Why Bankruptcy in Illinois Might Not Turn Out the Way You Think


A state hasn’t gone bankrupt since the Great Depression. The specter of a new economic depression has revived the once far-fetched idea. Illinois’ tough financial situation makes it a prime candidate, but how would that work?

Public sector bankruptcies are rare, recently taking over cities like Detroit or the US territory of Puerto Rico, but more likely to involve small-scale water or sewer districts. Now entire states are under discussion, their budgets ravaged by $4 trillion in underfunded pension obligations and plummeting revenues triggered by the coronavirus pandemic.

Senate Majority Leader Mitch McConnell has angered bipartisan governors, including JB Pritzker of Illinois, by suggesting states consider bankruptcy instead of federal bailouts. Bankruptcy would allow states to restructure their debts, but it could also jeopardize spending on social services and public safety.

While bankruptcy is often touted as the quickest and cleanest way to take control of Illinois’ towering retirement obligations, a filing would more likely threaten everyday state contractors, with the ironic ripple effect of potentially pushing some into insolvency.

Chief among them would be safety net hospitals dependent on state Medicaid payments. Many may be forced to close. The rigidity of construction contractors could block long-promised infrastructure investments. Even struggling cities and counties that rely on state sales tax revenue could be burned.

In corporate bankruptcies, trustees are appointed to settle competing creditor claims and approve asset sales, restructuring plans, or liquidation of the debtor. Restructuring cannot proceed unless it is shown to be a better outcome for creditors than liquidation.

In municipal bankruptcy, liquidation is not an option and the hierarchy of secured and unsecured creditors is murkier.

If Illinois declared bankruptcy, general bondholders would be lumped in as unsecured creditors, alongside health care providers seeking Medicaid payments and municipalities owed funds for police and government protection. other vital services. The fate of pension payments could depend on whether they are considered an inviolable property right or a contract that can be voided in bankruptcy.

“If you look at how municipal bankruptcy works, it fixes the debt structure under adult supervision,” says Douglas Baird, a law professor at the University of Chicago. “A big open question for state bankruptcy is who is going to provide adult supervision?”

STATE SOVEREIGNTY

An administrator deciding which state obligations to honor — someone with no response to voters — is hard to imagine. In municipal bankruptcies, the state assumes the role, with the consent of the municipality.

The Supreme Court has ruled that municipalities cannot be forced into bankruptcy under Chapter 9 of the Federal Bankruptcy Code. States are not permitted to file under any circumstances. Congress should act, as it did for Puerto Rico in 2016. Even then, legislation would present constitutional issues related to state sovereignty.

In municipal bankruptcies, the creditors with the highest claims are bondholders on projects secured by statutory or tax liens. Mortgages also grant first-ranking security over specific assets. But in the event of a state bankruptcy, secured claims would pale next to those of general obligation bondholders, vendors, healthcare providers and other unsecured creditors.

“What happens with state services is going to depend primarily on what the state intends to do and, of course, the level of distress,” says Robert Christmas, a bankruptcy attorney involved in the case. Detroit affair. “Structures such as statutory revenue sharing with municipalities could be repealed or temporarily suspended to allow the state more flexibility to provide essential public services.”

When Detroit filed for bankruptcy in 2013, Michigan appointed an emergency manager. The result was a negotiated slog that left bondholders at a 38% discount, employees with reduced pensions and city retirees losing most of their health insurance coverage.

The scale of the current crisis is reflected in forecasts of $160 billion to $180 billion in lost state revenue for the fiscal year beginning July 1. Illinois is struggling with $138 billion in underfunded retirement liabilities and $17 billion in unpaid Medicaid claims.

David Skeel, a University of Pennsylvania law professor and state bankruptcy evangelist, tweeted on April 27 following McConnell’s comments that “state services are more likely to be cut, and to be severely cut, apart from bankruptcy if the state is in distress. A great virtue of bankruptcy is that it ensures that each constituency bears some of the sacrifice.”

But he saw the limits of reorganizing public sector bankruptcies while serving on a seven-member oversight board in the Puerto Rico case. In a law review article last fall, he noted that the council had “significant power,” subject to the consent of elected officials. “It has been difficult at times,” he wrote, lamenting the lack of progress in pension and labor law reform.

In Illinois, the treatment of pensions is complicated by constitutional protections against benefit reductions, which were reaffirmed by the Illinois Supreme Court in 2015.

CONTRIBUTION EXTENDED

Christmas, a Nixon Peabody partner in New York who represented the city of Chicago, says pension claims would fall into the unsecured category if no property rights were granted. Otherwise, the right of ownership is a right to a cash payment that probably cannot be changed much. “What could happen is an extension of the required contributions over a longer period,” he says.

Bruce Markell, a law professor at Northwestern University and a former bankruptcy court judge, says, “If I had to come up with a plan, I would probably deal with pensions separately.

Arkansas was the only state to file for bankruptcy in 1933 after racking up road construction debts and property losses from the 1927 Mississippi flood. During the 1930s, the Supreme Court of United States first declared the municipal bankruptcy unconstitutional before overturning the decision.

“The grounds he gave there for saying that municipal bankruptcy was after all constitutional — pointing out in particular that the decision to use bankruptcy rested with the state itself — apply (to the states today) , at least to some extent,” says U of C. Baiard.

Skeel noted that the court also ruled that municipal bankruptcy cannot usurp political decision-making authority, writing, “A state bankruptcy law that adheres to these principles would be equally valid.”

But Illinois seems far from embracing the concept. It is one of approximately 35 states that do not allow municipal bankruptcies. More than ten years ago, two filings by a municipality in the Saint-Louis area were rejected by the courts.


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