Three Potential Legal Obstacles To Using Detroit’s Bankruptcy To Slash Pensions

Credit: AP

The legal issues surrounding Detroit’s bankruptcy filing are a mess. And, depending on how these thorny and uncertain issues are resolved, this bankruptcy could potentially force thousands of retirees into abject poverty. Detroit city manager Kevyn Orr, an appointee of Gov. Rick Snyder (R-MI), hopes to use bankruptcy to cut Detroit’s $11.5 billion debt down to just $2 billion — potentially cutting an average retiree’s pension benefits by 83 percent in the process.

Pensioners are at risk because of a hole in federal law — the federal Pension Benefit Guaranty Corporation provides a minimal level of benefits to retirees when a private business goes bankrupt, but it provides no such security to pensioners in the public sector. As a result, retired Detroit police officers, firefighters and other former city employees could lose the lion’s share of benefits that are not particularly generous to begin with. The average retired Detroit police officer or firefighter receives just $30,000 a year in pension benefits — as compared to $42,000 in Kansas City, $47,000 in Dallas, or $58,000 in Los Angeles.

Several potential legal roadblocks stand between Detroit and bankruptcy, however — or at least between Kevyn Orr and his plan for sweeping pension cuts. Here are a few:

1. The Michigan Constitution

The most obvious obstacle to this bankruptcy is a state judge’s decision last Friday declaring it unconstitutional under the Michigan state constitution. That constitution provides that “[t]he 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.” Thus, to the extent that Detroit’s bankruptcy filing seeks to diminish already-accrued pension benefits, the filing itself may be unlawful.

The state judge’s ruling ordering the bankruptcy filing withdrawn is already on appeal, and it’s likely that this issue will ultimately be resolved by the state supreme court — which has a 5-2 Republican majority. So there is no guarantee that the trial judge’s order will ultimately be upheld on appeal.

2. Federal Bankruptcy Law

Even if federal bankruptcy courts proceed with resolving Detroit’s bankruptcy, federal bankruptcy law itself may prevent incursions into retirees’ pensions. Under federal law, Detroit may only file for bankruptcy if it “is specifically authorized” to do so under state law. On its face, this provision appears to preclude Detroit from filing bankruptcy, since the Michigan constitution also appears to prohibit Detroit from taking any action that would reduce its pension obligations.

Georgetown Law Professor Adam Levitin suggests that another provision of law may apply, however — a provision that would allow Detroit’s bankruptcy to move forward while also protecting pensioners. That provision provides that a court must confirm that Detroit “is not prohibited by law from taking any action necessary to carry out” a plan to discharge the city’s debts. Thus, because the Michigan constitution prohibits Detroit from reducing accrued pension obligations, the combination of this constitution and federal law “should protect unionized and non-unionized employees’ accured pension benefits.”

Nevertheless, Levitin also warns of a potential bait-and-switch. It’s possible that the Michigan courts could permit Detroit to file bankruptcy — perhaps on the assumption that federal law protects the pensioners and thus the state constitution would not be violated by such a filing — only to have a federal bankruptcy judge decide to slash those pensions anyway. Moreover, as Levitin also notes, the Michigan constitution may not provide complete protection to retirees and current workers — “it’s worth noting what the Michigan constitution does not do: it provides no protection for non-accured pension benefits. Current employees might find the terms of their pension plans changed going forward. It’s also not clear to me whether this provision extends to protect accrued retiree health benefits.”

3. Premature Filing

Finally, federal bankruptcy law requires Detroit to show that it “has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of” the debts it seeks to discharge in bankruptcy. Orr himself predicts a legal fight over “whether or not the city made a good faith effort to negotiate with creditors over its more than $18 billion of debt.”