3 Questions on State Bankruptcy

E-Newsletter Issue #65/February 17, 2011

States face colossal fiscal pressures, including mounting public pension obligations that now represent a $1 trillion unfunded gap, according to the Pew Center on the States . That gap—combined with other mounting fiscal woes—has prompted a discussion of something states haven’t discussed before—bankruptcy.

Although the idea of states declaring bankruptcy has been met with scrutiny across the political spectrum, some have suggested that allowing states to reorganize their debt through bankruptcy might help relieve those pressures and help states get their fiscal houses in order. To help better understand this issue, we asked Kenneth Katkin, professor of law at the Salmon P. Chase College of Law at Northern Kentucky University, to answer a few questions about bankruptcy and states.

  1. Why can’t states use the federal bankruptcy system to reorganize their debt?

“There are two reasons why state governments currently cannot use the federal bankruptcy system to reorganize their debt. First, the federal bankruptcy code does not allow—and has never allowed—state governments to declare bankruptcy. Since 1937, the bankruptcy code has allowed ‘municipalities’ to declare bankruptcy. The term ‘municipality’ is defined in the bankruptcy code as a ‘political subdivision or public agency or instrumentality of a state.’ This definition is broad enough to include cities, counties, townships, school districts and public improvement districts. It also includes revenue-producing bodies that provide services which are paid for by users rather than by general taxes, such as bridge authorities, highway authorities and gas authorities. But it does not include state governments.

“The second reason stems from the U.S. Constitution. The contracts clause of the U.S. Constitution prohibits state governments from ‘impairing the obligation of contracts.’ As originally understood and enforced, this clause prohibited state legislatures from passing any laws to relieve either private debt or the state government's own debt. Beginning in 1934, however, the Supreme Court began to interpret the contracts clause more flexibly and not as an absolute bar to state debt relief laws. Even under the flexible modern approach, however, the Supreme Court in 1977 reiterated that ‘a state cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money (on something else.)’ Thus, were Congress to amend the federal bankruptcy code to authorize states to repudiate debt, the Supreme Court would then need to decide the novel constitutional question of whether such debt repudiation would nonetheless violate the contracts clause of Article I, Section 10.”

2.  What benefits would allowing states to file for bankruptcy provide?

“Bankruptcy is designed to give a ‘fresh start’ to debtors who enjoy no reasonable prospect of satisfying their financial obligations. It is difficult to predict all the consequences that would follow a state government's voluntary entry into bankruptcy. Clearly, state governments that pursue voluntary bankruptcy would seek relief from certain debt obligations, particularly pension debt now owed to retired state employees and interest payments now owed to holders of state bonds. In bankruptcy, state governments also might seek relief from contract debt owed to vendors and contractors that have done business with the state.  A federal bankruptcy court has the power to grant all such relief.

Like private parties who declare bankruptcy, a state government that declared bankruptcy would find it more difficult and more expensive to obtain credit in the future. Vendors would be justifiably hesitant to conduct business with the state unless they were paid in full for their work, in advance. Morale within the state government's career work force could be expected to suffer. And although state legislators presumably would recoil at the loss of state government buildings or state parks or state vehicles to foreclosure, liquidation of some components of a bankrupt's estate to satisfy creditors is an ordinary incident of bankruptcy.”

3.  What steps would the federal government have to take to allow for state bankruptcy?

“To allow for state bankruptcy, Congress would need to amend the federal bankruptcy code to add state governments to the list of entities who may apply for bankruptcy. In addition, a state would need to amend its own state laws to authorize it to make application for federal bankruptcy. Finally, the United States Supreme Court would need to rule on whether the contracts clause of Article I, Section 10 of the United States Constitution prohibits states from declaring bankruptcy even if authorized to do so by Congress, or imposes any restrictions on the terms, conditions or circumstances under which state governments might declare bankruptcy. If it chose to do so, Congress could require the Supreme Court to rule expeditiously on these questions.”

Kenneth Katkin teaches and writes in the areas of constitutional law, communications law, legislation, federal jurisdiction and entertainment law at the Salmon P. Chase College of Law at Northern Kentucky University. He received his law degree from the Northwestern University School of Law.

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