Can U.S. States Declare Bankruptcy?

Almost all U.S. states are legally required to balance their budgets, which means they may be forced to cut spending on vital services and possibly slow the economic recovery out of the COVID19 pandemic.

The National Governors Association has asked Congress for $500 billion in direct aid after receiving $150 billion in the $2.1 trillion CARES Act. They are also asking for flexibility to use funds received not just on COVID-19 related expenses, as was stipulated in the third stimulus package. The Center on Budget and Policy Priorities projects states' shortfall could be over $500 billion and concentrated in fiscal year 2021, which begins in October.

3 Things Needed Before States Can Declare Bankruptcy

Bankruptcy in the U.S. is governed by federal law and handled in federal courts. States are not allowed to declare it as per the U.S. Bankruptcy Code. Changes to the bankruptcy code would require Congress to pass legislation. It was recently tweaked with the CARES Act to provide relief to businesses and individuals. However, changing the rules for states to go through Chapter 9 proceedings would be an extremely difficult challenge for Republicans concerned about the national debt ballooning.

States declaring bankruptcy would also go against the U.S. Constitution, said the Council of State Governments. According to the contracts clause (Article 1 Section 10) states are barred from "impairing the obligation of contracts." The U.S Supreme Court in 1977 interpreted this as "a state cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money to promote the public good rather than the private welfare of its creditors."

"Thus, even if Congress were to pass a law allowing states to declare bankruptcy, such an action would likely face a contracts clause challenge," said Heather Poole, an analyst at the Office of Legislative Research, Connecticut General Assembly.

But there's a third key requirement. States have sovereign rights and would have to consent to participate. Even if they agreed, it wouldn't work, according to Bruce Markell, a Northwestern University law professor and former U.S. bankruptcy judge. He told Bloomberg Law, that because a state is sovereign, you can't have a federal oversight board overseeing the restructuring. "How can you have independent review of government financial decisions?" asked Markell. "It’s all political—where do you raise taxes or force concessions by creditor blocks, consisting primarily of bondholders, pension plans, and labor contracts?"