.S. states defaulted on their debts.

States were also especially strapped for cash immediately after the Civil War and during the Great Depression. 

As many cities and states stared into the financial abyss during the Great Depression, Congress took action and for the first time allowed governmental entities—municipalities, including cities and special taxing districts, but not the states themselves—to declare bankruptcy. 

While the Supreme Court initially struck down Congress’ attempt to provide for municipal bankruptcies as impinging on states’ sovereignty, it reversed course two years later in 1938 after Congress again passed a law providing for municipal bankruptcies and upheld Congress’ ability to do so.

According to Stanford University law professor Michael McConnell, a former federal appeals court judge, the Supreme Court held that the new statute was OK as it “did not interfere with state sovereignty because it was drawn to ensure that the state retained control of its fiscal affairs, and because the state consented to the bankruptcy proceeding.”

Still, Congress has never amended the bankruptcy code to allow a state itself to take advantage of the bankruptcy process, though today even counties—which at common law were considered to be a part of the state itself—can take advantage of the bankruptcy process created by Congress.  

Nevertheless, states retain the ultimate authority over whether their municipalities and other political subdivisions can declare bankruptcy. If a state has not authorized it, that route remains closed, even though Congress has otherwise made it available.

"Blue-State Bailouts"?

It’s against this backdrop that late last week Senate Majority Leader Mitch McConnell, R-Ky., set off a firestorm with his comments that he would favor allowing financially troubled states to declare bankruptcy rather than providing any “blue-state bailouts.”

Regardless of the senator’s intentions, the idea of letting states “use the bankruptcy route” to fix their financial problems is no simple task and isn’t particularly relevant to the COVID-19 crisis.

Government bankruptcies are the result of decades of fiscal mismanagement and not a temporary crisis.  

As the senator is undoubtedly aware, Congress would first have to pass legislation allowing states to take advantage of the bankruptcy process.

And even if he could gain enough support in both houses of Congress and obtain the president’s signature to pass this proposal into law, constitutional questions still remain. 

As others have pointed out, unlike municipalities, which are creatures of state law, states themselves are sovereigns. They have entered into their own contracts—both with those to whom they have sold bonds and the public employees to whom they have promised future retirement benefits—without setting aside enough funds to pay them. 

The argument can be made that they are responsible for making good on those contracts, and if that isn’t financially possible, for attempting to renegotiate them.

Subjecting them—even voluntarily—to the extensive federal oversight involved in the bankruptcy process would extensively intrude on a state’s sovereignty—maybe even unconstitutionally so.

Despite its goals, bankruptcy is not always an orderly or even fair process. Bankruptcy involves making hard choices, and oftentimes, certain creditors who otherwise would have had higher priority of repayment are pushed further back in line. By definition, there’s not enough money to go around.

Rather than having the state’s elected officials make those decisions, an unelected, unaccountable federal bankruptcy judge would do so, or at a minimum be significantly involved in the process by having ultimate authority to accept or reject any plan put forward by the bankrupt state. 

That could have both benefits and pitfalls, but would ultimately lead to those decisions being made by an official of a different sovereign who is further removed from the oversight of that state’s residents.

And even if a state can only voluntarily invoke the process as the Senate majority leader suggested, it’s not clear that would be enough to save the idea from this constitutional conundrum.  

Even if states can’t declare bankruptcy, they’re not completely defenseless against creditors. States still have their shield of sovereign immunity. They can’t be sued unless they consent to it.

And even if states do waive their sovereign immunity and consent to be sued, that’s a much more limited intrusion than wholly submitting a state’s financial decisions to federal oversight.  

What About Puerto Rico?

Congress passed a bankruptcy-like mechanism to allow Puerto Rico to restructure its debts. While the experience may be instructive, there are differences.

First, Puerto Rico is a federal territory, not a state, so it does not have the same level of sovereignty as states.  

Second, as the Puerto Rico restructuring shows, it is far from a painless process, and a federal judge will be forced to resolve many politically sensitive disputes—especially the amount and source of funds used to pay pensioners.  

States do face an impediment in restructuring their own debts—one put in place by the Framers themselves. It’s the Constitution’s Contracts Clause, which largely prohibits states from interfering with private contracts and substantially limits a state’s ability to repudiate its own contracts.

All this is to say that the Senate majority leader’s point is a fair one with no easy solution.  

While the current crisis has undoubtedly placed a financial strain on many governmental entities, many of these same entities and states grappled with financial struggles and ballooning deficits for years before the current pandemic was on anyone’s radar.

The fiscal outlook for Illinois, for example, is particularly problematic, with credit-rating agencies recently downgrading its debt to just above junk-bond status.  

It hardly seems fair to provide unrestricted funds to these states to make up for these preexisting shortfalls. Congress has already supplied emergency funds to the states—provided that the states use the money for coronavirus-related purposes—and may be willing to do so again.  

What the Senate majority leader and others, including President Donald Trump, seek to avoid is having the federal government essentially guarantee state debts and revenue streams by providing additional funds to the states to make up for preexisting budget gaps—especially those states’ unfunded pension liabilities.

Allowing states to pursue bankruptcy may create as many problems as it solves. McConnell’s statements that “[bankruptcy] saves some cities” and that “there’s no good reason for it not to be available” to the states, too, glosses over serious constitutional questions, but the point stands that states—not the federal government—are responsible for their budgets. 

States that were already on a path to insolvency prior to COVID-19 face more pressure now to develop responsible budgets and must attempt to reduce their outstanding debts before they spiral out of control.

This piece originally appeared in The Daily Signal