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A growing number of governors are voicing concern about the damage inflicted on both the revenue and the expenditure sides of their states’ budgets by the COVID-19 pandemic. To allay these concerns, the $2 trillion Coronavirus Aid, Relief, and Economic Security (or CARES) Act provided $150 billion to state and local governments in addition to a $30 billion education fund, a $45 billion disaster relief fund, and other smaller programs. But even these massive sums are proving inadequate to prevent the enormous disruptions caused by large-scale business shut-downs, plummeting tax revenues, and new healthcare and unemployment insurance expenses. Moreover, this threat only grows with each day that states like New York, New Jersey, Illinois, and California delay fully reopening for business.

The situation is particularly dire for the many states that entered the current crisis with “preexisting conditions” that render them less able to cope with these challenges owing to repeated failures in addressing their budget issues. That’s especially true for states with heavily underfunded public employee retirement benefits. Many states that have offered generous retirement benefits to their employees have not funded these benefits in full, partly because the needed money has been spent elsewhere in the budget. Accounting gimmicks, as well as high investment returns in the past decade, have kept overburdened states afloat. But just as economic catastrophe is driving debt-laden companies such as JC Penney, Neiman Marcus, and Hertz into bankruptcy, many states are being forced to confront similar burdens.

It is in this context that the idea of including states under Chapter 9 of the U.S. bankruptcy code, which allows cities, counties, and other municipalities to file for bankruptcy, has resurfaced. This proposed expansion would allow state governments to file for bankruptcy.

Although controversial, the idea of political jurisdictions filing for bankruptcy is far from radical. In fact, since 1980, there have been a total of fifty-four Chapter 9 filings involving cities, counties, towns, and villages.

In theory, allowing states to go through the bankruptcy process would overcome today’s political obstacles and finally create the conditions for financially troubled states to rectify their unsustainable financial conditions.

It this realistic? Consider the facts.

Ideally, insolvent states would try to right their fiscal conditions. That means legislatures and governors would make the hard budget adjustments necessary for states to meet their obligations to the public, retirees, and bondholders. But it is apparent, especially for the most financially overburdened states, that doing so is neither politically feasible nor economically possible without severe cuts to public services.

A decade ago, General Motors and Chrysler both descended into bankruptcy after decades of mismanagement and poor performance, as well as excessive labor and retiree costs. In a similar fashion, decades of mismanagement and short-term political decision-making by state governments have finally collided with economic reality. But today, states don’t have the option of “wiping the slate clean” via bankruptcy.

So, what options do states have? Their preferred option would be to get a federal bailout. But that would provide no incentives to reform overly generous public employee labor compensation, which is the root cause of their problems; such a bailout would only encourage states to continue making poor choices. It would also require residents of fiscally prudent states to bail out state which refuses to live within their means, many of which are wealthy. Alternatively, states, as sovereign entities, could simply default on their debts. But that would mean public employees are protected at the expense of taxpayers and bondholders. And this would make it unlikely that these states could borrow money at anything other than “junk bond rates,” ever again. Worst of all, current taxpayers in New York and Illinois would end up paying higher interest rates, getting fewer services, and funding public-sector retirees now living in Florida.

Until Senate Majority Leader McConnell made clear that no bailout would be forthcoming this year, the idea of states seeking bankruptcy protection was only a hypothetical suggestion. In fact, McConnell took the bold step of suggesting that expansion of Chapter 9 bankruptcy to include state governments was an attractive alternative which Congress should seriously consider as a means of alleviating the crisis many states now face. Naturally, this sent shock waves through states like Illinois, New York, and California with huge underfunded pension liabilities.

But in the absence of a Federal bailout, McConnell’s suggestion appears a better alternative than selective default and debt repudiation, which would create many new problems and do little to solve current problems. This is especially true since many of the most troubled states are constrained by state constitutional provisions that prohibit the flexible options that states should use to rectify their balance sheets in a comprehensive way. Most important, many state constitutions contain provisions that have been interpreted by courts to guarantee that state and local employees have a right to pension benefits based on the formula in effect at hire, without reduction, until retirement, essentially rendering these obligations untouchable.

The idea of extending bankruptcy to states is not new; in fact, Trends touched on this topic in the April 2020 issue. University of Pennsylvania law professor David Skeel, a specialist in corporate finance and bankruptcy, first introduced the idea after the Great Recession of 2007-to-2009. He argued that a procedure for bankruptcy could instantly reduce states’ unsustainable bond debt, cut wasteful spending, and allow states to rework unsustainable public employee retirement benefit obligations. Duke Law professor Steven Schwarcz even designed a model state bankruptcy law that would achieve these objectives.

What’s the bottom line? Extending bankruptcy mechanisms to the states would avoid some of the problems with the current alternatives. But Chapter 9 bankruptcy, as currently formulated, is no panacea for taming countervailing political dynamics. The more recent bankruptcy experiences of larger and more indebted municipalities like Detroit have exposed the difficulties of keeping the process free of politics. Furthermore, in order to avoid some of the problems that have arisen in municipal bankruptcies, it appears that commonsense reforms will need to be made before making states eligible for bankruptcy.

Given this trend, we offer the following forecasts for your consideration.

First, this will be an important fault line for the 2020 elections, even though it is unlikely that bankruptcy expansion or Federal bailouts will make it into the Phase Four COVID19 relief act.

Democrats have already endorsed state bailouts as part of the so-called HEROES Act. However, few pivotal states in terms of winning control of the Senate or achieving electoral college victory would benefit from this bailout. Furthermore, in many House districts, public employees are increasingly being perceived as “overpaid parasites” by the broader electorate. Meanwhile, voters will watch as, slow-to-reopen blue states like Illinois, New York, New Jersey, and California teeter-on-the-brink, while red states like Missouri, Florida, Georgia, and Texas return to stable growth. —Unless something disrupts this pattern before November, it will be a political plus for Republicans and political minus for Democrats.

Second, assuming Republicans win back control of the House and retain the Presidency and Senate, bankruptcy will become available to state governments.

To avoid pitfalls, this legislation must be carefully crafted taking into account the unique political and constitutional aspects of the situations. For example, under America’s system of constitutional federalism, states as sovereign entities would retain the option to repudiate their debts in whole or in part, subject to their own laws. And, unlike Chapter 11 corporate bankruptcy, Chapter 9 provides no option for creditors to initiate involuntary bankruptcy proceedings. But, giving states the option to file for bankruptcy would not only provide them with a workable alternative to outright default, but it could also give them leverage in reaching consensual adjustments without ever having to resort to an actual bankruptcy filing.

Third, opening-up the bankruptcy alternative to states will allow them to side-step ill-conceived state laws.

Under the Supremacy Clause of the U.S. Constitution, Federal bankruptcy law overrides state constitutional constraints letting the court adjust earned and unearned pension benefits of existing workers and current retirees. On paper, bankruptcy preserves the property rights for vested benefits but allows the reworking of all contractual promises, including public employee pension contracts.

Fourth, bankruptcy law rigorously enforced will ensure that all creditors are treated equally and will create incentives to avoid unsustainable future commitments.

Requiring all claimants to share equally in the pain of bankruptcy and demanding that the plan be “economically feasible” is not only fair, it also creates positive incentives for all parties by restraining "moral hazard" and creating incentives to hold state governments accountable. Chapter 9, like Chapter 11, requires that any reorganization plan not “unfairly discriminate” among different groups of creditors that hold the same priority. Raising the possibility that public employee pensions would be subject to cuts as part of bankruptcy would create powerful incentives for public employees to accept more realistic benefit promises and then to pressure state governments to fund them adequately. Thus, the threat of bankruptcy and the shared pain it could bring about would provide incentives for both bondholders and public employees to pursue greater public fiscal sustainability going forward. Courts would also rigorously apply the requirement that any plan should be economically feasible, meaning that the plan must promise long-term sustainability, not just short-term relief. Therefore, failure to clearly address looming, underfunded retirement obligations would render any proposed plan infeasible. And,

Fifth, when Chapter 9 is amended to accommodate states, judges will be appointed in such a way as to minimize conflicts of interest.

There are about 90 bankruptcy districts across the United States, and each one has its own judge. The bankruptcy courts generally have their own clerk’s offices. In a regular bankruptcy case, the judge is selected at random by the clerk of the court. However, in Chapter 9 proceedings, the judge is not chosen at random. Instead, the chief judge of the U.S. Court of Appeals chooses a judge from the bankruptcy court where the case is located. But since those bankruptcy judges have to live in the same community as the public employees whose benefits are on the chopping block, this creates personal incentives for the judge to favor public employees over bondholders. Alternatives include appointing a judge from another state or appointing a judge at random from any of the 90 districts. The stakes are high and failing to keep the judge independent would all but assure that state bankruptcy will fail to achieve its goals and that state debt problems and political obstacles in the path of their resolution will persist.

References
1. Mercatus Center Policy Briefs. June 11, 2020. Veronique de Rugy & Todd Zywicki. The Difficult Path to State Bankruptcy.
https://www.mercatus.org/publications/covid-19-economic-recovery/difficult-path-state-bankruptcy

2. April 15, 2020. Trend Editors. An Extraordinary Opportunity to Fix America’s Pension Crisis.
https://audiotech.com/trends-magazine/an-extraordinary-opportunity-to-fix-americas-pension-crisis/

3. CHICAGO TRIBUNE. MAR 30, 2020. MARK GLENNON. Commentary: Pension bailouts are not the answer for Chicago and Illinois — even during a pandemic.
https://www.chicagotribune.com/opinion/commentary/ct-opinion-coronavirus-pensions-bailouts-20200330-72mzxrkerrfgfmsbuars6vkbga-story.html

4. Apr 28, 2020. Elizabeth Bauer. Pension Bailout Or Bankruptcy? That’s Missing The Bigger Picture.
https://www.forbes.com/sites/ebauer/2020/04/28/pension-bailout-or-bankruptcy-thats-missing-the-bigger-picture/#2645d05d14ed

5. The New York Time. April 17, 2020. Mary Williams Walsh. Illinois Seeks a Bailout From Congress for Pensions and Cities.
https://www.nytimes.com/2020/04/17/business/dealbook/illinois-pension-coronavirus.html

6. Wall Street Journal. April 24, 2020. Andrew Biggs. A Bailout for Illinois? Not Without Strict Conditions.
https://www.wsj.com/articles/a-bailout-for-illinois-not-without-strict-conditions-11587765373

7. Illinois Policy. August 13, 2019. Adam Schuster. Nearly 40% of Education Spending Consumed by Pension Costs.
https://www.illinoispolicy.org/nearly-40-of-education-spending-consumed-by-pension-costs/

8. Illinois Policy. August 13, 2019. Adam Schuster. WHY CONGRESS SHOULD REJECT ILLINOIS’ $44 BILLION BAILOUT REQUEST.
https://www.illinoispolicy.org/why-congress-should-reject-illinois-44-billion-bailout-request/

9. Yankee Institute for Public Policy. April 23, 2020. Mark E. Fitch. Bailout or bankruptcy for states? Connecticut faces long-term “structural imbalance.”
https://yankeeinstitute.org/2020/04/23/bailout-or-bankruptcy-for-states-connecticut-faces-long-term-structural-imbalance/

10. com April 30, 2020.Pamela Boykoff. Debate emerges: Should businesses be protected from Covid-19 lawsuits?
https://edition.cnn.com/2020/04/29/business/business-liability-congress/index.html

11. Financial Times. APRIL 22, 2020.Andrew Edgecliffe-Johnson & Lauren Fedor.US business groups seek protection from coronavirus lawsuits.
https://www.ft.com/content/1ae66ded-7154-4881-ae9b-d9583e7e4676

12. com. May 1, 2020. Marisa Schultz. GOP leaders draw red line on next phase of coronavirus aid legislation.
https://www.foxnews.com/politics/gop-leaders-draw-red-line-on-next-phase-of-coronavirus-aid-legislation