Extending Bankruptcy Law to States: Is It Constitutional?

Puerto Rico cannot pay its debts. A significant number of states—with Illinois leading the way—teeter on the brink of fiscal disaster. Expenditures exceed revenues; debt service is a rising percentage of budgets; pension liabilities are woefully underfunded; credit ratings plummet; time is running out.

If these states were private corporations, and even if they were cities, they could voluntarily file for bankruptcy protection under federal law. That would enable them to negotiate with their creditors to restructure their debts, and to renegotiate contractual obligations such as pay, retirement, pensions, and health care.

Often these future obligations are untouchable as a matter of state constitutional law. Only federal law can preempt state law and provide a way forward. But the relevant federal law, Chapter Nine of the Federal Bankruptcy Code, does not apply to states, or to state­like territories like Puerto Rico. As some states come to face gargantuan fiscal shortfalls, scholars and public policy analysts have proposed that Chapter Nine, which now applies only to municipalities, be amended to include states within its ambit.

That this would, on balance, benefit struggling states is by no means clear, even assuming it could be done. The increase in borrowing costs might outweigh the savings from debt and contract renegotiation. I leave that question to experts on public finance. The question I wish to address is whether it would be constitutional to extend federal bankruptcy law to states.

It has long been assumed that it would be unconstitutional to subject states, which are sovereign entities, to the kind of federal judicial control that bankruptcy entails. But that assumption has come under question. If city and county governments can avail themselves of bankruptcy, why not states? And if states consent to bankruptcy—no one is proposing involuntary bankruptcy for states—why doesn’t that satisfy any federalism concerns? These arguments are substantial and might well carry the day. My purpose here is examine them in light of generally established constitutional principles, and especially the precedents set by the Supreme Court in connection with municipal bankruptcy.

Bankruptcy Protection for Cities

Prior to 1934, bankruptcy law applied only to private persons and companies. That changed during the Great Depression. In 1934, Congress, at the behest of municipal governments overwhelmed with bonded indebtedness, extended bankruptcy law to cities and special districts. Creditors immediately challenged that law in court. In Ashton v. Cameron County Water Improvement District (1936), the Supreme Court held the municipal bankruptcy law unconstitutional on federalism grounds.

According to the five ­justice majority:

“If obligations of states or their political subdivisions may be subjected to the interference here attempted, they are no longer free to manage their own affairs; the will of Congress prevails over them. . . . And really the sovereignty of the state, so often declared necessary to the federal system, does not exist.”

Significantly, the Court posed the rhetorical question: “If federal bankruptcy laws can be extended to respondent, why not to the state?”

Congress responded by passing a new statute in 1937 that was only cosmetically changed from the prior version. This time, the Supreme Court approved. In United States v. Bekins (1938), the Court reasoned that:

“the statute is carefully drawn so as not to impinge upon the sovereignty of the State. The State retains control of its fiscal affairs. The bankruptcy power is exercised in relation to a matter normally within its province and only in a case where the action of the taxing agency in carrying out a plan of composition approved by the bankruptcy court is authorized by state law. It is of the essence of sovereignty to be able to make contracts and give consents bearing upon the exertion of governmental power.”

In other words, the statute did not interfere with state sovereignty because it was drawn to ensure that the state retained control of its fiscal affairs, and because the state consented to the bankruptcy proceeding.

Modern Constitutional Objections to State Bankruptcy

Modern objections to state bankruptcy are similar. Opponents argue that bankruptcy for states would interfere with state sovereignty. Proponents respond with three main arguments for the constitutionality of state bankruptcy: 1) state bankruptcy is justified by the same constitutional logic that justifies municipal bankruptcy; 2) state bankruptcy would not interfere with the state’s governmental powers; and 3) bankruptcy would be a voluntary exercise of state authority to waive its sovereign immunity. Let us consider each of these of these arguments.

  1. What is the significance of the fact that states are sovereign while municipalities are not?

The argument that state bankruptcy can be justified along the same lines as municipal bankruptcy overlooks traditional constitutional differences between municipalities and states. Municipalities have traditionally not been understood as sovereign entities.

As Justice Cardozo put the point in his dissent in Ashton:

“There is room at least for argument that within the meaning of the Constitution the bankruptcy concept does not embrace the states themselves. In the public law of the United States a state is a sovereign or at least a quasi sovereign. Not so a local governmental unit, though the state may have invested it with governmental power. Such a governmental unit may be brought into court against its will without violating the Eleventh Amendment. It may be subjected to mandamus or to equitable remedies. ‘Neither public corporations nor political subdivisions are clothed with that immunity from suit which belongs to the state alone by virtue of its sovereignty.’ ”

The basis for this difference lies in the old common ­law understanding that cities are municipal corporations formed by their residents for particular purposes that are neither wholly public nor wholly private. Cities were not understood to be sovereign governments in any formal sense of the term and so lacked some typical governmental prerogatives. As Justice Cardozo pointed out, and it remains the case, Eleventh Amendment sovereign immunity does not apply to cities.

Under civil rights law, for instance, cities can be sued when states cannot. Antitrust law does not treat cities the same way it treats states. But cities are regarded as governments for some important purposes. In National League of Cities v. Usery (1976), for example, the Supreme Court regarded cities as having the same status as states for purposes of the Tenth Amendment and general federalism principles. For purposes of qualified immunity, city officials and state officials stand on the same footing. The state action doctrine applies to cities and states in the same way. Cities are amphibious creatures: governmental but not sovereign.

Congress evidently shared this conception. The 1937 bankruptcy act applied to cities and special districts, which are municipal corporations, but not to counties, which the common law regarded as subdivisions of the states in which they were located, and therefore as partaking of sovereignty. It was only in 1946 that Congress amended the statute to include counties, and that extension was never tested in the Supreme Court.

To the extent that the constitutionality of the 1937 act rested on the non­sovereign character of municipal corporations, as suggested by Justice Cardozo’s Ashton dissent, an extension to the states would be unconstitutional. Only if the constitutionality of the 1937 act rested on other rationales could state bankruptcy be a viable constitutional path.

  1. How much does bankruptcy intrude into sovereign powers?

The second theory of the constitutionality of state bankruptcy, which dates back to the briefs and opinion in Bekins, is predicated on the idea that an extension of the bankruptcy code would not interfere with the sovereign authorities of the jurisdictions to which it applies.

Unlike ordinary bankruptcy in the private context, municipal bankruptcy is completely voluntary. First, the state must enact legislation permitting its municipalities to avail themselves of the Chapter Nine process, and then the city must do so. In addition, under the 1937 act, the federal bankruptcy court was denied any authority to create its own plan, to force a city to raise taxes, or to require a city to reduce specific expenditures. The role of the bankruptcy court was limited to approving or disapproving a plan drawn up by the city and presented to the court.

This theory understands bankruptcy not as interfering with the city’s sovereignty, but rather as empowering the city to act on its sovereign interests. As the Bekins Court said, when a state permits its cities to file for bankruptcy, “the State acts in aid, and not in derogation, of its sovereign powers.” In effect, under this theory, extension of federal bankruptcy law is best understood as a means by which the federal government lends to cities and states its power to impair contracts, a power otherwise reserved under the Constitution for the federal government.

As the Court said: “The natural and reasonable remedy through composition of the debts of the district was not available under state law by reason of the restriction imposed by the Federal Constitution upon the impairment of contracts by state legislation. The bankruptcy power is competent to give relief to debtors in such a plight.”

This line of argument was especially prominent in the brief for the Solicitor General in support of the 1937 bankruptcy act in Bekins. If this theory holds water, it would be a strong argument for the constitutionality of state bankruptcy. Unfortunately for state bankruptcy, it is a quite unrealistic way of thinking about the consequences of bankruptcy. While the bankruptcy court does not have formal authority to write its own plan, it does have the ability to attach conditions and to refuse to accept a plan unless the state satisfies certain demands.

Additionally, in the statute there are two points at which state sovereign interests will surely be affected. The first is the requirement that, in order to invoke bankruptcy protection, the jurisdiction be insolvent. In order to determine the solvency of a governmental entity, which owns little attachable property and whose revenues are taxes, the court must evaluate the tax rate, along with the state’s obligations and expenses. If the court is not satisfied that the state has exhausted its ability to raise revenue and reduce spending, presumably the court will not find the state insolvent. This determination of solvency effectively gives the court power over some of the most important and fundamental sovereign activities of the jurisdiction. The power of taxation is as much at the core of sovereignty as anything could possibly be: the American Revolution was fought over the proposition of no taxation without representation.

In addition to the insolvency standard there is also the best­-interest­-of-­the-creditors standard, which in private bankruptcy means that creditors will be better off under the plan than they would be in case of liquidation. In the case of state bankruptcy, liquidation is not an option. In the legislative history of the 1937 act, the best-interest standard was defined according to two prior decisions, both based on the concept that the city had not exhausted its taxing capacity. Thus, viewed realistically, state bankruptcy would cut deeply into the inherently sovereign powers of the state over taxation and expenditure. It would not be possible for a Court to genuinely say, as the Supreme Court did in Bekins, that “the State retains control of its fiscal affairs.”

  1. Is the voluntary nature of state bankruptcy enough to make it constitutional?

The third argument for state bankruptcy’s constitutionality relies on the voluntary nature of the process. States are permitted to waive their sovereign immunity under the Eleventh Amendment; why should they not be permitted to waive their sovereign immunity against the intrusion of bankruptcy courts?

This argument raises a fundamental question: What is federalism for? If federalism protects states’ rights, then it follows that an entity that has rights ought to be able to waive those rights. Indeed, the ability to waive a right in return for valuable consideration is often seen as part of its value.

Alternatively, if federalism diffuses power and thus guarantees a kind of diversity and a check against tyranny and oppressive centralized authority, in order to protect the liberties of the people, then the state should not be able to waive this central structural aspect of federal constitutionalism.

The Supreme Court considered an analogous question in New York v. United States (1992). This case concerned a radioactive waste disposal law that imposed certain mandates on state governments, mandates that the Court concluded were beyond the powers of Congress. The Court’s ruling is striking because the objecting state, New York, and other states had actually lobbied in favor of the legislation—only to change their minds years later. How could the Court possibly rule the law unconstitutional as a violation of federalism when it was what the state wanted?

The Supreme Court answered:

“The Constitution does not protect the sovereignty of States for the benefit of the States or state governments as abstract political entities, or even for the benefit of the public officials governing the States. To the contrary, the Constitution divides authority between federal and state governments for the protection of individuals. State sovereignty is not just an end in itself: ‘Rather, federalism secures to citizens the liberties that derive from the diffusion of sovereign power.’ . . . State officials thus cannot consent to the enlargement of the powers of Congress beyond those enumerated in the Constitution.”

If that logic were applied to the extension of bankruptcy to state governments, the extension would be in trouble.

This view of federalism—as a structural protection for citizens rather than a set of “states’ rights” for the benefit of state governments—is increasingly dominant today. In Bond v. United States (2011), the Court recently stated in ringing tones: “Federalism is more than an exercise in setting the boundary between different institutions of government for their own integrity.” It went on to explain that “the limitations that federalism entails are not therefore a matter of rights belonging only to the States. States are not the sole intended beneficiaries of federalism.”

On the other hand, the pragmatic perspective of the Bekins Court could still exert a pull. Like cities, many states made profligate promises in the past that now are binding on future taxpayers under the Contracts Clause, commandeering resources needed to pay for vital public activities and services. It is difficult to see why states as employers should be less able than private employers to reorganize their financial affairs in order to operate effectively in the future. Taxpayers, and even courts, may be inclined to ask whether the sovereign interests of the public might not be better served by breaking the stranglehold of old contracts, even at the cost of submission to the scrutiny of federal bankruptcy judges.

Conclusion

It is impossible to be sure. On balance, I think the precedents are against extending Chapter Nine to states or to Puerto Rico. Moreover, the modern Court’s commitment to federalism is much stronger today than it was in the 1930s, when the municipal bankruptcy precedents were set. But the Court has a strong pragmatic streak, and the most prominent principled defenders of state authority—Justices Rehnquist, O’Connor, and Scalia—are no longer on the Court. 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, if any, as a matter of constitutional theory.

Moreover, it is unlikely that Congress would simply add states to the list of entities covered by Chapter Nine. More likely, it would craft a new scheme, perhaps based on the model of the legislation now under consideration for Puerto Rico. This would give Congress the opportunity to legislate in ways most likely to survive constitutional review.

The essential elements of bankruptcy protection are the ability to restructure debts and the ability to reform pension liabilities. If that can be done without touching the states’ authority over taxing and spending, and while respecting the states’ preexisting policies regarding priorities for debt payment, a bankruptcy­-like scheme—perhaps pursued under a euphemistic label—is entirely possible.

Michael McConnell

Michael McConnell, a former judge on the Tenth U.S. Circuit Court of Appeals, is a professor and director of the Constitutional Law Center at Stanford Law School and a senior fellow at the Hoover Institution.

About the Author

Responses

Sovereignty and Orderly Defaults

In his illuminating and timely Liberty Forum essay on the constitutional impediments to a state-level bankruptcy procedure, Michael McConnell emphasizes the importance of the sovereignty of the states in the framework of American federalism. Unlike Detroit and San Bernardino, and perhaps unlike Puerto Rico, the states are considered fully sovereign with respect to taxation, expenditures,…

Read More

State Bankruptcy and the Federal Order

While a federal bankruptcy law for states might be a desirable policy, its constitutionality is doubtful. Now, I am not a constitutional lawyer and cannot speak to the details of United States case law, but I do study fiscal federalism in comparative context: its conditions, operations, and consequences. Accordingly, I will analyze how a federal…

Read More

In What Circumstances Would the Threat of State Bankruptcy Be Credible?

Michael McConnell’s Liberty Forum essay does an excellent job of outlining the legal case that enabling states to declare bankruptcy is not necessarily inconsistent with constitutional principles or with existing case law. From the perspective of a public choice economist, however, there is another salient issue. What those who study the outcomes of institutional arrangements and…

Read More

A State Bankruptcy Policy and the Constitution: Michael McConnell Responds

I am grateful to Jonathan Rodden, Jason Sorens, and Steve Slivinski for their thoughtful responses to my essay, entitled Extending Bankruptcy Law to States: Is It Constitutional? I am particularly grateful because they addressed the many public policy issues about state bankruptcy, which I did not. I confined my essay to the legal/constitutional questions. But the…

Read More

Recent Popular Posts

Related Posts

Comments

  1. libertarian jerry says

    The United States government,most of the States and many of the smaller political jurisdictions in America are fiscally bankrupt. The only reason that the Federal Government hasn’t declared bankruptcy is because of that governments ability to create revenue by borrowing or by creating currency and credit out of thin air thru its money creation machine the Federal Reserve private bank. The main object of the Federal Income Tax is to be able to pay the interest on the Debt Notes of the Federal; government. In essence every American is put into debt and the Federal Government has first lien on the fruits of the labor of the average citizen in order to pay off that debt.
    The problem stems basically from 2 areas. 1. The promise of most governments in America,especially the Federal Government,to solve the social/economic problems of its citizens by wealth redistribution thru taxation,money creation(inflation)and debt. 2. The going off of or the changing of the original Constitution to allow for this redistribution process. The fact is that America has gone so far off of it’s Constitutional mandate that the Constitution,especially in fiscal matters,is a dead letter.
    The problem stems from these bankrupt political entities creating a Dependency Class that out vote the productive Economic Class. When you have a society that on one level or another the amount of government employees and the amount of “entitlement” recipients outnumber,and thus out vote,the productive wealth creators then you have a recipe for fiscal disaster and economic bankruptcy. This is exactly what has happened in America over the past several decades. Unfortunately America is past the point of no return. Eventually our money will be worthless,what is left of our Bill of Rights will be discarded and America will descend into a new dark age of serfs living in a police state.

  2. Scott Amorian says

    If I’m following this correctly, for a state to declare bankruptcy it would first have to become a non-state and become a federal district; at least temporarily.

    The problem is that in theory the national government could intentionally or accidentally create conditions to force a state into bankruptcy and then enlarge itself at the expense of the state, or at least to enforce its will onto the state. That is unacceptable.

    The citizens of a financially ill state need to reform their state’s political system. If they cannot I would question whether their government is a proper republican form of government and approach the problem from that angle.

Trackbacks

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>