Preparing for State Bankruptcies

It's no secret that major law firm bankruptcy practices are ramping up for a historic rise in Chapter 11 filings, workouts and other restructuring work as industries are battered by the COVID-19 pandemic.

Controversial comments by Senate majority leader Mitch McConnell in April raised the possibility that restructuring lawyers could also gain a new clientele: state governments.

States can't file for bankruptcy under the current bankruptcy code. But after Kentucky Sen. Mitch McConnell said that some struggling states may have to consider a Chapter 9 filing instead of counting on a federal bailout — remarks that were rebuked as overtly partisan by lawmakers on both sides of the aisle — restructuring attorneys have nevertheless been gaming potential scenarios.

"[McConnell] made that statement tongue in cheek, basically to tell blue states to take a hike," said John Rapisardi, chair of O'Melveny & Myers' global restructuring practice. "But it is certainly possible, via the 10th Amendment, for a state to access bankruptcy if Congress was able to amend the bankruptcy code."

Rapisardi is the lead bankruptcy counsel to the government of Puerto Rico and has been tasked with reorganizing the territory's $70 billion in debt — a restructuring that has already generated more than $500 million in attorney fees. He said the territory's experience could provide a rough blueprint for states to reorganize their debt in bankruptcy court.

"In the Puerto Rico restructuring, we've learned a lot about the dynamics the impact Chapter 9 has on creditors' rights," he said. "We are gearing up for this issue and looking at various states struggling, particularly Illinois.

"In terms of deficits and underfunded pension liabilities, though PROMESA [the Puerto Rico Oversight, Management and Economic Stability Act] we have gained a lot of insight into how you might attack the problems states are running against," Raspiardi added. "With the coronavirus, the situation has only gotten worse, and the problem will not go away."

Even with the framework in Puerto Rico as a guide, much would have to change in the U.S. bankruptcy code before states could even attempt to seek such relief, as they are sovereign under the Constitution and cannot fully submit themselves to federal oversight.

Larry Larose, a partner in Sheppard Mullin's finance and bankruptcy practice group who focuses on municipal restructurings, pointed out that there would be even more roadblocks for states.

"It's an interesting legal issue as to whether the federal government can craft statutes that permit states to declare bankruptcy that will pass constitutional muster," he said, adding that under the current standards, a municipality can only lodge a Chapter 9 petition if the state consents.

"In terms of states filing for bankruptcy, all of those issues become magnified," he said. "A state would have to submit itself to federal jurisdiction, but who consents? The governor? The legislature? Or does it go to the people through a referendum?"

Those questions themselves may deliver work for law firms; as Larose explained, any conclusion the federal government may reach would almost certainly be litigated.

"There won't be a clear path," he said.

Peter Friedman, O'Melveny's bankruptcy litigation group leader, agreed that move to allow states to declare bankruptcy would likely be fought in court.

"Another barrier people don't usually talk about, is that states can't file for bankruptcy because if they do, in effect they are taking steps to violate the Contracts Clause, a provision of the Constitution that bars states from taking action to impair contracts," he said. "It's a complicated question that's ultimately addressed through extensive litigation, and it's not surprising to see the issue reviewed by the Supreme Court in a number of historical cases involving states and bankruptcy."

Larose said that even if state bankruptcies never fully come to fruition, he expects to see increased municipal restructuring work at the local, city and agency level.

"Bankruptcy for states is probably not a silver bullet, but there could be bankruptcy-lite for some states," he said. "There's a federal statute that says states could commit part of themselves to federal jurisdictions and reorganize parts of themselves in federal court. These may be baby steps as opposed to putting a whole state through the process, but given what we've seen in the last two months, and anticipating what's coming, something needs to be done."

Even as restructuring lawyers chart the possibilities, Daniel Guyder, a partner in Allen & Overy's U.S. restructuring group, said it was important to consider not only if and how states could file for bankruptcy, but whether they should.

"It would create opportunities for law firms, and most people in those sectors would probably welcome this change because it is a new avenue for services and the opportunity to help clients," he said. "But there's a practical another side of that: is this really the kind of thing we want to encourage of our states when there are other tools in their toolbox to manage challenges?"

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Samantha Stokes, based in New York, is a staff reporter at American Lawyer covering the business of law. You can reach her at [email protected] or on Twitter: @stokessamanthaj.