Posted by: Debby Durkee | November 29, 2010

Give states a way to go bankrupt.

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Give states a way to go bankrupt.

David Skeel, a law professor and a writer with a book out about the new financial regulatory bill, says the best way to save the American taxpayer from defaults of states such as California and Illinois is for Congress to get busy finding a way to allow states to go into bankruptcy. He also says they need to act quickly before we begin to hear a drumbeat of: “We must bailout the states.” This is from The Weekly Standard.

… In the topsy-turvy world we now inhabit, letting states file for bankruptcy to shed some of their obligations could save American taxpayers a great deal of money.

The financial mess that spendthrift states have gotten themselves into is well known. California…has a deficit that could reach $25.4 billion next year, and Illinois’s deficit for the 2011 fiscal year may be in the neighborhood of $15 billion. There is little evidence that either state has a recipe for bringing down its runaway expenses, a large portion of which are wages and benefits owed to public employees. This means we can expect a major push for federal funds to prop up insolvent state governments in 2011, unless some miraculous alternative emerges to save the day. This is where bankruptcy comes in.

…The constitutionality of bankruptcy-for-states is beyond serious dispute. The real question is whether the benefits would be large enough to justify congressional action. The short answer is yes. Although bankruptcy would be an imperfect solution to out-of-control state deficits, it’s the best option we have, at least if we want to have any chance of avoiding massive federal bailouts of state governments.

…The main objection to bankruptcy for states is that it would interfere with state sovereignty—the Constitution’s protections against federal meddling in state affairs. The best known such barrier is the Tenth Amendment, but the structure of the Constitution as a whole is designed to give the states a great deal of independence. This concern is easily addressed. So long as a state can’t be thrown into bankruptcy against its will, and bankruptcy doesn’t usurp state lawmaking powers, bankruptcy-for-states can easily be squared with the Constitution. But the solution also creates a second concern. If the bankruptcy framework treads gingerly on state prerogatives, as it must to be constitutional, it may be exceedingly difficult for a bankruptcy court to impose the aggressive measures a state needs to get its fiscal house in order.

Neither of these considerations—state sovereignty or the limited force of a bankruptcy framework that gives wide berth to governmental decision-makers—is hypothetical. We now have more than 70 years of experience with a special chapter of the bankruptcy code—now called Chapter 9—which permits cities and other municipal entities to file for bankruptcy. For decades, this chapter did not get a great deal of use. But since the successful 1994 filing for bankruptcy by Orange County, California, after the county’s bets on derivatives contracts went bad, municipal bankruptcy has become increasingly common…Snip –

…If a municipal or state bankruptcy law allowed the court to ignore the property interests of creditors who had been promised specific state tax revenues or had been given other collateral, it might violate the Takings Clause of the Fifth Amendment. But the current chapter for municipal bankruptcy respects these entitlements (as does current corporate bankruptcy), and a chapter for states could easily be structured to do the same.

In the decades since the constitutionality of municipal bankruptcy was affirmed by the Supreme Court, the most serious obstacle in practice has been the rule that only insolvent municipalities can file for bankruptcy…Current corporate bankruptcy does not require a showing of insolvency, and the new financial reforms allow regulators to take over large banks that are “in default or in danger of default.” Although these reforms are in other ways deeply flawed, the “in default or danger of default” standard would work well for states.

Given that a new bankruptcy chapter for states would clearly be constitutional, and the entrance hurdles could easily be adjusted, the ultimate question is whether its benefits would be great enough to justify the innovation. They would, although a bankruptcy chapter for states would not be nearly so smooth as an ordinary corporate reorganization. When a business files for bankruptcy, the threat to liquidate the company’s assets—that is, to simply sell everything in pieces and shut the business down—has the same effect on creditors that Samuel Johnson attributed to the hangman’s noose: It concentrates the mind wonderfully. Because creditors are likely to be worse off if the company is simply liquidated, they tend to be more flexible, and more willing to renegotiate what they are owed. Snip –

The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees. Ideally, bondholders would vote to approve a restructuring. But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be “crammed down” over their objections under certain circumstances. This eliminates the hold-out problem—the refusal of a minority of bondholders to agree to the terms of a restructuring—that can foil efforts to restructure outside of bankruptcy.

The bankruptcy law should give debtor states even more power to rewrite union contracts, if the court approves. Interestingly, it is easier to renegotiate a burdensome union contract in municipal bankruptcy than in a corporate bankruptcy. Vallejo has used this power in its bankruptcy case, which was filed in 2008. It is possible that a state could even renegotiate existing pension benefits in bankruptcy, although this is much less clear and less likely than the power to renegotiate an ongoing contract.

Whether states like California or Illinois would fully take advantage of such powers is of course open to question. During his recent campaign, Governor-elect Jerry Brown promised to take a hard look at California’s out-of-control pension costs. But it is difficult to imagine Brown taking a tough stance with the unions…

…The risk that politicians won’t make as much use of their bankruptcy options as they should does not mean that bankruptcy is a bad idea. For all its limitations, it would give a resolute state a new, more effective tool for paring down the state’s debts. And many a governor might find alluring the possibility of shifting blame for a new frugality onto a bankruptcy court that “made him do it” rather than take direct responsibility for tough choices.

This brings us back to the issue of federal bailouts. When taxpayer-funded bailouts are inserted into the equation, the case for a new bankruptcy chapter becomes overwhelming. And it’s a case for Congress to move now on the creation of a state bankruptcy law.

With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so.

The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge

…The case for bailing out financial institutions rested on a concern that their creditors would “run” if the bank defaulted, and that the big banks are so interconnected that the failure of one could have devastating spillover effects on the entire market.

With states, none of these factors applies in anything like the same way. California’s most important creditors are its bondholders and its unionized public employees. The bond market wouldn’t be happy with a California bankruptcy, but it is already beginning to take account of the possibility of a default. And bondholders can’t pull their funding the way a bank’s short-term lenders or derivatives creditors can. As for California’s public employees, there is little reason to suspect they will be running anywhere.

Bankruptcy isn’t perfect, but it’s far superior to any of the alternatives currently on the table. If Congress does its part by enacting a new bankruptcy chapter for states, Jerry Brown will be in a position to do his part by using it.

http://www.weeklystandard.com/articles/give-states-way-go-bankrupt_518378.html

Hat Tip: http://www.pajamasmedia.com/instapundit/

A commenter at the website The Volokh Conspiracy comes up with a novel idea: “Any law that lets states be bailed out should require them to renounce their state status and revert to being territories, to be reorganised by the federal government as new states. That has the advantage of getting rid of the old, dysfunctional, state government, removing the state and its inhabitants from national influence until they’ve had a chance to learn some wisdom, and being enough of a penalty to make bailouts unattractive to other states.”

http://volokh.com/2010/11/26/david-skeel-on-bankruptcy-for-states/#comment-1070752

Bankruptcy for states seems to be the best solution, but with Obama and his coziness with the unions, it might be a difficult one for him to swallow. It’s time to make the case that the rest of the country is not willing to enable the states that are beholden to unions. It’s time for some tough love. There is no turnip left to squeeze blood from. Reality bites, but that’s the problem with liberals – they don’t like reality. They like to make things up as they go along. Sorry, time to face it and move on.

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Responses

  1. […] We highlighted David Skeel’s state bankruptcy law proposal here on our website: http://politicallyempowered.wordpress.com/2010/11/29/give-states-a-way-to-go-bankrupt/ […]


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