Detroit Pensions Not Protected By Constitution In Bankruptcy

The fallout from the economic collapse in late 2007 continues. The recent filing by the City of Detroit for bankruptcy protection is the largest public sector bankruptcy petition ever filed. Looming in the background was Michigan’s Public Law 436, which granted the City consent to seek bankruptcy protection from pension obligations. At risk were the pensions of every City employee and retiree.

Detroit estimated its debt to be $18 billion. $4 billion of the debt was attributed to pensions, retiree health care, and life insurance. The average non-public safety pension was $18,000 per year and the average public safety pension was $30,000 per year. Most of the City’s pension obligations were unfunded due to the City’s failure to make necessary contributions as well as failed high risk investments.

The retirees raised federal and state constitutional challenges to the bankruptcy petition. Michigan’s public pensions are contractual obligations per the state constitution. The Bankruptcy Court, relying on Supreme Court precedent, ruled that the pensions were not protected from the bankruptcy proceedings.

One of the retirees’ challenges was that the Bankruptcy Code violated the Tenth Amendment and prevented the Bankruptcy Code from trumping state law or state constitutional provisions, even with the consent of a state legislature. The argument was based upon the principle that under the Tenth Amendment, authority not specifically granted to the federal government by the United States Constitution is reserved to the states, and that a municipality such as Detroit is an agency of a state.

The Court rejected the challenge, ruling that the Tenth Amendment did not apply since the bankruptcy laws only apply to a limited portion of the State of Michigan’s financial affairs, namely the financial affairs of a single municipality, and not the finances of the entire State. The Court reasoned that through the Bankruptcy Code, Congress was not seeking to control the State’s legislative authority on financial matters in general, and that thus the Code did not violate the separation-of-powers principles of the Tenth Amendment.

The retirees also argued that the application of the Bankruptcy Code to their pensions was unconstitutional under the so-called contract clause of the U.S. Constitution. The contract clause prohibits the government from “impairing” any existing contracts. By its very nature, bankruptcy law permits debtors to cancel debt by cancelling contracts. The retirees argued that subjecting their pensions to bankruptcy would impair the contractual obligation of the State to provide pension benefits. The Court rejected the argument, holding that the contract clause prohibited only states from passing laws that impaired contracts but did not apply to Congress.

Most significantly, the retirees argued that Michigan’s Public Law 436 violated the contract clauses of both the federal and Michigan Constitutions. The Court again rejected the argument, ruling that since bankruptcy is a right guaranteed by the federal Constitution, the power to impair contracts pursuant to the bankruptcy clause was a necessary exception to the contracts clauses.

In short, the Court found statutory and constitutional bankruptcy provisions give states broad powers to impair contracts between private parties as well as government entities and private citizens regardless of whether the services entitling one party to payment have been rendered or, as in the case of pensions, the pension rights have vested, even when those pension rights were guaranteed by a state constitutional provision that declared pensions contracts. The Court held that a contractual pension right is no different than any other contract subject to cancellation under bankruptcy laws.

If there was any good news for retired public employees in this decision, it was that simply because the pension obligation was subject to discharge, the City was not relieved of its burden of showing that the pension obligation should be discharged. The City was still obligated to present a plan of bankruptcy adjustment that is appropriate under the bankruptcy laws and the laws of Michigan and that serves the interests of the City and all its creditors. What will ultimately happen is anybody’s guess.

In re City of Detroit, 2013 WL 6331931 (E.D. Mich. 2013).

We have posted a table of post-retirement benefits/contract clauses on our website at http://www.LRIS.com/2014/01/22/post-retirement-benefits-contract-clause-table-of-cases/.