Updated: November 1, 2015
Issue: There has been talk in Washington, D.C. about Congress considering a federal law that would allow financially troubled states like Illinois to declare bankruptcy as a way to help balance spending and revenues. Bankruptcy would allow a state government to reduce its debts and, theoretically, enable them to cut pay, benefits and pensions for teachers and public employees despite contractual protections. This discussion intensified in 2012 when the City of Detroit formally filed for bankruptcy protection in court. In 2014 a federal bankruptcy court and Detroit officials finalized a restructuring of the city’s debts over 10 years that included reductions in pension benefits to help balance revenues and spending.
Discussion: Illinois officials consistently say that despite its deep financial problems, the state isn’t going to declare bankruptcy because there is no law allowing a state to declare bankruptcy. Even if there was such a law, state officials say they would not use it.
The discussion about states declaring bankruptcy stems from a front–page story in the January 21, 2013 New York Times describing how some legislators in Washington were seriously discussing legislation to allow states to declare bankruptcy. The idea has not progressed beyond the discussion stage.
A bankruptcy provision for the states would face a difficult road to become law. There are constitutional questions and legal questions, and the public can expect strong opposition from organized labor, retirees, bondholders and service providers for the states. It is unlikely that a proposal like this would be enacted very quickly.
Bankruptcy protection, essentially, prevents a creditor from suing you to recover debts that are not being paid. Under current federal law, individuals, businesses and municipalities can file for bankruptcy. In return for not getting sued by creditors, a federal bankruptcy court can relieve you of that debt or restructure the unpaid debt to make it easier to repay as much of it as can be paid, either over time or by selling off assets.
State governments currently cannot file for bankruptcy – and do not have to – because they are granted “sovereign immunity” under the U.S. Constitution and cannot be sued for unpaid debts.
Some in Congress are pushing the idea of a state bankruptcy law because in theory bankruptcy would allow a state to renegotiate union contracts, pension agreements, the repayment of bonds and contracts with service providers like hospitals. With this power, state leaders could, in theory, reduce payments to every entity that is owed money. This is what happens when a municipality files for bankruptcy. Municipalities such as Detroit, like private corporations, are legal creations of the state and can declare bankruptcy.
But there are legal questions about this kind of proposal that would generate lengthy lawsuits: For instance, a bankruptcy law would change a state’s sovereign immunity status, so would that mean anyone could then be able to sue a state? How would a federal bankruptcy law affect the pension protections in the Illinois Constitution that were upheld in 2015 by the Illinois Supreme Court?
It’s not even a sure bet that any state would want to declare bankruptcy. No entity can be forced into bankruptcy, not even municipalities. Right now, any person, company or local government that declares bankruptcy forfeits certain rights about what they can spend to a court. It would be no different for a state. The governor of an officially bankrupt state might have to get the approval of a federal judge in order to spend any tax dollars. It’s very unlikely that a governor would want to give up that kind of broad control to a court.