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Background

There are 38 states that treat pension benefits as a contractual right. Of these, 12 have explicit protection in the
state’s constitution. (See the table “Legal Status of Pension Benefits” at the end of this article.)

Detroit is a disaster 60 years in the making.

  • Since 1950, it has lost 63% of its population.
  • Employment in the city declined by 53% since 1970.
  • Municipal debt is $64,295 per working person.
  • The city has a $5.7 billion liability for post-employment benefits. 99.6% of the total is unfunded.
  • In 2012 the city had a negative cash flow of $115 million before borrowing.
  • The city has run out of cash.

The State of Michigan, seeing no chance of the city working its way out of this mess, authorized a bankruptcy filing.

The validity of the bankruptcy petition was challenged, principally by beneficiaries of the city’s pension plans.

On December 5, 2013, Steven Rhodes, U.S. Bankruptcy Judge, issued a ruling in favor of the City of Detroit’s
bankruptcy petition. More importantly, the judge also ruled on the treatment of unfunded pension obligations
that had protection under the Michigan constitution.

Key points

  • State constitutional protection of pension benefits does not preclude a chapter 9 bankruptcy filing.
  • State constitutional protection of pension benefits is eliminated by a municipal bankruptcy filing.
  • Federal bankruptcy courts are empowered to impair pension claims in municipal bankruptcies, even those
    protected under the state constitution.
  • Once a state authorizes a municipality to file bankruptcy, the state cannot intervene in the bankruptcy
    process.
  • State courts cannot intervene in the bankruptcy process.

Implications for state and local governments

Can the threat of bankruptcy be used as a bargaining tool in straightening out municipal finances?

Judge Rhodes’ ruling notes that states are precluded from modifying contractual rights under the Contracts

Clause of the U.S. Constitution. It is even more difficult to modify pension plans where constitutional protection
has been enacted. This has led to endless dithering in addressing the financial plight of states and municipalities,
and to litigation when changes are actually made. Arizona has been litigating pension legislation since April
2011. The State of Illinois just enacted pension law changes last week. It is likely that these will be litigated.

What happens if the beneficiaries of the plans of state agencies and local governments are unwilling to accept
the changes that result from the political process? Can bankruptcy be used as the nuclear option to get a
resolution?

These are the ramifications:

  • When a bankruptcy filing is made, the parties lose legal rights. Pension beneficiaries lose their protection
    against impairment, and the state loses control over the process.
  • All creditors are dragged into the process. As the City of Detroit ruling notes, states are not allowed to
    cherry pick which liabilities are impaired. This would have a chaotic effect on the ability of governments to
    access the credit markets and on relationships with vendors.
  • Even secured debt can be impaired in a bankruptcy.
  • The process would have to be repeated on an entity-by-entity basis. Some governmental units will be
    insolvent, others not. The effect would be uneven.
  • A bankruptcy petition can only be made if the debtor is insolvent. This could produce self-destructive
    behavior on the part of municipalities.

Conclusion

A threat of bankruptcy can be used to drag beneficiaries kicking and screaming into a settlement, but the process
is incredibly messy. It will be preferable to enter into a voluntary settlement outside of bankruptcy court. “The
threat is stronger than the execution.” (Attributed to Aron Nimzowitsch, chess grandmaster)

Implications for pensioners

  • Your benefits are at risk in bankruptcy court, even if they have protection under the state constitution.
  • Preventative action to protect benefits will be more effective than arguments made during bankruptcy.
  • Individuals need more than one source of retirement income, preferably ones not subject to impairment in
    a municipal bankruptcy.

Low investment returns that result from the government’s zero interest rate policy (ZIRP) make defined benefit plans
impossible to maintain. ZIRP and defined benefit pension plans are mutually exclusive. The private sector has been
exiting these plans for over 20 years. The public sector didn’t get the memo. Now there is bankruptcy risk.

It is never a good idea to rely on the good behavior of politicians. The best approaches are to control your own
retirement savings, and take action to avoid underfunding of pensions that are under government control.

Illinois now allows public sector unions the right to sue if funding falls short of funding commitments.
Taxpayers should be happy about this, as it will put a brake on spending. Municipal governments will have to
pay attention to the mix between cash and deferred compensation.

Illinois also enacted an optional defined contribution plan where employees would contribute the same amount
as to the traditional defined benefit plan. This is not a 401(k) plan. The employees do not have the right to make
elective contributions. Illinois had the opportunity to do this, but fell short. Allowing too many participants to
withdraw from the traditional plan would have impaired the state’s ability to pay current benefits.

Action

If you don’t like your defined benefit plan being blown up by politicians promoting zero interest rate policies,
consider that when you vote.

If you don’t like your pension plan being blown up by governmental entities skipping contributions, support
politicians that favor balanced budgets and full funding of pension obligations.

Make your own savings decisions. Support the adoption of 401(k) plans. If you don’t like the investment
returns, you can compensate by saving more.

Don’t rely exclusively on a government pension for retirement.

Implications for investors

  • Outcomes in a bankruptcy process are uncertain.

    Bankruptcy may be the only way that constitutionally protected pension benefits can be modified. Large
    municipalities with significant unfunded pension liabilities are bankruptcies waiting to happen, especially in
    states with constitutional guarantees.

    Bankruptcy can produce results that are stark. In Detroit’s case, estimates of recovery go as low as 16 cents
    on the dollar. “The average Detroit pensioner gets $19,000 a year – the cut would leave them with $3,040.”
    (Dominic Rushe, theguardian.com, 12/2/2013) These are not golden parachutes.

    The interests of bondholders run contrary to the interests of the pensioners. If pensioners are going to get more
    than a 16% recovery, it comes at the expenses of other creditors. A 0% recovery for some of them is pretty stark, too.

  • The existence of huge benefit obligations makes the current investment environment different from the 1930s.

    The investment community has used the low bond default rate of the 1930s to promote the safety of muni bond
    funds. That was then and Detroit is now. The level of post-retirement benefits (pensions and healthcare) is much
    greater now than it was in the 1930s.

    Based on the precedent in the GM bankruptcy, it is likely that bondholders will get a larger haircut than the
    pensioners. What were the investors in Detroit bonds thinking?

  • There is a real possibility of additional large municipal bankruptcies in future years.

    The government’s zero interest rate policy allowed a papering over of problems in municipal finance in the
    short-term, but made defined benefit pension plans an untenable proposition. The eventual adjustment, as is
    happening in Detroit, will be catastrophic. Now when we have a bankruptcy, it is a doozie.

Action

Do a review of the municipality’s pension funding behavior before purchasing their bonds.

Avoid the bonds of municipalities that have significant unfunded pension liabilities.

Avoid the bonds of municipalities that have been unable to make annual recommended contributions.

If you own a municipal bond fund, know what bonds are owned.
(See the table “Under Funded Municipal Pensions” at the end of this article.)

Appendix – Analysis of Judge Rhodes’ ruling

Detroit is the largest municipal bankruptcy in the history of the United States, but it will not be the last. It is
important to understand the legal framework under which pension claims can be impaired, even when there are
state constitutional guarantees.

The following analysis is on the wonkish side, but is worth a read. References are to page numbers in the ruling.

Issue #1: Does protection of pension benefits under state constitutions preclude a chapter 9 bankruptcy filing
where pension benefits may be impaired?

One of the objections to the bankruptcy petition was that it violated the Contracts Clause of the U.S.

Constitution. States are precluded from impairing contracts. The argument was that Michigan empowered the
court to do this by approving the bankruptcy petition. This argument, if accepted, would have undermined the
foundation of the U.S. bankruptcy process.

The court ruled that federal bankruptcy courts are empowered to impair contracts.

“B. Chapter 9 Does Not Violate the Contracts Clause of the United States Constitution

The Contracts Clause of the United States Constitution, which is Article 1, Section 10, provides, ‘No
State shall… pass any… Law impairing the Obligation of Contracts, …’

As the court stated in In re Sanitary & Imp. Dist., No. 7, 98 B.R. 970 (Bankr. D. Neb. 1989):
The court further concludes that the Bankruptcy Code adopted pursuant to the United States

Constitution Article 1, Section 8 permits federal courts through confirmation of a Chapter 9 plan
to impair contract rights of bondholders and that such impairment is not a violation of by the
state or the municipality of Article 1, Section 10 of the United States Constitution which prohibits
a state from impairing such contract rights.

Or, more succinctly stated, “The Bankruptcy Clause necessarily authorizes Congress to make laws
that would impair contracts. It has long been understood that bankruptcy law entails impairment of
contracts.” Stockton, 478 B.R. at 15, 17 U.S. 122 (page 52-53)

There is a separation of powers issue here. The authorization of a bankruptcy petition empowers the federal
government to do certain things, the principal one being to compromise claims. The state does not surrender
“political and government powers.”

“Because state and local officials must authorize the filing of a chapter 9 petition, 11 U.S.C. Section
109(c)(2), and because they retain control over ‘the political and government powers’ of the
municipality, these state officials remain fully politically accountable to the citizens of the state and
municipality.” (Page 72)

Conclusion

State constitutional protection of pension benefits does not preclude a bankruptcy filing.

Issue #2: Do constitutional protections of pension benefits remain in force during a chapter 9 bankruptcy?
This is the wording of Michigan’s constitutional protection of pension benefits.

“The accrued financial benefits of each pension plan and retirement system of the state and its political
subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.
(Michigan Constitution, Article 1, Section 11)” (Page 76)

The ruling basically says that the Contract Clause of the U.S. Constitution applies to the states, but not to the
federal government in a bankruptcy case.

“When the State Consents to a Chapter 9 Bankruptcy, the Tenth Amendment Does Not Prohibit the
Impairment of Contract Rights That Are Otherwise Protected by the State Constitution.” (Page 73)

“The constitutional foundation for municipal bankruptcy was well-articulated in Stockton:

In other words, while a state cannot make a law impairing the obligation of contract, Congress
can do so. The goal of the Bankruptcy Code is adjusting the debtor-creditor relationship. Every
discharge impairs contracts. While bankruptcy law endeavors to provide a system of orderly,
predictable rules for treatment of parties whose contracts are impaired, that does not change the
starring role of contract impairment in bankruptcy.

It follows then, that contracts may be impaired in this chapter 9 case without offending the
constitution. The Bankruptcy Clause gives Congress express power to legislate uniform laws of
bankruptcy that result in impairment of contract; and Congress is not subject to the restriction
that the Contracts Clause places on states.

For Tenth Amendment and state sovereignty purposes, nothing distinguishes pension debt in a municipal
bankruptcy from any other debt. If the Tenth Amendment prohibits the impairment of pension benefits
in this case, then it would also prohibit the adjustment of any other debt in this case.” (Page 74)

The ruling then articulated why Michigan pensions are simply contractual rights and are not given greater
protection.

“In the 1963 Constitution, this provision enhancing the protection for pensions was included: ‘The
accrued financial benefits of cash pension plan and retirement system of the state and its political
subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.’
(Michigan Constitution, Article IX, Section 24)” (Page 76)

“First, the language of article IX, section 24, gives pension benefits the statue of a ‘contractual
obligation.’ The natural meaning of the words ‘contractual obligation’ is certainly inconsistent with the
greater protection for which the Plans now argue. (Page 78)

Second, if the Michigan Constitution were meant to give the kind of absolute protection for which the
Plans argue, the language in the article IX, section 24 simply would not have referred to pension benefits
as a ‘contractual obligation.’

Fifth, an even greater narrative must be considered here, focusing on 1963. Bekins had long since
determined that municipal bankruptcy was constitutional. That of course meant that even though states
could not impair municipal contracts, federal courts could do so in a bankruptcy case. Indeed, Michigan
law then allows municipalities to file bankruptcy.

It was within that framework of rights, expectations, scenarios and possibilities that the newly
negotiated, proposed and ratified Michigan Constitution of 1963 explicitly gave accrued pension benefits
the stature of contractual obligations. That new constitution could have given pensions protection from
impairment in bankruptcy in several ways. It could have simply prohibited Michigan municipalities
from filing bankruptcy. It would have somehow created a property interest that bankruptcy would be
required to respect… Or, it could have established some sort of a secured interest in the municipality’s
property… It could even have explicitly required the State to guaranty pension benefits. But it did none
of these.

Instead, both the history from the constitution convention, quoted above, and the language of the
pension provision itself, make it clear that the only remedy for impairment of pensions is a claim for
breach of contract.” (Page 79-80)

This general rule covering contractual pension claims is clear. Once the process goes into bankruptcy court,
state constitutional protections are lost.

“It follows that if a state consents to a municipal bankruptcy, no state law can protect contractual pension
rights from impairment in bankruptcy, just as no law could protect any other types of contract rights.

Stated another way, state law cannot reorder the distributional priorities of the bankruptcy code. If the
state consents to a municipal bankruptcy, it consents to the application of chapter 9 of the bankruptcy
code. This point was driven home in the Stockton case:

A state cannot rely on the Section 903 reservation of state power to condition or to qualify, i.e. to ‘cherry
pick,’ the application of the Bankruptcy Code provisions that apply in chapter 9 cases after such as case
has been filed…

While a state may control prerequisites for consenting to permit one of its municipalities (which is arm
of the state cloaked in the state’s sovereignty) to file a chapter 9 case, it cannot revise chapter 9.” (Page
92-93)

Conclusion

Once a state authorizes a chapter 9 bankruptcy filing, it agrees to follow federal law allowing for impairment of
pension liabilities. State constitutional protections no longer apply.

Issue #3: Can state courts intervene in the bankruptcy process?

“Filings of bankruptcy petitions are a matter of exclusive federal jurisdiction. State courts are not
authorized to determine whether a person’s claim for relief under a federal , in a federal court, and
within that court’s exclusive jurisdiction, is an appropriate one. Such as exercise of authority would be
inconsistent with and subvert the exclusive jurisdiction of the federal courts by allowing state courts to
create their own standards as to when persons may properly seek relief in cases Congress has specifically
precluded those courts from adjudicating… The ability collaterally to attack bankruptcy petitions in the
state courts would also threaten the uniformity of federal bankruptcy law, a uniformity required by the
Constitution. (Gonzales v. Parks, 830 F.2d 1033)” (Page 100)

Conclusion

State courts have no say in the process.

Legal Status of Pension Benefits
State Contractural Statutory Gratuity Undetermined Special Constitutional Protection
of Public Pension Benefits
Alabama X No
Alaska X Yes
Arizona X Yes
Arkansas X No
California X No
Colorado X Yes
Connecticut X No
Delaware X
No
Limited protection for
elected/appointed officials
Florida X Yes
Georgia X Yes
Hawaii X Yes
Idaho X No
Illinois X Yes
Indiana X No
Iowa X No
Kansas X No
Kentucky X Yes
Louisiana X Yes
Maine X No
Maryland X No
Massachussets X No
Michigan X Yes
Minnesota X No
Mississippi X No
Missouri X No
Montana X No
Nebraska X No
Nevada X No
New Hampshire X No
New Jersey X No
New Mexico X No
New York X Yes
North Carolina X No
North Dakota X No
Ohio X No
Oklahoma X No
Oregon X No
Pennsylvania X No
Rhode Island X No
South Carolina X No
South Dakota X No
Tax and Financial ISSUES 10
State Contractural Statutory Gratuity Undetermined Special Constitutional Protection
of Public Pension Benefits
Tennessee X No
Texas X Yes
Utah X No
Vermont X No
Virginia X No
Washington X No
West Virginia X No
Wisconsin X No
Wyoming X No
Totals 38 5 4 3 12
Under-Funded Municipal Pensions
Pension
Liability < 70% Funded Recommended Contribution < 70% Funded Total Liability ($, Mil.) Unfunded Liabilty ($, Mil.) Bond Rating Rating Firm Charleston, WV 24% 39% $270 $65 Chicago, IL 52% 43% $27,294 $14,193 BBB+ Fitch Detroit, MI 93% 76% $7,910 $7,356 CCC Fitch Fargo, ND 69% 60% $174 $120 Jackson, MS 65% 64% $506 $329 Little Rock, AR 59% 44% $498 $294 New Orleans, LA 61% 54% $1,993 $1,216 Omaha, NE 43% 45% $1,429 $614 Philadelphiia, PA 62% 70% $18,337 $11,369 A- Fitch Portland, OR 50% 62% $5,462 $2,731 Providence, RI 42% 100% $1,874 $787