From Sacramento to Albany, state governments, whipsawed by financial calamities from falling tax revenue to rising pension costs, are grappling with multibillion-dollar deficits and yawning budget gaps. An air of crisis hangs over the states. Ratings agencies warn of downgrades. Bondholders fret over possible default. State officials, legislators and interest groups of all kinds debate what is necessary to salvage finances: spending cuts, layoffs and, yes, even tax increases.
Into this uncertain and volatile mix, add a once-unthinkable word when it came to states: "bankruptcy."
Led by Republicans Newt Gingrich and Jeb Bush, the call for legislation empowering states to declare bankruptcy and restructure debts and obligations is gaining volume, if not necessarily resonance. The debate over state insolvency rages, at least in policy circles. Talk, however, usually centers on what bankruptcy might accomplish: pare back public pensions, renegotiate union contracts, slash debt and deficits.
But the legal complexities and constitutional ambiguities inherent in such a law are rarely discussed. Neither are actual mechanisms for implementation. That's understandable. It's messy. State bankruptcy cuts to the heart of a federalist system, with fractured political powers, bifurcated courts and uncertain hierarchies. Can states legally go bankrupt? The question looks simple, the answer anything but. "It's a very close call," says Richard Levin, one of the drafters of the modern U.S. Bankruptcy Code in the '70s and now head of restructuring at Cravath, Swaine & Moore LLP. Levin quickly adds that constitutional considerations are only part of the equation: "Simply because Congress may do something doesn't mean it should."
Allowing states to go bust takes insolvency into uncharted legal and financial waters. Some advocates, such as University of Pennsylvania Law School professor David Skeel, say a state bankruptcy could be an extension of the federal code governing municipal insolvencies, known as Chapter 9. "I feel that what's been done with municipal bankruptcy ... provides a pretty clear road map for what a state bankruptcy law could do," he says.
Those critical of an extension of Chapter 9 believe a state bankruptcy law would put multiple strains on the constitutional line separating federal supremacy powers and states' rights. "I think it's a terrible idea," says University of Texas School of Law professor Jay Westbrook. "Constitutionally and otherwise, Chapter 9 can't really tell municipalities what to do, much less states." Westbrook says an extension would expose weaknesses of the process. "The essence of bankruptcy is balance between debtor and creditor. In Chapter 9, there's no balance. It's all debtor. If Chapter 9 works badly for a water district, how would it work for a sovereign member of the federation?"
In this kind of bankruptcy process, divisions of power would pit state against federal, and possibly one branch of state government against another. Here's an example: Say a state goes bankrupt and seeks reorganization. In court, the attorney general, as the state's chief legal officer, would negotiate on behalf of the state. The AG might put a plan forward and agree to conditions. However, the AG has no say over the legislature. And only a legislature can raise taxes. In some cases, it would require a state constitutional amendment to reduce pensions. Add to this a federal judge who would oversee the process. Under Chapter 9, the judge has no authority to dictate terms or implementation. And a state has sovereign immunity, which means the governor or legislature may simply refuse to go along with anything the judge rules or reject the reorganization plan itself.
That two prominent states' rights advocates such as Gingrich and Bush would push for a plan that might put the fate of a state in a federal courtroom shows just how jagged the fault lines can be. Much as they might want to gut the power of unions and public-sector pensions, those that adhere to original-intent jurisprudence can't be comfortable with this kind of congressionally mandated mechanism. As Westbrook jokingly says, "Anyone who would have suggested this in the Continental Congress would have been shot."
Not surprisingly, the issue of state bankruptcy is proving deeply divisive. "I don't think it's a good idea," says Levin. "Leaving aside what makes sense in a state bankruptcy statute and what constitutional limits are, I would argue that if a state were willing and able to use it, it would be willing to make the necessary changes outside of bankruptcy. Why wouldn't the state make the changes without getting a scarlet letter 'B' stamped on its map?"
In contrast, one of his fellow drafters of the 1978 Bankruptcy Code is an enthusiast. "I think a Chapter 9 structure can be extended to the states and probably should be," says Kenneth Klee, founding partner of the Los Angeles law firm Klee, Tuchin, Bogdanoff & Stern LLP and a professor at the UCLA School of Law. "It is not fair or reasonable to ask American taxpayers to underwrite the profligacy of certain states with a blank check."
Klee and Levin do agree that the issue of a statute to deal with insolvent states never came up when they drafted the Bankruptcy Code. "At the time, no one thought it would be necessary for a state to file for bankruptcy," says Klee, who as associate counsel to the Judiciary Committee in the U.S. House of Representatives, was a principal draftsman of sections of the code dealing with corporate and municipal bankruptcy. "Nobody thought about it," agrees Levin, also legal counsel to the committee. "It just wasn't an issue."
The possibility that a state could become insolvent has grown likelier since the financial crisis. But even as states sink into debt, remedies remain so politically supercharged that stasis remains the default. Raising taxes and clipping bondholders are taboo to the right, while the left rejects slashing payrolls, rejiggering retirement benefits and cutting pensions.
The only way to provide a clean and equitable start is through a bankruptcy mechanism, backers advocate. Tax hikes, bondholder liabilities, retirement benefits -- "none of these are popular to discuss. I think, as a matter of fairness, all those people should be brought to the table as part of a financial restructuring," says Klee, who would like to name this part of the code Chapter 17. (Skeel favors Chapter 8.) "It's very unpopular to talk about bankruptcy in states, but when you look at alternatives, I'm not sure there are meaningful ones that make sense."
Some states have already acted. The Illinois legislature early this year boosted corporate tax rates by almost half and individual tax rates by two-thirds. Many critics not only reject tax hikes in a fragile economy but question whether more taxes can solve a $15 billion state budget deficit and almost $80 billion in underfunded pension liabilities. Bankruptcy "isn't something we'd likely contemplate seriously," says Barbara Flynn Currie, a Democrat and the Illinois House majority leader. She makes two points: First, the debt level compared to gross state product is far less than comparable metrics in, say, Greece or Ireland. More importantly, a state bankruptcy would "so roil financial markets that it would be very destructive to our country's economy. ... It would so shake confidence in public investment, it would make it much harder for any state to sell bonds."
To better understand the tangle of legal and policy issues, a history lesson is in order. It's doubtful a state has ever gone bankrupt in the strict legal sense of the word. Many, however, were insolvent and defaulted on debt. After the Civil War, a section of the 14th Amendment banned former Confederacy states from repaying debt to those who underwrote the war. In the 1930s, Arkansas defaulted on its debts.
Perhaps the closest a state came to bankruptcy -- that's what it was called at the time -- was Indiana in the 1840s. Indiana plowed millions of dollars it didn't have into a rash of costly, corrupt, failed public-works projects: canals, turnpikes and railroads. The state couldn't pay its debts and defaulted in 1841. London creditors cut the debt in half twice over a five-year period and seized uncompleted projects. Alas, all of them ended up as muddy sinkholes, save the Wabash and Erie Canal.
Despite Indiana's bout with bankruptcy, the Great Depression is the touchstone for modern bankruptcy approach and legislation. But even then, in terms of public-sector insolvencies, the focus was on municipalities, not states. As tax revenue plunged, municipalities lost their ability to service debt. By 1934, over 2,000 municipalities had gone broke.
Before legislation was enacted to address the issue, bankrupt municipalities faced enormous legal hurdles to get their debt under control. Municipalities are considered entities of a state. Under the Constitution, while the federal government can impair the obligation of contracts, states can't. So municipalities had no legal mechanism to reduce debt and bind creditors. Even if most creditors agreed to a voluntary restructuring, one or two could force tax hikes to pay off their debt in full through court-ordered compulsion, called a writ of mandamus.
Urged by the Roosevelt administration, Congress in 1934 passed a law authorizing municipal bankruptcy, called Chapter IX. However, the Supreme Court judged the law unconstitutional two years later, ruling that it was an invasion of state sovereignty. Congress passed a similar law in 1937. By then, the court was more sympathetic, upholding the constitutionality of the legislation in the 1938 case United States v. Bekins.
That ruling remains the legal foundation of municipal bankruptcies. Skeel, Klee and some other scholars believe that if a state bankruptcy law conforms to the Bekins decision, it shouldn't run into constitutional issues. Critics aren't so sure.
Pretty much everyone sees Chapter 9 -- it traded Roman numerals for an Arabic number when the modern code was promulgated -- and legal decisions surrounding it as the template for any states-related bankruptcy. Chapter IX and the updated version that followed gave insolvent municipalities powerful tools, including an automatic stay on debt repayments and the ability to bind all creditors to a plan. Perhaps the biggest legal benefit was the ability to get around the contracts clause by placing adjudication in a federal court.
Chapter IX remained in effect for almost 40 years. In 1975, New York City neared default, and the administration of then-President Gerald Ford rejected a federal bailout. So lawmakers wrestled with an updated legal mechanism that could accommodate muni bankruptcy and address issues such as union contracts. The result was a 1976 section of the code called Chapter 9. (It turned out New York City didn't file. Some believe that just the threat of bankruptcy was enough to get unions on board and to forge an out-of-court rescue plan.)
Two years later, when the Bankruptcy Code itself was revised, Chapter 9 was tweaked. According to Klee, the most significant change was a section delineating which provisions of the Bankruptcy Code would apply to Chapter 9 and which wouldn't. Some aspects of a Chapter 11 cramdown are incorporated in Chapter 9, but not all. Chapter 9 has a best-interest-for-creditors test, but it isn't the same as Chapter 11's.
Muni bankruptcies have since occurred rarely. Since Chapter IX took effect in 1937, only 620 municipalities have filed, according to James Spiotto, a Chicago-based partner at Chapman and Cutler LLP and municipal bankruptcy's unofficial scorekeeper. The vast majority of these have been tiny improvement districts that issue bonds to finance anything from sanitation systems to school buildings.
Orange County, Calif., was by far the biggest Chapter 9 in history. It filed in 1994 after a $1.7 billion investment pools loss. Since the crisis, the only city of any size to file is Vallejo, Calif., a suburb of San Francisco with 116,000 people. For more than a year, Harrisburg, Pa., has teetered on insolvency, largely because of a nearly $300 million garbage incinerator the city constructed on borrowed funds. A number of lawyers talk of a Chapter 9 filing, but the city has yet to act.
There are huge differences between Chapter 9 and Chapter 11, the part of the code that governs corporate reorganizations. One fundamental distinction: Municipalities can't be liquidated through an involuntary bankruptcy filing. As Marc Levinson, counsel to Vallejo, said last year, a city "can't go out of business."
Municipalities must voluntarily file for Chapter 9; creditors can't force them. After filing, a bankrupt municipality has the exclusive right to put forth a reorganization plan. Unlike Chapter 11, Chapter 9 has no absolute priority rule, which orders classes of debt and ensures that equity stakeholders get wiped out first. Municipal residents may be the equivalent of shareholders, but they aren't considered creditors under Chapter 9. So debt can be reduced without raising taxes first.
Because municipalities are considered instruments of the state, Congress requires state permission before filing. Klee says this was inserted as a nod to the state sovereignty issue. However, only 24 states have laws enabling this process. And even then, it isn't a sure thing. Late last year, the city of Hamtramck, Mich., sought permission to file for Chapter 9, only to have Gov. Jennifer Granholm nix the request.
A federal judge plays a very different role in a municipal bankruptcy from corporate reorganizations. Because of separation-of-powers issues, a judge has no authority over municipal operations and can't appoint a trustee or remove officials, no matter how neglectful or reckless they are. A judge can't order services to be cut or taxes raised. "Judges under Chapter 9 don't have a lot of authority. They're gatekeepers," says Omer Kimhi, a law professor at the University of Haifa in Israel. Kimhi, who wrote his doctoral thesis on Chapter 9, is very critical of its effectiveness. He differentiates between financial and economic difficulties. Corporations that file for Chapter 11 and have financial difficulties can reorganize successfully. Those that have economic problems liquidate. Municipalities tend to have economic woes. Yet, they can't liquidate.
In his view, restructured debt doesn't solve the underlying issues of most municipalities that have filed for Chapter 9. He cites the fact that many towns that file once and restructure end up filing again. Take Prichard, outside Mobile, Ala., a city of 25,000 that filed for Chapter 9 on Oct. 27, 2009, eight years after exiting a previous Chapter 9.
Despite Chapter 9's pronounced bias toward debtors' rights, municipalities still do everything in their power to avoid a filing. That's undoubtedly a function of fear -- from the bond market, from voters, from other municipalities worried about contagion. It's also an acknowledgement that a bankruptcy restructuring simply may not work in the long run.
All these aspects of Chapter 9 -- the voluntary nature of a filing, state sovereignty, the limited role of a judge, the inability to get mandated tax increases, the efficacy of a plan -- have critical implications for state bankruptcy laws.
This much everyone agrees on. A state would have to file for bankruptcy voluntarily, presumably with approval of both the governor and state legislature. A federal judge would have no more authority in a state bankruptcy than in a municipal one, possibly less. And then there's sovereignty, which may pose even more serious limits on state bankruptcies than municipal-related insolvencies.
A municipality is an organ of the state. A state is sovereign. That means a state can tell a bondholder it can't pay its obligations, and there's nothing a creditor can do. After all, states can't be sued unless they waive their sovereign rights.
At least that's the theory. But some legal scholars say it's not so simple when it comes to bankruptcy. Stephen Lubben, a professor at Seton Hall University School of Law, cites a 2006 Supreme Court decision, Central Virginia Community College v. Katz, as potentially critical in determining just how liability-free a state may be and what limitations to sovereignty there are. In that case, a bookstore went bankrupt and sued the community college for moneys owed. The college refused to pay, citing immunity against lawsuits under state sovereignty. A bankruptcy judge disagreed. The judge cited the so-called bankruptcy clause of the U.S. Constitution, Article 1, Section 8, Paragraph 4, which empowers Congress to make "uniform laws on the subject of bankruptcies throughout the United States." The judge said this provision trumps state sovereignty. In a 5-to-4 decision, the Supreme Court agreed.
Lubben posits a series of questions: What if a state refuses to pay a bondholder? The bondholder puts those assets in a limited liability company and declares bankruptcy. Could a federal bankruptcy judge order the state to pay what it owes as part of a bankruptcy proceeding? Would the state lose its sovereign immunity? Would the judge have enforcement powers? If it sounds like a constitutional mess, it probably is.
But sovereign immunity isn't the only legal twist that could upset the state-federal equilibrium. Under the section of the Constitution that delineates powers, states are expressly prohibited from making laws that impair "the obligation of contracts." The only way around this, conventional thinking goes, is through use of the Constitution's supremacy clause, which says a federal law trumps a state one. So, in theory, a state could use the federal bankruptcy system to abrogate contracts, whether bonds or pension obligations, which it normally couldn't do.
Or can it? In 1974, the New Jersey and New York legislatures repealed a covenant of a 1962 bond series covering what would eventually become the Port Authority transport system. The U.S. Trust Co. of New York sued New Jersey. In 1977, the Supreme Court ruled that the state's repeal violated the contracts clause. Levin suggests this ruling could bedevil a voluntary state bankruptcy. "If the state voluntarily files for bankruptcy, who is impairing the obligation? Is it Congress or the state or the combination of the two? There is, of course, no precedent."
He goes on to ask questions about tensions between federal bankruptcy and the contracts clause: If a state "doesn't repudiate its obligations and simply doesn't pay, is the contract clause going to prevent that? If the contract clause would prevent that, then does bankruptcy power trump the contract clause? And does it trump it when the state itself is the actor in repudiating the obligation? It would be a constitutional thicket that Congress doesn't need to wander into for all the other policy reasons."
Of course, there are other practical issues involved in a state that abrogates its debt. As Illinois' Flynn Currie emphasizes, the bond market would go crazy. Kimhi talks about reputational costs of a muni bankruptcy, where access to bond markets by the municipality is at least temporarily shut down and where other cities find it difficult or costly to raise debt. A state filing could have an even more profound effect. It could affect bond ratings and the ability to borrow both for municipalities within the state and other states as well. Westbrook warns that a state bankruptcy might even harm U.S. Treasury bonds.
While critics maintain a state bankruptcy law, even if constitutional, is both ineffective and unnecessary, advocates say the mere threat of bankruptcy is conducive for renegotiating with interest groups such as unions. "If you didn't have a bankruptcy ultimatum, the unions could just say no,?" Skeel says.
That kind of clout should extend to bondholders, Skeel and others argue. It is possible to renegotiate with bondholders outside bankruptcy. But any renegotiation is voluntary. It doesn't bind everyone, and there could be holdouts. Intractable bondholders or the ones with the cleverest lawyers could end up extracting better terms.
Modifying pensions is even more problematic. Many state constitutions enshrine pension rights, requiring an amendment to alter those provisions. Could a court-supervised bankruptcy ease that? Advocates of a Chapter 9 extension believe so. Critics say not. "Nothing is more fundamental than the right of the people to have their own [state] constitution," says Westbrook.
Ultimately, for any state bankruptcy to work, there has to be consensus. Various branches of governments, interest groups and financiers must all congregate under some federal courtroom version of a big tent. They'd have to agree on a single vision, or at least enough of one to form a reorganization plan that various constituencies can accept. If not, a state bankruptcy would be little more than a time out. "You have to hope for a moment of clarity where everybody becomes of one mind," says Lubben. "That might be optimistic."