Should Congress consider creating a legal regime to enable states to restructure their obligations?
With the cacophony of alarm bells as our states sit insolvent thanks to enormous unfunded healthcare and pension liabilities and municipal bond obligations, the answer clearly is yes.
Come the Spring, the Federal Government’s stimulus support for the states runs out. So, what happens when states can’t meet its obligations? Either the states simply default or the Federal Government bails them out. The first option would result in near chaos and the second option may be fiscally irresponsible. Unlike distressed corporations that can benefit from chapter 11, states do not have a legal restructuring regime to which to turn to use as leverage to conduct extensive and global negotiations to fix their balance sheets. Without an in-court solution, the multi-party negotiations necessary to actually solve the states’ current problems are unlikely.
Consequently, Congress should consider enacting a law that provides states with a forum to bring all parties together if an out-of-court negotiated resolution cannot be reached.
In considering the creation of legal regime for state restructurings, Congress should pay careful attention to chapter 11 of the Bankruptcy Code. While chapter 11 is not perfect, it is genius and it does work. In enacting chapter 11, Congress recognized that companies operating as going concerns generally are more valuable than companies that are liquidated. In recognizing this, the purpose of chapter 11 is to preserve jobs, maximize value of the corporate enterprise and treat similarly situated stakeholders fairly. Thus, chapter 11 was drafted to provide companies with the tools to achieve this purpose. And, the existence of chapter 11, at times, allows companies to avoid bankruptcy as creditors, shareholders and other stakeholders may be incentivized to settle as they compare the best out-of-court deal that can be achieved with what might be imposed upon them by a court.
A state restructuring regime would need to recognize that states are run and governed best when they balance their budgets and keep taxes low, while providing the best and necessary services to their citizens. The purpose of a state restructuring regime, therefore, would be to preserve necessary services, keep taxes reasonable and treat stakeholders - e.g., municipal bondholders, public employees and private citizens - fairly. As Congress considers a state restructuring regime, legitimate questions will be raised:
- What will be the impact on municipal bond issuers and the overall market if a state defaults on its obligations and seeks bankruptcy court protection?
- Will governors have the political will to file for bankruptcy and then conduct meaningful negotiations with public unions and other stakeholders?
- Will companies and individuals do business with states that have the right to file for bankruptcy and, therefore, modify or eliminate certain contracts and obligations?
- What would the future cost of borrowing be for a state that commences a bankruptcy?
While these questions are legitimate, they are similar to the questions asked by boards of directors and management teams in large corporate bankruptcies. Large corporations in financial distress are always concerned that a chapter 11 filing will have long-term, adverse ramifications to their businesses. However, experience demonstrates that the concerns generally are over-blown and a company that successfully emerges from chapter 11 can both compete and win. Indeed, investors flock to restructured companies and these companies, in general, are able to secure low cost debt, retain employees and build value.
Take General Motorsas an example. As the economy imploded and the bond obligations and unfunded liabilities of General Motors became overwhelming, it was commonly believed that a General Motors bankruptcy would be a disaster for General Motors and the economy. Yet, the chapter 11 cases of General Motors (which many argue were unfairly tilted towards certain stakeholders at the expense of others by the federal government) appear to be a success. The tools of chapter 11 were used to strengthen General Motors’ foundation and enable it to emerge from chapter 11 as a competitive operating entity, thereby preserving jobs and a critical manufacturing base in the United States.
A state restructuring regime could be used in an analogous way. While municipal bondholders would not necessarily recover in full on their bonds and public healthcare and pension obligations could be modified, a state either negotiating a resolution to its fiscal problems out of court with the specter of bankruptcy as a backdrop or utilizing bankruptcy to achieve a resolution may emerge from the process with a strong foundation. This could lead to investment, better services and a renewed focus for the betterment of its citizenry. With the potential devastating impact on our economy that could be caused by the current financial woes of the states and limited options for states do deal with their long-term fiscal problems, Congress should consider enacting a restructuring regime for states.
Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.