Can States Declare Bankruptcy?

The issue of states and municipalities using the bankruptcy code has become a hotly reported topic.   The debate has emerged as states and municipalities are struggling with the burden of meeting unexpected expenses while managing a reduction in tax revenue as a result of the COVID-19 pandemic response. 

Senate Majority leader Mitch McConnell was recently quoted in an interview stating “I would be in favor of allowing states to use the bankruptcy route.”  McConnell’s statement reflects his opinion that states that have previously mismanaged their finances should be able to use bankruptcy protection to wipe out their unfunded liabilities. 

However, the idea of states being able to pursue bankruptcy protection is concerning to municipal bond holders.  If states can secure relief and restructure their debt, bond holders will likely take the hit.  The debate therefore, is can states use the bankruptcy code to restructure or eliminate their obligations?  In short, the answer is no.

When filing for bankruptcy protection, the applicant must demonstrate insolvency as defined in Title 11 of the US code.  Under that definition, a municipality is insolvent if it is either 1) generally not paying its undisputed legitimate debts, or 2) unable to pay its debts as they become due.  Because most municipalities (and all states) have the power to tax, meeting the insolvency definition is very difficult.  Beyond the difficulty of proving insolvency, states’ sovereignty proscribed in the 10th and 11th Constitutional Amendments would not permit the bankruptcy court the necessary oversight over a state in a bankruptcy proceeding.  While a state cannot declare bankruptcy under current legislation (and that is unlikely to change), that does not prevent states or local governments from defaulting on their debts. This creates both opportunities and heightened default risk in the municipal bond markets.  Broader selling may create opportunities to acquire under-priced issues, while bonds with a higher risk of issuer default should be carefully reviewed, and avoided for those seeking principal protection.