State governments may not seek protection under federal bankruptcy laws. The Constitution grants Congress in its enumerated powers the power to pass bankruptcy laws, which indicates an intention for the federal government to preempt states on the issue of bankruptcy (rather like patent and copyright law). Throughout the Union, state governments from California to Illinois — whatever the legal definition of bankruptcy might be under the U.S. Constitution and under federal statutes — are virtually bankrupt. The congressional response may be a new bankruptcy law which will allow state governments to seek relief as a bankrupt debtor.

Should Congress pass a bankruptcy law which would allow state governments to seek bankruptcy relief? Can Congress pass such a bankruptcy law? State governments are intended to be sovereign. States are not mere instrumentalities of the federal government. The Constitution places extraordinary power in state governments, particularly state legislatures. These bodies, at least when the Constitution was adopted, picked all U.S. senators, chose how presidential electors were selected, determined the districts of House members, and — alone — had the power to ratify constitutional amendments.

As an exclamation point to these state powers, the Tenth Amendment of the Bill of Rights provided that powers not clearly given to the federal government were reserved to the states or to the people. Less noticed, but certainly relevant, is the first amendment passed after the Bill of Rights, the Eleventh Amendment. The language of this amendment, like all constitutional language, is terse and clear:

The Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State.

State governments cannot be hauled into federal courts except, implicitly, by citizens of the state sued. Bankruptcy courts are federal courts. The practical insolvency of many states is tied to instruments of debt executed by the states and held by citizens of other states or of foreign governments. The Eleventh Amendment has also been interpreted in an 1890 case, Hans v. Louisiana, to provide state governments with sovereign immunity even to lawsuits brought in federal court by citizens of the state being sued. Sovereign immunity — the immunity of a sovereign government from being sued against its will — is part of our system of government.

Bankruptcy laws carry with them an inherent surrender of sovereignty. Consider, for example, if a federal bankruptcy law were passed that allowed state governments to declare bankruptcy — imagine the ramifications if California sought relief under that law. Could California pursue the traditional “straight bankruptcy,” in which a petitioner has all his debts discharged and any non-exempt assets that he owns are used to pay a portion of outstanding debts? That would mean sovereign states denying their duty to repay bondholders, and our constitutional system assumes that the legal obligations of sovereigns are a promise which must be honored. Which assets of the state could be considered “exempt” from this new bankruptcy law and which assets would be non-exempt? Land is the greatest asset of many states, so could a bankruptcy judge compel states to deed its lands to the bankruptcy court, which would then sell it to the highest bidder?

The type of bankruptcy intended under any new federal law would almost certainly be of the “reorganization” type, in which a federal bankruptcy judge works with the debtor and with creditors to devise a plan for paying most or all of the debts through a restructuring of the debtor’s operations. That sounds harmless enough on the surface, until we consider what that really means. A federal judge would dictate to constitutional, elected officers of a sovereign state how they must spend their money and operate their “business.” 

Ponder that. Might the federal judge order state legislators to raise the state income tax rates by five percent? Or might he direct the state to enact a new type of use tax on its citizens? Would federal law clerks review the state budget and recommend to the federal bankruptcy judge which items of the budget were excessive and which items were not? Who could seek bankruptcy relief? The state’s governor? The state legislature? The state attorney general? The state comptroller? What if these parties disagreed? Who would ultimately decide the proper parts of state government to seek bankruptcy relief? The final determiner of proper parties to an action would have to be the federal bankruptcy court itself.

Would a federal bankruptcy law that allowed states to declare bankruptcy also allow creditors of a state to force the state into involuntary bankruptcy? Where is the boundary between what creditors and federal bankruptcy judges can do and what rights the states retain as sovereign polities? Federal judges already order state officers to undertake actions which many people believe exceed any federal power under the Constitution, such as the busing of school children to achieve de facto desegregation. This legacy does not indicate an inhibited federal bench. If federal judges gain the power to “reorganize” state finances, then history suggests that these judges will use the fullest extent of those powers.

The practical argument for allowing state governments to seek relief from bankruptcy courts is that these courts can grant governors and state legislatures leverage in dealing with public employees unions and gaping holes in public retirement systems. Past deals with public employees, which often provided the support necessary to elect politicians at the state government level, would be trimmed down to meet the actual resources of these states. The danger of default could be finessed. Paul Maco, former head of the Securities and Exchange Commission’s Office of Municipal Securities, warns: “All of a sudden, there’s a whole new risk factor.” Default would certainly make it very hard to sell instruments of debt to investors, and the interest rates on those bonds would be much higher — creating a new burden on taxpayers.

Public employees unions are also showing their teeth. Charles Loveless, Legislative Director of AFSCME (American Federation of State, County and Municipal Employees), says: “They are readying a massive assault on us. We’re taking this very seriously.” These unions will put political pressure on members of Congress as well as state governments. Individual unions may also engage in strikes which threaten garbage collection, water line maintenance, and emergency response services. Any federal bankruptcy law which allowed state governments to seek reorganization would also face constitutional challenges in federal courts, probably initiated by the very public employees unions which states are seeking to constrain. The outcome of that litigation could take years. 

The issue of a sovereign government reaching the point of inability to pay its obligations is not unique to the United States. Ireland, as noted, has begun to simply print euros, an action which appears to be technically within the European Union Treaty. But that action, like the pending default of state governments, threatens to undermine confidence in governments of the modern industrial nations to meet basic obligations. Whatever the temporary fix for this issue, the long prognosis seems bleak.

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Richard Robinson said:

Just What the FRB Ordered Imagine. Bailing out entire states and then the Feds own them as well. Maybe people should watch this, http://topdocumentaryfilms.com/american-dream/. A little gruff but if you're mad and what's destroying America, you won't mind.

January 21, 2011