Suggestions states and cities can file for bankruptcy bring up constitutional questions

Suggestions in Washington D.C. that states can file for bankruptcy rather than depend on American taxpayers to bail them out of their financial messes would require a change to federal law that would almost certainly get hung up on constitutional grounds, according to bankruptcy experts.

The legal disputes involve the question: If a state cannot make good on its financial obligations, should that loss be paid by taxpayers nationwide or should it be born by municipal bond holders who have financed the state?

On Wednesday, U.S. Senate Majority Leader Mitch McConnell, R-Kentucky, said federal taxpayers should not be paying for financial obligations of the states and cities while they can reorganize under Chapter 9, such as the city of Detroit did.

But under Chapter 9, states cannot seek bankruptcy remedies, and any constitutional amendment would create issues with the contract clause of the Constitution, attorneys said.

"If you talked to 100 bankruptcy lawyers, they would say the law has to change," said Marc Levinson, senior counsel at Orrick Herrington & Sutcliffe LLP, who handled an insolvency case for the city of Vallejo.

Even if the case proceeds on eligibility challenges, states cannot afford to be in financial and legal limbo for two or three years, said Levinson. Hypothetically, the prospect of a state the size of California falling into bankruptcy is enormous.

"If you took PG&E and multiplied it by 10,000 or more that's what you have with the state of California," he said.

UCLA School of Law professor Kenneth N. Klee, who studies state and federal bankruptcy law, said one option could be an equity receivership, a Depression-era mechanism in which the federal government took control of the ailing railroad industry to restructure its debts.

Kenneth N. Klee

"There is some precedent for this but because of sovereignty issues with the Supreme Court, there is a question whether a statute could constitutionally provide it," said Klee. "I think it can, but I'm probably in the minority. I don't think the Constitution is inflexible enough to have no remedy whatsoever when you have an insolvent state," he said. Northern Pacific Ry. Co. v. Boyd, 228 U.S. 482 (1913).

Cities are a different story and have more restructuring remedies. Vigilant city financial planners are already scrambling with fiscal year budgets starting July 1.

"Cities ought to be concerned like small businesses. This is a nightmare," Levinson said.

Now financial planners will be eying legacy costs, such as health care and pensions, which are not as stable as six months ago, according to Levinson. Revenue is also down, and overtime costs for emergency responders due to the coronavirus adds up.

Paul R. Glassman, who handles mostly debtor-side bankruptcy proceedings, said the likelihood of municipal bankruptcy have risen as costs have increased and revenues have declined. But first entities are hanging back to see budget impacts and what aid they might get.

"Some of the impact might take a little longer because the revenues of cities are based upon property taxes while sales taxes and hotel occupancy revenues fall faster," said Glassman, a shareholder at Stradling Yocca Carlson & Rauth PC who helped restructure the city of San Bernardino.

Of nine governmental entities across the country that filed for bankruptcy over the past 25 years, six were from California, according to figures by Stradling Yocca.

San Bernardino, Stockton and Vallejo had systemic issues tied to bond debt, rising pensions and labor contracts. Pensions, which are fixed and a harder burden for governments to tackle, was an issue during bankruptcy proceedings for Stockton, but retired employees got to keep their payments in the end.

Single altering events, such as high judgments, led Desert Hot Springs and Mammoth Lakes to file for protections. Orange County, which filed for bankruptcy in the 1990s, dissolved due to a treasurer betting on derivatives. Outside of California, Detroit had pension problems while Puerto Rico faced legal hurdles because it was a territory. Out of Puerto Rico came a special federal law in 2016 called Puerto Rico Oversight, Management, and Economic Stability Act, which allowed the territory to restructure its debt.

Chapter 9 filings are not permitted by every state. California permits cities to file but imposes limitations known as "gatekeeper requirements."

"It depends on what the legislation looks like. Right now under the current legislation that permits cities to file, the state in which the city is located must opt into the Chapter 9 system to permit a filing," Glassman said.

It's still early. Meanwhile, Levinson has a mantra: "Bankruptcy is the worst option until it is the only option."