Opening Bankruptcy Court to the States

Imagine a time a year or two into the future. A large American state has reached the limit of its ability to raise taxes and cut spending. It then is unable to roll over its debt. It defaults.

Imagine also that a hedge fund has bought a good deal of that debt in the distressed debt markets. It puts all that debt in a newly formed limited liability company, or L.L.C., and when the state in question defaults on the debt, the L.L.C. files a Chapter 11 petition.

And then the debtor (the L.L.C.) seeks to enforce that debt, as it is the only asset in the debtor’s bankruptcy estate.

“Impossible!” you say, since states enjoy sovereign immunity. Well, outside of bankruptcy they do. But in 2006, the Supreme Court held that the Bankruptcy Clause to the Constitution represents an exception to the normal rule of sovereign immunity. So maybe this little scheme might work, at least if the L.L.C. were given a few other assets to make the scheme a little less obvious.

This possibility raises the question of whether we should amend the Federal Bankruptcy Code to allow states to file for relief under Chapter 9, like municipalities, counties and other subsidiary governmental entities can already do. Even if states never filed under Chapter 9, such an amendment might be a good idea for a few reasons.

In particular, the threat of a bankruptcy filing might help states overcome holdout problems of two kinds. First, if like Argentina in the prior decade, the states find it difficult to get some minority bondholders to agree to a reasonable restructuring deal, the threat of imposing the deal via bankruptcy might be useful. Second, the same sort of threat might make negotiations with unions and other long-term creditors a bit more balanced.

What’s the downside? For a Constitutional purist, the notion of a state submitting itself to the jurisdiction of a federal bankruptcy court seems wrong, for reasons that I have found are often hard to articulate. If the process is voluntary — as Chapter 9 currently is — there does not seem to be a 10th Amendment problem involving the powers reserved to the states. And the Supreme Court has taken care of the 11th Amendment regarding suits against states.

via Opening Bankruptcy Court to the States.

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