The Bankrupt States of America: When State and Local Governments Seek Bankruptcy Protection

The good news is that the California legislature finally passed a budget (including millions of dollars of budget cuts), and, we assume, will no longer be issuing IOU's to its vendors in lieu of real US dollars. The bad news, is that the state's financial problems are far from being over and that many of the cuts, not to mention its increasing unemployment rate and mortgage crisis, will affect the quality of people's lives in the state for many years to come. Unfortunately, more state and local governments around the rest of the country are finding themselves in similar situations: as of February, Illinois was broke, too.

The distress isn't limited to those government entities with long-held liberal political leanings, either, as many might assume. This week we read that traditionally conservative Arizona is looking to sell off its legislative halls and other public buildings in a sell/leaseback plan designed to raise some quick cash to help close its state shortfall estimated at $3.4 billion. The state is also looking at contracting out the operation of its prison system.

So what happens when state and local governments can't pay their bills? Are such entities entitled to seek bankruptcy protection from their creditors the way private citizens and businesses are? In 1937, during the Depression, Congress extended bankruptcy protection to municipalities via the addition of Chapter 9 to the Bankruptcy Code.

In contrast, Congress has never extended such protection to the states themselves. Under Chapter 9 the term "municipality" is defined as a "political subdivision or public agency or instrumentality of a State." The definition is broad enough to include cities, counties, townships, school districts, and public improvement districts. It also includes revenue-producing bodies that provide services that are paid for by users, usually in the form of tolls or other usage fees, such as bridge authorities and highway authorities, and public utilities. But actual states are left without the option of having a court restructure its finances as in a bankruptcy filing; state lawmakers would have to reorganize its spending and debt on their own.

While Chapter 9 allows for a similar process of debt reorganization for municipalities as Chapter 11 does for businesses, it makes no provision for liquidation of the assets of the municipality and distribution of the proceeds to creditors. Such a liquidation or dissolution would violate the Tenth Amendment to the Constitution which reserves to the states of sovereignty over their internal affairs. In fact, due the Tenth Amendment and the Supreme Court's decisions in cases upholding municipal bankruptcy legislation under Chapter 9, the bankruptcy court generally is not as active in managing a municipal bankruptcy case as it is in corporate reorganizations under chapter 11. The bankruptcy court under Chapter 9 is generally limited to approving the petition (if the debtor is eligible), confirming a debt adjustment plan, and ensuring implementation of the plan.

So while municipalities can reorganize, or "adjust debt-, a state must find creative ways to muddle through. California has been borrowing money just to keep itself running. It has mandated its 238,000 state workers to begin "Furlough Fridays" - unpaid days off on the first and third Friday of every month through June 2010. The furloughs will save the state $1.3 billion over the next 17 months, but will also end up costing the state revenue as those workers pay less tax on smaller incomes. Other than education and debt payments, California has stopped making payments on nearly everything, including state agencies, public safety, payments for state purchases and tax refunds.

The trickle-down effect of stopped payments is busting the budgets of cities and counties across California. Riverside County, located between Los Angeles and San Diego, is seeking the court's permission to stop providing state mandated services if the county does not receive state funding.

Usually individuals and corporations that find themselves in dire financial traits would first cut off their debt service payments. What if a state decided to keep itself going by not paying back money it has borrowed? Remember, states do not have the option of bankruptcy, and the people it owes money to could go to court to force the state to pay. The consequences of a default would make the state's financial situation worse. That's because it would greatly hinder its ability to borrow in the future. States generally survive by borrowing money. And as we are realizing with each passing day, that is a very bad idea.

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