Nov 29, 2010,
Vol. 16, No. 11
By DAVID SKEEL
Anyone who proposed even a decade ago that a state should be permitted
to file for bankruptcy would have been dismissed as crazy. But times have
changed. As Arnold Schwarze-neggerfs plea for $7 billion of federal
assistance for California earlier this year made clear, the states are the
next frontier in gtoo big to fail.h In the topsy-turvy world we now
inhabit, letting states file for bankruptcy to shed some of their
obligations could save American taxpayers a great deal of money.
The financial mess that spendthrift states have gotten themselves into
is well known. California—recently dubbed the gLindsay Lohan of statesh in
the Wall Street Journal—has a deficit that could reach $25.4
billion next year, and Illinoisfs deficit for the 2011 fiscal year may be
in the neighborhood of $15 billion. There is little evidence that either
state has a recipe for bringing down its runaway expenses, a large portion
of which are wages and benefits owed to public employees. This means we
can expect a major push for federal funds to prop up insolvent state
governments in 2011, unless some miraculous alternative emerges to save
the day. This is where bankruptcy comes in.
When the possibility is mentioned of creating a new chapter for states
in U.S. bankruptcy law (Chapter 8, perhaps, which isnft currently taken),
most people have two reactions. First, that bankruptcy might be a great
solution for exploding state debt; and second, that it canft possibly be
constitutional for Congress to enact such a law. Surprisingly enough, this
reaction is exactly backwards. The constitutionality of
bankruptcy-for-states is beyond serious dispute. The real question is
whether the benefits would be large enough to justify congressional
action. The short answer is yes. Although bankruptcy would be an imperfect
solution to out-of-control state deficits, itfs the best option we have,
at least if we want to have any chance of avoiding massive federal
bailouts of state governments.
Start with the issue of constitutionality. The main objection to
bankruptcy for states is that it would interfere with state
sovereignty—the Constitutionfs protections against federal meddling in
state affairs. The best known such barrier is the Tenth Amendment, but the
structure of the Constitution as a whole is designed to give the states a
great deal of independence. This concern is easily addressed. So long as a
state canft be thrown into bankruptcy against its will, and bankruptcy
doesnft usurp state lawmaking powers, bankruptcy-for-states can easily be
squared with the Constitution. But the solution also creates a second
concern. If the bankruptcy framework treads gingerly on state
prerogatives, as it must to be constitutional, it may be exceedingly
difficult for a bankruptcy court to impose the aggressive measures a state
needs to get its fiscal house in order.
Neither of these considerations—state sovereignty or the limited force
of a bankruptcy framework that gives wide berth to governmental
decision-makers—is hypothetical. We now have more than 70 years of
experience with a special chapter of the bankruptcy code—now called
Chapter 9—which permits cities and other municipal entities to file for
bankruptcy. For decades, this chapter did not get a great deal of use. But
since the successful 1994 filing for bankruptcy by Orange County,
California, after the countyfs bets on derivatives contracts went bad,
municipal bankruptcy has become increasingly common. Vallejo, California,
is currently in bankruptcy, and Harrisburg, Pennsylvania, is mulling it
over. The experience of these municipal bankruptcies shows how
bankruptcy-for-states might work, what its limitations are, and why we
need it now.
Municipal bankruptcy dates back to the last epic financial crisis, the
Great Depression of the 1930s. According to testimony in a 1934
congressional hearing, 2,019 cities and other governmental entities had
defaulted on their debt at that time. Back then, the leading advocates of
a bankruptcy option for local government were progressives, especially
those whose cities were overwhelmed by debt. In 1933, Detroit mayor and
future Supreme Court justice Frank Murphy assured Congress that bankruptcy
would be gan orderly and legal wayh to assist gthe people of these great
urban centers that are now simply being crushed out of existence by taxes
and by debts.h The New Deal Congress obliged by enacting the first
municipal bankruptcy law shortly thereafter.
As with much New Deal legislation, the early history of municipal
bankruptcy law was rocky. The Supreme Court struck down the original law
in 1936, concluding that it would infringe on state authority, even if the
state vigorously welcomed the law. (One reason for rejecting municipal
bankruptcy, according to Justice James Clark McReynolds, whose opinion was
and is widely criticized but who was perhaps prescient, was that state
bankruptcy might be next.) But two years later, after the famous gswitch
in timeh from its earlier pattern of striking down New Deal legislation,
the High Court gave its blessing to a 1937 version of the law. Congressfs
revisions to the municipal bankruptcy legislation were slight, but the
Court was ready to uphold it. Because the law was gcarefully drawn so as
not to impinge upon the sovereignty of the State,h the Court concluded,
and made sure that the state gretains control of its fiscal affairs,h it
now passed constitutional muster.
Municipal bankruptcy differs in a few key respects from the law
applying to nongovernmental entities. Unlike with corporations, a cityfs
creditors are not permitted to throw the city into bankruptcy. A law that
allowed for involuntary bankruptcy could not be reconciled with anyonefs
interpretation of state sovereign immunity. A city must therefore avail
itself of bankruptcy voluntarily; no one else, no matter how irate, can
trigger a bankruptcy filing. And when municipalities do file for
bankruptcy, the court is strictly forbidden from meddling with the reins
of government. The current law explicitly affirms state authority over a
municipality that is in bankruptcy and prohibits the bankruptcy court from
interfering with any of the municipalityfs political or governmental
powers. A court cannot force a bankrupt city to raise taxes or cut
expenses, for instance. Such protections have long since quieted concerns
that municipal bankruptcy intrudes on the rights of the states, and they
would similarly assure the constitutionality of a bankruptcy chapter for
states.
One can imagine other constitutional concerns coming into play. If a
municipal or state bankruptcy law allowed the court to ignore the property
interests of creditors who had been promised specific state tax revenues
or had been given other collateral, it might violate the Takings Clause of
the Fifth Amendment. But the current chapter for municipal bankruptcy
respects these entitlements (as does current corporate bankruptcy), and a
chapter for states could easily be structured to do the same.
In the decades since the constitutionality of municipal bankruptcy was
affirmed by the Supreme Court, the most serious obstacle in practice has
been the rule that only insolvent municipalities can file for bankruptcy.
Because a struggling city theoretically can raise taxes or slash programs,
it often isnft clear if even the most bedraggled city needs to be in
bankruptcy. In 1991, a court concluded that Bridgeport, Connecticut—which
wasnft anyonefs idea of a healthy city—had not demonstrated that it was
insolvent, and rejected Bridgeportfs bankruptcy filing. To avoid this
risk, without making bankruptcy too easy for states, Congress would do
well to consider a somewhat softer entrance requirement if it enacts
bankruptcy-for-states legislation. Current corporate bankruptcy does not
require a showing of insolvency, and the new financial reforms allow
regulators to take over large banks that are gin default or in danger of
default.h Although these reforms are in other ways deeply flawed, the gin
default or danger of defaulth standard would work well for states.
Given that a new bankruptcy chapter for states would clearly be
constitutional, and the entrance hurdles could easily be adjusted, the
ultimate question is whether its benefits would be great enough to justify
the innovation. They would, although a bankruptcy chapter for states would
not be nearly so smooth as an ordinary corporate reorganization. When a
business files for bankruptcy, the threat to liquidate the companyfs
assets—that is, to simply sell everything in pieces and shut the business
down—has the same effect on creditors that Samuel Johnson attributed to
the hangmanfs noose: It concentrates the mind wonderfully. Because
creditors are likely to be worse off if the company is simply liquidated,
they tend to be more flexible, and more willing to renegotiate what they
are owed.
One can imagine something like a liquidation sale for cities and even
states. Indeed, in the early 1990s, professors Michael McConnell and
Randal Picker proposed that Congress amend the existing municipal
bankruptcy chapter to allow just that. They argued that many of a cityfs
commercial, nongovernmental properties could be sold in a municipal
bankruptcy, and the proceeds simply distributed to creditors. (They also
suggested that municipal boundaries could be dissolved, with a bankrupt
city being absorbed by the surrounding county.) Although California has
taken small steps in this direction on its own—it recently contracted to
sell the San Francisco Civic Center and other public buildings to a Texas
investment company for $2.33 billion—it seems unlikely that Congress would
give bankruptcy judges the power to compel sales in bankruptcy. Nor could
it do so with respect to any property that serves a public purpose.
Liquidation simply isnft a realistic option for a city or state. (The same
limitation applies to nation-states like Ireland and Greece, whose
financial travails have reinvigorated debate about whether there should be
a bankruptcy-like international framework for countries.)
With liquidation off the table, the effectiveness of state bankruptcy
would depend a great deal on the statefs willingness to play hardball with
its creditors. The principal candidates for restructuring in states like
California or Illinois are the statefs bonds and its contracts with public
employees. Ideally, bondholders would vote to approve a restructuring. But
if they dug in their heels and resisted proposals to restructure their
debt, a bankruptcy chapter for states should allow (as municipal
bankruptcy already does) for a proposal to be gcrammed downh over their
objections under certain circumstances. This eliminates the hold-out
problem—the refusal of a minority of bondholders to agree to the terms of
a restructuring—that can foil efforts to restructure outside of
bankruptcy.
The bankruptcy law should give debtor states even more power to rewrite
union contracts, if the court approves. Interestingly, it is easier to
renegotiate a burdensome union contract in municipal bankruptcy than in a
corporate bankruptcy. Vallejo has used this power in its bankruptcy case,
which was filed in 2008. It is possible that a state could even
renegotiate existing pension benefits in bankruptcy, although this is much
less clear and less likely than the power to renegotiate an ongoing
contract.
Whether states like California or Illinois would fully take advantage
of such powers is of course open to question. During his recent campaign,
Governor-elect Jerry Brown promised to take a hard look at Californiafs
out-of-control pension costs. But it is difficult to imagine Brown taking
a tough stance with the unions. Even in his reincarnation as a sensible
politician who has left his Governor Moonbeam days behind, Brown depends
heavily on labor support. He doesnft seem likely to bring the gravy train
to an end, or even to slow it down much.
But as Voltaire warned, we mustnft make the perfect the enemy of the
good. The risk that politicians wonft make as much use of their bankruptcy
options as they should does not mean that bankruptcy is a bad idea. For
all its limitations, it would give a resolute state a new, more effective
tool for paring down the statefs debts. And many a governor might find
alluring the possibility of shifting blame for a new frugality onto a
bankruptcy court that gmade him do ith rather than take direct
responsibility for tough choices.
This brings us back to the issue of federal bailouts. When
taxpayer-funded bailouts are inserted into the equation, the case for a
new bankruptcy chapter becomes overwhelming. And itfs a case for Congress
to move now on the creation of a state bankruptcy law.
With the presidential election just two years away, the pressure to
bail out California, Illinois, and perhaps other states is about to become
irresistible. As we learned in 2008 and 2009, it is impossible to stop a
bailout once the government decides to go this route. The rescue of Bear
-Stearns in 2008 was achieved through a glockuph of its sale to JPMorgan
Chase that flagrantly violated corporate merger law. To bail out Chrysler
and General Motors, the government used funds that were only authorized
for gfinancial institutions,h and illegally commandeered the bankruptcy
process to give the car companies a helping hand. There is, in short, no
law that will stop the federal government from bailing out profligate
state governments like those in California or Illinois if it chooses to do
so.
The appeal of bankruptcy-for-states is that it would give the federal
government a compelling reason to resist the bailout urge. President Obama
is no doubt grateful to California for bucking the national trend in the
election this month, but even he might resist bailing the state out if
there were a credible, less costly, and more effective alternative. Thatfs
what bankruptcy would offer.
Indeed, even those who still believe (quite mistakenly, in my view)
that the 2008 bailouts were an unfortunate necessity for big financial
institutions like Bear Stearns and AIG, and that bankruptcy wasnft a
realistic alternative, should agree on the superiority of bankruptcy for
states. The case for bailing out financial institutions rested on a
concern that their creditors would grunh if the bank defaulted, and that
the big banks are so interconnected that the failure of one could have
devastating spillover effects on the entire market.
With states, none of these factors applies in anything like the same
way. Californiafs most important creditors are its bondholders and its
unionized public employees. The bond market wouldnft be happy with a
California bankruptcy, but it is already beginning to take account of the
possibility of a default. And bondholders canft pull their funding the way
a bankfs short-term lenders or derivatives creditors can. As for
Californiafs public employees, there is little reason to suspect they will
be running anywhere.
Bankruptcy isnft perfect, but itfs far superior to any of the
alternatives currently on the table. If Congress does its part by enacting
a new bankruptcy chapter for states, Jerry Brown will be in a position to
do his part by using it.
David Skeel is a law professor at the University of Pennsylvania.
His book The New Financial Deal: Understanding the Dodd-Frank Act and
its (Unintended) Consequences (Wiley) is due out in
December.
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