Pension Protection and the Detroit Bankruptcy

In previous posts, I’ve discussed how public employee pensions are protected by the Contract Clause of the federal and state constitutions, and I’ve explained the intricacies of constitutional provisions like that in California. It turns out that constitutional pension protections interact interestingly with bankruptcy law, as we’re finding out in the ongoing Detroit bankruptcy.

* * *

The city of Detroit couldn’t pay its bills, and so, on July 18, 2013, it declared bankruptcy under Chapter 9 of the federal Bankruptcy Code, the chapter reserved for municipalities. Detroit estimated that it had $18 billion of debt-about $12 billion of unsecured debt and $6 billion of secured debt-and 100,000 creditors. Almost all of the unsecured debt is related to health and life insurance benefits and unfunded pension obligations; the unfunded pension obligations alone are $3.5 billion, according to the city. The pension funds themselves dispute that amount; using more charitable actuarial assumptions-including higher estimates of annual rates of return on investments-they argue that total unfunded pension obligations are “only” $1 billion. Obviously, the city argues that these more charitable assumptions are too charitable; but whoever is right, the liabilities are substantial.

On March 13, 2013, after the release of several reports on Detroit’s finances, the governor of Michigan had announced, consistently with Michigan law, that a “financial emergency” existed in Detroit and appointed an “emergency manager” to run the city. The emergency manager met and negotiated with creditors, but ultimately recommended bankruptcy, which led to the governor’s decision to authorize the city to file for bankruptcy.

Many parties filed objections to the bankruptcy in federal bankruptcy court. On December 5, 2013, bankruptcy judge Steven Rhodes issued an opinion taking up about 95 pages of the Bankruptcy Reporter and discussing over a dozen separate state and federal legal theories, including federal constitutional objections to Chapter 9 on federalism grounds, federal constitutional objections to the use of bankruptcy courts (which are executive tribunals, as opposed to regular courts) on separation-of-powers grounds, a variety of state constitutional claims, and a variety of claims under Michigan law, including challenges to the authority of the emergency manager, as an unelected official, to file for bankruptcy.

Judge Rhodes rejected all the arguments and concluded that the city was eligible to file for Chapter 9 bankruptcy; this post will focus solely on the arguments related to public-employee pensions (somewhat reorganized for greater comprehensibility).

* * *

First, might Chapter 9 violate the federal Contract Clause? No, it doesn’t. As Article I, § 10 of the U.S. Constitution says, “No State shall . . . pass any . . . Law impairing the Obligation of Contracts.” By its explicit terms, the Clause binds only states, not the federal government. And a good thing, too, from the perspective of bankruptcy law, which is all about impairing contracts. One of the most important features of bankruptcy law is that it eventually discharges the unpaid portion of the debtor’s debts. (States can have insolvency laws of one sort of another, but one thing state insolvency law can’t do is discharge debts.) Thus, Chapter 9 is perfectly consistent with the federal Contract Clause.

But if Chapter 9 itself (Congress’s action) can’t violate the federal Contract Clause, what about the municipality’s action in filing for Chapter 9? We’re getting closer: at least here we have the action of a state (since municipalities are creatures of state law). But the federal Contract Clause only bans laws impairing the obligation of contracts, and a decision to file for bankruptcy isn’t a law. (For example, states don’t violate the Contract Clause by merely breaching contracts.)

So what about P.A. 436, the Michigan statute setting up the process by which the governor could authorize the emergency manager to file for Chapter 9? This is a state law-and since pretty much any bankruptcy will impair some contracts, the Michigan legislature knew when it passed the law that doing so would result in the impairment of some contracts. But that theory is foreclosed by United States v. Bekins (1938). In Bekins, the Supreme Court established that, even if municipalities can’t impair their own contracts, it doesn’t violate the Contract Clause for them to get their contracts impaired through the federal bankruptcy process. Essentially, the “consent” of the federal government (in the form of the provision of a federal process that the states can choose to use) authorizes some state contractual impairments that would otherwise be unconstitutional.

So much for the federal Constitution. What about the Michigan Constitution, though? There are two relevant provisions there. One is a general Contract Clause mirroring the federal version: “No . . . law impairing the obligation of contract shall be enacted” (emphasis added). And another is a specific Pension Clause: “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” (emphasis added). Note the “diminished or impaired” language for pensions, as opposed to the mere “impairing” language for contracts generally. The Chapter 9 objectors argued that, under the Michigan Constitution, pensions have stronger protection than other contracts-and that the application of Chapter 9 to cut pensions would violate the Michigan constitution for this reason.

But (as the bankruptcy court recognized) it seems unlikely that the Pension Clause is any stronger than the Contract Clause. Observe the wording of the Michigan pensions provision: pension obligations are contractual obligations. If the Michigan constitution had really intended to give pensions greater protection than contracts generally, it wouldn’t have characterized pension obligations as contractual obligations, nor would it have copied the “impair” verb from the state Contract Clause. The more likely explanation is that the Michigan constitution, adopted in 1963, was explicitly trying to move away from the previous “pension as gratuity” legal regime and toward a “pension as contract” regime, so that pensions would start to get contractual protection-the same protection as other contracts. In any event, the difference in language is immaterial, because “impair or diminish” and “impair” basically mean the same thing.

So the Michigan Pension Clause doesn’t give pensions any greater protection against impairment than the Michigan Contract Clause all by itself. Not that it would have made much difference if it did: once Detroit chooses to go into bankruptcy (and unlike for people or corporations, there’s no such thing as an involuntary municipal bankruptcy), the federal bankruptcy scheme goes into effect, with all of Detroit’s debts getting the priorities set by federal bankruptcy law. Michigan law is powerless to change these priorities: under the federal Constitution’s Supremacy Clause, federal law, including bankruptcy law, trumps all state law, including state constitutional law.

Similarly, P.A. 436, the Michigan statute, allows the governor, in authorizing a municipal bankruptcy, to “place contingencies” on the local government in order to proceed under Chapter 9. Should the governor have included a condition in his authorization that would prevent the City from impairing pension benefits? For the same reasons, the answer is no: pensions have no more special status than any other contracts under Michigan law, and even if they did, such a contingency would be invalid because federal rules govern in a federal bankruptcy proceeding.

* * *

This leads to a potentially more serious set of objections. When municipalities enter bankruptcy, they know that they won’t be able to prevent pension obligations (or contract obligations generally) from being impaired. So perhaps municipalities’ doing so might violate Michigan’s Pension Clause (and/or Michigan’s Contract Clause)? As noted above, Bekins forecloses such an argument under the federal Contract Clause, but maybe Michigan courts might conclude that the state Contract Clause limits municipalities more than its federal counterpart does.

On first glance, this argument might seem to violate the Supremacy Clause. If Michigan law-or even the Michigan constitution-barred an individual or corporation from filing for bankruptcy, that would violate the Supremacy Clause, since a state can’t prevent someone from taking advantage of federal rights. But perhaps controlling municipalities is different, since municipalities are part of the government, so a state constitutional provision could be thought of as the state binding “itself.” Perhaps a better argument is that the federal Bankruptcy Code itself requires municipalities to have state authorization (from a statute or from a state officer) before they can file for Chapter 9; and some states in fact expressly forbid their municipalities from filing for Chapter 9. So it’s not crazy to think that a state constitutional provision could have the same effect (or, which is more or less the same, that the state constitution would prevent the governor from authorizing such a bankruptcy under P.A. 436).

And this is exactly the argument made in Webster v. Michigan, a case filed in state court on July 3, 2013, two weeks before the bankruptcy filing. The state court didn’t get around to holding a hearing until July 18-the same day as the bankruptcy filing-and entered an “Order of Declaratory Relief” the next day, on July 19, in an extremely hurried affair. As state judge Rosemarie Aquilina wrote:

IT IS HEREBY ORDERED

P.A. 436 is unconstitutional and in violation of [the Michigan Constitution’s Pension Clause] to the extent that it permits the Governor to authorize an emergency manager to proceed under Chapter 9 in any manner which threatens to diminish or impair accrued pension benefits; and P.A. 436 is to that extent of no force or effect;

. . .

In order to rectify his unauthorized and unconstitutional actions described above, the Governor must (1) direct the Emergency Manager to immediately withdraw the Chapter 9 petition filed on July 18, and (2) not authorize any further Chapter 9 filing which threatens to diminish or impair accrued benefits.

A copy of this Order shall be transmitted to President Obama.

The last sentence was handwritten, apparently by the judge herself. The President doesn’t have any legal role in the bankruptcy process (though perhaps the precedent of presidential meddling in the Chrysler bankruptcy was fresh in her mind). But it’s a free country, and nothing prevents a judge from sending mail to the President. Rhodes, the federal bankruptcy judge, had to decide what effect to give this somewhat irregular state court judgment. He decided to give this judgment no effect at all. The state court judgment was filed after the city had filed its petition-but, under the Bankruptcy Code, the federal district courts (which refer bankruptcy cases to bankruptcy courts) have exclusive jurisdiction over all bankruptcy cases once they’re filed. So, Judge Rhodes reasoned, the state court lacked jurisdiction and one could thus safely ignore anything it did. (But one can question this decision: the state court judgment didn’t purport to control the bankruptcy case; it merely decided an issue of the governor’s power under state law. The resolution of that issue might require the governor to try to withdraw the case, but it’s not totally obvious that the case is precluded by the bankruptcy court’s exclusive jurisdiction.)

Also, once a bankruptcy case is filed, all other actions seeking “to exercise control over property of the estate” are automatically stayed. Judge Rhodes wrote that the state court judgment was void because it violated this automatic stay. This is related to the exclusive jurisdiction point, though perhaps a bit weaker, since the state court judgment was about the governor’s and emergency manager’s authority, not about exercising control over the property of the bankruptcy estate. Nonetheless, when the state appealed Judge Aquilina’s order to the Michigan Court of Appeals, the court cited the automatic stay as a reason not to proceed. Once the automatic stay is lifted, conceivably, the case can be reopened. But by then the bankruptcy case will be over, and it may be too late to put the genie back into the bottle.

So Judge Aquilina’s order seems essentially dead, and the federal bankruptcy case is progressing. Judge Rhodes’s opinion clears away several constitutional objections to the municipal bankruptcy, some related to public-employee pensions and others related to other provisions; it seems a shame that he didn’t independently consider the issues decided by Judge Aquilina. But these arguments-that a state constitution can deprive a municipality of the authority to enter bankruptcy when public employee pensions could be impaired-seem not inherently crazy, and may yet resurface another day.

Alexander “Sasha” Volokh is an associate professor of law at Emory Law School. An archive of his previous Reason.org articles is available here.