What Happens When a State Becomes Insolvent?

Member Group : Lincoln Institute

The economic crisis and bankruptcy plaguing Puerto Rico will soon come to other states. The State of Illinois is the most likely candidate that may have to seek protection from creditors with Connecticut, Massachusetts, New Jersey, and Kentucky rounding out the worst 5 states in terms of financial strength.

I have spent an entire career helping organizations avoid bankruptcy. As a certified public accountant, I have noticed a set of events that organizations go through leading up to insolvency and eventually bankruptcy.

The longer a state waits to address its fundamental financial problems, the less likely financial survival will be. In the case of Puerto Rico, the events leading to its bankruptcy on May 3, 2017 were occurring a decade or more before with little to no wherewithal to solve the problem.

What is different with a state bankruptcy is that federal approval and legislation is required to allow it to occur. Thus far only Puerto Rico has been able to file for protection. States are not able to file bankruptcy without federal approval and legislation.

The Puerto Rico Oversight, Management, and Economic Stability Act, PROMESA, provided for the establishment of an oversight board appointed by the president and confirmed by the Senate with oversight by the courts.

An interesting op-ed by a citizen of Puerto Rico, the hardships of living under reorganization are painfully apparent. First, the elected officials of Puerto Rico are no longer effectively in control of

While PROMESA covers Puerto Rico and other territories of the United States, chapter 9 of the bankruptcy code of the United States covers municipalities, school districts, and cities. States because they have sovereign immunity cannot file bankruptcy. States however can become insolvent as has happened with Puerto Rico. Upon insolvency, the federal government can step in as a lender of last resort and appoint an administrator over the state’s finances.

Since a state has never filed for bankruptcy, the case law does not exist and the PROMESA oversight protection provides a clue as to how such an insolvency would be dealt with.

So what does insolvency look like?

First, insolvency is a condition in which your financial options are extremely limited. For instance creditors are less likely to continue lending money, the interest rates start to increase at a rapidly increasing rate reflecting bankruptcy costs and ability to pay such as an Chicago public school system, and stacks of unpaid bills force the state creditors to cut off essential services.

What happens is that the availability or financial capacity of the state declines.  Specifically, the availability and access to cash to fund operations becomes impaired.

Once cash becomes impaired, governments will typically be faced with layoffs and cuts first to nonessential services and then to essential services.

Attempts to increase taxes to increase funds available will only work on those with no options. In other words, the company or organization that has the ability to move will do so. Those unable to move will become less competitive if they are not able to pass the cost on to the consumer.

Concurrently, the state will find that fewer companies will relocate to the state until the financial outlook is more certain. The longer this uncertainty exists the greater the likelihood of a downward spiral to bankruptcy or insolvency. This is where decisive action must be taken or the financial rescue becomes impossible.

For state to declare bankruptcy, a bill similar to PROMESA will have to be passed in order for the financial reorganization to begin.

Unfortunately, most states in trouble financially are usually under the misguided opinion that they can tax their way out of the problem. Since we live in a world where people and companies are free to move, this assumption is fatal.

Due to free movement of people and organizations, states operate in as much of a competitive environment as do corporations. Only the most vulnerable have no options.

In a financial spiral, populations of workers and taxpayers start to move further negatively impacting tax revenue and putting the state in a death spiral.

The longer it takes the state to realize the crisis the more severe the results will be.

Creditors in bankruptcy, particularly bondholders, will be paid very little of the amount owed.   Even public sector workers however will be negatively impacted. These workers will see their pay cut, benefits going forward slashed and layoffs to bring spending under control.

Property owners however will also be negatively affected since the state through an oversight board could increase property taxes substantially high enough to render the property worthless. If such an irresponsible action were to be taken, however, the probability of future survival of the state would be severely impacted.

In decades of doing financial restructuring, the worst thing a debtor can do is to delay facing the crisis head on. The longer the crisis responses are delayed the more severe the austerity measures in the last likely the survival.

It’s time for all of us to take this crisis seriously.

Col. Frank Ryan, CPA, USMCR (Ret) represents the 101st District in the PA House of Representatives.  He is a retired Marine Reserve Colonel and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring.  He has served on numerous boards of publicly traded and non-profit organizations.  He can be reached at [email protected]