Detroit may cut pensions less than other claims, Michigan bankruptcy court holds

By Peter DeChiara

pdechiara@cwsny.com

Posted December 2014

Does a bankruptcy plan for an insolvent municipality “discriminate unfairly” within the meaning of the Bankruptcy Code if it spares pension claims from cuts as deep as those imposed on other creditors of the city?  No, according to the recent decision of the bankruptcy court for the Eastern District of Michigan approving Detroit’s bankruptcy plan.  See In re City of Detroit, Michigan, Case No. 13-53846 (Bankr. E.D. Mich. Nov. 12, 2014).

The issue arose in the Detroit Chapter 9 bankruptcy, the largest municipal bankruptcy  in US history, because there the insolvent city targeted its employees’ and retirees’ pensions as a major source of potential savings.  At the outset of the case, city employee unions, retiree associations, and even Detroit’s own retirement system vigorously objected to proposed cuts to accrued pension benefits, citing the express prohibition in the Michigan state constitution against vested public-sector pension benefits being “diminished or impaired.”  Bankruptcy judge Steven Rhodes ruled, however, that once the city filed bankruptcy, pension claims enjoyed no greater protection than ordinary contracts.

Although the court gave Detroit the green light to cut the pensions of its employees and retirees, the city, after  obtaining a promise of financial aid from the state, requested court approval for a plan of adjustment that sought lesser pension reductions than the city had earlier proposed.  The plan proposed recoveries for pension claims that the court estimated to be as high as 60 cents on the dollar, while providing certain bond claimants who had voted to reject the plan with a recovery of about 44% and other unsecured creditors who also rejected the plan with a recovery of about 13%.

Section 1129(b)(1) of the Bankruptcy Code, which applies both in Chapter 11 corporate reorganizations and Chapter 9 municipal bankruptcies, requires that the debtor’s plan must, among other things, not “discriminate unfairly” with respect to classes of claims that are impaired by the plan and do not vote to accept it.  In the Detroit case, certain creditors, including the bond creditors, argued that the city’s plan unfairly spared pension claims.  Certain academic commentators also weighed in on the issue, opining that the Bankruptcy Code does not tolerate recovery levels for pension claims higher than those of other claims.

In his order approving Detroit’s plan of adjustment, Judge Rhodes concluded that the higher level of recovery for pension claims did not constitute unfair discrimination under Section 1129(b)(1).  He reasoned that different treatment was justified for pensions because the city’s recovery depended in large part on “its ability to marshal the support of … its retirees, employees and their labor unions.”  The judge also noted that the different levels of recoveries reflected various settlements that had been reached between the city and its creditors, and that such settlements were themselves reasonable.  Finally, Judge Rhodes reasoned that the “special protection” given to government pensions by the Michigan constitution justified differential recoveries, since such constitutional protection for pensions should have caused other creditors to expect to receive less.  (The judge did not explain, however, why this “special” state-law protection was sufficient to shape the expectations of creditors at the plan confirmation phase of the case, but was not special enough to elevate pensions above ordinary contracts at the outset of the case and protect them from being cut at all.)

That a city’s bankruptcy plan does not “discriminate unfairly” when it spares pension claims was also the conclusion reached by bankruptcy judge Christopher Klein in his October 30, 2014 bench ruling approving Stockton, California’s plan of adjustment.  In that case, City of Stockton, No. 12-32118 (Bankr. E.D. Cal.), the court had earlier ruled that California state law did not shield pensions from being cut in a Chapter 9 case.  Nonetheless, according to media reports (the October 30 bench ruling is not yet public), the judge approved a plan of adjustment for the city that substantially reduced the claims of bondholders but left pensions untouched.

By allowing any cuts to previously earned pensions that enjoy special state law protection, the Detroit and Stockton cases set worrisome precedent.  But at least these courts were sensible enough in their interpretation of the “discriminate unfairly” test to give the cities flexibility to spare pensions from cuts as deep as those of other creditors.