Can a State File Bankruptcy? (ReBroadcast)

According to Illinois Comptroller Leslie Munger, the state of Illinois has a backlog of unpaid bills of just over $7 billion. Revenue projections suggest Illinois is not likely to climb out of this financial hole anytime soon. When the debt of private companies overwhelms their revenues, these companies often file bankruptcy. If bankruptcy was good for General Motors, why isn’t it also good for the state of Illinois?

The short answer is that a state cannot file bankruptcy. All bankruptcy law is federal law. Although federal law says that people and corporations can file bankruptcy, no federal law says that a state can file bankruptcy.

Federal law does say that, if state law allows it, municipalities and other local governmental bodies can file under chapter 9 of the Bankruptcy Code. Thus, the city of Detroit could file a chapter 9 bankruptcy but not the state of Michigan.

States, of course, can make their own laws, but the U.S. Constitution forbids from simply passing its own bankruptcy law. At the time of the Constitution’s drafting, states sometimes tried to abandon valid debts owed by the state or one of its citizens. A New York creditor might find try to enforce a debt in Georgia only to find that a Georgia state law had nullified the debt.

One of the ways the U.S. Constitution tried to solve this problem was to prevent any state from “impairing the obligation of contracts.” Known as the Contract Clause, this language prohibits a state bankruptcy law. If I borrow $100 from you and agree to pay you back with interest, we have a contract. If the state passes a law that says you cannot collect the full amount, it is has “impaired” my contractual obligation to you.

Many state constitutions, including Illinois, also have a similar rule that is applied in much the same way as the Contract Clause in the U.S. Constitution. These general state constitutional protections for contracts are in addition to specific protections for special state obligations like state employee pensions. The Contract Clause only applies to the states. This explains why Congress pass a bankruptcy law, but the states cannot.

So far, we have discussed why a state cannot file bankruptcy in a legal sense, but could a state become “bankrupt” in the more ordinary sense of the word by just not paying its bills? The Contract Clause prohibits states not only from passing laws impairing the obligations of its citizens’ contracts but also prohibits states from passing laws impairing the obligation of its own contracts. A state cannot declare it will never pay its bills – that would be a clear impairment of its contracts.

A state might attempt a less drastic solution, such as announcing a temporary moratorium on debt repayment. The state might argue that is has not impaired the essential obligation of the contract. The money will be paid, just at a later time.

The case law is not very clear about what would happen in such a circumstance. In past cases, the courts have been willing to tolerate some state changes to contracts during a financial emergency, for example when states were acting to alleviate their citizens’ financial woes in the Great Depression. The type of contract also matters. The alteration of a pension contract will receive more court scrutiny than a state supply contract. Finally, a more severe change is less likely to be okay – a one- or two-year debt moratorium may be okay where a five-year moratorium will not.

Because the states have limited tools to deal with their financial distress, there have been proposals for Congress to pass a law allowing a state to file bankruptcy. Some have raised constitutional objections to a bankruptcy law for states, but the chief hurdles seem to be practical and political. It is not likely that Congress will pass a bankruptcy law for states anytime soon. States like Illinois will have to find their own financial and political solutions to their debt problems.