State and Local Bankruptcy

Unintended Consequences

  • The national conversation now underway whether Congress should enact preemptive authority for states to file for bankruptcy is treacherous because of its unintended consequences. The mere existence of a federal law allowing states to declare bankruptcy would only serve to increase interest rates, rattle investors, raise the costs of state government, create more volatility in financial markets, and erode state sovereignty under the 10th Amendment to the U.S. Constitution.  

States Versus Municipalities

  • The bankruptcy conversation further demonstrates a basic misunderstanding about the function and operation of states and local government.
  • Bankruptcy is not a legal option for states, as constitutionally recognized sovereigns, because states have taxing authority and constitutional or statutory requirements to balance budgets. The mechanics of bankruptcy, moreover, are inapplicable to a sovereign entity.
  • Alternatively, bankruptcy may be an option for some municipalities under Title IX of the federal Bankruptcy Code because municipalities are legal corporations, not sovereign entities. Eligibility for Chapter IX relief is narrowly tailored by several factors. States determine whether their municipalities, as "political subdivisions, public agencies, or instrumentalities of the state," may pursue this option. One key eligibility factor is that a municipality must be insolvent and unable to meet its obligations when they fall due. According to the Congressional Budget Office, 23 states have not passed laws on municipal bankruptcy while 26 states authorize Chapter IX filings (i.e. 12 states impose no restrictions; 14 states require approval from a state authority before filing). Currently, only Georgia legally prohibits its municipalities from filing under Chapter IX.  

State Actions

  • Post-Great Recession, growing budget deficits have confronted most states that are required to balance their budgets annually or biennially. States have risen to this challenge by making tough spending cuts and, when necessary, raising taxes, which is within their power as sovereign entities.
  • During this time, unfunded pension and health care liabilities have also grown because of the lower rate of return on investments and deferred annual contributions. In 2010 alone, at least 20 states modified their pension plans to help mitigate and eliminate unfunded liabilities.
  • Throughout this difficult period, states never contemplated walking away from their obligations to residents or the bond markets by requesting that the federal government allow states to receive bankruptcy protection.
  • NGA leadership issued a preemptive statement on January 25, and again in a February 4 joint leadership letter with the NCSL that declared opposition to any congressional legislation that would permit states to file for bankruptcy protection. 
Learn more about NLC's work on City Finance.         

Source

"Facts you Should Know". Joint fact sheet by NLC, NGA, NCSL, CSG, NACo, USCM, ICMA, NASBO, NASACT, GFOA, and NASRA. February 2011.