JURIST Guest Columnist, Igor Shleypak, University of Illinois College of Law Class of 2014, discusses Detroit’s bankruptcy, pension restructuring and how Chapter 9 bankruptcy may become a more viable option for local governments in financial trouble…

Growing up in the Detroit area, there are constant reminders of the situation the Motor City finds itself in: buried under massive debt, nostalgia for the glory days of the Big Three and the sad possibility that Robocop may have been right. The simple truth is that Detroit has been hurting for some time. Over the past 60 years, the city has lost more than half of its population, its major industrial support has all but abandoned it and the city has suffered chronic mismanagement and corruption. Today, the city’s revenue streams are starting to run dry, yet at the same time the city finds itself in debt for as much as $20 billion. Over half of that debt is owed to underfunded employee health and pension funds, and if something is not done soon this debt will become unmanageable. Due to such burdens, it is no wonder that the city declared the largest Chapter 9 municipal bankruptcy in the history of the US. Now, if Detroit hopes to successfully reorganize, it must make the hard choice between honoring its past obligations to its employees or discharging its debt in the hopes of a better financial future.

Chapter 9 municipal bankruptcy is a unique legal construct that not only deals with the Federal Bankruptcy Code, but also with the federal and state constitutions. Unlike a normal Chapter 11 reorganization, Chapter 9 is limited by the 10th Amendment, which reserves to the individual states those powers “not delegated to the United States by the Constitution, nor prohibited by it to the States[.]” Consequently, while a court dealing with a Chapter 11 bankruptcy can replace the governing body of a company with a trustee and then subsequently liquidate the company, when dealing with a Chapter 9 bankruptcy, the court is expressly forbidden from interfering with the political powers of the debtor and is unable to liquidate the debtor’s assets. Moreover, due to the dearth of Chapter 9 filings in the history of the bankruptcy code, the jurisprudence is highly undeveloped. Furthermore, it is not entirely clear how a state constitution fits into the picture. In this case, the Michigan constitution provides that the accrued pension benefits “shall be a contractual obligation thereof which shall not be diminished or impaired thereby[.]” Finally, there has yet to be a case where a municipality sought to restructure its pension obligations when the pension was protected by a state constitution.

Despite these hurdles, Detroit may still be able to restructure its obligations. The purpose of Chapter 9 is to allow local governments to do under federal law what they are unable to do under state law. The states are prevented from passing any “Law impairing the Obligation of Contracts” because they are bound by the contracts clause of the US Constitution. Therefore, once a municipality enters into a contractual obligation, it cannot unilaterally amend that obligation. While the states are not allowed to offer any sort of relief from such burdens, Congress can do so by exercising its inherent power to establish “uniform Laws on the subject of Bankruptcies throughout the United States[.]” Congress used that very power to establish the bankruptcy code, and Chapter 9 in particular. The limitations of the 10th Amendment still prevent a local government from being forced into bankruptcy, as such action interferes with the political sovereignty of the state. However, a state can authorize its local governments to request Chapter 9 protection.

Once the petition is filed, the debtor receives almost all of the protections afforded under the bankruptcy code. This includes the ability to restructure general unsecured claims against the debtor, such as the underfunded portions of a pension fund. For any debt to be restructured, a bankruptcy court must confirm the debtor’s plan. A key requirement to confirmation, however, is that “the debtor is not prohibited by law from taking any action necessary to carry out the plan[.]” This has been traditionally interpreted to mean that the debtor’s actions, as proposed by the plan, must conform with state laws. In In the Matter of Sanitary & Improvement Dist., #7, for example, this meant that the debtor could not confirm a plan which would issue bonds whose provisions violated Nebraska state law. For Detroit, this could mean not being able to confirm a plan that potentially violates the Michigan constitution.

The real question for Detroit is whether modifying its pension obligations constitutes an action that is prohibited by law. On the surface, the answer seems unequivocally “yes.” When examined further, the answer is not as clear. As the slim amount of existing jurisprudence holds, this appears to be a question of timing more than anything else. In Sanitary & Improvements Dist. #7, the problem concerned the issuance of bonds which did not guarantee their full payment prior to payment of warrant holders, a restriction which was against state law. However, the restriction only applied to the bonds that were being issued as part of the plan, i.e. the bonds that would be issued after bankruptcy as a means to finance the court-approved restructuring plan. The restriction did not apply to the impairment of the pre-petition bonds while in bankruptcy. Following this reasoning, the court in In re City of Columbia Falls, Mont., Special Imp. Dist. No. 25 held that the provision at issue there only “applie[d] to postpetition actions after confirmation of the plan[.]”

To analogize, between the time that the petition is filed and either a plan is confirmed or the case is discharged, the debtor enters a sort of “bankruptcy bubble.” The “bubble” grants the debtor certain powers that are otherwise unavailable. One of these powers is to modify and impair contractual rights. This power can allow Detroit to modify its pension obligations while in bankruptcy. However, once a plan is confirmed, or the case discharged, the Michigan and Federal Constitutions take effect and only that which the city achieved in bankruptcy would remain. In other words, Detroit’s plan can be confirmed if it proposes restructuring its existing pension debt and a plan to pay it off. However, if part the of the plan requires further reductions of pension obligations after confirmation, then such a plan would not be confirmable. Of course, this is merely one possibility extrapolated from the limited amount of case law available. The US Supreme Court has yet to interpret this provision, but under this theory, a city like Detroit could successfully restructure its pension obligations.

Even if Detroit can modify its pension obligations, the bigger question is whether it should do so. The effect that such a modification would have on the city and the nation as a whole is likely to be immeasurable. Detroit’s other financial difficulties certainly exacerbate the problem, but the pension issue by itself is not entirely unique to Detroit. One study [PDF] found that 61 of the largest US cities have a combined underfunded pension obligation of about $100 billion and another $118 billion in underfunded health care obligations. Another study puts the total underfunded pension liability for all municipalities at over $2 trillion. Even a relatively financially stable city like Chicago has a pension fund that is only about 52 percent funded [PDF]. As a result, a successful pension restructuring through bankruptcy could have ripple effects throughout the nation. Specifically, Chapter 9 may become more alluring for local governments seeking creative ways to solve their budget problems.

Modifying its debt, particularly pension debt, is an important step in Detroit’s recovery. Needless to say, the city has some difficult decisions to make in the weeks ahead. No matter the outcome, city planners and pensioners around the nation will be watching eagerly for what is to come.

Igor Shleypak is the Notes Editor of the Journal of Law, Technology and Policy, Director of External Affairs for the Jewish Law Students Association and participant on the Duberstein Bankruptcy Moot Court. His experience includes an externship with the Honorable Laura Liu of the Cook County Circuit Court, Foreclosure Division and the Michigan Energy Office. He earned his Bachelor of Arts in political theory and constitutional democracy from Michigan State University. Currently, Shleypak is a law clerk for Dodson, Piraino & Associates.

Suggested citation: Igor Shleypak, Pensions and Chapter 9 Bankruptcy: How Detroit May Boldly Go Where No Municipality Has Gone Before , JURIST – Dateline, Aug. 28, 2013, http://jurist.org/dateline/2013/8/igor-shleypak-detroit-bankruptcy.php