Bankruptcy for the States: Back In Time to Help Your State Steal Your Salary, Benefits, and Pension.

By: Brett Redmayne-Titley


The threat of the federal government providing State bankruptcy protections has disappeared from the news since it first surfaced, to much republican applause, six months ago. This is an ominous silence.


The fiscal crises most states are experiencing will necessitate their need to use bankruptcy protection.  All State employees, or employees whose jobs or pensions exist per contracts with the State, should be alarmed because State bankruptcy protections will suddenly, if not overnight, take away your contractual rights. Chapter 9 bankruptcy protection is currently available only to municipalities. If Chapter 9 is applied to the states it will mean the reduction of any expected pension benefits for current employees and retired former employees. Contracts with current employees and with sub-contractors to the States will also be under the control of the court and likely dramatically reduced.


It has been a quiet four months since the idea of allowing the States to declare bankruptcy re-submerged.  Spawned by David Skeel in an op-ed piece in The Weekly Standard the possibility of allowing the States to further financially assault their employees via bankruptcy was immediately seized upon by congressional legislators like Newt Gingrich. “We’re faced with the danger that the states are going to try to show up and say to Washington: You have to give us money,” Gingrich said. “And I think we have to have an alternative that allows us to say no.” From October 2010 to February 2011 the States bankruptcy proposal was warmly received by the Republican side of the aisle.


Then just as suddenly this bankruptcy issue disappeared from the press.  Small follow-up articles were to be found only on the back pages of selected newspapers.  Ignore this silence at your own peril.


Congress will certainly provide State bankruptcy legislation for two reasons; Congress has its own staggering financial problems and to avoid state bail-outs has no choice but to offer this option to the States and; the states will have no choice but to use it.


Federally August 2 is looming.  Using the recent budget crisis of 2010 and its last minute back door rendition of a budget as a working example it is obvious that Congress and the administration will use exigent circumstances as the convenient excuse to do as it pleases in whatever last-minute negotiations ultimately produce a budget.  Funding for the states is a significant portion of the federal budget. Already several states have requested emergency funds over the last year. California Governor Arnold Schwarzenegger requested $7 billion in emergency federal assistance.  With virtually all the remaining states in various degrees of financial difficulty, and having little recourse, they will certainly attempt to continue to turn to the federal government for additional funds.  Obviously the federal budget could use cutting its losses with the states.


State’s bankruptcy would appear to be an easy decision for Congress. The federal budget is already technically bankrupt and certainly is facing catastrophic budget cuts. This combined with the current “Tea Party” excuses of limited government will provide ample reason for Congress to quickly push Chapter 9 bankruptcy to the presidential pen in short order. The administration will certainly put a good face on this by stating that the use of bankruptcy by the States will at their election only.  This is, they will say, a measure to be used “just in case”.


As economic and financial circumstances force the States closer to insolvency, many like California, and this week Minnesota, will have no choice but to look at draconian measures to alleviate their budget shortfalls.  Despite denials that the States would be interested in bankruptcy the facts indicate that States bankruptcy protection under Chapter 9 of the Federal Bankruptcy Code will be warmly received.


Chapter 9 protections exist but are only available to cities and counties; not the states. Orange County California declared bankruptcy in 1994 due to staggering losses to its pension fund caused by their comptroller who, subsequently went to prison .Most recently, Vallejo Calif. declared bankruptcy in 2008 and Harrisburg, PA has recently announced its plans to use Chapter 9.


Many states are in a worse financial situation than the Federal government. With huge annual deficits compounding yearly and little ability to procure new funding via bond issues that now have inferior bond ratings spending cuts and tax increases are the only options. Indeed, each State will soon face its own “Aug 2” financial fate. Chapter 9 bankruptcy immediately cures these problems.


Bankruptcy by its nature can also be a threat, a very strong message or severe clout in getting the cooperation of stubborn unions and employees.  As pointed out by David Skeel the threat alone may be enough to benefit the state financially since this threat may allow for more financially beneficial negotiations because actual bankruptcy will be more severe than the negotiations themselves. “The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees.” writes Skeel. “Ideally”, he continues, “bondholders would vote to approve a restructuring. But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be “crammed down” over their objections under certain circumstances”


New York City in 1975 used the threat of bankruptcy to force tough negotiations that lead to NYC’s financial recovery. In his op-ed in the Wall Street Journal, Jonathan Henes, sums up the weight of Chapter 9. “New York City avoided bankruptcy because it had the option to file for bankruptcy”, he said .This will certainly be in the mind of the Congress.


The States have the need to maintain their lack of interest in bankruptcy.  In preparation for their upcoming bankruptcy many state treasurer’s including California, cited various reasons, that they would “never” use bankruptcy.  A quick examination of their actual financial circumstances indicates that the states will have no choice.  In turn, they have no choice but to deny their interest in bankruptcy because any admission amounts to their acknowledgment that they intend to cheat their current employees, pension holders, and bondholders.  This acknowledgment would likely result in employees taking steps to liquidate their pension funds and cause the State bond market to be useless in garnering further capital. However, considering the huge gains for each state, via chapter 9, pensioners and bond holders will be of little concern.


California, and this week Minnesota, are prime examples of states in dire financial straits.  Already California’s annual budget deficit is $25.4 billion, and despite Jerry Brown’s budget cuts there remains a huge budget gap that will again continue over into next years budget discussions, which in turn will again mean additional draconian cuts.  Like all states, California’s biggest fiscal problems are current state employee pension obligations, future pension obligations, employee’s salaries and benefits, and payment of State Obligation Bonds. Additionally, state employee unions involved in previous negotiations have rarely been perceived by state governments as helping the problem.  Yet all this and other fiscal problems are substantially reduced once the state declares bankruptcy. All fiscal obligations of a contractual nature are immediately negated and up to potential complete revision per the court. Considering these financial savings, and the opportunity to finally “put the unions in their place”, State Governors and Treasurers will find all this much too tempting to resist.


As noted by University of Chicago and Northwestern University study (subsequently certified by Stanford University) California pension fund obligations are, despite denials, likely to exceed $500 billion.  These obligations are contractual, but will be subject to drastic revisions and reductions under bankruptcy protection.


Regarding bond obligations; California’s current General Obligation Bonds exceed $70 billion.  Bonds, like pension funds, also become under the jurisdiction of the court when placed under the protection of chapter 9 bankruptcy.  As such the bondholders can expect a fraction of the promised return on their investment. Jonathan Henes correctly points out, “The biggest surprise may await the holders of a state’s general obligation bonds. Though widely considered the strongest credit of any government, they can be treated as unsecured credits, subject to reduction, under Chapter 9.”


All state employee contracts, whether with the state employees themselves or for state contractors and their employees will also be subject to the control of the courts.  The contracts will be effectively void and subject to court mandated alterations.  These will include many benefits and savings to the state by way of reduced salaries, reduced benefits, and, again, reduced pension obligations.


As for the unions; they get a sideline seat.  The court’s main interest i.e., restructuring the state back to solvency will have little concern for the dictates of the unions. The right to collective bargaining will go the way of Wisconsin as contracts are reconstituted by the courts without a voice from the unions.


Bankruptcy is literally effective upon the moment it is filed with the Federal bankruptcy courts. “The automatic stay of section 362 of the Bankruptcy Code is applicable in chapter 9 cases”. 11 U.S.C. §§ 362(a), 901(a). “The stay operates to stop all collection actions against the debtor and its property upon the filing of the petition.”  At that exact moment in time when the application is filed with the court clerk the court, not the State, is now in charge approving and renegotiating all terms and conditions of State fiscal matters, with the goal achieving solvency for the state.


And renegotiate it will. All state contractual obligations will now be under the jurisdiction of the court.  Since the mandate of Chapter 9 bankruptcy is to achieve solvency the court will look at all avenues, including restructuring contractual obligations. These will include drastic cuts in pension funds, bondholder obligations, and current state contracts.  Not just with employees, but with subcontractors as well.  With the need for the states to cut large percentages of their annual budgets in order to achieve solvency, the courts will affect drastic cuts in these areas.  If you are a pension holder, bondholder, or employee per state contract the terms of bankruptcy means that you have lost a significant fraction of your income and/or benefits.


For frustrated Governors, State Treasurers and state legislators, this will all seem too good to be true.


The federal government will certainly provide bankruptcy protection via Chapter 9 as an option to the states.  This will likely, just like this past February, cause immediate concern, and possibly panic. By then it will be too late. Each state will be forced to incur its own “AUG 2” moment with ideological partisan fighting masked in tax increases and spending cut arguments leading to the type of civil unrest we now see occurring in Greece. Public employees will be sitting on the sidelines while the remaining legacy of un-kept state promises is dissected before their eyes. It is a safe bet that, as sure as States Bankruptcy is coming, you and all state workers will not be happy with the result.






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