Can states file for bankruptcy? Should they? What you need to know

As states struggle under the weight of the coronavirus pandemic, Congress and the president have enacted a series of massive bills to try to bolster the health care response and help rescue the economy.

But Senate Majority Leader Mitch McConnell, R-Ky., recently made a comment that suggests he’s tired of big spending for cash-strapped states.

The National Governors Association has asked Congress for $500 billion more in direct federal aid, on top of the $150 billion provided in the $2.2 trillion coronavirus relief bill that passed in recent weeks. Depending on how long the crisis lasts, that number could go higher.

McConnell said in a radio interview that states might be better off declaring bankruptcy than by expecting additional funding from the federal government.

"I would certainly be in favor of allowing states to use the bankruptcy route. It saves some cities. And there’s no good reason for it not to be available," McConnell said. "My guess is their first choice would be for the federal government to borrow money from future generations to send it down to them now so they don’t have to do that. That’s not something I’m going to be in favor of."

Bankruptcy gives a "fresh start" to debtors who are unable to satisfy their debts. Declaring bankruptcy may involve a restructured payment schedule for obligations, such as pension debt or interest payments on bonds, as well as relief from bills from vendors. The parties may negotiate over the terms, overseen by specialized bankruptcy courts.

For states, bankruptcy would be a novel approach, since it doesn’t currently exist under law. And given the unusual confluence of urgent congressional business, along with the difficulties of carrying out ordinary legislative activities in an era of social distancing, experts do not expect state bankruptcy to become a reality in the immediate future.

McConnell’s comments prompted widespread criticism, including from some Republicans.

Maryland Republican Gov. Larry Hogan, said, "Mitch McConnell, I think, probably regrets saying that. If he doesn't regret it yet, I think he will regret it. The last thing we need in the middle of an economic crisis is to have states filing bankruptcy all across America and not able to provide services to people who desperately need them."

Rep. Pete King, R-N.Y., called McConnell’s comment "shameful and indefensible," while New York’s Democratic governor, Andrew Cuomo, called it "one of the really dumb ideas of all time." 

So what’s the hubbub all about? Let’s take a closer look.

It’s important to note that, under current law, states cannot declare bankruptcy. So Congress would need to pass a law allowing it.

The primary reason for the lack of state bankruptcy provisions is the U.S. Constitution. "Under the Constitution, states are ‘sovereign’ entities, and the federal government has limited power to act on them directly," said Vincent Buccola, an assistant professor of legal studies and business ethics at the University of Pennsylvania’s Wharton School. 

In an analysis, Kenneth Katkin, a law professor by Northern Kentucky University, wrote that "the contracts clause of the Constitution prohibits state governments from ‘impairing the obligation of contracts.’ As originally understood and enforced, this clause prohibited state legislatures from passing any laws to relieve either private debt or the state government's own debt." 

While the Supreme Court’s interpretation of bankruptcy law has varied during the 20th century, state bankruptcy was never seen as a permissible option. Even if a law did pass,  David Schleicher, a professor at Yale Law School, told us there would be constitutional challenges. 

While there is no historical precedent for states having access to bankruptcy, "there are many historical instances of states defaulting on their debts," Schleicher told PolitiFact. 

In the 1840s, eight states and one territory defaulted on their debt; for some, payments resumed quickly, while others renounced their debt and never paid. In the 1870s, he said, most southern states renounced their Reconstruction-era debt, and in 1933, Arkansas defaulted on its debt.

Most recently, there was discussion of allowing state bankruptcies in the wake of the Great Recession. The U.S. House even held a hearing on the idea.

However, the concept drew fire from Wall Street, public-employee unions, and governors from both parties, who worried about the risk of rising interest rates, Bloomberg reported. Nothing was enacted.

Matt Fabian, a partner with Municipal Market Analytics, told Bloomberg that today’s discussion of state bankruptcy is "just a red herring. State bankruptcy is probably not possible under the U.S. Constitution, and there’s even less chance that Congress would attempt to allow it."

Unlike states, cities are able to declare bankruptcy under Chapter 9 of the bankruptcy code. That chapter allows for the reorganization of municipalities, which include cities, towns, villages, counties, taxing districts, municipal utilities, and school districts.

"Municipalities, which are created by states, can use Chapter 9 as part of the bankruptcy law designed specifically for governmental organizations," even though states cannot use it, Buccola said. To avail itself of bankruptcy, the municipality must be authorized by its state.

The Great Depression in the 1930s saw a spike in municipal defaults, but they became less common in subsequent decades. Many of those that did occur stemmed from small local governments facing a giant debt due to embezzlement or a sizable legal judgment, Schleicher said. 

New York City managed to avoid bankruptcy in the 1970s thanks to negotiations between the state, investors, and labor unions. There has been another uptick of municipal bankruptcies since the Great Recession, including Jefferson County, Ala., Stockton, Calif., and Detroit.

Buccola said that a state bankruptcy provision would likely look more like chapter 9 for municipalities than either chapter 11, which is used by businesses, or chapter 7, which is used by individuals. 

Under such a system, "the state alone could propose adjustments to its debts, and it would be up to a federal judge to determine whether the package of adjustments a debtor state proposes meet the requirements of the law," Buccola said.

Samir Parikh, a law professor and co-director of the Center for Business Law and Innovation at Lewis & Clark Law School, said the states’ current fiscal challenges stem not just from the unusual circumstances of the coronavirus pandemic, but also from past decisions on matters such as pensions for retired state workers.

States "need to find a way to address their pension underfunding," Parikh said. "Concessions from labor unions represent the best bet. Many state constitutions prohibit states and municipalities from unilaterally altering pension and health care benefits. Municipal bondholders are the other group that would need to take a haircut."

He said that in Detroit’s now-ended bankruptcy, for instance, judges were asked to serve as arbitrators to negotiate with unions and bondholders with an eye toward a consensus settlement. "The parties were incentivized because they were worried about the debtor having the power to unilaterally alter payments and benefits."

For a state, declaring bankruptcy could have negative consequences on the future perceptions of their creditworthiness.

"States and municipalities are hesitant because they could get locked out of credit markets, and those funds are necessary to fill large gaps in budgets," Parikh said. 

In addition, potential vendors might decline opportunities to work with the state, for fear that they wouldn’t get paid the agreed-upon amounts. And state officials might have to contemplate selling off state assets, such as park lands, to raise money.

The main alternative to state bankruptcy is the one McConnell was reacting against — increased federal financial support for states, which ultimately must come either from taxpayers or from issuing additional debt.

Another possibility would be a hybrid model that includes higher federal aid along with a bankruptcy system for the most difficult cases, such as states that have had longstanding pension imbalances.