In reaction to the fiscal difficulties experienced by state governments over the past three years, several politicians and academics proposed that Congress legislate a new chapter to the Bankruptcy Code under which the financial obligations of a state may be restructured. This essay is forthcoming in an edited volume (Conti-Brown and Skeel, eds., Confronting Fiscal Crisis in American State Government (Cambridge U Press)) which is the product of a conference held at Stanford law School in May 2011. This chapter argues that, if a formal bankruptcy process is valuable for states, it should be legislated at the state rather than federal level for the following reasons: (1) state circumstances and political preferences vary, and state-by-state legislation would permit each state to tailor its bankruptcy process; (2) the state would internalize the cost of issuing debt under the bankruptcy regime of its choice and this would reduce the rent-seeking distortions in the legislative process; (3) a state in financial distress is more likely to initiate its own bankruptcy mechanism than one legislated by the federal government and this would reduce the unpredictability of ad hoc unilateral adjustments currently implemented by the states; and (4) a state-by-state approach would minimize the pressures for a federal bailout, particularly if combined with federal legislation that expressly sets a default bankruptcy regime from which the states can opt out.

The state bankruptcy statute would be incorporated into all prospectively created obligations of the state. For some period of time, however, it will have a retroactive application that raises some policy and constitutional issues. This chapter suggests that a state bankruptcy regime is likely to survive challenges under either state or federal constitution if (1) the state can invoke the process only in severe and unforeseen distress, (2) the statute provides for the oversight by the state courts, and (3) the regime promotes the usual bankruptcy objective of creating a surplus while ensuring that no creditor is worse off than if it pursued its individual remedies in a world without bankruptcy. These conditions are not difficult to satisfy and, indeed, are also congenial to the design of an effective regime.