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New research by Penn Law Professor David A. Skeel, Jr., analyzes Detroit’s bankruptcy

December 30, 2013

The question whether public employee pensions can be restructured in bankruptcy captured national headlines earlier this month when a federal judge, ruling that Detroit could enter bankruptcy, said that the pensions of city workers could be reduced, even though the Michigan Constitution expressly protects them.

In a new research paper distributed by the University of Pennsylvania Law School’s Institute of Law and Economics, Penn Law Professor David A. Skeel, Jr., explains why that ruling may be upheld, if, as seems likely, the case makes its way to the U.S. Supreme Court this term or next.

Skeel, the S. Samuel Arsht Professor of Corporate Law, is one of the nation’s leading bankruptcy experts and the author of Debt’s Dominion: A History of Bankruptcy Law in America.

His paper “Can Pensions Be Restructured in (Detroit’s) Municipal Bankruptcy?” makes it clear that even though Detroit employees are likely to lose pension benefits they had been promised, certain limits apply.

Until recently most observers believed that political and legal obstacles made it impossible to restructure pensions, even when a city went bankrupt. But that conventional wisdom has been upended in recent years by government financial crises across the country, from Vallejo, California, to Central Falls, Rhode Island, and most prominently in Detroit. Government officials and taxpayers alike are increasingly concerned that pension promises made by cities, school districts, and other state entities are unsustainable.

In Michigan, Skeel notes, public employee pensions are protected by a provision of the state Constitution adopted in 1963 to ensure that a school district or city could not simply change its mind about providing benefits to its workers. The amendment makes pensions a contract obligation, which “shall not be diminished or impaired.” It also requires pensions to be fully funded, something Detroit failed to do over the years, underfunding its pensions by an estimated $3.5 billion.

“The question posed by Detroit is this,” Skeel writes, “what happens when a Michigan city has promised pension benefits to its employees – a promise protected by [the state Constitution] – but has failed to fully fund the pensions … and may not be capable of paying the benefits in full? Can the obligations be restructured or the municipality pay pension beneficiaries less than the full amount?”

The short answer, according to Skeel, is yes; Chapter 9 of the federal bankruptcy law gives financially distressed municipalities the authority to restructure unfunded pension obligations.

Skeel explains that the starting point for determining whether pensions can be restructured in Chapter 9 bankruptcy is the Supremacy Clause of the U.S. Constitution, which gives federal law priority over any kind of state law, including state constitutional provisions, when there is a conflict between the two.

Under Chapter 9, he notes, municipal workers have the right to file a claim in the Detroit bankruptcy for the full value of their promised pensions. But that doesn’t mean the claim will be paid in full.

Instead, he suggests, the pension beneficiaries’ claim will be protected to the extent funds have been set aside, since those funds will be treated as belonging to the pension beneficiaries rather than to Detroit or its creditors.  But the unfunded portion can be restructured.

Courts, he says, including the U.S. Supreme Court, are likely to agree with that approach, concluding that neither the Michigan Constitution nor the U.S. Constitution stands in the way of such an outcome.

Skeel goes on to observe that while the unfunded portion of Detroit pensions is subject to adjustment, the entire unfunded portion cannot simply be wiped out. He notes that several Chapter 9 provisions, including requirements to take into account the best interests of creditors and to treat differently situated creditors fairly, permit courts to conclude that obligations to pensioners stand on a somewhat different footing than obligations to bond holders. “It does not justify payment in full, but it may justify a higher payout than some classes of unsecured claims, ” he writes.

Skeel notes as well that value of the collection of the Detroit Institute of Arts, said to be worth billions of dollars, could influence the size of payouts, whether or not the artwork is sold to fund pension benefits and other bankruptcy claims, a hotly contested issue in the case.  “Regardless of the conclusion, it is unlikely that paintings will be sold,” Skeel writes. “But if the art is an asset in the case, its value may need to be reflected in the payout Detroit promises to its creditors.”

A copy of Skeel’s white paper from the Social Science Research Network is available  here.