Detroit’s eligibility problem: Can state officials OK its bankruptcy?

July 22, 2013

The biggest municipal bankruptcy proceeding in U.S. history is less than a week old but it’s already promising to generate enough legal controversy to gainfully employ the platoons of lawyers vying for a role in the Chapter 9 case. A state court judge in Lansing, Michigan, has teed up a fight over Michigan Governor Richard Snyder’s right to authorize Detroit’s petition for Chapter 9 protection. That’s a novel procedural question, as I’ll explain below. I don’t think doubts about Snyder’s authorization will stop U.S. Bankruptcy Judge Steven Rhodes from pushing Detroit’s Chapter 9 proceeding forward – but they may well impact Rhodes’s eventual determination of the city’s eligibility for Chapter 9 protection.

The issue, as in the bankruptcies of the California cities of Stockton and San Bernardino, is state constitutional safeguards for the pension benefits of municipal workers. Anticipating that the city would try to cut retirement benefits, two sets of pension beneficiaries, as well as Detroit’s two retirement systems, sued in Ingham County Circuit Court before Detroit entered Chapter 9, in an attempt to block the city’s bankruptcy. Their argument, in a nutshell, is that Michigan’s governor is bound to uphold the state constitution, which includes a provision barring the impairment of pension rights for state workers, so he cannot authorize a bankruptcy filing that contemplates any pension reductions. Detroit’s emergency manager, Kevyn Orr of Jones Day, filed for Chapter 9 before any ruling in the three state-court pension suits. But last week, after the Chapter 9 petition, the pensioners returned to court to argue that because the petition was filed under improperly granted gubernatorial authority, it must be withdrawn.

On Friday, Ingham County Judge Rosemarie Aquilina agreed. Aquilina, who sits in the state capital of Lansing, ruled that Governor Snyder’s authorization of a Chapter 9 petition that “threatens to diminish or impair accrued pension benefits” was a violation of the state constitution. She ordered Snyder to instruct Orr to withdraw the petition and barred him from granting Orr permission to file any other Chapter 9 petition that didn’t safeguard pension rights.

Over the weekend, Detroit’s lawyers at Jones Day responded with a motion in federal bankruptcy court to extend Chapter 9’s automatic stay of litigation to suits against the governor, Michigan Treasurer Andy Dillon, and other city and state officials – including a stay of the pension suits before Judge Aquilina. The state attorney general, Bill Schuette, also filed a state court appeal of Aquilina’s rulings.

From developments on Monday, it seems like Rhodes, the federal bankruptcy judge, will have the next word on whether the Chapter 9 goes forward. He ordered a hearing Wednesday on Detroit’s motion to extend the stay of litigation, which is opposed by the city pension funds’ counsel at Clark Hill. Judge Aquilina, meanwhile, adjourned a hearing in one of the pension challenges to the Chapter 9 filing. The Michigan appeals court, according to Reuters, has not acted on the AG’s filing.

My prediction is that the authority of the Michigan governor to approve Detroit’s Chapter 9 filings will end up being litigated in both the Michigan state courts and the federal bankruptcy court, with the state Supreme Court’s answer to the question eventually informing Judge Rhodes’s ruling on whether Detroit is eligible for Chapter 9 protection. But there are all kinds of precedential issues along the way to that procedural outcome. Foremost, of course, is whether Michigan courts can enjoin a federal bankruptcy proceeding. The Constitution’s Supremacy Clause – which holds that when state and federal law are in tension, federal law trumps – would suggest not, but bankruptcy law expert Adam Levitin of Georgetown University Law Center told me Monday that there may be abstention doctrine considerations that could require the bankruptcy court to defer to state court. “It would surprise me if the bankruptcy judge were to proceed (to a resolution) while this is pending in state court,” said Levitin, who wrote about Judge Aquilina’s rulings at the Credit Slips blog.

Nevertheless, Levitin and bankruptcy lawyer Benjamin Feder of Kelley Drye & Warren said that Judge Rhodes’s consideration of the Michigan governor’s authority is likely to come in an eligibility proceeding, a unique element of Chapter 9 bankruptcies. Unlike ordinary people or even corporations that ask for relief from their creditors by filing for bankruptcy, municipal debtors must prove they’re eligible for bankruptcy protection. They have to satisfy several statutory requirements, showing, among other things, that they negotiated in good faith with creditors before filing for Chapter 9. Detroit’s emergency manager, Orr, has said he’s expecting a fight over eligibility, including an argument by pensioners that the city did not negotiate with them in good faith. It would make sense, said Feder, for the bankruptcy judge to consider the governor’s authority in the context of eligibility. “This is a gating issue,” he said. (Feder is not currently representing anyone in the Detroit Chapter 9, though he’s hoping to become involved.)

Feder said that if the bankruptcy court finds the governor improperly approved the Chapter 9 filing, the Michigan legislature may have to fix the state’s procedures for authorizing municipal bankruptcies. That could take years.

But Levitin predicted that the bankruptcy judge will ultimately uphold the Michigan governor’s authority to authorize Detroit’s filing. He offered two reasons why. First, while the state constitution bars impairment of retirees’ pensions, the governor did not explicitly order any pension cuts when he approved Detroit’s Chapter 9. He merely authorized the city to seek protection. And second, according to Levitin, because the federal bankruptcy code includes a prohibition on the violation of any other law (including, presumably, state constitutions), the Michigan governor cannot sanction the violation of Michigan law by authorizing Detroit’s Chapter 9. Even if he wanted to, in other words, the governor couldn’t give Detroit the power to break the law through Chapter 9 because Chapter 9 doesn’t permit laws to be broken.

Levitin’s second argument really applies more to any potential restructuring plan Detroit proposes than to the threshold question of the governor’s authority to authorize a Chapter 9 petition. (The one precedent he cites involves a 1989 ruling by a bankruptcy judge in Nebraska, who refused to confirm a sanitation district’s Chapter 9 plan because it violated a state law on repayment of bondholders.) And that, of course, leads to the really big unanswered question in Detroit’s bankruptcy: Can the city use federal bankruptcy to push through a plan that cuts retiree benefits despite the state constitution’s protection of those benefits?

As I’ve written any number of times (and just confirmed with Levitin and Feder), no federal bankruptcy court has ruled whether municipalities may cut pension benefits through a Chapter 9 plan. The issue pits the Supremacy Clause and the Bankruptcy Code against the Contract Clause and the 10th Amendment, which reserves to states the right to manage their own affairs. That constitutional tension has been an issue in both the San Bernardino and Stockton bankruptcies, but when U.S. Bankruptcy Judge Christopher Klein of Sacramento recently ruled (over objections by bond insurers) that Stockton is eligible for Chapter 9, he ducked an explicit holding on whether protected pension rights can be cut via Chapter 9. (He did say that bankruptcy is all about impairing contracts, so that pensioners can’t rely on the Contract Clause.)

It’s frustrating to watch cities careen into bankruptcy without any guidance on the legality of imposing cuts on retiree benefits. Feder told me Monday that one way or another, the U.S. Supreme Court or Congress is going to have to confront the question. Levitin, who said that Detroit may be able to break collective bargaining agreements with municipal workers outside of a Chapter 9 plan, told me he believes the Supreme Court will be extremely reluctant to weigh in, at least until there’s a split in the federal circuits.

That, of course, will be too late for the citizens, pensioners and bondholders of Detroit, Stockton and San Bernardino.

(This post has been corrected. A previous version incorrectly reported Levitin’s affiliation.)

(Reporting by Alison Frankel)

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If there are unfunded liabilities in the absolute sense with regards to Detroit’s finances, no amount of legal ruling will magically create the resources that the plaintiffs want. Law is a tool, not an absolute, and I think it is time that the people and government of Detroit admit that they made a long-term mistake about the prospects of the city.

Institutions and people go bankrupt, but land, property, and real wealth is not destroyed during these proceedings, simply reallocated. Time to move on.

Posted by TCOLE | Report as abusive

I find it interesting that the unions saw the need to plan ahead and get protection for their benefits. They knew that someday they would break the bank and be asked/forced to take reductions.

Posted by tmc | Report as abusive

Like flies bickering over a rotting corpse …

Posted by deLafayette | Report as abusive