Washington Law Review

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State Default and Synthetic Bankruptcy

October 01, 2012 | 87 Wash. L. Rev. 657

Abstract:  An insolvent state does not need bankruptcy if sovereign immunity would protect it from lawsuits and other collection efforts. To the extent that a state is not judgment-proof and needs bankruptcy, we may not need to modify the Federal Bankruptcy Code to allow it to file. First, a substantial share of state spending flows through their municipalities, and these municipalities have substantial obligations of their own. Unlike states, municipalities can file for bankruptcy under current law, and a state could substantially reduce the cost of accomplishing its own fiscal goals by forcing its municipalities to file. Second, states may be able to create their own synthetic “bankruptcy” mechanisms, or bankruptcy without the federal code. State obligations are creatures of state law; states do not need a federal bankruptcy discharge. Federal law would not preempt a state composition mechanism used to adjust these debts, and any adjustment that would have been confirmed by a bankruptcy court would likely survive a Contract Clause challenge as well. Even if a state does not enact a composition mechanism, it could capture most of the benefits of federal bankruptcy by directly altering the rights of its creditors. A synthetic bankruptcy mechanism created by a state would not precisely replicate a federal bankruptcy chapter for states. Perhaps the best argument for federal bankruptcy is that it could operate with significantly lower transactions costs. In a world without omniscient judges, however, transactions costs can actually increase welfare by enhancing the ability of a state to make credible commitments.

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