At various points in the 19th century, American state governments defaulted on, and later rejected the binding effect of, various debts they had incurred. It is notoriously difficult to demand full payment from a sovereign country unwilling or unable to pay its debts. Would an American state government be any different? The question hinges on the legal status of a U.S. state as a quasi-sovereign debtor with a unique legal status that has evolved over time with case law.
State Government Defaults
In the 1830s, the public finances of American states and the federal government were diverging sharply. The federal government debt was paid off in 1835 and so, instead, state government securities took their place as preferred investments. As state governments issued bonds liberally for all sort of projects, often to sponsor railway or banking companies, investors overestimated their safety. Several states defaulted on bonds during financial troubles associated with the Panic of 1837 and, in the case of Southern states, decades later after the Civil War as well. Some state governments altogether expressly repudiated some of their debts. Thus, an American state-level court could be bound by state law to dismiss suits for repayment of old debts, rendering fruitless state-court lawsuits by creditors seeking to secure a repayment.
As with national governments, investors in U.S. state bonds had little legal recourse. If state courts are unfriendly, one idea might be to sue for repayment in a federal court. Unfortunately for creditors, American states have a measure of sovereign immunity granted by the U.S. Constitution, specifically its 11th Amendment, enacted in 1795. This amendment barred federal courts from taking up cases brought by someone, foreigner or American alike, against a state government other than the government of their own home state. So, a state could simply repudiate debts and disgruntled creditors would have little means of being made whole.
“The Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State.”11th Amendment to the U.S. Constitution
The literal words of the 11th Amendment were extended further with an 1890 ruling by the United States Supreme Court, in Hans v. Louisiana. The precedent set by the case prohibited citizens of a state from suing even their own state government in federal court. So, how was any creditor to seek redress?
Even the broadened interpretation of the 11th Amendment left some openings for disgruntled holders of defaulted state bonds. After the Civil War, North Carolina repudiated more bonds than any other Southern state. In 1901, a New York firm named Schafer Brothers owned some bonds issued in 1867 to finance a state-owned railroad in North Carolina. Unsurprisingly given the repudiation of the bonds, the firm was refused permission to sue North Carolina in the state’s own courts. Further, as a private person from another state, Schafer Brothers could not sue North Carolina in federal courts because the relevant constitutional amendment, whatever the edge-cases that have arisen over time, clearly prevented states from being sued in federal court by the citizens of other states, foreign or domestic.
However, a senator from North Carolina came up with an idea to get his state to pay on the bonds. The idea involved the firm donating ten bonds, of the 252 which it owned, to the state of South Dakota. The 11th Amendment bars citizens from suing another state government but leaves the door open to governments suing U.S. states. This was not a novel idea. A Massachusetts lawyer and later U.S. Supreme Court Justice Benjamin Curtis had in 1844 suggested such a transfer, albeit envisioning a foreign government recipient, as a means of collecting on these debts.
As for South Dakota, the state then had a law on the books setting out that any such gift of securities for the benefit of the state, or a public institution like a state university, must be accepted and that lawsuits must be brought to courts, if needed, to collect on defaulted bonds. The New York firm was essentially hiring the government of South Dakota, now a fellow bondholder, to bring the suit on its behalf. To discourage the state from merely settling out of court for pennies, Schafer Brothers expressed that it might give South Dakota even more bonds as a donation to the state if the suit was won.
Aftermath of South Dakota v. North Carolina
South Dakota succeeded in bringing a case to the United States Supreme Court. In arguments heard in 1903, North Carolina insisted that the suit was a circumvention of the 11th Amendment. However, the Supreme Court held, in a five-to-four decision, that North Carolina must pay South Dakota $27,400 in principal and interest on the ten bonds. To set a firebreak should the successful suit by South Dakota have consequences for other bondholders or should other holders sell their securities to a state like South Dakota, the government of North Carolina ultimately also settled with Schafer Brothers directly. The firm was paid 25% of the value of the bonds and interest, for the 242 bonds they still held.
Nonetheless, the firebreak was threatened immediately. Inspired by the ruling in South Dakota v. North Carolina, some North Carolina bonds were gifted to other state governments, such as New York and Michigan in 1905 and others to Rhode Island and Nevada in 1909. However, states were generally hesitant to bring suits against other states on these sorts of grounds. So, New York, Michigan, and Nevada outright refused to even accept the donation they were given. Rhode Island accepted the bonds and demanded payment by North Carolina, only to then drop this demand. They were not prepared to take the issue to court.
Besides other state governments, the 11th Amendment also left the door open to suits against states in federal courts brought by foreign governments, though not private citizens or subjects of these foreign states. Therefore, repudiated North Carolina bonds were also offered to foreign states like Venezuela and Colombia. These also refused to accept them.
In yet another situation though, creditors of a defaulting state, in this case Virginia, were able to secure a recovery. The grounds for this were very different though and rather unique to Virgina’s situation. Certain provisions of its defunct bonds allowed the bonds’ coupons to be used as payment for “all taxes, debts, dues, and demands due the state”.
This provision provided a workaround. If a creditor were to present the bonds’ coupons as payment for taxes, the state could refuse to accept them and argue that such repudiated bonds could not be used in this way. They could then sue the taxpayer for payment of taxes on terms acceptable to the government. Unlike other state debt cases, this sort of case could be brought to a federal court, which could agree to take it up, because such a lawsuit is not a suit against a state but against an individual and would thus not violate the 11th Amendment which clearly is meant to protect states against lawsuits against them and not by them against their taxpayers. So, a federal court could in this case enforce the Virginia bonds.
Principality of Monaco v. Mississippi
The instance of a foreign creditor suing for payment of defaulted U.S. state bonds was eventually put to the test. While Venezuela and Colombia may have refused to accept gifted securities and sue for payment. In 1916, the government of Cuba asked the U.S. Supreme Court to take up a case against North Carolina related to defaulted bonds it had received. Cuba had acquired the bonds through the Corporation of Foreign Bondholders of London, which represented British holders of defaulted securities. Cuba was seeking over $2 million in unpaid principal and interest. However, this would not be the case that would put these schemes to the test once more as the government of Cuba withdrew the suit before any hearing took place.
Nonetheless, in 1933, the Principality of Monaco was gifted fifty-five bonds with $100,000 face value issued by the state of Mississippi in 1833 and 1838 to support the state’s backing of the Planters’ Bank and Union Bank. These debts were repudiated in 1841 and principal went unpaid when due between 1850 and 1866. In an 1890 amendment to its state constitution, Mississippi protected itself from having to repay these bonds and made even more explicit to holders that this was its irreversible decision.
“… the State shall not … assume, redeem, secure, or pay any indebtedness or pretended indebtedness alleged to be due by the State of Mississippi to any person, association, or corporation whatsoever, claiming the same as owners, holders, or assignees of any bond or bonds, now generally known as ‘Union Bank’ bonds and ‘Planters Bank’ bonds.”Section 258 of the 1890 Mississippi Constitution
The donors said that they gifted their defaulted bonds to the European principality, after ninety years without payment, since they understood that “such a suit could only be maintained by a foreign government or one of the United States”. Once again, the 11th Amendment got in the way of American citizens suing for payment in federal courts but would the decision in South Dakota v. North Carolina stand with respect to a foreign government.
Monaco, a foreign state, promptly petitioned the U.S. Supreme Court to be able to sue Mississippi. The principality was represented by Frederic R. Coudert, who had also represented the government of Cuba about 17 years earlier in its aborted efforts to receive payment on defunct securities. To the court, Mississippi argued it could not be sued for, among other reasons, the protections offered by the 11th Amendment. In 1934, the court acknowledged that the 11th Amendment did not provide conclusive instruction.
Unfortunately for Monaco and other bondholders, the court unanimously refused to take up the case on the grounds that, while the United States federal government itself, and other states, could sue a state in federal court, a foreign state could not. The chief justice argued this was just because there would be no reciprocity as a U.S. state could not sue a foreign government without the latter’s consent. This form of sovereign immunity was simply being provided to U.S. states as well. The court made a distinction between a state being sued by the federal government and by other states on the one hand and by a foreign state on the other. The logic was that by accepting the U.S. Constitution, a constituent state was effectively granting consent to suits by other states and the federal government but this did not have any relevance in cases with parties beyond the United States.
“The waiver or consent, on the part of a State, which inheres in the acceptance of the constitutional plan, runs to the other States who have likewise accepted that plan, and to the United States as the sovereign which the Constitution creates. We perceive no ground upon which it can be said that any waiver or consent by a State of the Union has run in favor of a foreign State. As to suits brought by a foreign State, we think that the States of the Union retain the same immunity that they enjoy with respect to suits by individuals whether citizens of the United States or citizens or subjects of a foreign State. The foreign State enjoys a similar sovereign immunity and without her consent may not be sued by a State of the Union.”Opinion of Chief Justice Hughes in Principality of Monaco v. State of Mississippi
Whatever the legal basis, foreign creditors of American states, and no doubt some domestic ones as well, lamented the ruling. They argued that it was peculiar that the U.S. federal government was neither responsible for the actions of its constituent units nor accepting of foreigners bringing suits against the states in federal courts. So, there are few avenues to get an unwilling U.S. state to repay its debts unless held to account by another state or the federal government and either of these parties would be hesitant to take up the matter.
The various lawsuits of the late 19th and early 20th centuries with respect to the repudiated debts of various U.S. states reveals the peculiarities of investments in sovereign bonds. Sovereign bond issuers are naturally the beneficiaries of sovereign immunity. Bankrupt states, wherever they are in the world and whether unitary or federal in nature, generally do not allow lawsuits by their disgruntled creditors and if they do, they won’t for very long. Even if a court of a bankrupt government did agree to hear such a case and even if they ruled in favor of a creditor, there is little they could do to compel payment by a bankrupt government that could simply change the law on which such a ruling was based. The exact source of security for a government bond, the powers of the state, is also the risk with such investments.
More from the Tontine Coffee-House
Read about the Panic of 1837 and the repudiation of U.S. state debts and the story of bonds issued by the state of Texas when it was briefly an independent country. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
1. 292 U.S. 313. Principality of Monaco v. the State of Mississippi. 21 May 1934.
2. Lee, Thomas H. “The Supreme Court of the United States as quasi-international tribunal: Reclaiming the Court’s original and exclusive jurisdiction over treaty-based suits by foreign states against states.” Columbia Law Review, vol. 104, no. 7, Nov. 2004, pp. 1765–1885.
3. Orth, John V. “State Debts & Federal Jurisdiction.” Duke Journal of Constitutional Law & Public Policy, vol. 7, no. 1, 2012, pp. 1–16.
4. Ratchford, B. U. American State Debts. Duke University Press, 1941.