Finance

Detroit Becomes Biggest U.S. City Ever Eligible for Bankruptcy

Public pensions were dealt a historic blow Tuesday when a Detroit bankruptcy judge sided with the city in ruling that entitlements could be subject to cuts in municipalities under Chapter 9 protection.
by | December 3, 2013
 

A Detroit bankruptcy judge dealt public pensions a historic blow Tuesday when he sided with the city in ruling that the entitlements could be subject to cuts in municipalities under Chapter 9 protection.

The decision came as part of U.S. Bankruptcy Judge Steven Rhodes’ 140-page opinion that concluded Detroit is eligible for bankruptcy protection. The decision on pensions is a precedent-setting one as Rhodes is the first bankruptcy judge to rule on retirees’ status as creditors.

Rhodes, who spent one and a half hours delivering his opinion from the bench, concluded that the city’s pension debt was similar to other creditor debt and that any state constitutional protections for pensions did not apply in federal bankruptcy court. Unions have argued that pensions, which are protected under Michigan's constitution, cannot be impaired. Detroit's claim is that state constitutional protections no longer hold in federal bankruptcy court and that pension payments can be cut like any other debt to creditors.

“Nothing distinguishes pension debts from other municipal debts, notwithstanding the state constitution,” Rhodes said, according to media reports. He added that “it has long been understood that bankruptcy law entails the impairment of contracts … [and] pension rights are contract rights under the Michigan constitution.”

However he warned that his decision does not mean he will approve a plan with deep pension cuts. “This court will not lightly or casually exercise power … to impair pensions,” he said.

Still, the decision sent waves through city governments on Tuesday as many have been closely watching the Detroit case as a potential precedent setter for pension protections in bankruptcy.

"It’s huge," said Frank Shafroth, director of the George Mason University Center for State and Local Government Leadership, of the decision. He added that, given the potential implications for this decision on other municipalities, this was not a decision Rhodes came to easily. "I really think at the end of the day, that the judge could not perceive a way that Detroit could actually have a plan of recovery and get back on its feet unless there were some haircuts to these pensions."

Some, though, are concerned about the ruling's ripple effects given Detroit's unique status. Many factors have worked against the city for years: declining population and revenue, decreased state revenue sharing, escalating personnel costs, mounting debt and high-risk financial gambles that didn't pay off. Not every distressed city has those particular strikes against it.

"I do have some concerns about bad facts leading to a bad precedent," said Michael Nadol, a managing director of PFM Group, in an interview prior to the ruling. He added that "the truly extraordinary nature of Detroit's case" may warrant some unusual measures, "But I’m not sure it’s the right case to be setting precedent for other distressed municipalities."

Previous bankrupt municipalities have avoided the issue by not proposing cuts to retirees in their restructuring plan or, in the case of Central Falls, R.I., negotiating an agreement with retirees prior to submitting a restructuring plan. San Bernardino, Calif., which filed for bankruptcy last year, is arguing that the mammoth state pension system CalPERS should take a haircut right alongside the city's bondholders and other shareholders. (California's pensions are protected as contracts under that state's constitution.) The two sides are currently in mediation on the issue.

Shafroth and others have said that the debate over pension status in bankruptcy is an issue that will make its way to the U.S. Supreme Court. If the Detroit ruling stands, it could change the nature of negotiations between unions and cities.

"The unions have said, 'Pensions are constitutionally protected, we don’t have to be at the table,'" Shafroth said. "The decision today says, 'Oh yes you do.'"

But unions say Detroit employees have already been to the negotiating table (the city negotiated paycuts and benefits cuts last year) and there is no more room to cut. They point out that the city's pensions, which are less than $20,000 per year for the average retiree, don't afford much wiggle room either. Donald Smith, a 69-year-old city retiree, said his "heart skipped a beat" when he heard the ruling Tuesday. He has a monthly pension of $889 after nearly 30 years with the city and a $1,000 monthly Social Security check. After healthcare deductibles and rent, he lives on about $300 per week.

"I have no idea how I’m going to manage," he said.

The unions have already filed their appeal to Tuesday's ruling and Rhodes is considering a motion to allow that appeal to bypass the district court and go directly to the U.S. 6th Circuit Court of Appeals.

"We are hopeful that our arguments will prevail on appeal regarding the state constitution protecting the rights of retirees," said Michael Artz, associate general counsel at the American Federation of State, County and Municipal Employees. "We think we have strong arguments for our side."

Detroit filed for bankruptcy on July 18, claiming $18 billion in debt, a figure, particularly an estimated $3.5 billion in pension liabilities, unions challenged during the city's eligibility hearing. Rhodes said Tuesday determining the level of underfunding was not important in determining the city's eligiblity, but routinely cited that figure and others used by the city when summing up his opinion that Detroit was financially insolvent.

Detroit’s plan of adjustment is due on Mar. 1; city attorneys said they hope to file it before that date.

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