Detroit judge’s pension ruling is no panacea for beleaguered cities

By Alison Frankel
December 4, 2013

In Tuesday’s ruling that Detroit is eligible for federal bankruptcy protection, U.S. bankruptcy judge Steven Rhodes set crucial precedent on a municipality’s right to cut pension benefits through the Chapter 9 process. Michigan’s state constitution, like those of many other states, specifically protects the pension rights of public employees. Before Detroit even filed for Chapter 9 in July, some of its pensioners went to state court to block the bankruptcy, arguing that it’s a violation of the state constitution to tamper with their benefits. Rhodes squelched that litigation and asserted his federal-court jurisdiction, but retirees and unions continued their challenge to the city’s right to meddle with their pensions, just as California’s vast public pension fund, Calpers, has relentlessly resisted any suggestion that the bankrupt cities of Stockton and San Bernardino might reduce their pension obligations. In a first-ever ruling on the impairment of pension obligations in a Chapter 9 proceeding, Judge Rhodes held Tuesday that neither the Contracts Clause nor the Tenth Amendment of the U.S. Constitution prohibits Detroit from cutting pension benefits, even if those benefits are protected in the state constitution.

“Municipal pension rights are contract rights, and…the impairment of such contract rights in a municipal bankruptcy case is a regular part of the process,” Rhodes concluded, according to a court-issued summary of his findings. “Because the State of Michigan authorized the filing of this case, municipal pension rights in Michigan can be impaired in this bankruptcy case, just like any other contract rights.” (Rhodes read his eligibility ruling from the bench; a written opinion is to follow.)

With that finding, Rhodes gave a definitive answer to a constitutional question that the judges overseeing the Stockton and San Bernardino Chapter 9 cases have skirted: Can insolvent cities legally reduce their pension obligations through the federal bankruptcy process? Rhodes has supplied critical precedent that changes the balance of power in municipal bankruptcies. “Pensions can no longer count on getting 100 cents on the dollar in every municipal bankruptcy due to their recognized super-senior status,” wrote analyst Mark Palmer in a blog post for BTIG. “Now, they may be subject to cuts or to being treated as unsecured creditors in the same claim pool as the bond insurers.”

James Spiotto of Chapman and Cutler, a leading authority on pension obligations and Chapter 9 bankruptcy, told me that Rhodes – who could have ducked the constitutional question at this stage of the case – went out of his way to provide what Spiotto called “practical wisdom”: When there’s a higher purpose of saving a city from ruin, pensions may be impaired. “It’s an extraordinarily important decision,” agreed bankruptcy lawyer David Warfield of Thompson Coburn (who, like Spiotto, is not directly involved in the Detroit case). “It does indicate a willingness on the part of bankruptcy courts to tackle the pension issue.” Warfield told me he expects Rhodes’s ruling to embolden other municipalities struggling to meet pension obligations to take the plunge into Chapter 9.

But he also cautioned against treating Rhodes’s conclusions about constitutionality as an answer for all insolvent cities. It’s not, according to Warfield and Spiotto. As a practical matter, Rhodes is only a single trial-level judge, and unions represented by Lowenstein Sandler have already filed an appeal of Tuesday’s decision. (In a statement, the Official Committee of Detroit Retirees, represented by Dentons, said it is also likely to appeal; Robert Gordon of Clark Hill, who represents retired Detroit police officers and firefighters, didn’t return my call for comment.) Even if Rhodes’s decision is ultimately upheld by the 6th Circuit Court of Appeals, it won’t be binding on bankruptcy courts in other federal circuits. And, of course, any city that wants to cut pension benefits through Chapter 9 still has to prove it’s eligible for bankruptcy protection, which requires (among other things) a showing that it is insolvent and that it has attempted to negotiate in good faith with its creditors.

More fundamentally, though, the impact of Rhodes’s decision is restricted by the peculiarities of Chapter 9, which permits states to determine whether and under what conditions their municipalities can seek bankruptcy protection. Warfield pointed me to a Chapter 6 study conducted by Chapman and Cutler. According to the Chapman report, only 12 states offer unconditional authorization. Twelve others – including California and Michigan – authorize Chapter 9 filings but only under certain conditions. Three states expressly restrict the use of Chapter 9 and two others prohibit it. (Illinois, which passed a statewide pension reform law on Tuesday, is one of the states that sets strict limits on bankruptcy protection.) The other 21 states don’t address the use of Chapter 9, so, according to Chapman and Cutler, their municipalities are not specifically authorized to file for bankruptcy protection.

Obviously, Rhodes’s ruling on Detroit’s right to cut pension benefits through Chapter 9 won’t help cities that can’t use Chapter 9. The Detroit judge, moreover, considered the constitutionality of pension impairment through Michigan’s Chapter 9 process, in which the governor authorized Detroit’s filing. Look at the text of the summary of his ruling: “Because the State of Michigan authorized the filing of this case, municipal pension rights in Michigan can be impaired in this bankruptcy case, just like any other contract rights.” Cities in states with different Chapter 9 conditions might well have different issues with state rights under the Tenth Amendment, though Spiotto said such arguments might not amount to much as long as the state has authorized the use of Chapter 9.

Perhaps more significantly, different states also have different pension structures, as Calpers emphasized when I asked the California fund about Judge Rhodes’s decision. Mary Williams Walsh of The New York Times, who is always in the vanguard of reporting on pensions and bankruptcy, wrote yesterday about the reverberations of the Detroit ruling in Chapter 9 cases under way in California. Karol Denniston of Schiff Hardin, who represents a mutual fund that holds Stockton bonds, told Walsh that Rhodes’s analysis “changes the dynamic at the negotiating table in a major way, because we’ve now had a bankruptcy judge say you can impair pensions.”

Calpers, however, doesn’t believe Rhodes’s ruling is relevant to California’s pension system. In an email statement, a representative of the enormous fund told me first that Rhodes “failed to recognize the difference between a two party contract and the unique nature of a state public employee retirement system, which creates a three-way relationship among a public agency, its employees and the retirement system.” But the statement went on to distinguish the Calpers structure from the pension plan Rhodes considered. “Unlike Detroit, Calpers is not a city pension plan,” Calpers said. “Calpers is an arm of the state and was formed to carry out the state’s policy regarding public employees. The Bankruptcy Code is clear that a federal bankruptcy court may not interfere in the relationship between a state and its municipalities. The ruling in Detroit is not applicable to state public employee pension systems like Calpers.”

It would have been completely out of character for Calpers – a fierce, fierce advocate, as we’ve seen in the Stockton and San Bernardino cases – to admit defeat in the constitutional fight over pension impairment, and I’m intrigued by its argument that statewide systems have more impermeable protection than citywide plans because they’re an arm of the state.

Perhaps, said Spiotto of Chapman and Cutler, who said he admires Calpers’s doggedness. But he said the parsing of Rhodes’s decision misses the larger point: Pension funds and the cities and states that pay into them have to figure out how to keep municipalities afloat or else everyone suffers. Spiotto believes the smartest approach is to avoid Chapter 9 altogether and instead negotiate consensual plans. “In the long term,” he said, “if the city isn’t going to survive unless you make adjustments to its pension obligations, you’ve got to talk about how you make the adjustments.”

Amen to that.

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