© 2011 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 12 edition of the Bloomberg Law Reports—Bankruptcy Law. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P.

Under current law, states are not permitted to file for relief under the Bankruptcy Code. Opponents of a bankruptcy solution for states' growing fiscal woes allege several negative factors regarding bankruptcy filings by states, including: (1) the fact that bankruptcy proceedings are often expensive and time consuming; (2) the potential negative effect on credit ratings; and (3) the uncertain outcome in view of the relatively limited number of municipal bankruptcy cases filed under Chapter 9 that may serve as a model for state bankruptcy cases.

However, states with severe financial issues, such as California, Illinois, and New Jersey, should be able to file for bankruptcy relief for many of the same reasons that corporations need to be able to resort to Chapter 11. These include: (1) being able to compel a reasonable adjustment of debts upon creditors who are unwilling to voluntarily accept a settlement through negotiation by invoking the bankruptcy court's cram down power; (2) staying all litigation and other creditor actions in order to grant the debtor a breathing spell within which a plan of adjustment of debts may be negotiated; and (3) consolidating all creditor claims in a single forum, the United States Bankruptcy Court.

Fears of State Bankruptcies Roiling Bond Markets Are Overblown

Critics of a state bankruptcy option fear the potentially destabilizing impact that it may have on municipal bond markets. It is admittedly fair to posit that bonds may be re-priced to reflect an increased risk profile from an investor's vantage point. But this is a small price to pay in comparison to the advantages derived from allowing states to put their fiscal houses in order. Surely the threat of a massive federal bailout using billions of dollars of taxpayer monies is outweighed by speculative concerns about unhinging the municipal bond market. Moreover, in the Chapter 9 arena, special revenue bondholders receive favorable treatment in that they maintain their collateral security and such bonds continue to be serviced during the pendency of the bankruptcy (provided that funds are available). In addition, special revenue and general obligation bondholders do not have to worry about the threat of preference liability under Chapter 9 with respect to pre-bankruptcy payments on account of their bonds. Similar protections could be engrafted into the Bankruptcy Code for the benefit of states and their bondholder constituents.

Constitutional Issues

One objection to the suggestion that states be authorized to file for bankruptcy has been that the United States Constitution would have to be amended to allow for such a possibility.2 However, this objection is without merit because the constitutional issues have been resolved in the context of Chapter 9 municipal debt adjustment cases.3

States' Rights and the Tenth Amendment

The main constitutional obstacle to state bankruptcies is provided by the Tenth Amendment, U.S. Const. amend. X, which provides: "The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people." Chapter 9 resolves this issue in 11 U.S.C. §§ 901 and 904. First, § 901 provides that many sections of other chapters of the Bankruptcy Code shall not apply in a Chapter 9 case, with the result being that the bankruptcy court's powers are limited mostly to approval of the Chapter 9 petition at the outset of the case and consideration of the plan of adjustment. In other words, a bankruptcy judge is limited in terms of the matters that he or she may properly consider in the context of a municipal bankruptcy case, and the bankruptcy for state option too can easily be squared with the Constitution. Importantly, the following exclusions are provided by § 901:

  1. No involuntary petitions may be filed against municipalities. 
  2. No forced liquidation or asset sales; no conversion to Chapter 7.
  3. No power to appoint a trustee to operate municipal government.
  4. No power to restrict unsecured borrowing.
  5. No power over employment or payment of professionals (but at end of the case, the court must find that the professional fees were "reasonable"). 
  6. No competing plans by creditors.
  7. The automatic stay protects the debtor and individual municipal officials from suit. 
  8. Executory contracts can be rejected using a more relaxed standard because 11 U.S.C. § 1113 does not apply. 
  9. Preference and fraudulent transfer suits may be brought (but payments on bonds and notes may not be recaptured as preferences). x. An official creditors' committee may be appointed by the United States Trustee, but the municipal debtor need not compensate the committee's professionals, nor must it reimburse their expenses.

Next, § 904 specifically provides that the bankruptcy court may not interfere with the debtor municipality's political or governmental powers, its property or revenues, or its use of any income-producing property, as follows:

Notwithstanding any power of the court, unless the debtor consents or the plan so provides, the court may not, by any stay, order, or decree, in the case or otherwise, interfere with–

  1. any of the political or governmental powers of the debtor;
  2. any of the property or revenues of the debtor; or 
  3. the debtor's use or enjoyment of any income-producing property.4

States are not included within the definition of "municipality" provided in 11 U.S.C. § 101(40), and therefore states are not eligible to file under Chapter 9. However, Congress could amend the definition of the term "municipality" to include a state, or it could draft a new chapter of the Bankruptcy Code applicable to states, containing provisions similar to current §§ 901 and 904 in order to avoid a violation of the Tenth Amendment.

Cram Down and the 'Contracts Clause'

States are generally restricted in their ability to enact mini-bankruptcy codes to reduce their debts by the U.S. Constitution's "Contracts Clause," which prohibits states from passing laws that impair the obligation of contracts. Specifically, the Contracts Clause provides:

No State shall enter into any treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law or Law impairing the Obligation of Contracts, or grant any Title of Nobility.5

In recognition of the strictures of the "Contracts Clause," Chapter 9 provides that state composition of indebtedness laws may not bind any creditor that does not voluntarily accept a reduction of its debt. Specifically, 11 U.S.C. § 903 provides:

This chapter does not limit or impair the power of a State to control, by legislation or otherwise, a municipality of or in such State in the exercise of the political or governmental powers of such municipality, including expenditures for such exercise, but-

(1) a State law prescribing a method of composition of indebtedness of such municipality may not bind any creditor that does not consent to such composition; and (2) a judgment entered under such a law may not bind a creditor that does not consent to such composition.6

For example, the United States Supreme Court has ruled that a New Jersey state composition statute could not reduce the outstanding principal amount of unsecured claims against the wishes of creditors.7 However, more recently, the First Circuit has held that a law of Puerto Rico abrogating certain terms of a collective bargaining agreement may not violate the Tenth Amendment.8

In view of the Contracts Clause's restriction on the ability of states to enact laws imposing debt reduction plans on creditors, states need:

[T]he power of the bankruptcy court to "cram down" against the votes of a class of dissatisfied creditors a reasonable plan that has been proposed by a municipality. As long as the plan (i) represents a reasonable effort by the municipality to pay its debts, without necessarily exercising its full taxing authority, (ii) is accepted by the votes of at least one class of creditors who are "impaired" (that is to say, whose claims are adjusted to some extent under the plan) and who are not "insiders" with respect to the municipality, and (iii) the other requirements for the confirmation of a plan are met, the bankruptcy court can cram down the plan against the votes of a dissatisfied class of creditors.9

To be sure, using the protection of the Bankruptcy Code should always be a remedy of last resort. If states were given the power by Congress to seek bankruptcy relief, they would undoubtedly use it sparingly. Indeed, cities have not demonstrated a great eagerness to voluntarily commence Chapter 9 proceedings, given the paucity of municipal filings since the enactment of municipal bankruptcy law in the 1930s. However, the ability to threaten to invoke the cram down power of the bankruptcy court in negotiations with creditors would undoubtedly tend to make creditors more reasonable in agreeing to much needed debt adjustments by certain states, thereby avoiding bankruptcy filings, federal bailouts, substantial tax increases, and the other undesirable alternatives that are facing certain states today. Why shouldn't our states have more tools at their disposal in terms of restructuring their debt?