Should American states like California and Illinois file for bankruptcy? Turns out it can be done but with a cost!

A number of the states in the USA are completely broke with little chance of paying off their debts.  California is one that reportedly has a $500 billion unfunded pension liability problem.  $500 billion is obviously more than the citizens of the state of California can pay so some have talked about the possibility of a federal bailout.  I am personally against a bailout because it will only continue the problem of overspending and unfunded pension liabilities that California can’t afford.

Numerous other states have huge debt problem often related to their unfunded pension liabilities.  Hawaii, Connecticut, and Massachusetts, Oregon and New Jersey are among the small states mentioned.  California, Illinois, and New York are the large states with huge debt problems.  One article says as many as 46 states need bankruptcy.  According to reports I’ve read Utah seems to be the best financially managed state in the union and it has little debt.

For many states it was the housing collapse that resulted in a great reduction in tax revenues that started the slide.  For other like California the unfunded pension problem has been building for years.  For states like New Jersey and Nevada, who relied on gambling taxes, times are really tough as people have slowed down on gambling because of the slow economy. But most states that are in financial trouble seem to have some level of this same unfunded pension liability problem.  A state bankruptcy would allow the bankruptcy courts to throw out these pension contracts just like with a city if the law can be changed to allow states to go bankrupt.

As I wrote in a previous blog, states are sovereign entities and they thus cannot go bankrupt.  But there is a way for California and the other states to make it happen anyway.  Congress can pass a law allowing the individual states to declare bankruptcy but the states would have to petition the Congress for such a right.  Without the petition the law won’t change and states will be stuck with their debts.

Congress passed the law that originally created chapter 9 municipal bankruptcy seventy years ago during the great depression.  Chapter 9 allowed cities and counties to file for bankruptcy protection and 600 such entities have taken advantage of this law since it was passed in the 1930s.  Presumably Congress could now authorize a whole new chapter in the bankruptcy code.  We could call it “chapter 10.”  A chapter 10 would eliminate the barriers to states filing and eliminate the “sovereign entity” problem that still exists today.

Apparently Newt Gingrich is in favor of just such a law.  Ironically it is the republicans, who are not normally bankruptcy friendly, who seem to be more in favor of just such a law.  This appears to be because the republicans do not want any state to receive a federal bailout which would impose a tax on the whole country to pay for the worst fiscally managed states.  If  states like California, Illinois and the others would file bankruptcy then a federal bailout would be unnecessary.

With a bankruptcy these states can eliminate their debts such as the unfunded pension liabilities that have plagued cities.  With a bankruptcy the state can also save its assets.  In a chapter 9 bankruptcy the law is clear that the bankruptcy court cannot interfere with the city’s day-to-day activities and the cities can even borrow money during the bankruptcy.

In a chapter 9 municipal bankruptcy the court also cannot force the city to sell any of its assets like city land or buildings.  Presumably this would apply to states’ bankruptcies too.  A state could therefore keep all of its assets during and after the bankruptcy.  As I reported in a previous blog this is because of constitutional protections like separation of powers that prevent a court from interfering with any day-to-day functioning of a city because a city is a public entity.  A public political entity like a city (or a state) simply cannot be operated or directly interfered with by a bankruptcy court.  This is made clear on the federal courts website under chapter 9 bankruptcies.

A state could presumably enjoy these protections in a chapter 10 bankruptcy just like the cities can protect their assets under chapter 9.  Bankruptcy would mean for these states that they could continue to run their affairs as usual with no interference from the bankruptcy court and they would not have to sell any assets.  They could just cancel the debts of all kinds including these pension contracts that were negotiated with the unions.  They could renegotiate new contracts that the states could afford and that were on par with what people earn in the private sector.  Bankruptcy could indeed save the states from disaster and financial ruin.

But there is a price to pay for all of this.  State bond interest rates will have to  increase to reflect the new threat that a state can go bankrupt.  There is currently no such threat as states cannot now go bankrupt so state bonds are given a very good rating.  Since bond investors will now have to risk that the state can go bankrupt and wipe out their investment, the state will have to pay a higher interest rate to attract investors.  Presumably once the law is passed allowing states to go bankrupt then any state can declare bankruptcy as often as the law allows.

I would argue that if the states don’t get this debt problem under control then the bond rates could increase anyway as they would have a greater risk of defaulting on the bonds.  The bond issue can be dealt with so the effect of a bankruptcy on state bonds will be lessened.  Bonds could be given some kind of special preference for instance.  If the states can protect the bond holders position in the bankruptcy or reaffirm (agree to pay) the bond debts then the harm to the bond market could be minimized.  Then states could still find buyers for bonds in the future when they need a new road or bridge or airport.

My advice to the states with the most debt is to strongly consider the bankruptcy option.

I am a San Diego bankruptcy attorney.  Please visit my websites at www.farquharlaw.com or www.freshstartsandiego.com.  Or call me for free with any bankruptcy or debt related question you might have at (619) 702-5015.  Call now for a free credit report and analysis!

For a free e-book: “13 THINGS YOU SHOULD DO TO PREPARE FOR YOUR BANKRUPTCY FILING” please send a request by e-mail to: farquharesq@yahoo.com.

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Will Detroit be the first major US city to file for Chapter 9 municipal bankruptcy? Bankruptcy will eliminate the pension obligations but guess who will stand in the way!

Some city in America needs to be the first to demonstrate that its okay for a city to declare bankruptcy so it can get out of debt.  A city needs to get the message out that any city who does go bankrupt will emerge from bankruptcy with not only all of its assets intact but the city will be stronger, more free from debt burdens, and more able to pay its ongoing bills for services like police, fire, schools, and sanitation.

Detroit is indicating that they may have to close half of their schools to pay for the pensions that the government has promised its public employees according to an article posted in The Blaze.  Apparently the schools are already so bad that only 25% of people graduate from high school in Detroit.  Closing up to half of these schools is going to make the situation far worse.  Detroit has also announced that there is going to be an increase in class size to over 60 kids per class.

Detroit officials have also stated that they will have to cut off  a variety of city services like  police patrols, road repairs, garbage collection, and street lights according to an article posted in Business Insider and on The Blaze.  As the author points out, this amounts to abandoning these parts of the city to drug dealers, gangs, and homeless.   The article describes the abandoned buildings that are cordoned off with barbed wire as people prowl the grounds to collect scrap metal.  The city is starting to sound like something out of an apocalyptic movie or an extremely poor third world country.  It’s certainly not now the shining city on the hill.

This is obviously an unacceptable situation for America and its time we began to look at bankruptcy for these financially hardest hit cities.  Cities like Detroit cannot pay for their unfunded pension liabilities or for any of their debts at this point.  The unfunded pension liability problem has reached a crisis level in America.  In better economic times many towns, cities, and states had signed agreements with public employee unions to provide very generous public pension benefits.  Some employees work extra hard their last year to increase their pensions even more.  Some retire with 80% to 90% of their inflated last year salary and they get this for life.  These are “defined benefit” plans.  Some public pension plans allow a divorcing spouse to also get a separate pension that springs out of the other spouse’s pension.  Needless to say these benefits don’t exist in the private sector any longer because the private sector can’t afford them.  Neither can these cities.

The costs of these pensions can amount to billions of dollars over and above what the city has to pay for them.  That is why they are unfunded.  Now is it fair that residents of these cities get their taxes raised significantly to pay public employees for pensions that the residents of the city don’t have?  Chicago did just that and its residents woke up to find that their taxes were raised 60% overnight.

As a bankruptcy attorney I help people and businesses file for bankruptcy all the time.  I see what it does for them.  It sets them free from their horrible debt load and allows them to move on with a fresh start.  A city can also file for bankruptcy under chapter 9 of the bankruptcy code.  The legal right for cities to file bankruptcy was created about 60 years ago during our last great depression.   There have been almost 600 municipal bankruptcy filings in the last 60 years including Orange County here in California along with the city of Vallejo.

A chapter 9 bankruptcy operates like a chapter 11 reorganization bankruptcy.  That means that there is no liquidation of assets or shutting down of operations like in a Chapter 7 but there is instead a reorganization of finances and a re-negotiation of existing contracts.  The re-writing of contracts is just what these cities need.

The big advantage to a Chapter 9 bankruptcy reorganization (over a chapter 11 for businesses) for a city like Detroit is that the collective bargaining agreements can be re-written or thrown out altogether in the bankruptcy.  Collective bargaining is the process whereby unions representatives and representatives of a city sit down and negotiate labor conditions like pay and pensions.  When the two sides reach an agreement a binding contract is formed between the two parties.  Cities can break these contracts in bankruptcy.

A Wall Street Journal article talks about the financial crisis in Harrisburg Penn.  The city cannot afford to pay its bills just like Detroit and those in power are considering bankruptcy.  Some legislators are resisting though and some are calling for selling city assets.  I often tell my clients not to do anything with their assets until they look at bankruptcy.  City assets are exempt in a Chapter 9 bankruptcy which means that the city can keep them and no bankruptcy judge can force the city to sell its city property like buildings or land.

This is important for Harrisburg politicians to understand before they begin to sell city assets merely to avoid the stigma of a bankruptcy.  The city may need and want to keep those assets going forward into the future.  A city official, I believe, is obligated to do what is in the best interest of the city and it seems that if a city can keep assets by filing bankruptcy then that avenue needs to be considered.  If some city officials resist even considering bankruptcy protection then I would ask who are they working for?

Could it be that they are working on behalf of public unions who contribute to their campaigns?  These unions will be the big losers in the bankruptcy as they will be forced to settle for smaller pay and pension contracts.  They stand to lose the most if cities file for bankruptcy.

On the US Courts website there is a page describing chapter 9 bankruptcies.  In this section the Court goes to great lengths to emphasize that the Court’s powers are limited in a Chapter 9 bankruptcy.  The Court’s powers are limited in their ability to interfere in any way with a city which chooses to file for bankruptcy.  This is because a city is a public entity and thus a city not like a private business or individual who may go bankrupt.  There are constitutional considerations here relating to issues like separation of powers that restrict a bankruptcy court from interfering with a bankrupt city’s daily functioning in any way.

The bankruptcy court cannot do certain things in a municipal bankruptcy such as they “cannot interfere with any political or governmental powers of the debtor”, or “any property or revenues of the debtor” or “the debtor’s use and enjoyment of any income producing property of the debtor”.  They go on to say that the day-to-day activities of the debtor are not subject to court approval and the debtor may even borrow money while in bankruptcy and that the court cannot appoint a trustee or move for liquidation.

As the Court says “the municipal debtor has broad powers to use its property, raise taxes, and make expenditures as it sees fit”.  Also they point out that the debtor (the city) can “reject collective bargaining agreements and retirement benefit plans” and the city can do this without going through any of the usual procedures of a chapter 11.  In short the can eliminate these collective bargaining agreements quickly and efficiently and free the city from these unpayable burdens without disrupting city services, assets, or activities at all.  The way seems clear for any city who can’t pay for these pensions to get out of them now and cities don’t need to sell any assets in a bankruptcy and no court can force them to.

What this means is that the city/municipality has far more rights in a chapter 9 than you or your business would in a chapter 7 or 13 bankruptcy.  The city can continue to operate as before with no interference from the court and they can borrow money and not be forced to sell assets.  You and I would have our assets sold in a personal bankruptcy if they exceeded the allowable exemptions but the Court has limited powers over a city in a chapter 9 because of the constitutional protections cities enjoy.  This amounts to an extreme advantage to a city in a chapter 9 bankruptcy.  The ball is really in their court.  So much so that I wonder why there are not more of them filing as it is a clear way out of the unfunded pension liability predicament.

There will be losers though and there is the problem.  The public service unions and their employees will lose their cushy contracts with these guaranteed pensions.  They are not going to like this at all and they will undoubtably flex their political muscle.  The city official in the Harrisburg Penn. case has probably already heard from his union backers who have probably told him to resist bankruptcy and sell assets instead so the unions can get their member’s pensions.

I would ask though if the city officials work for the people of the city or for the unions.  I think it’s the residents of these broke cities that need to demand that their politicians save their basic city services and their city property by filing bankruptcy and getting rid of these unpayable obligations.  What they will get is freedom, a fresh start, and a functioning city.

Detroit can show the rest of America the way home.  They should not shut their schools or discontinue police or fire protection to their residents.  Nor should they sell any city assets because they can keep them in a bankruptcy.  They should file for chapter 9 bankruptcy and eliminate their employee union benefits and save the city.  They can be the first one out of the gate and show others that it can work.  I expect number of cities will follow Detroit once bankruptcy has worked give freedom to the residents of Detroit.

I am a San Diego bankruptcy attorney.  Please visit my website at www.farquharlaw.com or www.freshstartsandiego.com.  Or call my office for a free consultation at (619) 702-5015.  Call now for free credit report and analysis! 

For a free e-book: “13 THINGS YOU SHOULD DO TO PREPARE FOR YOUR BANKRUPTCY FILING” please send a request by e-mail to: farquharesq@yahoo.com.