How to Change Bankruptcy Law

Our government isn’t very good at knowing when and how to change bankruptcy law, and every time it contemplates doing so it makes the wrong decision. With Puerto Rico staring at insolvency and Congress debating some sort of relief for the island, it appears this dubious streak may remain intact.

The commonwealth's government, in case you haven't kept track, is broke. A decade-long recession and profligate spending will do that. It wants Congress to give it a mechanism to reorganize its debts. Chapter 9 of the bankruptcy code allows municipalities, utilities, and government entities of the 50 states to receive bankruptcy protection, but a state cannot reorganize its own general obligation debt. For reasons no one can quite recall, Chapter 9 does not apply to U.S. territories.

Some people (including myself) proposed last year that the federal government extend Chapter 9 to Puerto Rico. Doing so would provide it enough breathing room to reform its finances, given that only $20 billion of the island's $72 billion of total debt consists of the general obligation debt exempt from Chapter 9. Others—most notably the Heritage Foundation—argued against the unfairness (to lenders) of what would essentially be an ex post change in the debt agreements. They're not wrong, but given the perilous nature of the island's finances, an extension of Chapter 9 is the least-bad option available, and it would prevent the need for a federal bailout.

However, the Treasury contends that merely extending Chapter 9 to Puerto Rico is insufficient, and it is pressing Congress to allow it to haircut all of Puerto Rico's debt, including general obligations. Treasury and the House members who advocate this debt-cramming insist it would be a one-off that would not apply to the states and would not be a precedent affecting future efforts by states to reorganize their debts.

That assumes a future Congress would never seek to change the bankruptcy code when an insolvent state arrives as a supplicant on its steps. When Illinois finds it difficult to pay its general obligation debt a few years from now, would Congress offer a bailout or seek to change the bankruptcy code along the same lines as in Puerto Rico? The superficial way Congress will paper over the issue in the current legislation is by not explicitly creating a mechanism to reduce general obligation debt but instead allowing a fiscal control board to do the dirty work, and instructing it to "respect" credit priorities, whatever that means.