Pensions and Bonds in Municipal Bankruptcies: Will Detroit Be a Game-Changer?

The City of Detroit (“Detroit”) filed its Plan of Adjustment of Debts on February 21, 2014 and its Amended Plan for the Adjustment of Debts for the City of Detroit on March 31, 2014 (“Detroit Plan”). See In re City of Detroit, Michigan (Bankr. E.D. Mich. Case No. 13-53846), ECF Docket Nos. 2708, 3380. The Detroit Plan raises hotly contested issues, which will require Bankruptcy Judge Steven W. Rhodes to consider the balance Congress struck in Bankruptcy Code Chapter 9 between Congress’ Bankruptcy Power and the States’ rights under the Tenth Amendment of the Constitution. This article addresses the Detroit Plan’s proposed treatment of (i) municipal employee pension claims; and (ii) general obligation bond claims. Judge Rhodes’ ruling on that treatment will almost certainly be appealed, likely to the Supreme Court. The Supreme Court’s decision could very well be a game-changer for municipal bankruptcies.

Pension Claims. Detroit maintains two retirement systems: the Police and Fire Retirement System (“PFRS”) for uniformed employees and the General Retirement System (“GRS”) for most of Detroit’s remaining employees. The Detroit Plan provides parallel treatment for members of both systems. Detroit will cease providing health benefits to retirees in either system.¹ Eligible retirees will be transitioned to Medicare; the remainder will receive stipends for purchasing insurance on health insurance exchanges established under the Patient Protection and Affordable Care Act. The Detroit Plan provides for the elimination of supplemental pension benefits after July 1, 2014 based on cost of living adjustments. The Detroit Plan also reduces monthly pension payments for members of both. If PFRS members and GRS members vote in favor of the Detroit Plan and $816 million in contributions (described below) are received from third parties: PFRS monthly pension benefits will be reduced by 6% and GRS monthly pension benefits will be reduced by 26%. If PFRS and GRS members vote to reject the Detroit Plan and/or the $816 million in contributions are not made, PFRS monthly pension benefits will be reduced by 14% and GRS monthly pension benefits will be reduced by 35%.

Following confirmation of the Detroit Plan, the PFRS will be funded exclusively until January 20, 2023 by a portion of the contributions during that period of (i) $366 million by foundations seeking to preserve the assets of the Detroit Institute of Art (“DIA”); (ii) $100 million by DIA Corp., a non-profit corporation to be established pursuant to the Detroit Plan to which the assets of the DIA will be transferred in trust for the people of the City of Detroit; and (iii) $350 million from the State of Michigan. During the same period, the GRS will be funded exclusively by (i) $675 million from the Detroit Water & Sewer Department (“DWSD”) (presumably resulting from the transfer or sale of the DWSD) and (ii) a portion of the $366 million contributions by the foundations and the $100 and $350 million contribution by DIA Corp. and the State of Michigan described above. FPRS and GRS members who vote to reject the Detroit Plan will obtain the benefit of the Michigan contribution only if the Bankruptcy Court approves certain releases of Michigan, Detroit and certain public officials. For the period after January 20, 2023, Detroit must contribute sufficient funds to ensure the payment of retirees’ reduced pension benefits.

Under the Detroit Plan, current Detroit employees may be entitled to a very modest increase in their pension benefits with respect to the services they provide after July 1, 2014, based on a very small (2% (for PFRS) and 1.5% (for GRS)) percentage of their average base pay (excluding overtime, bonuses and unused sick time) during their final 10 years of employment. Provision is also made for restoring a portion of the pre-bankruptcy pension benefits if the PFRS and GRS have projected funding levels exceeding 80% for the period ending June 30, 2023. However, those restored payments may not reduce that projected funding below 80%. The Detroit Plan establishes mandatory investment return assumptions to be used for the period ending June 30, 2023 at 6.5% for PFRS and at 6.25% for the GRS. During the same period, Detroit may not change the method for calculating the PFRS or GRS pension benefits.

The Detroit Plan significantly reduces retiree income. GRS employees will lose as much as one-third of their monthly pension income, although they retain their social security benefits. PFRS employees, many of whom are not eligible for social security, will lose at least 6% of their retirement income and as much as 14% of their retirement income. The Detroit Plan also imposes on retirees the risk that the DIA and Michigan contributions do not materialize and imposes on current municipal employees the investment risk with respect to any enhancement of their pension benefits for services provided after July 1, 2014.

The Detroit Plan’s proposed modification of pension benefits raises important issues. Article 9, § 24 of the Michigan Constitution expressly prohibits the diminution or impairment of public employee pensions. The Tenth Amendment recognizes and protects state sovereignty. Chapter 9 of the Bankruptcy Code prohibits the confirmation of a plan providing for the debtor to take any action prohibited by state law. See 11 U.S.C. § 943(a)(4).

Article 9, § 24 of the Michigan Constitution, however, expressly characterizes pension benefits as contractual obligations. It is beyond question that the Bankruptcy Clause of the U.S. Constitution permits bankruptcy courts to modify the payment terms of contracts. Indeed, in holding that Detroit had met the requirements of 11 U.S.C. § 109(c) and was eligible for relief under Chapter 9, Judge Rhodes held that municipal employee pension benefits could be modified in bankruptcy, but has also made it clear that Detroit’s restructuring cannot be placed solely on the backs of retirees. In re Detroit, ECF Docket No. 1945.

General Obligation Bond Claims. Chapter 9 protects liens on or pledges of the “special revenues” of municipalities. 11 U.S.C. §§ 902(2); 922(d) and 927. Holders of special revenue bonds are, therefore, secured creditors. Chapter 9 does not expressly address general revenue municipal bonds. However, holders of those bonds have historically assumed that they were “secured” by the pledge of the full faith and credit of the issuing municipality.² Indeed, Chapter 9 plans have typically provided for full payment of general revenue bonds. The Detroit Plan does not do so.

Holders of limited and unlimited tax general obligation bond claims will receive pro rata shares of notes Detroit will issue pursuant to the Detroit Plan. The Debtor estimates that those creditors will receive distributions equal to 15% of their claims. Holders of claims under Certificates of Participation (“COP’s”) issued in connection with a pre-petition refunding of Detroit’s pension funding debt (“COP Claims”) will also receive a pro rata share of notes Detroit will issue pursuant to the Detroit Plan. To receive their distributions, however, they will have to either litigate their claims or consent to the reduction of their claims to 40% of the unpaid principal of the COP’s they hold. Detroit had not estimated the amount holders of COP Claims will receive under the Detroit Plan.

The Detroit Plan treats Detroit’s tax general obligation bonds and the COP’s as general unsecured claims. Holders of those claims have argued, and will continue to argue that, like special revenue bonds, general obligation bonds should be treated as secured claims–secured by Detroit’s full faith and credit (and ability to tax its residents). Holders of tax general obligation bond claims and COP Claims have also objected to the disparate treatment between their unsecured claims and unsecured pension benefit claims. That treatment, they contend, unfairly discriminates against them in violation of Bankruptcy Code § 1129(b)(1) by providing significantly greater recoveries on pension benefit claims.³ Holders of Detroit’s general obligation bonds may also argue that limiting the use of the DIA Proceeds to pay pension benefit claims unfairly discriminates against them. The transfer of the DIA’s assets to a non-profit corporation as currently proposed by the Detroit Plan looks like a sale of an asset of Detroit. Arguably, the “sale proceeds” should be equitably distributed among all unsecured creditors.

What Next? Even as amended, the Detroit Plan remains a work in progress. Significant negotiating remains to be done; exhibits and documents must be prepared and finalized. Additionally, much needs to be done by third parties for the Detroit Plan, to be feasible. The Michigan Legislature has not yet approved Governor Snyder’s proposal to pump $350,000 into Detroit’s pension plans. The proposal enjoys fairly widespread popular support, but it is not clear that the Republican-dominated Legislature supports it. Governor Snyder has expressed his concern that, if the proposal is not approved by May, it will never be approved. Similarly, even the form of the transfer of the DWSD to a regional authority or private owner remains to be determined. Despite the amendments to the Detroit Plan, Judge Rhodes has kept the case on a fairly tight schedule. The hearing on the Detroit Plan is confirmation is set to begin on July 16, 2014 and conclude no later than August 1, 2014.

Judge Rhodes’ ruling on the confirmation of the Detroit Plan will almost certainly be appealed, most likely up to the Supreme Court.⁴ The Court’s ruling could be a game-changer. A ruling on the pension issue could either preclude the use of bankruptcy to modify (i.e., reduce) municipal pension obligations or turn the bankruptcy courts into the venue of choice for financially strapped municipalities to deal with those liabilities. A ruling on whether Detroit can impair general obligation bonds will substantially impact (positively or negatively) the municipal bond market. At the very least, the Detroit bankruptcy case will likely generate Supreme Court guidance in an area of bankruptcy lacking much by way of guidance. 

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¹ Under the Plan, life insurance, death benefits, health, vision and dental insurance will be provided to retirees through a Voluntary Employee Benefits Association funded, in part, by unsecured notes issued by Detroit.

² When the City of Central Falls entered bankruptcy, the Rhode Island Legislature ensured full payment of bond claims by providing them with secured status. The Michigan Legislature has not yet done so.

³ Some commentators have also pointed out that GRS retirees could make the same argument vis-à-vis the more generous treatment of PFRS retirees under the Detroit Plan.

⁴ In fact, Judge Rhodes’ ruling that Detroit is eligible for Chapter 9 relief is already on a direct appeal to the U.S. Court of Appeals for the Sixth Circuit. That court’s ruling will almost certainly be appealed to the Supreme Court.