State Default and Synthetic Bankruptcy

• Publication year: 2021

STATE DEFAULT AND SYNTHETIC BANKRUPTCY

Richard M. Hynes(fn*)

Abstract: An insolvent state does not need bankruptcy if sovereign immunity would protect it from lawsuits and other collection efforts. To the extent that a state is not judgment-proof and needs bankruptcy, we may not need to modify the Federal Bankruptcy Code to allow it to file. First, a substantial share of state spending flows through their municipalities, and these municipalities have substantial obligations of their own. Unlike states, municipalities can file for bankruptcy under current law, and a state could substantially reduce the cost of accomplishing its own fiscal goals by forcing its municipalities to file. Second, states may be able to create their own synthetic "bankruptcy" mechanisms, or bankruptcy without the federal code. State obligations are creatures of state law; states do not need a federal bankruptcy discharge. Federal law would not preempt a state composition mechanism used to adjust these debts, and any adjustment that would have been confirmed by a bankruptcy court would likely survive a Contract Clause challenge as well. Even if a state does not enact a composition mechanism, it could capture most of the benefits of federal bankruptcy by directly altering the rights of its creditors. A synthetic bankruptcy mechanism created by a state would not precisely replicate a federal bankruptcy chapter for states. Perhaps the best argument for federal bankruptcy is that it could operate with significantly lower transactions costs. In a world without omniscient judges, however, transactions costs can actually increase welfare by enhancing the ability of a state to make credible commitments.

INTRODUCTION ................................................................................ 658

I. THE NATURE OF A STATE'S FISCAL CRISIS SHOULD DICTATE THE STRUCTURE OF THE RESOLUTION MECHANISM ............................................................................... 662

A. States and Their Municipalities Resemble Complex Holding Companies ............................................................ 663

B. Debt Service Payments Do Not Account for a Large Share of State Budgets ....................................................... 665

C. Pension Obligations Constitute a Substantial Burden on States. . ................................................................................ 668

II. NON-BANKRUPTCY LAW MAY PREVENT THE ENFORCEMENT OF STATE OBLIGATIONS ........................... 671

A. Sovereign Immunity May Prevent Creditors from Suing a State ................................................................................. 675

B. State Laws Amending Creditor Rights May Survive a Contract Clause Challenge ................................................. 680

III. AN INSOLVENT STATE COULD USE BANKRUPTCY UNDER EXISTING LAW ............................................................ 683

A. States Can Use Municipal Bankruptcy to Reduce Expenses ............................................................................. 683

B. States Can Create Synthetic Bankruptcy-Bankruptcy Without the Code ................................................................ 686

IV.SYNTHETIC BANKRUPTCY MAY BE A GOOD SUBSTITUTE FOR FEDERAL BANKRUPTCY ........................ 690

A. Minimalist Bankruptcy Is Likely to Be Either Unnecessary or Insufficient ................................................ 690

B. Federal Bankruptcy May Offer No Real Advantages

Over Synthetic Bankruptcy ................................................ 694

1. The Contractarian Argument for Synthetic Bankruptcy ................................................................... 695

2. Federal Bankruptcy and the Allocation of Power ......... 698

3. The Role of Transactions Costs .................................... 703

CONCLUSION .................................................................................... 704

INTRODUCTION

Some scholars and politicians have called for a change in law(fn1) that would allow states to file for bankruptcy under the federal code.(fn2) At the moment, states don't need bankruptcy protection. States have relatively little debt, at least if we define debt narrowly to mean liabilities owed to capital markets.(fn3) More importantly, if a state truly wants to default, there may be very little that its creditors can do to force the state to pay. The Eleventh Amendment prevents nearly all creditors from suing a state in federal court without the state's consent, and sovereign immunity allows the state to prevent most creditors from suing in state court as well.(fn4) Even if a state's creditors do manage to sue, existing Contract Clause doctrine allows a state to use its financial distress to excuse its non-performance.(fn5) In other words, non-bankruptcy law can resolve state financial distress tolerably well. It did so both when states defaulted on their bonds in the nineteenth century(fn6) and when states unilaterally altered their (or their municipalities') collective bargaining agreements in the twentieth and twenty-first centuries.(fn7)

Although states don't need bankruptcy protection at the moment, we may someday want an insolvent state to use bankruptcy to return to solvency. Payments to bondholders may not currently comprise a significant portion of a state's budget, but this situation could change if a state incurred dramatically more debt and interest rates rose significantly. In addition, states have made substantial commitments to their current and former workers that may be expensive to keep. If some or all of these creditors can sue or exert other pressure on a state, this pressure could create problems that bankruptcy is designed to mitigate.(fn8) Because bonds and similar debts are unlikely to account for a significant share of an insolvent state's obligations, an effective bankruptcy chapter must constitute more than a minimalist procedure that leaves the rights of current and former workers untouched(fn9) and does not allow a judge to modify the rights of a class of creditors without their approval.(fn10)

This Article does not advocate for the modification of states' obligations to their workers or other creditors. One can reasonably argue that a state's taxpayers or the recipients of its discretionary spending should bear the costs of financial distress instead of those to whom the state has made promises.(fn11) One can also argue that courts should stay out of the matter and leave the resolution to the political process.(fn12) Rather than engage these debates, this Article argues that if courts are to play a role in deciding whether a state should perform its obligations, states should have access to some version of bankruptcy.

Although states cannot file for protection under the federal bankruptcy code, existing law may still allow them to use bankruptcy to resolve their insolvency. First, a state could substantially reduce its expenses by forcing its municipalities into bankruptcy. The bankruptcy code allows municipalities to file,(fn13) and the code defines the term "municipality" broadly to mean a "political subdivision or public agency or instrumentality of a State."(fn14) Grants to localities (a subset of municipalities) account for more than half of some states' spending,(fn15) and many of the obligations reported as state debts are really municipality debts.(fn16) If a state can use the federal bankruptcy code to reduce the obligations and expenses of its municipalities, it can reduce the cost of accomplishing its own goals.

Second, state law governs the most significant obligations of a state and its municipalities, including their bonds, pensions, and collective bargaining agreements. Accordingly, states can manipulate the rules applicable to their own disputes. Instead of rejecting a collective bargaining agreement or proposing a plan of reorganization in bankruptcy, a state could enact laws that modify the rights of its creditors (including its contractual counter-parties). If sovereign immunity does not prevent their lawsuit, creditors would argue that the state laws violated the Contract Clause. The court would apply a test that is similar to, and perhaps more lenient than, the one it would use in a federal bankruptcy reorganization of a state.(fn17) The state and its creditors could use aggregate litigation methods to combine the suits in a small number of courts to reduce transactions costs.(fn18) In the extreme, a state could create its own composition mechanism that would roughly replicate a federal bankruptcy chapter for states.

This Article uses three different definitions of bankruptcy. The general term "bankruptcy" is defined broadly to mean a single proceeding that compels all creditors to accept "some arrangement or disposition of their claims against the bankrupt's property, whether they agreed to it or not."(fn19) The term "federal bankruptcy" shall mean bankruptcy pursuant to the federal bankruptcy code. The term "synthetic bankruptcy" shall mean bankruptcy without the federal bankruptcy code-either a state composition agreement or the direct alteration of the rights of creditors combined with aggregate litigation techniques.

A state-created synthetic bankruptcy process would not precisely replicate a federal bankruptcy chapter for states.(fn20) First, if we are willing...