Plan Ahead: How to Stop State Bailouts

This timely and important piece looks at whether it makes sense to set up a bankruptcy procedure for states, a process that currently exists only for cities and other municipalities. Law professor David Skeel makes a compelling case that it would be perfectly constitutional for Congress to set up a bankruptcy system for states. But should we? He argues:

The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees. Ideally, bondholders would vote to approve a restructuring. But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be “crammed down” over their objections under certain circumstances. This eliminates the hold-out problem—the refusal of a minority of bondholders to agree to the terms of a restructuring—that can foil efforts to restructure outside of bankruptcy.

The bankruptcy law should give debtor states even more power to rewrite union contracts, if the court approves. Interestingly, it is easier to renegotiate a burdensome union contract in municipal bankruptcy than in a corporate bankruptcy. Vallejo has used this power in its bankruptcy case, which was filed in 2008. It is possible that a state could even renegotiate existing pension benefits in bankruptcy, although this is much less clear and less likely than the power to renegotiate an ongoing contract.

But if governors of states like California and Illinois won’t cut spending and renegotiate union contracts, would they really put their states into a bankruptcy proceeding?

The risk that politicians won’t make as much use of their bankruptcy options as they should does not mean that bankruptcy is a bad idea. For all its limitations, it would give a resolute state a new, more effective tool for paring down the state’s debts. And many a governor might find alluring the possibility of shifting blame for a new frugality onto a bankruptcy court that “made him do it” rather than take direct responsibility for tough choices.

The nub of the concern underlying Skeel’s proposal is the fear that California and other states will come to the feds looking for a bailout. Without an alternative like bankruptcy, the administration and the Congress might be tempted to give it to them. As a reader points out, we can imagine, just as happened in the 2008 financial meltdown, state officials pleading that they are on the brink of a meltdown, prisons will close, police will be fired, governments will shut down, etc.

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Plan Ahead: How to Stop State Bailouts

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