Zombieland/the Detroit bankruptcy: why debts associated with pensions, benefits, and municipal securities never die ... and how they are killing cities like Detroit.

• Author: Chung, Christine Sgarlata
• Position: II. Key Legal Questions: Pensioner Rights, Bondholder Rights, and Taxpayer Rights through IV. Where Does This Leave Us? with footnotes, p. 817-847

2. KEY LEGAL QUESTIONS: PENSIONER RIGHTS, BONDHOLDER RIGHTS, AND TAXPAYER RIGHTS

   Against this backdrop of hard choices and competition for meager resources, Detroit's bankruptcy presents two key legal questions: 1) Can Detroit use Chapter 9 bankruptcy proceedings to reduce or restructure accrued pension benefits of retired city workers when the Michigan Constitution states 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" (207) and also states that "[n]o ... law impairing the obligations of contract shall be enacted?" (208) 2) How will debts associated with Detroit's municipal securities--and particularly its UTGO--be dealt with, when (i) Detroit is already levying taxes at or near statutory maximums; (ii) City residents cannot absorb taxes increases, and (ii) Detroit does not have (and will not have, without restructuring) sufficient funds to pay its debts?

   In the following subpart, I discuss legal questions surrounding pension impairment in Part A, and issues relating to Detroit's UTGO bonds in Part B.

   1. Can Detroit Use Chapter 9 Bankruptcy Proceedings to Reduce or Restructure Accrued Pension Rights of Retired City Workers, Given Michigan Constitution Pension Clause?

      On December 5, 2013, Judge Steven Rhodes held that Detroit is eligible to be a Chapter 9 debtor despite the fact that neither the City nor the State explicitly carved out accrued pension benefits and protected them from adjustment. (209) Judge Rhodes also held that accrued pension benefits are subject to impairment in Chapter 9 proceedings, despite the Pension Clause. (210) In the following section, I discuss the debate surrounding pension impairment and Judge Rhodes's ruling.

      1. The Emergency Manager Puts Pension Impairment on the Table.

         Pension impairment has been a hot button issue in the Detroit bankruptcy ever since June 14, 2013, when the Office of the Emergency Manager published a proposal to the City's creditors which referenced adjusting pension obligations. (211) In his proposal, Orr outlined Detroit's dire financial condition and called for a "thorough overhaul and restructuring" of the City's obligations. (212) Among other initiatives, the June 14 proposal outlined the City's plans to invest $1.25 billion over ten years to improve basic and essential City services such as police, fire and EMS. (213) The June 14 proposal also outlined the City's intention to expand its income and property tax bases, rationalize and adjust income tax rates, and improve tax and fee collection efforts. (214)

         With respect to creditor recoveries, Orr proposed the following: (i) "treatment of secured debt commensurate with the value of the collateral securing such debt, including the repayment or refinancing of the City's revenue bonds, secured unlimited and limited tax general obligation bonds, secured installment notes and liabilities arising in connection with swap obligations;" (215) (ii) "pro rata distribution of $2,000,000,000 in principal amount of interest-only limited recourse participation notes to holders of unsecured claims," including holders of unsecured limited and unlimited tax general obligation bonds, the service corporations (based on the COPs), the pension systems (based on pension underfunding), and retirees (based on OPEB); (216) and (iii) "[a] 'Dutch Auction' process for the City to purchase the notes." (217) Also at the meeting respecting the June 14 proposal, Orr announced his decision to not make the scheduled $39,700,000 in payments due on the COPs and swap transactions. (218)

         With respect to claims for unfunded pension liabilities, Orr stated that "[b]ecause the amounts realized on the underfunding claims will be substantially less than the underfunding amount, there must be significant cuts in accrued, vested pension amounts for both active and currently retired persons." (219) In subsequent comments, Orr acknowledged the Pension Clause of the Michigan Constitution, but reportedly suggested that neither it nor the Contracts Clause prevented a bankruptcy court from impairing pensions as part of a plan of adjustment under Chapter 9. (220)

      2. Retirees initially Seek Refuge in State Court

         On July 3, 2013, with the possibility of impairment on the table, petitioners filed two separate lawsuits in state court seeking a declaratory judgment that Public Act 436 (the Act pursuant to which Orr was appointed) violated the Michigan Constitution to the extent that it purported to authorize Chapter 9 proceedings without first carving out (or otherwise ring-fencing) accrued pension benefits to protect them from adjustment. (221) The petitioners also sought an injunction preventing defendants from authorizing any Chapter 9 proceeding in which vested pension benefits might be impaired. (222) Shortly thereafter, the Detroit pensions systems filed a similar lawsuit. (223)

         On July 18, 2013, the Ingham County Circuit Court found that Chapter 9 for Detroit would impair accrued financial benefits in violation of the Pension Clause. (224) The court entered a preliminary injunction enjoining officials from taking further action on behalf of the City through a Chapter 9 proceeding where pension benefits might be impaired. (225) One day later, the court issued a declaratory judgment order holding that accrued pension benefits could not be impaired under the Michigan Constitution, and also made the following rulings: (i) "PA 436 is unconstitutional and in violation of ... [the Pension Clause,] to the extent it permits the Governor to authorize an emergency manager to proceed under Chapter 9 in any manner which threatens to impair or diminish accrued pension benefits;" (ii) "[t]he Governor is prohibited by ... [the Pension Clause] from authorizing an emergency manager under PA 436 to proceed under Chapter 9 in a manner which threatens to diminish or impair accrued pension benefits;" and (iii) "[b]y authorizing [] Emergency Manager [Orr] to proceed under Chapter 9 to diminish or impair accrued pension benefits, [the Governor] acted without authority under Michigan law and in violation of ... [the Pension Clause]. (226)

      3. The Debate Moves to Bankruptcy Court

         This City's bankruptcy filing moved the debate to bankruptcy court. On July 16, 2013, Emergency Manager Orr recommended to Michigan governor Richard Snyder and to the state's treasurer that the City file for Chapter 9 relief. (227) On July 18, the same day the state court issued its judgment, Governor Snyder authorized the City to file a Chapter 9 petition. (228) Although section 141.15661(1) of the Michigan Compiled Laws purports to permit the governor to "place contingencies on a local government in order to proceed under chapter 9," (229) Governor Snyder did not do so. Instead, Governor Snyder explained that he was "choosing not to impose any such contingencies today. Federal law already contains the most important contingency--a requirement that the plan be legally executable." (230) Orr filed the City's Chapter 9 petition that same day. (231) After the bankruptcy court entered an order staying pre-petition litigation (including the state court actions), more than one hundred parties (including pensioners and other stakeholders) (hereinafter, collectively, the Objectors) filed objections to Detroit's eligibility in the bankruptcy court action. (232)

         Citing the Pension Clause, public worker stakeholders argued that Detroit is not eligible to be a Chapter 9 debtor because the State (and the City) failed explicitly to protect accrued pension benefits from impairment. (233) Among other arguments, these Objectors asserted that (i) Chapter 9 is unconstitutional on its face under the Bankruptcy Clause of Article I, Section 8 of the United States Constitution because it violates the uniformity requirement, and under the Contracts Clause of Article I, Section 10 to the extent it would permit the impairment of contracts to which the state is a party; and (ii) Chapter 9 is unconstitutional as applied under the Tenth Amendment to the United States Constitution to the extent it does not prohibit the bankruptcy court from impairing vested pension benefits owed to Detroit's retired city workers. (234)

      4. Judge Rhodes's Opinion Regarding Eligibility

         On December 5, 2013, following extensive briefing and hearings, Judge Rhodes issued a 143-page ruling respecting Detroit's eligibility for Chapter 9 relief. (235) After cataloging Detroit's debts and the impact of the City's financial crisis on the City's beleaguered residents, Judge Rhodes observed that a plan of adjustment may be Detroit's only hope for survival:

         The City of Detroit was once a hardworking, diverse, vital city, the home of the automobile industry, proud of its nickname--the "Motor City." It was rightfully known as the birthplace of the American automobile industry. In 1952, at the height of its prosperity and prestige, it had a population of approximately 1,850,000 residents. In 1950, Detroit was building half of the world's cars. The evidence before the Court establishes that for decades, however, the City of Detroit has experienced dwindling population, employment, and revenues. This has led to decaying infrastructure, excessive borrowing, mounting crime rates, spreading blight, and a deteriorating quality of life. The City no longer has the resources to provide its residents with the basic police, fire and emergency medical services that its residents need for their basic health and safety. Moreover, the City's governmental operations are wasteful and inefficient. Its equipment, especially its streetlights and its technology, and much of its fire and police equipment, is obsolete. To reverse this decline in basic services, to attract new residents and businesses, and to revitalize and reinvigorate itself, the City needs help. (236) Having framed the case in this fashion...