American States Are Already Free To Seek Shelter In Bankruptcy Court

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Blue State governors are up in arms about the prospects that the corona pandemic and their own mismanagement might force their states into bankruptcy. The political optics of their longstanding fiscal failures could be exposed, as well as their coddling of public-employee unions. They are going to have a hard time, though, arguing that there is a constitutional bar against Congress permitting states to declare bankruptcy.

Constitutional objections raised to the notion of a federal bankruptcy option for states largely emanate from those who feed off the taxpayers and who thought there to be a constitutional right to an unlimited state and local tax deduction on federal returns. That had long allowed such mismanaged states as New York to offload a significant portion of their state and local tax burdens to the taxpayers of fiscally conservative, low tax states.

The Eleventh Amendment, applied by the federal judiciary in a manner almost entirely divorced from anything resembling its literal text, provides that states cannot be involuntarily sued in federal court. Never mind that exceptions exist, such as those vindicating Fourteenth Amendment rights and others that may be provided under federal statutory law by Congress when certain conditions are met.

The Eleventh Amendment does not bar states from bringing suits in federal court or consenting to being sued in federal court. At most, the Eleventh Amendment would prevent nothing more than actions seeking to involuntarily force states into bankruptcy. No constitutional rationale exists under the Eleventh Amendment preventing states from voluntarily seeking federal bankruptcy protection, and it might well be the best option for a number of them.

The Constitution’s “contract clause,” in Article I, Section 10, does bar states from impairing contracts and has therefore been held to prevent states from enacting their own state bankruptcy statutes. Yet it hasn’t barred municipal bankruptcies under current federal bankruptcy law. The Constitution recognizes only “states,” not cities, towns, counties, municipalities, etc., which are deemed political subdivisions, or creations, of the states in which they are located.

In one famous case, Trenton v. New Jersey, the Supreme Court in 1923 concluded that a “municipality is merely a department of the State” and that the state “may withhold, grant or withdraw powers and privileges as it sees fit.” A municipality wishing to seek federal bankruptcy protection under Chapter 9 must first seek authorization to do so from the state that created it.

If a municipal bankruptcy does not violate the Contract Clause, it is difficult to see how or why a state bankruptcy would, particularly since a state would be “impairing contracts” entered into by a municipal entity it created when authorizing a bankruptcy filing by the municipality. If a “state” can create a “municipality” having the ability to declare bankruptcy in a federal court what logic would deny the state that created the “municipality” the right that it granted the political subdivision it created.

There is also Puerto Rico. The bankruptcy code’s definition of “state” has been held to include Puerto Rico’s unincorporated territory. While Congress did not formally amend the bankruptcy law in respect of Puerto Rico, it did in 2016 create an “oversight board” to reorganize Puerto Rico’s debt obligations without apparent constitutional objection.

It might be too cute for a state to declare itself one big “municipality” coextensive with the “state” and authorize itself to file for bankruptcy under Chapter Nine of the existing federal bankruptcy law. No constitutional basis obtains, though, that would bar a state from voluntarily seeking federal bankruptcy protection when it is constitutionally empowered to create an entity that can seek bankruptcy with the state’s authorization.

This is good news for the Senate majority leader, Mitch McConnell, who started this whole brouhaha by suggesting that some states might go the bankruptcy route. For it means that objections to Congress passing legislation permitting states to voluntarily seek bankruptcy protection are political, not constitutional, Governor Andrew Cuomo’s objections to federal enactment of state bankruptcy provisions notwithstanding.

Such provisions, after all, would not compel New York to seek bankruptcy protection. Rather, they would allow New York the option of voiding its existing contracts, thereby allowing the state to properly restructure its labor agreements and pension obligations. If done without reneging on bond obligations, such a strategy would permit New York to rectify its structural budgetary problems, enhance its appropriate access to credit markets, and again make New York economically competitive.


Mr. Schindler is a patent attorney based on Long Island, New York.

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