State Contract Impairment Clauses and the Validity of Chapter 9 Authorization
| Publication year | 2015 |
State Contract Impairment Clauses and the Validity of Chapter 9 Authorization
Bradley Hull
Although chapter 9 bankruptcy provides an opportunity for financially distressed municipalities to escape their debts, it also allows municipalities to impair their contractual obligations. The U.S. Constitution and most state constitutions, though, have a Contract Clause that prohibits states from passing any law impairing the obligation of contracts. The U.S. Supreme Court has foreclosed the argument that chapter 9 bankruptcy violates the federal Contract Clause, but has not foreclosed the argument under the similar clauses of state constitutions. Chapter 9 requires a municipality to have state authorization before filing bankruptcy, and state courts have the authority to determine the constitutionality of a state authorization under their state constitutions.
This Comment argues that, except for the rare circumstance where a municipality has absolutely no contractual obligations, state authorization of a municipal bankruptcy under chapter 9 violates a state constitution's contract impairment clause. States have generally applied the U.S. Supreme Court's interpretation of the federal Contract Clause to their own state clauses. However in the last century, the Supreme Court's Contract Clause jurisprudence has become inconsistent with the text, purpose, and original interpretation of the clause. Thus, state courts should abandon this jurisprudence when interpreting their own clauses, and adopt a stricter standard more in line with the Court's earlier decisions. Under such a standard it becomes clear that only municipalities without any contractual obligations should be authorized to file bankruptcy. By authorizing any other municipal bankruptcy filing, states violate their state constitutions' contract impairment clauses.
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During the Great Depression, Detroit mayor Frank Murphy proclaimed, "This is a great, rich city . . . It never has repudiated an obligation nor defaulted upon a debt—and it never will."1 Today, however, the city's narrative looks quite different. In 2013, Detroit filed the largest municipal bankruptcy in U.S. history.2 Detroit was facing over 100,000 creditors and $18 billion of debt, unfunded pensions, and healthcare liabilities.3 The city turned to the bankruptcy process to escape its financial distress, and ultimately the bankruptcy court accepted a plan that cut Detroit's financial obligations by $7 billion.4 However, Detroit had to overcome more than 100 legal objections to its filing before the bankruptcy process even began.5 One of these objections arose under the contract impairment clauses of the U.S. Constitution and Michigan's constitution.6
The Contract Clause of the U.S. Constitution states: "No state shall . . . pass any . . . Law impairing the Obligation of Contracts."7 Nevertheless, municipal bankruptcies, such as Detroit's, allow municipalities, acting as subdivisions of the state with state authorization, to impair their contractual obligations.8 The Supreme Court, though, has foreclosed the argument that chapter 9 violates the Contract Clause of the U.S. Constitution.9 However, most states have a similar clause that also prohibits the enactment of laws that impair contractual obligations.10 The Supreme Court has also rejected the argument that chapter 9
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proceedings violate state constitution contract impairment clauses because of the supremacy of the federal bankruptcy power.11 Importantly though, the Court has not foreclosed the argument that state authorization of a chapter 9 bankruptcy violates these contract impairment clauses.12 This precise issue arose in the Detroit bankruptcy.
A Michigan trial court held in Webster v. Michigan that the law allowing the state's governor to authorize Detroit's bankruptcy filing was unconstitutional under Michigan's constitution.13 The court held that P.A. 436, the law empowering the governor to authorize a chapter 9 filing, violated the state constitution "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."14
Michigan's constitution has both a Contract Clause and a similarly worded Pension Clause.15 Importantly, Michigan's Pension Clause is no more powerful than its contract impairment clause.16 The Pension Clause simply makes clear that pensions are contracts, and, therefore, they have the same protection as all other contracts under the state's contract impairment clause.17 Thus, the court's holding in Webster was that the state's contract impairment clause does not allow the authorization of a chapter 9 filing because it "threatens to diminish or impair" an existing contractual obligation.18
However, the federal bankruptcy judge presiding over Detroit's bankruptcy, Judge Rhodes, gave the Michigan court's decision essentially no weight in considering the constitutional challenges to the bankruptcy.19 Judge
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Rhodes voided the Michigan decision because it was filed after Detroit had filed its bankruptcy petition20 and held that the "fundamental reason" to void the decision was that the Michigan court lacked jurisdiction.21 Once a petition has been filed, the bankruptcy court has "exclusive jurisdiction to determine all issues related to the City's eligibility to be a chapter 9 debtor."22
Judge Rhodes determined that Detroit's bankruptcy was constitutional under both the U.S. Constitution and Michigan's constitution.23 He held that pension rights are contractual rights and that contractual rights could be impaired when the state has consented to chapter 9 bankruptcy.24 However, he did not independently consider if the state's authorization violated Michigan's contract impairment clause.25 Judge Rhodes's decision left this very important question unresolved.26
This Comment will address head-on the issue that the bankruptcy court in Detroit punted, and show why the Michigan trial court's opinion that it voided was actually correct. First, this Comment will provide a brief history of municipal bankruptcies and their relevance today. Ultimately, the Analysis section of this Comment will show that state constitutional contract impairment clauses prohibit state authorization of chapter 9 bankruptcy filings, except in the very rare cases of municipalities with absolutely no contractual obligations.27 Section I of the Analysis will show that state constitutions have the power to prohibit a state from authorizing a chapter 9 filing. Section II will show that state courts should abandon federal Contract Clause jurisprudence and adopt a stricter standard when interpreting state constitutions' contract impairment clauses. Section III will establish such a standard and apply it to state authorization of chapter 9 bankruptcies. Section IV will argue that from a policy perspective, this constitutional guarantee should trump the potential effectiveness of municipal bankruptcy. The Conclusion of this Comment will discuss the proper course of action for states going forward, including constitutional amendments and alternatives to municipal bankruptcy.
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A. Municipal Bankruptcy Proceedings and Limitations
Chapter 9 of the Bankruptcy Code allows financially distressed municipalities to seek protection from their creditors while they formulate a plan to adjust their debts.28 A chapter 9 bankruptcy is similar to a chapter 11 reorganization, but with a few notable distinctions due to limitations imposed on the federal bankruptcy power by the Tenth Amendment's29 protections of state sovereignty.30 Municipalities are only "department[s] of the State, and the State may withhold, grant or withdraw powers as it sees fit."31 Thus, Congress had to accommodate Tenth Amendment limitations in the Bankruptcy Code, which caused chapter 9 to have some unique characteristics.32
Unlike chapter 11 debtors, municipalities are not allowed to liquidate their assets in order to satisfy their debts, and, therefore, cannot be forced into a chapter 7 liquidation33 by the bankruptcy judge.34 Municipalities also can only enter bankruptcy voluntarily; involuntary petitions are never allowed.35 Also, very different than chapter 11 bankruptcy, the court's power is highly constrained in a chapter 9 bankruptcy.36 Without the municipality's consent, the court cannot interfere with any of the municipality's "political or governmental powers," "property or revenues," or "use or enjoyment of any income-producing property."37 As later discussed in Part C of the Background,
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the most important distinction for the purposes of this Comment is that a municipality cannot file for bankruptcy without state authorization.38
Despite the distinguishing rules, the general purpose of chapter 9 remains essentially the same as reorganization under chapter 11.39 As the Bankruptcy Court stated in In re Addison Community Hospital Authority, "The general policy considerations underlying the municipal debt adjustment plan of Chapter 9 are the same as that of Chapter 11 reorganization: to give the debtor a breathing spell from debt collection efforts and establish a repayment plan with creditors."40
B. Relevance of Municipal Bankruptcy
Municipal bankruptcies are more relevant today than they have been at any other point in U.S. history.41 Historically, municipal bankruptcies have been quite rare,42 and many bankruptcy casebooks barely even cover the topic.43 Recently, though, municipal bankruptcy has become a much more relevant issue. Municipalities filed nearly twice as many chapter 9 bankruptcies in the last five years as in the preceding five years.44 In 2012, a record number of chapter 9 bankruptcies were filed.45 More important than the quantity increase, though, is that municipal bankruptcies have become larger than ever.46...
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