By Vince Sullivan

Law360 (April 22, 2020, 6:55 PM EDT) -- Senate Majority Leader Mitch McConnell told a radio host Wednesday that he would support a new option for state governments to file for bankruptcy protection as an alternative to borrowing money from the federal government to fund budget shortfalls as they struggle with the economic turmoil wrought by the COVID-19 outbreak.

The comments came during an interview with conservative radio host Hugh Hewitt on Wednesday while discussing unfunded pension liabilities incurred by state governments, according to a recording of the interview available on Hewitt's website.

McConnell and Hewitt were talking about financial aid for states in the context of the COVID-19 outbreak, and the majority leader said his caucus would insist that any funds sent to the state governments weren't used to plug budget gaps not directly tied to the pandemic, specifically mentioning public employee pension funds.

Hewitt asked if a new chapter of the U.S. Bankruptcy Code was needed to provide an option for state governments to restructure their debt and get out from under those pension liabilities.

"Yeah, I would certainly be in favor of allowing states to use the bankruptcy route. It saves some cities. And there's no good reason for it not to be available," McConnell replied. "My guess is their first choice would be for the federal government to borrow money from future generations to send it down to them now so they don't have to do that. That's not something I'm going to be in favor of."

In recent weeks, state and local governments have seen their revenues gutted by the outbreak and resulting stay-at-home orders that have essentially ground the economy to a halt. Efforts in Congress to provide relief to states and municipalities have stalled over concerns about how the funds will be used.

McConnell's comments Wednesday indicate that he and his colleagues in the Senate will be reluctant to provide any relief without certain conditions on the use of the money.

"I think it's going to be a broad discussion … throughout the conference. I mean, we all represent states. We all have governors regardless of party who would love to have free money," McConnell told Hewitt. "And that's why I said yesterday we're going to push the pause button here, because I think this whole business of additional assistance for state and local governments need to be thoroughly evaluated."

Another multibillion-dollar relief package for small businesses was approved by the Senate on Tuesday, and McConnell said those funds will be used to aid those employers who were forced to shut down or have had their business hampered by state-ordered closures and restrictions. He wants to make sure state governments, on the other hand, don't use any federal aid to pay obligations incurred outside of the outbreak, including pension obligations.

"There's not going to be any desire on the Republican side to bail out state pensions by borrowing money from future generations. So this is a much bigger conversation than we've had providing assistance for small business because the government shut them out, put them down, put them out of business, or assistance to hospitals which were overwhelmed by the COVID-19 disease. This is a very different decision," McConnell said.

The senator's office did not immediately respond Wednesday evening to a request for comment on his statements regarding state-level bankruptcy protections.

Chapter 9 of the Bankruptcy Code allows for municipal entities like cities and towns to file for bankruptcy protection and restructure their debt, usually through the extension of payment deadlines or refinancing with new loans.

The section comes with procedures that are slightly different from those included under Chapters 7 and 11 of the code that limit the roles of creditors and the court itself in the proceedings. Specifically, a court cannot order the liquidation of a municipality's assets because it would violate the sovereign powers of the states to manage their internal affairs, as preserved in the Tenth Amendment of the Constitution.

According to the federal court system's website, fewer than 500 Chapter 9 petitions have been filed since Chapter 9 was adopted in 1937.

Most notable among those petitions is the 2013 Chapter 9 case of the City of Detroit, which was the largest municipal bankruptcy case in American history when it was filed, with $18 billion of debt. The city's finances buckled under the strain of billions in pension and employee benefit obligations as thousands of residents were moving away from Detroit and its tax base dwindled.

When confirmed in November 2014, Detroit's Chapter 9 plan successfully slashed $7 billion in liabilities and freed up more than $1 billion in capital to reinvest in struggling municipal services.

The Commonwealth of Puerto Rico found itself in similarly dire financial straits in 2017 but was not able to file for bankruptcy using the Chapter 9 provisions of the code because it was specifically barred from doing so in the code, as was the District of Columbia. Instead, Congress passed the Puerto Rico Oversight, Management and Economic Stability Act, or PROMESA, that allowed for a bankruptcy-like process for restructuring the island's tens of billions of dollars in municipal debt.

No such protections exist for states, and no currently proposed legislation seeks to amend the Bankruptcy Code to allow them to file for bankruptcy. Any such change in the law would likely face a constitutional challenge, as the originally proposed Chapter 9 provisions did in 1934 and Puerto Rico's own restructuring legislation did in 2016.

--Editing by Haylee Pearl.

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