The Magazine

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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One can imagine something like a liquidation sale for cities and even states. Indeed, in the early 1990s, professors Michael McConnell and Randal Picker proposed that Congress amend the existing municipal bankruptcy chapter to allow just that. They argued that many of a city’s commercial, nongovernmental properties could be sold in a municipal bankruptcy, and the proceeds simply distributed to creditors. (They also suggested that municipal boundaries could be dissolved, with a bankrupt city being absorbed by the surrounding county.) Although California has taken small steps in this direction on its own—it recently contracted to sell the San Francisco Civic Center and other public buildings to a Texas investment company for $2.33 billion—it seems unlikely that Congress would give bankruptcy judges the power to compel sales in bankruptcy. Nor could it do so with respect to any property that serves a public purpose. Liquidation simply isn’t a realistic option for a city or state. (The same limitation applies to nation-states like Ireland and Greece, whose financial travails have reinvigorated debate about whether there should be a bankruptcy-like international framework for countries.) 

With liquidation off the table, the effectiveness of state bankruptcy would depend a great deal on the state’s willingness to play hardball with its creditors. 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.

Whether states like California or Illinois would fully take advantage of such powers is of course open to question. During his recent campaign, Governor-elect Jerry Brown promised to take a hard look at California’s out-of-control pension costs. But it is difficult to imagine Brown taking a tough stance with the unions. Even in his reincarnation as a sensible politician who has left his Governor Moonbeam days behind, Brown depends heavily on labor support. He doesn’t seem likely to bring the gravy train to an end, or even to slow it down much.

But as Voltaire warned, we mustn’t make the perfect the enemy of the good. 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.

This brings us back to the issue of federal bailouts. When taxpayer-funded bailouts are inserted into the equation, the case for a new bankruptcy chapter becomes overwhelming. And it’s a case for Congress to move now on the creation of a state bankruptcy law.

With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so. 

The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge. President Obama is no doubt grateful to California for bucking the national trend in the election this month, but even he might resist bailing the state out if there were a credible, less costly, and more effective alternative. That’s what bankruptcy would offer.

Indeed, even those who still believe (quite mistakenly, in my view) that the 2008 bailouts were an unfortunate necessity for big financial institutions like Bear Stearns and AIG, and that bankruptcy wasn’t a realistic alternative, should agree on the superiority of bankruptcy for states. The case for bailing out financial institutions rested on a concern that their creditors would “run” if the bank defaulted, and that the big banks are so interconnected that the failure of one could have devastating spillover effects on the entire market. 

With states, none of these factors applies in anything like the same way. California’s most important creditors are its bondholders and its unionized public employees. The bond market wouldn’t be happy with a California bankruptcy, but it is already beginning to take account of the possibility of a default. And bondholders can’t pull their funding the way a bank’s short-term lenders or derivatives creditors can. As for California’s public employees, there is little reason to suspect they will be running anywhere.

Bankruptcy isn’t perfect, but it’s far superior to any of the alternatives currently on the table. If Congress does its part by enacting a new bankruptcy chapter for states, Jerry Brown will be in a position to do his part by using it.

David Skeel is a law professor at the University of Pennsylvania. His book The New Financial Deal: Understanding the Dodd-Frank Act and its (Unintended) Consequences (Wiley) is due out in December.

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