Gregory S. KaplanDirector of Fixed Income, Managing Director | April 23, 2020

Special Municipal Bulletin

States cannot currently file for bankruptcy under the U.S. bankruptcy code.

There is no precedent of dual sovereigns (the states and national government) passing laws regulating the bankruptcy of one another.

The U.S. Constitution Contracts Clause precludes a state from impairing obligations.

Under the tenth amendment of the U.S. Constitution, states are granted broad powers to control their fiscal structure.

Bankruptcy would risk many stakeholders’ interests, not just bondholders, but pensioners, citizenry, public servants, and thus voters.

During the 2008 financial crisis, the topic of bankruptcy by states was raised and was summarily shot down by governors, bondholders, legislators, unions and other constituents.

On Wednesday, April 22nd, Senate Majority Leader Mitch McConnell said during a radio interview that he favors allowing states struggling with high public employee pension costs amid the additional burdens of the COVID-19 crisis to declare bankruptcy instead of utilizing a government bailout.

This resurrected a topic that has been revisited more than once in the past. While Congress can certainly change the law, it is not widely supported. When it was raised during the great financial crisis, the discussion was dropped after a single hearing in the House of Representatives due to overwhelming push-back.

The key points are below:

  • States cannot currently file for bankruptcy under the U.S. bankruptcy code. When the bankruptcy code was adopted in 1937, the definition of municipality did not include state governments, just “political subdivision or public agency or instrumentality of a state.”
  • There is no precedent of dual sovereigns (the states and national government) passing laws regulating the bankruptcy of one another. This relationship stands today.
  • The U.S. Constitution Contracts Clause precludes a state from impairing obligations. The Supreme Court would have to render an opinion to change this.
  • Under the tenth amendment of the U.S. Constitution, states are granted broad powers to control their fiscal structure. If states were granted bankruptcy power, the incentive to make tough policy choices would become diluted.
  • Bankruptcy would risk many stakeholders’ interests, not just bondholders, but pensioners, citizenry, public servants, and thus voters.
  • During the 2008 financial crisis, the topic of bankruptcy by states was raised and was summarily shot down by governors, bondholders, legislators, unions and other constituents. States can’t simply go out of business, liquidate, they function in perpetuity and need ongoing access to financial markets and support of their constituents.

CNR view: Mitch McConnell is throwing the term bankruptcy around loosely as a response to more state aid amid the pandemic. Some states have made poor decisions historically and now are irresponsibly talking of spending aid dollars to backfill pensions, but to help governments deliver critical services and support the greater public good in the near-term is as important as supporting the unemployed and large and small businesses. His comments directly conflict with House Speaker Nancy Pelosi who is pushing for direct state aid in the next stimulus legislation considered by Congress. President Trump has also indicated support for state aid in “phase four”. We have been very cognizant of states with historical mismanagement and grossly underfunded pension liabilities for many years (e.g. Illinois, New Jersey) and there is no repositioning needed in response to this remote risk. Further, having heard this rhetoric before, the bond market showed little reaction to the news.

Key Points

States cannot currently file for bankruptcy under the U.S. bankruptcy code.

There is no precedent of dual sovereigns (the states and national government) passing laws regulating the bankruptcy of one another.

The U.S. Constitution Contracts Clause precludes a state from impairing obligations.

Under the tenth amendment of the U.S. Constitution, states are granted broad powers to control their fiscal structure.

Bankruptcy would risk many stakeholders’ interests, not just bondholders, but pensioners, citizenry, public servants, and thus voters.

During the 2008 financial crisis, the topic of bankruptcy by states was raised and was summarily shot down by governors, bondholders, legislators, unions and other constituents.

Important Disclosures

This material is available to advisory and sub-advised clients of City National Rochdale, LLC, a Registered Investment Advisor and a wholly-owned subsidiary of City National Bank.

The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts and forward-looking statements presented herein are valid as on the date of this document and are subject to change.

Diversification does not ensure a profit or protect against a loss in a declining market.

Past performance is no guarantee of future performance. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

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