Disaggregating State Bankruptcy

Abstract

States today face fiscal challenges that they cannot surmount. With trillions in debt and billions in deficits, states are rapidly reaching the point where they cannot satisfy their obligations to pensioners, employees, and residents. This deterioration of state finances has, in turn, revived the debate over whether Congress should expand the Bankruptcy Code to allow states to file for bankruptcy. The debate, though, overlooks how, as a practical matter, bankruptcy is already available to financially distressed states. Chapter 9 of the Bankruptcy Code permits a state’s political subdivisions, public agencies, and instrumentalities to file for bankruptcy if the state authorizes them to. A state can therefore make its own debt bankruptcy-eligible by having a government entity, rather than the state, owe the debt, and by authorizing all government entities in the state to file for bankruptcy.

This disaggregation—states operating, and taking on debt, through government entities rather than the state itself—is already the norm. In fact, the vast majority of so-called “state debt,” some 90%, is owed not by states themselves, but by government entities eligible to file for bankruptcy.

The interaction of disaggregated states and Chapter 9 leads to a doctrinal oddity: Debt owed by the state itself is not bankruptcy-eligible, but that same debt, if owed by a state agency or instrumentality, is bankruptcy-eligible. That doctrinal oddity has enormous significance, both theoretical and practical. For theory, disaggregation shows that states can partition liability, confining distress to a particular entity instead of having that entity’s liabilities threaten the fiscal stability of the whole state. As for practice, disaggregation offers a superior alternative to adding a state-bankruptcy chapter to the Code. Disaggregation is simpler, fairer, and has fewer spillover effects, offering states a good way to address their current, dire, fiscal situations.

Keywords: bankruptcy, corporate law, local government law