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State Bankruptcies May Be Legal If System Structured Correctly

April 23, 2020, 7:37 PM

Allowing states to declare bankruptcy could be constitutional if Congress avoids infringing on state sovereignty and relies on court oversight rather than an outside board.

It wouldn’t be difficult to create a bankruptcy system for “a sovereign state essentially consenting to the jurisdiction of a specialized federal court,” said John J. Rapisardi, chair of O’Melveny & Myers’ global restructuring practice.

There is some debate whether Congress could simply expand existing bankruptcy code provisions that allow municipal bankruptcies, practitioners and scholars told Bloomberg Law.

Doing so could run afoul of states’ sovereign rights, as well as Constitutional protections for contract rights, they said.

Any new state bankruptcy provision would almost certainly generate legal challenges, but lawmakers themselves are a more immediate obstacle. Members of Congress aren’t likely to show much enthusiasm for Senate Majority Leader Mitch McConnell’s (R-Ky.) suggestion Wednesday that states file bankruptcy as an alternative to federal bailouts.

State Sovereignty

Municipalities—including counties, cities, towns, and even public companies like hospitals—can file under Chapter 9 of the bankruptcy code if a state authorizes them to do so.

Currently about half the states authorize some kind of municipal bankruptcy filing, said David Skeel, a University of Pennsylvania law professor who has written about the state bankruptcy question.

But states are different because their rights, sovereignty, and immunity are protected under the 10th and 11th amendments to the U.S. Constitution, Skeel said.

Those protections mean that states—unlike individuals or businesses—can’t be put into bankruptcy involuntarily by creditors, he said.

A voluntary state bankruptcy law could work if the law were structured properly, Skeel said. Such a law could look like current Chapter 9 or PROMESA, the 2016 law passed to allow Puerto Rico and other territories to restructure their debts, but without a federal oversight board, he said.

A law for state bankruptcies would likely be held constitutional as long as it mirrored existing federal law that permits municipalities to declare bankruptcy, according to Vincent Buccola, of the University of Pennsylvania.

Others questioned whether those existing frameworks could be applied to states.

Extending Chapter 9 to cover states wouldn’t work, said Bruce Markell, a Northwestern University law professor and former U.S. bankruptcy judge. Neither could reliance on the Puerto Rico Oversight, Management, and Economic Stability Act, he said.

In typical municipal bankruptcies, the state creates a board to oversee the restructuring, Markell said. It also can exercise influence by threatening to cut off funding. Neither is an option given state sovereignty, he said.

“How can you have independent review of government financial decisions?” Markell asked. “It’s all political—where do you raise taxes or force concessions by creditor blocks, consisting primarily of bond holders, pension plans, and labor contracts?”

Skeel, who serves on the seven-member federal board overseeing Puerto Rico’s financial restructuring, agreed that any law allowing states to declare bankruptcy couldn’t include a similar federal oversight board.

Contract Obligations

Another potential, albeit less concerning, constitutional issue is whether state bankruptcies violate the contracts clause in Article I of the Constitution.

The clause bans states from interfering with private contracts. Yet most bankruptcy proceedings allow debtors to cancel or alter contracts’ material terms.

On the one hand, “there’s an argument that Congress would be aiding and abetting states in passing laws to compromise contracts” if it passed a law authorizing states to file, Skeel said.

That argument got hashed out when municipal bankruptcies were first rejected, and later accepted, by the U.S. Supreme Court during the Great Depression, he said.

In 1936, the high court said a law authorizing states to go bankrupt violated both the contracts clause and state sovereignty, Skeel said. It reversed two years later.

“That’s when the Supreme Court shifted from striking New Deal legislation to upholding it,” he said.

The counterargument is that the contracts clause only prohibits states from altering contract rights. A law authorizing states to file bankruptcy would be federal, and thus not implicate the ban, Skeel said

Bankruptcy Needed?

Even if constitutional, state bankruptcy filings may not be necessary or desirable.

Creditors lack recourse should a state default on its obligations because immunity provided by the Constitution prevents a state from being sued, Buccola said.

The situation is akin to that of former President Harry S Truman, who was praised when he didn’t file bankruptcy when a number of his business partners were forced to do so, Markell said.

At the time, Truman was a pro tem judge whose wages were exempt from collection, and so he didn’t have to file in order to protect himself from creditors, he said.

The more likely motivation behind a state bankruptcy law is that it would provide political cover for lawmakers—both on a state and federal level, Buccola said. It “would provide political cover for Congress not to do a bailout,” he said.

At the same time, Rapisardi predicted that Congress is “very unlikely” to expand bankruptcy protections to states for political reasons.

“And even if such a measure was passed, it most certainly would be subject to constitutional challenges as we have seen in Puerto Rico,” he said.

—With assistance from Leslie A. Pappas in Wilmington, Del.

To contact the reporter on this story: Daniel Gill in Washington at dgill@bloomberglaw.com

To contact the editors responsible for this story: Laura D. Francis at lfrancis@bloomberglaw.com; Seth Stern at sstern@bloomberglaw.com

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