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By: Mark Glennon*

Could a formal bankruptcy proceeding for the State of Illinois be the answer to it’s fiscal crisis? If you think that’s out of the question, as many do, you’re wrong. On the contrary, though Congress isn’t working on it now, the option is quite viable, though subject to obstacles and open issues. The question is certain to gain growing national attention as a number of states sink further into insolvency, so it’s time to get up to speed. I have yet to see a single Illinois politician or reporter raise the question, but plenty of others outside the state are talking about it for Illinois. More on that later.

This article summarizes the basic issues.

First, why? Why would Illinois or any other state consider bankruptcy? Just as for insolvent corporations and municipalities that reorganize, a successful state bankruptcy would provide a fresh start by putting a state on a sustainable path that frees up funding for needed services — funding that’s getting crowded out by legacy debts. It would do that in three primary ways:

  • Debt that cannot be repaid gets adjusted down. In the case of governments, that includes unfunded pension liabilities insofar as there’s no realistic hope of paying them. For Illinois, that means part of its $130 billion pension debt could be erased notwithstanding the state constitutional pension protection clause. Unsecured bonds and other debts could also be cut. Illinois will never have a truly balanced budget or be restored to competitiveness unless those cuts are made, as we’ve written so often before.**
  • Unfavorable contracts and leases can be cancelled in bankruptcy, which include employment contracts and collective bargaining agreements.
  • Bankruptcy provides an orderly, rational process to sort out who gets what. Without it, a free-for-all eventually sets in for any entity that can’t meet its obligations. Creditors start suing and racing to courts to get the first judgement liens. Bankruptcy halts that tsunami of litigation and foreclosures.

There are constitutional objections to expanding bankruptcy to states. Bankruptcy for governments is a matter of Federal legislation — Chapter 9 the United States Bankruptcy Code. Today, it covers only cities, towns and other municipalities, but not states.

Expert legal opinions differ on whether Chapter 9 could simply be expanded by Congress to states, but my sense is that the weight of opinion is that Congress could, and eventually will, do so.

Congress unquestionably has the power to make bankruptcy laws — it’s expressly granted in the Constitution. Further, its power to apply bankruptcy to municipalities was upheld by courts over seventy years ago. Skeptics think putting state finances under control of a Federal bankruptcy court would upset the notion that states, unlike municipalities, are “sovereigns.”  They cite the 10th Amendment, which reserves to states powers not granted to the Federal government, and the 11th Amendment, which prohibits lawsuits in Federal courts against a state by citizens of another state. For those interested in the details, see the article linked here by Michael McConnell, a Stanford Law School professor.

A leading expert on the other side is David Skeel, a law professor at the University of Pennsylvania. He wrote outright that, “The constitutionality of bankruptcy-for-states is beyond serious dispute.” The key, as he sees it, is that bankruptcy would be entirely voluntary, which should eliminate any concerns about Federal intrusion on state sovereignty.

A professorial legal analysis, however, probably wouldn’t matter in the end. Courts often bend the rules or make new ones when major emergencies or humanitarian issues arise. Even Professor McConnell, who doesn’t like the idea of state bankruptcy, agrees with that

If we were facing a genuine fiscal meltdown, which could be solved only through bankruptcy or some equivalent process, and if the use of that process enjoyed the support of Congress, the President, and the affected states, it is not hard to imagine the Court swallowing its theoretical objections.

Beyond the legal issues, some fear that merely authorizing the option of bankruptcy would drive up state borrowing cost because potential bond buyers would face the added risk of having debt cancelled. That’s probably true for states in or near insolvency, but wouldn’t it also instill the needed borrowing discipline never to get to that point?  Bankruptcy would only be available upon insolvency — that’s already required under the Code — which means inability to pay what’s owed. If you can’t pay you won’t pay, bankruptcy or no bankruptcy, so it might not make a difference in the long run. In any event, higher borrowing costs would only result during the period from when it was authorized to when a state filed.

Remember that most objections to bankruptcy come from the municipal bond industry, so take them with a huge grain of salt. That industry primarily just wants to protect against losses on bonds already issued. The state shouldn’t be concerned about those; only future borrowing costs should matter. Future borrowing costs are lowered, not raised, if a successful bankruptcy reduces legacy debt.

And remember that the muni bond industry is already well aware that Congress could extend bankruptcy to the states. Rest assured they know all that’s being written here, and much more. They are way ahead of the curve. To some extent, they’ve already built bankruptcy risk into what they will pay for state bonds. And their efforts to shore up their position to assure they come ahead of taxpayers and other creditor are underway, discussed in our earlier article.

Public employee unions and their supporters also don’t like bankruptcy because of the threat it poses to pension obligations. That’s perhaps rational, if you assume states will in fact eventually find some way to pay scheduled obligations. Not Illinois, in my opinion. All sides need to get on the same page about the plain math. And a bankruptcy court should not be expected to cut pensions if it’s indeed feasible to pay them in full. Unions would be wise to recognize that bankruptcy courts so far have typically favored public pensioners over unsecured bondholders. However, time is not on the pensioners’ side: The muni bond industry is hard at work doing all it can to get first liens and other mechanisms to attain priority over pensions.

Unions also worry that collective bargaining agreements could be cancelled. Well, maybe. This highlights the most important general question about how state bankruptcy would work. And the issue applies to municipal bankruptcies as well: Who controls the bankruptcy proceeding?

The key here is that, on the face of Chapter 9, the bankrupt government — basically, the incumbent politicians — have exclusive power to submit the plan of reorganization. But it’s essential, if a bankruptcy is to be successful, that the same politicians and special interests responsible for bankrupting a government not control the bankruptcy, too. Otherwise, that government is doomed forever and a day.

That problem can be overcome in a number of ways that could be written spacifically into legislation expanding Chapter 9 to states. That is, Chapter 9 would not be extended ‘as is’ to states; appropriate changes for states certainly would be made.

Puerto Rico offers a particularly interesting way to address the problem. For Puerto Rico, Congress last year passed legislation similar to bankruptcy, known as PROMESA, that included appointment of a qualified ,seven-member oversight board. That board effectively has control over most major financial issues and will have to sign off on any reorganization plan that cuts debts. Opponents of bankruptcy for states are terrified that PROMESA may have set some sort of precedent. A national television ad campaign opposed PROMESA while Congress was considering it for just that reason. We’ll be writing separately about PROMESA and whether parts of it could work for Illinois.

The problem of who controls the bankruptcy can also be overcome at the state level. Detroit handled the problem in its bankruptcy by having the state appoint an emergency manager empowered to negotiate its reorganization plan. The same concept could work for appointment of a financially competent control board similar to New York City’s during its crisis in the 1970s.

Various “bankruptcy-light” proposals have also been floated. They would have Congress use its bankruptcy power to allow states cut pension debt through a proceeding short of a full bankruptcy. One, proposed by the Manhattan Institute, was the subject of a Chicago Tribune guest article last year.

But that’s about all you’ll find from the Illinois press about bankruptcy for states. Outside, however, the discussion has proceeded for some time. In 2011 the New York Times reported that policymakers were working behind the scenes to come up with a way to let states declare bankruptcy. They did their work “on tiptoe,” according to the Times, to avoid alarming the municipal bond community. Supporters included Jeb Bush and Newt Gingrich.

Legislation never materialized but the discussion continues. Bloomberg-Business Week wrote last year under the headline, “The Case for Allowing U.S. States to Declare Bankruptcy.” Significantly, William Isaac also wrote last year that both Illinois and Chicago should already be in bankruptcy. He’s the former Chairman of the FDIC and a nationally recognized insolvency expert.

I’m not quite to the point of saying bankruptcy for Illinois is unavoidable, but it’s getting mighty close.

*Mark Glennon is founder of Wirepoints. Opinions expressed are his own.

** For those who dismiss the possible need for bankruptcy, I’ll let two points suffice here:

  • The only legal ways to cut the state’s $130 billion unfunded pension debt, thanks to the Illinois Supreme Court’s interpretation of the Illinois Constitution, are 1) amendment of the state’s constitution, or 2) bankruptcy. However, the constitutional amendment might not work because serious objections would remain under the United States Constitution. Further, amending the state constitution then cutting pensions would would raise the question, “Why only pensions?” Shouldn’t other debts, especially unsecured bonds, be cut equally?  That would be an entirely fair objection, and the only way to fairly cut those other debts along with pensions is bankruptcy. Nobody has ever proposed a solution for Illinois that truly balances the budget and pays its debt. Pensions already consume about 25% of the state’s budget even though they remain badly underfunded, which keeps the pension debt growing rapidly.
  • The reason why Illinois can’t get a budget solution in place is there’s not any real one to be had. The true budget deficit is two to three times the official one that lawmakers can’t balance. See the numbers linked here. Spending has already been slashed, and tax increases attempting to stabilize the state would be suicide — they would backfire by accelerating the flight of our tax base, ultimately lowering revenue. Illinois will continue to sink rapidly into further debt unless existing obligations, especially pension debt, get cut.

 

 

 

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