THE BLOG
07/24/2013 09:53 am ET | Updated Sep 23, 2013

Detroit Bankruptcy Filing Puts Spotlight on Distressed Municipal Pensions

The reasons for Detroit's economic downfall are as varied as they are complex. Solving those issues will require creative urban planning, a significant operational restructuring and a balance sheet realignment that necessitates substantial sacrifices by many of Detroit's stakeholders. As the city moves forward with its historic bankruptcy filing, the battle lines are already being drawn as to who will share in those sacrifices, with the city's underfunded pensions finding themselves squarely in the crosshairs.

Bankruptcy filings by municipalities such as Detroit are subject to a unique statutory regime (chapter 9 of the bankruptcy code) that is different in many important respects from the laws that govern corporate restructurings under chapter 11. For example, unlike chapter 11, which includes several important protections for collective bargaining agreements and related pension obligations, chapter 9 does not afford preferential treatment for underfunded public pensions. Nevertheless, pension funds have emerged relatively unscathed from many recent municipal bankruptcies, most likely because such municipalities have lacked the political will (or financial necessity) to impose substantial cuts.

This seems unlikely to continue in Detroit's bankruptcy case. Detroit's underfunded pension obligations -- which the Emergency Manager estimated at $3.5 billion -- dwarf that of all prior municipalities that have sought bankruptcy protection. Last month, the Emergency Manager proposed a restructuring plan that substantially impaired the city's pension obligations, suggesting that those claims should be treated on equal footing with the city's unsecured municipal bonds. The proposal set off a political and media firestorm, as union supporters complained that it was inequitable to force individual pensioners to shoulder the same economic loss as sophisticated bondholders that had purposefully gambled on Detroit's precarious financial state.

The unions also took their battle to the courts, suing the Emergency Manager in state court to prevent him from putting Detroit into bankruptcy. The unions argued that any such bankruptcy filing would violate Article IX, Section 24 of Michigan's state constitution, which protects pension plans from being "diminished" or "impaired." The Emergency Manager, however, believes the federal bankruptcy code "preempts" or trumps the state constitution on this issue, and that pension claims can therefore be reduced in bankruptcy. Late last week, the state court ruled in favor of the unions, a decision that Michigan's Attorney General immediately appealed. Given the importance of this issue, and the lack of any guiding precedent, it will likely take some time for the litigation dust to settle.

If Detroit is allowed to remain in bankruptcy, the Emergency Manager will almost certainly try to coalesce creditor support around a plan of adjustment that substantially impairs pension claims. This would be a substantial victory for bondholders and other unsecured creditors, and a significant setback for Detroit's public pensions. For those in search of clues as to how a bankruptcy court could come out on this issue, consider looking westward to Stockton, California, which is currently engaged in a similar dispute with CalPERS, California's colossal pension fund administrator. Though the relevant constitutional provisions are not identical, both the Michigan and California pension funds fundamentally argue that their claims are entitled to unique protections under state law, and therefore are unlike other unsecured creditors. In Stockton, this has infuriated the city's bondholders, who believe that the constitutional provisions are irrelevant once a municipality is in bankruptcy, and that all unsecured creditors should be treated equally. Recently, the bankruptcy judge overseeing Stockton's case suggested that the bondholders may be right, though the issue was not squarely before the court. A decision in Stockton could come out in the coming months, potentially providing a precedent for Detroit to follow.

Of course, the battle between the Emergency Manager and Detroit's public pensions is about much more than just a constitutional debate; it also reveals another iteration of the timeless struggle to balance the interests of capital and labor. And critically, these issues transcend Detroit's financial predicament. If Detroit prevails in significantly reducing its pension obligations, it will potentially provide a blueprint for other jurisdictions to follow, emboldening municipalities nationwide to consider the strategic use of chapter 9 to address onerous pension obligations. As historic as Detroit's bankruptcy filing has been, it may only be a harbinger for more dramatic municipal failings still to come.