Member David Guaspari writes in, asking:

It seems clear that the political classes of New York and California will continue to misgovern their states into ruin, confident that the states are too big to fail and will be bailed out by the rest of the country.

Leaving aside prudential questions, what would it mean legally for a state to go bankrupt (or whatever would be the appropriate term)?

Does there already exist a mechanism–like the bankruptcy courts for individuals and corporations–for dealing with it?

If not, what might a salutory federal law look like–some shot across the bow making it likely that bail-outs will not be forthcoming? Presumably (unfortunately) the only liability destructive officeholders face is that of being voted out of office.

Here are three questions, each of which deserves an extensive answer, which I don’t think that I can supply with sufficient fullness. But here are some hints along the way.

To David’s first question: the meaning of bankruptcy is clear. The debtor is insolvent in one or two senses.

First, its liabilities exceed its assets. Second, even if its assets exceed its liabilities, they are not liquid enough to permit payment of the debts as they accrue. California is insolvent in this second sense. It is probably insolvent in the first sense as well. Places like Illinois and New York are close to the line in both senses. At the crisis point there are only stopgap measures, like the payment of scrip, which most banks will refuse to accept as it is in reality only a form of unsecured credit that goes to the back of the queue in any bankruptcy proceedings.

Given insolvency, bankruptcy does three things. First, it marshals the assets for distribution; second, it sets the priorities for various classes of creditors; third, it offers a discharge for the bankrupt party for most of these obligations.

In general secured creditors come first and unsecured creditors get what is left over. That pattern did not hold in the GM and Chrysler bankruptcies because federal intervention from the executive branch rigged the transactions so that the union pension claims were able to push aside the secured creditors’.

That issue looms large here because the most important feature of any state bankruptcy would be to discharge the pension obligations. It is doubtful that the obligations would be completely eliminated, but they could be extensively trimmed to bring them in line with private pension funds, which is both a financial and a moral necessity. Once that is done, the rest of the process should not be nearly as complicated.

To David’s second question: there is no obvious mechanism for state bankruptcies, even if there are some procedures, I believe, for municipal bankruptcies. This is a ticklish issue because states are sovereigns and it is a frightening prospect to think that when mired in bankruptcy, they could not discharge their essential functions because they could not pay their pension obligations, among others. So the battle over the form of bankruptcy will be acute, and I have no idea how this would play out–except badly.

To David’s third question: I don’t think that full-fledged bankruptcy is a realistic prospect as of now. I think that the much more sensible approach is to side-step the bankruptcy proceedings and find ways to attack the union pension obligations directly, given their enormous size. It is odd that these days the only sacred contracts are those which the state enters into with unions for the benefit of their members.

The key question is whether it will be possible to persuade the courts that these pension agreements were the result of political self-dealing, which means that they should be set aside unless it could be shown that the state received fair value for the services rendered when it made those deals. I think that case is bold but winnable, yet only when the situation becomes truly desperate. Funding that litigation will take some bankrolling, but the corporate law analogies on self-dealing make it pretty clear that the state legislatures violated all their duties of loyalty to the public at large when they entered into deals from which union pension funds got all the upside and everyone else got the downside. Not nice. Undoing it is the work of the next generation.

Full story: What Happens When a State Goes Bankrupt? – Ricochet.com