Can U.S. States Declare Bankruptcy?

Understanding the complexities of financial distress in the United States, one might wonder whether states have the option to declare bankruptcy. While the traditional perception is that states cannot declare bankruptcy, the reality is more nuanced. This article delves into the specifics of state financial crises, the legal framework, and the implications of controlled restructuring processes.

Legal Framework and Distinction

States in the United States are not eligible to declare bankruptcy under the Bankruptcy Code. To explore why, let's break down the legal distinctions and implications.

Stripping it down to its essence, states cannot declare bankruptcy. They do not fit the legal definition of “person” as outlined in the Bankruptcy Code. Specifically, states are not considered “persons” under 11 U.S.C. sec. 101 et seq.. As a result, they cannot file for bankruptcy relief under Chapters 7 or 11, which are primarily designed for individuals and businesses.

However, municipalities, public agencies, and political subdivisions of states can declare bankruptcy under Title 9 of the Bankruptcy Code. This provision allows these entities to seek relief when they face financial distress.

Historical Context and Specific Cases

Historically, there have been notable instances where state capitals faced severe financial troubles. One such case is New York City in the 1970s. During this period, the city resorted to creating a phony commission to sell worthless bonds, leading to a bail-out. This situation was unprecedented, as no private entity could have achieved the same outcome without filing for bankruptcy.

Further complications arose when Puerto Rico, a non-state entity, sought bankruptcy protection. The issue was whether Puerto Rico could legally declare bankruptcy under the current framework. The complexities of Puerto Rico's status led to the development of unique legal pathways, such as Chapter 9 of the Bankruptcy Code, which was designed for municipalities but applied to Puerto Rico.

Governance During Restructuring

When a state faces extreme financial distress, the restructuring process involves significant changes in governance. Under Chapter 9 proceedings, the governor and the general assembly are typically stripped of their powers. A federal arbitrator is appointed to oversee the state's efforts to restructure its finances. During this period, no new laws can be passed, and existing laws, taxes, and bills must be approved by registered voters of the state.

This process can last for up to seven years. If the state cannot rectify its financial situation, the debt is forgiven. This transition marks a shift from a representative democratic republic to a form of direct democracy, where all changes must be ratified by the voting public.

Conclusion

While U.S. states cannot declare bankruptcy, municipalities and other public entities can seek relief under Chapter 9 of the Bankruptcy Code. This legal framework plays a crucial role in managing financial distress at the local level, ensuring that states and cities can navigate through financial crises without altogether halting governance but with significant restrictions.