Updated: March 1, 2019
Issue: For the last several years, there have been periodic suggestions and proposals to enact a federal law that would allow financially troubled states like Illinois to declare bankruptcy in order to help balance spending and revenues.
The bankruptcy discussion stems from a 2013 New York Times describing how some legislators in Washington were seriously discussing legislation that for the first time would allow states to declare bankruptcy. The idea has not progressed beyond the discussion stage.
Theoretically, bankruptcy would allow a state to renegotiate union contracts, pension agreements, the repayment of bonds and contracts with service providers like hospitals in order to cut spending. With this power, state leaders could, in theory, reduce payments to every entity that is owed money.
This discussion intensified 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; partly because there is no law allowing a state to declare bankruptcy. And partly because bankruptcy for a state is unnecessary. Even if there was such a law, state officials say they would not use it.
Bankruptcy protection, essentially, prevents a creditor from suing you to recover debts that are not being paid. All bankruptcies are administered by the federal courts. Under current law, individuals, businesses, and in some states municipalities, can file for bankruptcy. In return for not getting sued by creditors, a 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 do not have to file for bankruptcy because they are granted “sovereign immunity” by the 11th amendment to the United States Constitution. Under the 11th amendment, no state can be sued in any federal court, including federal bankruptcy court, without its consent. No state, then, needs legal protection from a lawsuit that is not allowed by the Constitution.
There also are legal questions about a state declaring bankruptcy that would generate lengthy lawsuits: For instance, in Illinois, how would a federal bankruptcy law affect the pension protections in the state 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 federal 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.