David Skeel on Bankruptcy for States

by Reihan Salam

In the last The Weekly Standard, David Skeel wrote an excellent article on creating a bankruptcy code for state governments that merits serious and sustained attention. Skeel begins by explaining that bankruptcy for states would be constitutional and would not constitute an infringement on state sovereignty. He then makes the obvious point that a state bankruptcy would be very different from a corporate bankruptcy, not least because liquidation won’t be an option:

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.) 

I’ll note that a “liquidation sale” of the kind envisioned by McConnell and Picker would prompt a great deal of left-of-center alarmism, no matter how constrained. It might also make a ripe target for satire. 

 

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.

Simply put, this is the reason why bankruptcy for states is so vitally important, and why it will prove an extremely tough political fight. State governments need to be given the option of preserving core public services even if it means forcing creditors to take a haircut and forcing public sector employees to accept the kind of retiree health benefits and pensions offered to comparable workers in the private sector. 

And it’s urgent that Congress act in the next few months, for political reasons that Skeel makes clear:

 

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.

The clock is ticking.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.