In Detroit, bankruptcy may be the hidden elixir of pension reform

Nick Dranias | Vice President, Compact for America Educational Foundation

“It” appears to be sobering up the drunken sailor spending spree of Vallejo and San Bernadino, California. “It” is essential to Central Falls, Rhode Island and Prichard, Alabama climbing out of their financial collapse. And because of “It,” there is hope Detroit will finally rebound. The “It” is Chapter 9 municipal bankruptcy: the federal law allowing cities and other state subdivisions to seek relief from obligations they cannot afford to pay.

As recognized by federal Bankruptcy Court Judge Steven Rhoades in his recent decision, Chapter 9 just might be the only effective elixir of fiscal reform for Detroit, where nearly half of its $18.5 billion in debt consists of pension and post-retirement benefit obligations. By filing for bankruptcy, Central Falls, Rhode Island was able to negotiate a deal last year that froze some pension payouts at $10,000 annually and that reduced other pension benefits by up to 55 percent. If this example is followed, bankruptcy could very well restore the hope of solvency to Detroit — and sustainability to its pension plan.

Despite legitimate concerns about the human impact of such steep cuts, hard choices must be made to make whatever is left of Detroit’s pension plans sustainable. More than ten years ago, Prichard, Alabama negotiated a bankruptcy plan exchanging a one-time $16.5 million cash infusion for a mere 8.5 percent reduction to all existing and future pension benefit payments. This reform, unfortunately, proved insufficient to restore Prichard’s financial health. Because of an inability to pay pension obligations in the depths of the post-2008 recession, the city filed for bankruptcy again in 2009. The reductions in pension benefits will have to be much more significant if Prichard is to regain solvency.

As illustrated by Central Falls’ Chapter 9 plan, bankruptcy does not mean that pensioners will get nothing. But Prichard’s experience shows that public pension systems around the country are so lavish and unsustainable that deep cuts will likely have to be made to withstand a recession.

Not surprisingly, government employee unions discovered a new love for “states’ rights” in their failed attempt to block the use of Chapter 9 bankruptcy to reduce their overly generous retirement benefits. In Detroit’s bankruptcy case and in other cases brought in California, unions have invoked state constitutional provisions that declare public pensions are contracts which cannot be impaired or diminished. Based on these provisions, unions have argued that public pensions are somehow immune from bankruptcy.

Judge Rhodes was right to rule their argument was plainly wrong. The simple fact is that the state constitutional provision invoked by government unions does not contain any legal term that actually bars Detroit from filing for bankruptcy. Moreover, when adjusting pension obligations, bankruptcy courts are not required to observe state pension protections to the very extent they conflict with the debt adjustment provisions of the bankruptcy code. Bankruptcy is an expressly delegated federal power that preempts any conflicting state constitution or law under the Constitution’s Supremacy Clause so long as the filing is voluntary.

However, it is somewhat concerning that Judge Rhodes conceded that bankruptcy filings cause pension funds to be impaired. The state does not impair or diminish pension benefits by merely authorizing an insolvent city to file for bankruptcy. Rather, an insolvent city’s own inability to pay excessive pension benefits is what impairs or diminishes those benefits independently of any bankruptcy authority.

Likewise, an insolvent city filing a bankruptcy petition does not impair pension obligations, the obligation remains intact unless it is adjusted by the bankruptcy court. And by adjusting municipal debts, a bankruptcy court is only bringing to a head the inevitability of someone getting a haircut. Far from assisting Detroit in impairing pension obligations, Judge Rhodes was merely a handmaiden of the impairment of debts that was already compelled by financial reality, independent of any bankruptcy filing.

Even if public pension benefits were somehow specially protected from adjustment in bankruptcy, perhaps like income tax obligations or student loans, that would do nothing to block cities from filing for bankruptcy. The IRS, after all, cannot block an individual from filing simply because that individual might ask the court to reduce his income taxes. Instead, creditors like the IRS are required to object to the proceeding in bankruptcy court. Of course, neither pensioners nor public pension funds enjoy the protections from bankruptcy that apply to the IRS.

In short, as Judge Rhodes ruled, unions cannot lawfully block or sidestep an insolvent city’s Chapter 9 bankruptcy proceeding — and it is doubtful that the unions who are trying to do so are motivated by ensuring the rule of law. It seems more likely that they are trying to avoid an undesirable judicial forum. They would rather keep the fight over pension reform in state courts where the state judiciary’s own retirement interests are often threatened by such reform, and judge-made law has continuously blocked efforts to reform public pension plans. Fortunately, Judge Rhodes essentially rejected this forum shopping gambit.

Chapter 9 bankruptcy thus remains a potent brew for pension reform. But we should not wait for cities like Detroit, San Bernadino, Vallejo, Prichard, and Central Falls to collapse under the weight of excessive pension benefits before taking this medicine. Instead, state legislators across the country should pass a law that empowers insolvent pension funds to take a sip of this magic stuff themselves. The mere existence of such a law will maximize leverage by pension fund trustees to extract reasonable concessions from all stakeholders to reform the system voluntarily. If such concessions fail to materialize, filing for bankruptcy will allow pension funds to be restructured in an orderly and equitable fashion before the burden of excessive retirement benefits sinks the next American city — or state.

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