States on the Verge of Bankruptcy

Should states in fiscal crisis be able to declare bankruptcy? As states like California and Illinois hike taxes and slash spending to avert disaster, Congress is faced with growing pressure to rescue ailing state governments. Last week, e21 and the Manhattan Institute hosted a discussion to hear leading scholars debate the political, policy, and legal concerns surrounding the danger of state bailouts. To watch the video from the event, click here.

In addition, we asked the panelists to reflect on the discussion and offer some concluding comments. Did their views change on the question of whether a state should be able to declare bankruptcy? What were the big takeaways from the debate?

Clayton Gillette:

The core question is how bankruptcy for fiscally distressed states compares to the alternatives of a federal bailout or of allowing states to use their internal political and legal processes to deal with the situation. Bankruptcy has the potential benefits of bringing all stakeholders to the table to create an orderly disposition of claims and to allow consideration of which burdensome obligations might be rejected. Bankruptcy law, as federal law, could also overcome difficulties that arise from state constitutional and federal constitutional provisions that limit state capacity to alter existing arrangements. But bankruptcy plausibly could create contagion that spills over to other states and to the federal government, and thus that would justify or require a federal bailout. Because the federal government cannot credibly commit against bailouts, state bankruptcy cannot easily be seen as avoiding the moral hazard related to federal bailouts. Indeed, the availability of a bankruptcy option could create incentives for strategic behavior in negotiations about the terms of a bailout. Moreover, the various questions that would arise during bankruptcy, such as who must file, which state agencies are covered, and how the “solvency” of the state is evaluated, suggest that proceedings might not be orderly or expeditious, and would raise issues about the proper scope of judicial interference with state sovereignty. The feasibility of negotiating modifications of existing financial arrangements with creditors should be considered as a plausible alternative to formal bankruptcy, and it remains unclear whether those negotiations would be facilitated or frustrated by the availability a bankruptcy option.

E.J. McMahon:

On the issue of state bankruptcy, there was little disagreement on the constitutionality issue. The lawyers on our panel seemed to agree that it can be done in a constitutionally acceptable way. But it seemed to me that two key legal questions remain open:

Who would have the power to decide whether to file a bankruptcy petition -- the governor, the Legislature, or both? (No one seemed willing to embrace the idea of giving a state's voters a direct say over this in a referendum.)

Could a federal judge exercise broad discretion in a state bankruptcy proceeding--broader than now possible in a municipal bankruptcy--to restructure a state's liabilities, including pension benefits current protected by state laws or constitutional provisions? I heard nothing to persuade me that the mere existence of a path to bankruptcy will help states solve their problems, nor was I persuaded that a state bankruptcy option will forestall efforts by troubled states (or powerful constituencies within those states) to seek some sort of bailout from the federal government.

Glenn Siegel:

The reality is that quite a number of our states are in financial crisis. A new bankruptcy statute, properly drafted, could facilitate a return to solvency but it will have to be drafted in a way where it is sufficiently attractive to the states so that they will use it while simultaneously treating the stakeholders fairly.

A statute will need to assure that there is a proper allocation of losses between creditors, employees, pensioners, and taxpayers and that a state as a condition of receiving a reduction of its financial obligations will need to put its financial house in order. For example, the new statute could include its own version of the Chapter 11 provision that a corporation demonstrate that confirmation of the proposed plan is not likely to lead to a need for further reorganization at a later time. Such a requirement, which does not exist in municipal bankruptcies, would force a state to justify the compromises necessary to resolve its financial crisis by showing it has put its house in order.

Nicole Gelinas:

Many thanks to fellow panelists for contributing to a substantive discussion. I would be surprised if anyone in the audience came away thinking that state bankruptcy was a straightforward solution to helping states address their obligations. For example, panelists sympathetic to the idea of state bankruptcy didn't have an answer for how bankruptcy would address pension liabilities, most of which are at the local (as opposed to state) level. Nor did sympathetic panelists explain who among bondholders -- general obligation, public-authority, tax-secured -- could expect to be affected in "state" bankruptcy, or how bankruptcy would treat bondholders whose repayment depends on lawmakers' discretionary appropriation of funds, something governed by state, not federal, law. A suggestion for bankruptcy proponents: a case-study mockup of a complex state, complete with treatment of different groups of creditors and an explanation of how such treatment is grounded in corporate and municipal precedent, would be helpful to your cause (and don't forget the politics!).

David N. Schleicher:

Although the arguments in favor of the new bankruptcy code were fascinating and compelling, I was left with the three big questions.

First, I am still doubtful that many states could opt in to bankruptcy consistent with their own constitutions and the federal constitution. This struck me as a really hard question, and one that would need to be determined on a state-by-state basis. That said, the proponents' focus on how the proposal would generate needed clarity and certainty in a time of crisis actually made me more worried about this, as -- if clarity and certainty are what's needed if push comes to shove -- a policy with a questionable legal basis may reduce certainty.

Second, I wonder when state bankruptcy moves from op-ed to legislation how it will deal with the myriad practical complications raised by Nicole Gelinas and Glenn Siegel, I was in awe of how complicated a process this would be, and am still not sure how a "Chapter 8" would operate.

Finally, my biggest question is whether bankruptcy would address the core problems at the heart of the budget problems of many states. The answer to the question of *why* states are in this budget crisis should animate any possible response. Although there was some attraction in the idea (and the proponents were extremely compelling), I didn't get a clear picture of how bankruptcy would solve the problems of those states with an on-going budget problem that is rooted in failed politics rather than a one-time change in their economic condition. (And my sense is that this describes the states people are most worried about.) My concern is that, in these states, bankruptcy would make their politics even worse, removing responsibility and accountability from politician, parties and initiative voters for actually producing reasonable revenue-raising and budgeting policies. I also thought Clay Gillette's point about bankruptcy being a strategic tool states could wield to get better terms in a bailout was a real problem for the proposal.

I guess in the end, although I was fascinated by the proposal and see its allure, I remain unconvinced that it is how the federal government should respond to state budget crises.

David Skeel

Although some of the panelists were (and are) staunchly opposed to giving states a federal bankruptcy option, as I and others have proposed, the number of points of disagreement seems smaller than I had imagined. One important question is whether enacting a bankruptcy law would significantly and more than temporarily increase borrowing costs even for financially healthy states. I believe the bond markets are efficient enough to distinguish between healthy and profligate states, but others disagreed. Another concern is the possibility that bankruptcy might have unintended consequences. Several alternatives were suggested—such as bailouts with the kinds of conditions the International Monetary Fund attaches when it provides rescue financing for countries. I wasn’t persuaded that this strategy is either plausible or desirable. A great virtue of putting bankruptcy in place as an option if all else fails is that it doesn’t cost anything to taxpayers, and could reduce the need for federal outlays.