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U.S. Bankruptcy Court Judge Steven W. Rhodes last week accepted the city's petition enabling it to seek protection under Chapter 9 of the U.S. bankruptcy code, and ruled Detroit may legally reduce public pension benefits, despite protection of public pensions under Michigan's constitution.
Judge Rhodes' ruling — which came on the same day Illinois passed a wide-ranging pension reform bill for its state-administered plans — is reverberating throughout the country for cities grappling with bankruptcy or pension problems, from Chicago to San Bernardino and Stockton in California.
Michigan, Illinois and California all have stipulations in their state constitutions that retirement plans should not be impaired or diminished, but that did not protect the pension benefits in Detroit.
“Under the Michigan Constitution, municipal pension rights are contract rights. Therefore, because the State of Michigan authorized the filing of this case, municipal pension rights in Michigan can be impaired in this bankruptcy case, just like any other contract rights,” according to a summary of Judge Rhodes' ruling cited in a court news release.
“The biggest ramification is adjusting to the legal uncertainty that has been created from the certainty that pension benefits are bullet proof,” said Karol Denniston, municipal bankruptcy expert and San Francisco-based partner at law firm Schiff Hardin L.L.P. She added the ruling is noteworthy because it is the first time it has been said in a bankruptcy court that public pensions can be impaired.
“There is now a credible case that the table has been reset,” Ms. Denniston said. “There could be a direct or immediate possibility compared to a hypothetical” impairment to benefits.
Unions and retiree groups in Detroit and Illinois have vowed to appeal the ruling and legislation, respectively.
Illinois' pension reform is designed to save the state $160 billion over the next 30 years by making changes to state plans that include reducing cost-of-living adjustments, increasing retirement ages and capping pensionable salaries. The reform measure, which was signed by Gov. Pat Quinn on Dec. 5, is expected to be tied up in the courts for at least a year.
Meanwhile, the Detroit decision has a “better than 50% chance” of being appealed to the U.S. Supreme Court, said Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University in Fairfax, Va.
Judge Rhodes' ruling means public employee union leaders need to face a new reality, Mr. Shafroth said. The historic stance of some union leaders that they did not need to negotiate regarding pensions because of the constitutional protection is no longer safe, he added.
“You can't do (refuse to negotiate), effective 1 p.m. Tuesday (Dec. 3),” Mr. Shafroth said. “Everyone understands the rules of the world changed on Tuesday ... It was the new shot heard round the world.” Unions now have a huge stake in states or municipalities balancing their budgets because pension benefits might not be guaranteed anymore, Mr. Shafroth said.
Ms. Denniston said the ruling should result in a shift in negotiating strategies for unions in that they would be more likely to participate in talks.
Sarah Wetmore, vice president and research director at The Civic Federation, an independent government research organization in Chicago, agreed unions need to participate in pension reform talks, as they did for recently passed reform for the $420 million Chicago Park Employees' Annuity & Benefit Fund.
“Labor is an important participant in pension reform negotiations,” Ms. Wetmore said. “What happened in Detroit is definitely an added incentive for all parties to work together to ensure that the pensions are sustainable for employees, retirees and taxpayers.”
Sharon Almonrode, a pension fund litigation attorney and partner at The Miller Law Firm P.C. in Rochester, Mich., said Judge Rhodes might also need to consider whether Detroit inadvertently becomes a road map for other municipalities when reviewing the plan city officials submit early next year.
“I'm curious to know what will happen with the appeals, because the (6th U.S. Circuit Court of Appeals) is historically one of the friendliest jurisdictions and has a strong history of favoring the protection of retiree obligations,” Ms. Almonrode said. “Now, obviously, contracts get set aside in bankruptcy, but there's also going to be strong debate about whether the pension rights are contract rights.”
Up next on the chopping block could be pension guarantees for employees in San Bernardino and Stockton, Calif., where both cities have been declared eligible for bankruptcy. San Bernardino officials have been locked in a battle over pension contributions with the $277.3 billion California Public Employees' Retirement System, Sacramento, while Stockton has continued to make its payments to the state system after negotiating new deals with workers.
In his ruling, Judge Rhodes said any plan put together by Kevyn Orr, Detroit's state-appointed emergency manager, needs to be “fair and reasonable” to be approved. Mr. Shafroth took that to mean the pension plans will not receive equal cuts to other creditors that are in a better position to take a loss.
Mr. Shafroth added all creditors in California municipal bankruptcy cases are watching Detroit closely. If the criteria are to be “fair and reasonable,” it's going to take an “interesting dictionary to find a definition for this” if creditors get pennies on the dollars while pension benefits are fully paid, Mr. Shafroth said. CalPERS officials have said the state constitution does not allow for benefits to be diminished, just as Michigan and Illinois' constitutions say.
“The judge's decision on Tuesday was a different earthquake and there's going to be a lot of moving and shaking at CalPERS and in Sacramento,” Mr. Shafroth said.
In San Bernardino's case, Ms. Denniston said, “I don't think the court can really ignore (the ruling). This is a federal bankruptcy judge ruling pensions can be impaired in bankruptcy cases. Other judges would have to take that into consideration.”
The decision could help improve bankruptcy outcomes for bondholders. Stockton negotiated pension changes with employees outside of bankruptcy court, but Ms. Denniston said city creditor Franklin Templeton has a stronger argument for better payment terms for bondholders now about what is “fair and equitable” since a bankruptcy judge has said pensions can be impaired. The proposed exit plan has Franklin Templeton receiving less than 1 cent on the dollar for its $35 million in bonds.
In Illinois, lawmakers took about 18 months to pass pension reform for the state, which has the worst credit rating and funded pension plans in the country. But Chicago is in a similarly dire position and needs state legislation to reform its pension plans. Mayor Rahm Emanuel applauded the state for passing reform, but called on the Legislature last week to now address Chicago's situation.
“The pension crisis is not truly solved until relief is brought to Chicago and all of the other local governments across our state that are standing on the brink of a fiscal cliff because of our pension liabilities,” Mr. Emanuel said in a statement. “Without providing the same relief to local governments, we know that taxpayers, employees, and the future of our state and local economies will remain at risk.”
The Civic Foundation's Ms. Wetmore said legislators wanted to complete state pension reform before moving on to the city.
“The fact that the logjam is broken could be seen as a sense of optimism for Chicago pension funds,” she added.
Under state law governing city pension funds, Chicago's annual pension contributions will increase $590 million, raising total contributions to $1.4 billion in 2015, almost 30% of the city's operating budget after mandatory interest payments.
Only one of the four pension funds the city contributes to directly is more than 38% funded: the $1.4 billion Laborers' Annuity & Benefit Fund is 57.7% funded. Chicago does not have the authority to contribute more without state legislation.
“The city absolutely needs pension reform,” Ms. Wetmore said. “They don't have the money and there's no possible tax increase big enough to fund this.”
Kevin Olsen is a reporter at Pensions and Investments, a sister publication to Business Insurance.
The 25 largest U.S. cities have more than $125 billion in pension liabilities, according to a new report from Morningstar.