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Can the States Declare Financial Bankruptcy?

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Stephen R. Rolandi
June 7, 2020

In April, United States Senate Majority Leader Mitch McConnell of Kentucky made a controversial suggestion in a radio interview, saying that states unable to close budget deficits sparked by the COVID-19 pandemic should declare bankruptcy. Senator McConnell subsequently walked back that proposal in the face of bi-partisan criticism. I also believe he made that suggestion and then reversed himself, as current opinion polls suggest that he is in a tough re-election battle with former Marine pilot Amy McGrath.

Partisan politics aside, we have individuals, private companies, not-for-profit organizations, hospitals, counties, municipalities and other entities that file for bankruptcy and re-organization as a means of securing financial relief, but not the states.

McConnell’s initial suggestion for fiscally-strapped states to declare bankruptcy is not the first time that such a proposal has been made; indeed, it was proposed by some in the aftermath of the 2008 financial crisis, but was roundly criticized by Republican and Democratic lawmakers, as well as unions and the financial community.

As a student (and teacher) of public finance and public policy, this issue has now taken on greater importance in the current economic crisis—which TIME magazine called last month, “The Great Reckoning.” It is a topic worthy of discussion in public administration (the subject of bankruptcy by municipalities, counties and other political sub-divisions is beyond the scope of this article).

Let’s start with the United States Constitution, which set up a federal system of divided governmental powers between the national government and the states. In Article I, Section 10, which provides for the enumeration of certain powers to Congress, the states are prohibited from impairing, “The obligation of contracts.” The states are regarded as, “Sovereign,” entities, and the Federal government has limited power to act on them directly.

The Supreme Court has interpreted this provision at various times to hold that a state cannot refuse to meet its legitimate financial obligations. Bankruptcy in the United States is governed by Federal law and handled in the Federal courts.  

Pursuant to laws subsequently passed by Congress, such as the Federal bankruptcy Code (Title 11) and subsequent amendments, state bankruptcy has never been seen as a viable option, despite varying interpretations of the bankruptcy law by SCOTUS during the 20th Century (it should be noted that during the 19th Century, some states defaulted on their debt and some of these subsequently made restitution).

Thus, even if Congress were to pass a law permitting states to declare bankruptcy, such an action would likely face a legal challenge based on the contracts clause found in Article I, Section 10. Another legal obstacle would be that states have sovereign rights under the Constitution, and would have to consent to participate if Congress were to pass such a law. According to Law Professor Bruce Markell of Northwestern University and a former Federal U.S. Bankruptcy judge, with the fact that a state is sovereign, one could not have a Federal oversight fiscal control oversee the restructuring of debt. According to Professor Markell, independent review of government financial decisions would not be possible because of the parties involved (bond holders; pension plans and labor contracts and others).

Despite this, it is possible that a state might theoretically file a petition for bankruptcy pursuant to Chapter 9, which provides for re-organization/restructuring of debts, extension of debt maturities and refinancing of debt, according to Professor Vincent Buccola of the University of Pennsylvania’s Wharton School.

Even if this were to happen, it is very likely that states would not allow such petitions for bankruptcy to go forward, as there would be negative consequences on their future perceptions of their creditworthiness; states would not want to be locked out of credit markets if they were permitted to go bankrupt. In addition, vendors who do business with state governments might decline to engage in contracts for goods and services, for fear that they would not get paid. 

The McConnell proposal is bad public policy and based on dubious constitutional grounds. Many states are currently undergoing financial calamities,

but there are ways for states to resolve their fiscal crises such as targeted Federal aid for states with the most difficult circumstances; greater use of “rainy day” funds; debt control boards; allowing states to sell debt to the Federal Reserve Bank municipal bond-buying program designate cities and other measures.

This is a time for the Federal government, the states and the private sector to work collegially during this pandemic, and not at cross-purposes.

Author: Stephen R. Rolandi retired in 2015 after serving with the State and City of New York. He holds BA and MPA degrees from New York University, and studied law at Brooklyn Law School. He teaches public finance and management as an Adjunct Professor of public administration at John Jay College of Criminal Justice (CUNY) and Pace University. He is Immediate Past President of ASPA’s New York Metropolitan Chapter and served four terms on ASPA’s National Council, as well as many other association boards. You can reach him at: [email protected] or [email protected].

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