State Default and Synthetic Bankruptcy

By Hynes, Richard M. | Washington Law Review, October 2012 | Go to article overview

State Default and Synthetic Bankruptcy


Hynes, Richard M., Washington Law Review


Abstract: An insolvent state does not need bankruptcy if sovereign immunity would protect it from lawsuits and other collection efforts. To the extent that a state is not judgmentproof and needs bankruptcy, we may not need to modify the Federal Bankruptcy Code to allow it to file. First, a substantial share of state spending flows through their municipalities, and these municipalities have substantial obligations of their own. Unlike states, municipalities can file for bankruptcy under current law, and a state could substantially reduce the cost of accomplishing its own fiscal goals by forcing its municipalities to file. Second, states may be able to create their own synthetic "bankruptcy" mechanisms, or bankruptcy without the federal code. State obligations are creatures of state law; states do not need a federal bankruptcy discharge. Federal law would not preempt a state composition mechanism used to adjust these debts, and any adjustment that would have been confirmed by a bankruptcy court would likely survive a Contract Clause challenge as well. Even if a state does not enact a composition mechanism, it could capture most of the benefits of federal bankruptcy by directly altering the rights of its creditors. A synthetic bankruptcy mechanism created by a state would not precisely replicate a federal bankruptcy chapter for states. Perhaps the best argument for federal bankruptcy is that it could operate with significantly lower transactions costs. In a world without omniscient judges, however, transactions costs can actually increase welfare by enhancing the ability of a state to make credible commitments.

INTRODUCTION 658

I. THE NATURE OF A STATE'S FISCAL CRISIS SHOULD DICTATE THE STRUCTURE OF THE RESOLUTION MECHANISM .................662

A. States and Their Municipalities Resemble Complex Holding Companies ..................663

B. Debt Service Payments Do Not Account for a Large Share of State Budgets ..............665

C. Pension Obligations Constitute a Substantial Burden on States ...................668

II. NON-BANKRUPTCY LAW MAY PREVENT THE ENFORCEMENT OF STATE OBLIGATIONS ...............671

A. Sovereign Immunity May Prevent Creditors from Suing a State ................675

B. State Laws Amending Creditor Rights May Survive a Contract Clause Challenge ..............680

III. AN INSOLVENT STATE COULD USE BANKRUPTCY UNDER EXISTING LAW ............683

A. States Can Use Municipal Bankruptcy to Reduce Expenses .................683

B. States Can Create Synthetic Bankruptcy - Bankruptcy Without the Code ................686

IV. SYNTHETIC BANKRUPTCY MAY BE A GOOD SUBSTITUTE FOR FEDERAL BANKRUPTCY ................690

A. Minimalist Bankruptcy Is Likely to Be Either Unnecessary or Insufficient ....................690

B. Federal Bankruptcy May Offer No Real Advantages Over Synthetic Bankruptcy ...................694

1. The Contractarian Argument for Synthetic Bankruptcy ...............695

2. Federal Bankruptcy and the Allocation of Power ............698

3. The Role of Transactions Costs ..............703

CONCLUSION ...............704

INTRODUCTION

Some scholars and politicians have called for a change in law1 that would allow states to file for bankruptcy under the federal code.2 At the moment, states don't need bankruptcy protection. States have relatively little debt, at least if we define debt narrowly to mean liabilities owed to capital markets.3 More importantly, if a state truly wants to default, there may be very little that its creditors can do to force the state to pay. The Eleventh Amendment prevents nearly all creditors from suing a state in federal court without the state's consent, and sovereign immunity allows the state to prevent most creditors from suing in state court as well.4 Even if a state's creditors do manage to sue, existing Contract Clause doctrine allows a state to use its financial distress to excuse its nonperformance. …

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