Municipal Bankruptcy Poses More Limited Threat to Public-Sector Pensions Than Once Feared

By Peter D. DeChiara

pdechiara@cwsny.com

Posted June 2015

The December 2013 bankruptcy court decision allowing Detroit to cut accrued pension benefits, see In re City of Detroit, 504 B.R. 907 (Bankr. E.D. Mich. 2013), created alarm that municipal bankruptcies might soon threaten public-sector pensions nationwide.  However, while Chapter 9 municipal bankruptcies remain a concern, they appear to pose a more limited threat to public-sector pensions than once feared.

First, it is important to keep in mind that municipal bankruptcies are not permitted in many states.  As part of the Bankruptcy Code, Chapter 9 is federal law.  But to avoid running afoul of the Constitution’s Tenth Amendment reservation of states’ rights, Chapter 9 only allows a city or other municipality to file for bankruptcy if state law authorizes the filing.  See 11 U.S.C. §109(c)(2).   According to a study published by Governing magazine, about half of the states today either have no law specifically authorizing municipal bankruptcies, narrowly restrict the types of public entities eligible to file for Chapter 9 protection, or prohibit municipal bankruptcies altogether.  In about half the country, therefore, public-sector pensions now face little to no risk from Chapter 9.

Illinois, for example, is the state with the highest level of public-sector pension liability, measured as a percentage of state revenue.  Republican Governor Bruce Rauner, a former private-equity executive and harsh critic of public-sector unions, has called for use of Chapter 9 as a means to relieve Illinois cities, including Chicago, of their pension debt.  But Illinois law does not authorize its municipalities to file bankruptcy (with the sole exception of the Illinois Power Agency).  So long as the state legislature remains in Democratic hands, Illinois law will likely remain unchanged, meaning Chapter 9 poses no risk to public pensions in that state.

But even if a state authorizes municipal bankruptcies, a bankruptcy court sitting in that state may not allow pension cuts if the state’s constitution provides special protection to public-sector pensions.  In the Detroit case, the bankruptcy court ruled that public-sector pensions enjoy no more protection under Michigan law than ordinary contracts, even though the constitution of that state prohibits public employee pensions from being “diminished or impaired.”  See Detroit, 504 B.R. at 150-54.  Bankruptcy courts construing the constitutions of other states may come to a different conclusion.  For example, in 2014, the Arizona Supreme Court interpreted the pension clause in that state’s constitution, which was virtually identical to Michigan’s, as giving public-sector pensions greater than ordinary contract protection.  See Fields v. Elected Officials’ Retirement Plan, 234 Ariz. 214, 218-19  (2014).  Just last month, the Illinois Supreme Court, in a resounding rejection of pension reform legislation that would have cut accrued pension benefits, interpreted the pension clause in that state’s constitution as giving pensions protection exceeding mere contract status.  See In re Pension Reform Litigation, 2015 IL 118585, at *20 (May 8, 2015).  Were Chapter 9 filings ever authorized in Illinois, a bankruptcy court sitting in that state might be hard pressed, in light of the Illinois Supreme Court’s recent ruling, to follow the Detroit case’s conclusion that public-sector pensions enjoy no more protection in bankruptcy that ordinary contracts.

Assuming that a bankruptcy court held that an insolvent city could lawfully cut pensions, the next question is whether a city would seek to cut them.  Citing Stockton, California as an example, Stanford law professor Michelle Wilde Anderson argues that while cities in Chapter 9 more readily cut bond obligations and seek to reduce retiree health benefits, they tend to avoid pension cuts.  She explains that cutting pensions for retirees not only deepens the level of concentrated poverty in a city but that pension reductions also make it harder for the city to attract and retain qualified employees.  See  Onlabor: Workers, Unions, Politics, onlabor.org (May 1, 2015).  The bankruptcy plan formulated last month by another insolvent California city, San Bernardino, lends support to Anderson’s argument.  See May 18, 2015 San Bernardino Plan of Adjustment .  San Bernardino, which describes itself as a “poor city,” plans reductions to its bond and retiree health obligations, but – citing “severe retention and recruitment problems” – plans to leave pension benefits untouched.  Of course, not all Chapter 9 debtors will make the same economic and political calculus as the ones that prompted Stockton and San Bernardino to spare pensions, but those two recent examples show that pension cuts do not follow inexorably from a bankruptcy filing.

The Detroit decision created a pernicious precedent, but there appears to be less danger than originally feared that Chapter 9 filings will, any time soon, unravel public pensions across the country.  Most pensions will likely remain safe from the bankruptcy axe so long as Chapter 9 remains unavailable in many states, many state constitutions continue to provide pensions with heightened protection, and many city governments continue to see pension cuts as not just unfair but also as bad for the city’s economic and material well-being.