Detroit bankruptcy ruling: Implications for public pension plans

Written By: Thomas Dubbs Senior Partner Labaton Sucharow

Once the prosperous centre of America’s automobile industry and the birthplace of Motown music, Detroit now has a new title – the largest bankrupt city in US history. It is also the largest US municipal bankruptcy by debt, estimated at over $18 billion, including $3.5 billion in unfunded pension liabilities to the city’s two largest unsecured creditors – its two pension plans. These plans represent over 32,000 active and retired city employees whose pensions are now directly at risk in Detroit’s unfolding bankruptcy.

On December 3, 2013, a federal bankruptcy court in Detroit approved the city’s eligibility for bankruptcy under Chapter 9 of the US Bankruptcy Code, which governs municipal bankruptcies. Detroit had filed for bankruptcy in July 2013 following years of financial troubles. Earlier in March, those troubles had culminated in the Michigan governor declaring a state of financial emergency in Detroit and the appointment of a private bankruptcy attorney, Kevyn D. Orr, as Detroit’s “Emergency Manager.” Over 100 parties, many representing the city’s workers and retirees, subsequently filed objections to Detroit’s bankruptcy petition. Both the United States and the Michigan Attorney General intervened in the action because the case implicated significant constitutional issues under both the US and Michigan constitutions. The court held a highly publicised 9-day trial on factual issues in late October. About a month later, the court issued its landmark decision, paving the way for Detroit to proceed with a restructuring plan that is expected to have significant cuts for all of its creditors, including its pension plans.

Judge Steven W. Rhodes held that Detroit met the requirements for a municipality’s eligibility under Chapter 9 bankruptcy. Specifically, he found that the city was authorised to be a debtor under state law, was insolvent (as evidenced by the city’s dismal conditions, discussed at great length in the written opinion) and filed for bankruptcy in good faith. Although he determined that the city did not negotiate in good faith with creditors in the lead-up to the bankruptcy filing, he found that such negotiations were impracticable given the sheer number of Detroit’s creditors (over 100,000). The judge also rejected various constitutional challenges to Chapter 9 and the Michigan state law that authorised the appointment of Detroit’s Emergency Manager.

The most controversial and unprecedented part of the decision was its holding that Detroit’s pension benefits are not accorded any heightened protection in bankruptcy despite a provision in the Michigan state constitution (and found in other state constitutions) protecting accrued public pension rights against impairment. Effectively, the court ruled that federal bankruptcy law trumps any such protections in the Michigan state constitution. Thus, the city’s pensions may be cut in the same manner as the debts of other creditors in any future plan of adjustment submitted by Detroit. Nevertheless, the judge cautioned that this holding does not necessarily mean that he will approve such a plan of adjustment that cuts pension benefits, emphasising that he will not exercise such a power lightly.

The decision is already being appealed, with multiple notices of appeal by the city’s unions and pension plans filed quickly after the ruling, and the appeals may be expedited.

The implications of the decision for public pension funds in the US and generally are potentially wide-reaching. Michigan is considered to have some of the strongest protections for public pensions in the country. The fact that the Bankruptcy Court found, in spite of these provisions, that these funds may be vulnerable as a result of Detroit’s filing suggests that other pension plans in cash-strapped municipalities may be equally vulnerable. CalPERS, the largest US pension system that represents California state employees, has taken the position that the California constitution, which contains a pension provision similar to Michigan’s, overrides federal bankruptcy law. To date, at least two California municipalities that have entered bankruptcy have not challenged CalPERS’ position, excluding pensions from their restructuring plans. However, another recently bankrupt California city may test CalPERS’ position in its own ongoing bankruptcy proceedings. This legally uncharted issue may be further tested before the US Supreme Court. Investors and municipalities alike will need to watch these developments closely in 2014.