Debt Option #3: Bankruptcy

BANKRUPT: bank·rupt  /ˈbaNGkˌrəpt/

adjective: bankrupt

  1. (of a person or organization) declared in law unable to pay outstanding debts.


By all conventional measures, Illinois is bankrupt. The State Supreme Court would disagree, having said in its decision to strike down the 2013 pension law:


“The General Assembly understood that the provisions would be subject to the pension protection clause. In addition, the law was clear that the promised benefits would therefore have to be paid, and that the responsibility for providing the State’s share of the necessary funding fell squarely on the legislature’s shoulders. The General Assembly may find itself in crisis, but it… is a crisis for which the General Assembly itself is largely responsible.”


The shorthand version of the above statement is that so long as the state has the ability to tax, there is no crisis deep enough to strike down the pension guarantee clause of the Illinois Constitution, thus the suggestion that unless we choose to tax our way out of this mess, there needs to be a pathway for states to file for bankruptcy.


Let me say at the outset that I’m not saying that if Illinois were to be given the option of filing for bankruptcy that it should do it. What I am saying is that, unless the option is hanging over everyone’s head like the Sword of Damocles, there will be no incentive to sit down and come to a sensible solution to this problem. Imminent danger tends to focus the mind.


States cannot now file for bankruptcy for two reasons:


First, the federal bankruptcy code has never allowed state governments to declare bankruptcy. Since 1937, municipalities have been able to declare bankruptcy, but the term ‘municipality’ is defined as a ‘political subdivision or public agency or instrumentality of a state.’ This definition is broad enough to include cities, counties, townships, school districts and public improvement districts, as well as entities that provide services which are paid for by user fees. Congress would need to pass legislation to allow it.


The second reason stems is found in the “Contracts Clause” (Article I, Section 10, Clause 1) of the U.S. Constitution, which prohibits state governments from ‘impairing the obligation of contracts.’ As originally understood and enforced, this clause prohibited state legislatures from passing any laws to relieve either private debt or the state government’s own debt. Beginning in 1934, however, the Supreme Court began to interpret the contracts clause as not being an absolute bar to state debt relief laws, though in 1977 and 1978 , it ruled that ‘a state cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money (on something else.)’.


Thus, were Congress to amend the federal bankruptcy code to authorize states to repudiate debt (which is the whole rationale for bankruptcy in the first place), the Supreme Court would then need to rule that state bankruptcy would not violate the Contracts Clause.


In United States v. Bekins (304 U.S. 27 (1938)) as in cases that preceded and followed it, the Constitutional limit seems to some degree based on necessity and the absence of any reasonable alternative.


These decisions show that the States already have the power, despite the Contracts Clause, to adopt legislation restructuring their own obligations if the need is sufficiently dire—if raising taxes (or cutting expenditures on “the public good”) would not be sufficient to pay creditors because the State economy is imploding, taxpayers are fleeing and property values are dropping. Sound familiar?


But once we get to that point, it’s probably too late. State bankruptcy would serve no purpose unless it gives a State the power to restructure its obligations when the need is not sufficiently dire—when it still can raise taxes or cut expenditures. A State bankruptcy act that authorized the State to use the act to discharge its own debts might be the very State impairment that the Contracts Clause prohibits, particularly if it applied when the need was not sufficiently dire. We have a case of the cat chasing its tail.


As the crisis in public pensions has grown, more and more commenters have discussed ways in which pension obligations can be adjusted without running afoul of the Contracts Clause. In a recent paper, James Spiotto, Managing Director of Chapman Strategic Advisors LLC in Chicago noted that in the case of Home Building & Loan Assn. v. Blaisdell, 290 U.S. 398 (1934):


“The United States Supreme Court not[ed] that the constitutional protection against the abrogation of contracts was qualified by the authority the state possesses to safeguard the vital interests of its people and that the legislature cannot bargain away the public health or the public morals…Further, the economic interests of the state may justify the exercise of its continuing and dominant protective power notwithstanding any interference with contracts… [The C]ourt noted that there needs to be a rational compromise between individual rights and the public welfare. It articulated the conditions that justify interference with contractual rights, including: (1) an emergency is present, (2) the legislation is addressed to a legitimate end, (3) the relief afforded is of a character appropriate to the emergency and (4) the conditions do not appear to be unreasonable.”


This is known as the State’s exercise of its “police” power, which the Illinois Supreme Court in the Heaton case brushed aside as being insufficient to allow the State to enact the pension bill passed in December of 2014 which would have changed the benefit structure of its five government pension plans.


While not mentioning Heaton specifically, Mr. Spiotto continued in his piece:


“The question raised is whether public pension obligations must be observed to the financial ruin of the state or local government or whether the obligations can be adjusted, modified or reduced so that the government can fulfill its duty of providing essential public services at an acceptable level for its citizens…If financially mandated pension reform efforts under current state law have failed and state constitutional and statutory provisions are obstacles to any needed pension reform efforts, the answer should not and cannot be that the government reduces funding for essential governmental services, services decline to unacceptable levels, the government melts financially and corporate and individual taxpayers leave. As horrific and unacceptable that result, it is the probable reality states and local governments face if needed pension reform is not capable of being implemented. This is not the case of unwillingness to pay, which never is an acceptable excuse for not funding public pension obligations. Rather, this is the financial and practical inability to pay and still provide the services that are mandated by the vital mission of government.”


While any move to create a means by which state pension plans can be modified under the Federal bankruptcy law will face stiff headwinds both Constitutional and political, the time has clearly come for that discussion to be had.

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