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Give States a Way to Go Bankrupt

It’s the best option for avoiding a massive federal bailout.

Nov 29, 2010, Vol. 16, No. 11 • By DAVID SKEEL
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As with much New Deal legislation, the early history of municipal bankruptcy law was rocky. The Supreme Court struck down the original law in 1936, concluding that it would infringe on state authority, even if the state vigorously welcomed the law. (One reason for rejecting municipal bankruptcy, according to Justice James Clark McReynolds, whose opinion was and is widely criticized but who was perhaps prescient, was that state bankruptcy might be next.) But two years later, after the famous “switch in time” from its earlier pattern of striking down New Deal legislation, the High Court gave its blessing to a 1937 version of the law. Congress’s revisions to the municipal bankruptcy legislation were slight, but the Court was ready to uphold it. Because the law was “carefully drawn so as not to impinge upon the sovereignty of the State,” the Court concluded, and made sure that the state “retains control of its fiscal affairs,” it now passed constitutional muster.

Municipal bankruptcy differs in a few key respects from the law applying to nongovernmental entities. Unlike with corporations, a city’s creditors are not permitted to throw the city into bankruptcy. A law that allowed for involuntary bankruptcy could not be reconciled with anyone’s interpretation of state sovereign immunity. A city must therefore avail itself of bankruptcy voluntarily; no one else, no matter how irate, can trigger a bankruptcy filing. And when municipalities do file for bankruptcy, the court is strictly forbidden from meddling with the reins of government. The current law explicitly affirms state authority over a municipality that is in bankruptcy and prohibits the bankruptcy court from interfering with any of the municipality’s political or governmental powers. A court cannot force a bankrupt city to raise taxes or cut expenses, for instance. Such protections have long since quieted concerns that municipal bankruptcy intrudes on the rights of the states, and they would similarly assure the constitutionality of a bankruptcy chapter for states.

One can imagine other constitutional concerns coming into play. If a municipal or state bankruptcy law allowed the court to ignore the property interests of creditors who had been promised specific state tax revenues or had been given other collateral, it might violate the Takings Clause of the Fifth Amendment. But the current chapter for municipal bankruptcy respects these entitlements (as does current corporate bankruptcy), and a chapter for states could easily be structured to do the same.

In the decades since the constitutionality of municipal bankruptcy was affirmed by the Supreme Court, the most serious obstacle in practice has been the rule that only insolvent municipalities can file for bankruptcy. Because a struggling city theoretically can raise taxes or slash programs, it often isn’t clear if even the most bedraggled city needs to be in bankruptcy. In 1991, a court concluded that Bridgeport, Connecticut—which wasn’t anyone’s idea of a healthy city—had not demonstrated that it was insolvent, and rejected Bridgeport’s bankruptcy filing. To avoid this risk, without making bankruptcy too easy for states, Congress would do well to consider a somewhat softer entrance requirement if it enacts bankruptcy-for-states legislation. Current corporate bankruptcy does not require a showing of insolvency, and the new financial reforms allow regulators to take over large banks that are “in default or in danger of default.” Although these reforms are in other ways deeply flawed, the “in default or danger of default” standard would work well for states.

Given that a new bankruptcy chapter for states would clearly be constitutional, and the entrance hurdles could easily be adjusted, the ultimate question is whether its benefits would be great enough to justify the innovation. They would, although a bankruptcy chapter for states would not be nearly so smooth as an ordinary corporate reorganization. When a business files for bankruptcy, the threat to liquidate the company’s assets—that is, to simply sell everything in pieces and shut the business down—has the same effect on creditors that Samuel Johnson attributed to the hangman’s noose: It concentrates the mind wonderfully. Because creditors are likely to be worse off if the company is simply liquidated, they tend to be more flexible, and more willing to renegotiate what they are owed.

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