Chapter 9 Hysteria in the Wall Street Journal

The Wall Street Journal ran a column on municipal bankruptcy that is straight out of fantasyland. According to the WSJ, if municipalities are not able to shed their pensions in bankruptcy, the result will be a stampede of bankruptcy filings as cities file in order to stiff their bondholders. 

This argument is demonstrably wrong for two reasons. First, as bankruptcy law has been practiced for the last 80 years, pensions are inviolable in Chapter 9, yet we have never seen more than a handful of Chapter 9 filings.  To be sure, we don't have any legal rulings prior to the current spate of filings on the issue one way or another, but the understood practice is that pensions are unassailable in Chapter 9. I cannot find a record of any municipal bankruptcy filing since the 1930s that has resulted in an impairment of a pension plan, while many have impaired bondholders. Yet only a handful of municipalities have ever filed. That alone should show beyond any doubt how silly the WSJ argument is.  (I'll stay away from speculating on why it took such a preposterous position, but one will note, below, that the WSJ seems to see the issue as being about unions, rather than about pensions.)

Second, chapter 9 bankruptcy isn't very useful for municipalities hellbent on stiffing their bondholders. This is because most municipal bond debt is not unsecured general obligation bonds. Instead it is either secured debt or revenue bonds, which are functionally secured. Thus Detroit has about $6.4 billion in revenue bonds, but only $650 million in general obligation bonds. I can't say how representative this particular debt mix is, but the tsuris that attends a municipal bankruptcy filing surely isn't worthwhile to Detroit just to slough off $650 million in debt when total obligations are some $18 billion. 

The WSJ suggests that Chapter 9 wasn't adopted with a background of public employee union pensions.  That is simply false regarding both Chapter 9 and the major revision of Chapter IX in 1976. The dearth of public employee union pensions in the background might be true about the original Chapter IX; I just don't know what public employee unionization rates were in the 1930s (does the WSJ?). But there were surely municipal pensions in the 1930s, and the legal issue is pensions, not unions. The pensions at risk may well include non-unionized employees (e.g. political appointees). For the WSJ, however, the political issue seems to be unions, not pensions. 

If we want to look for the background to Chapter 9, we should take a time-machine back to 1974, when ERISA was passed.  ERISA (and PBGC) coverage excludes public employee pension plans. This makes sense if you think that public employees' pensions are protected outside of bankruptcy by the Contracts Clause of the federal constitution and that municipalities cannot touch pensions in bankruptcy. But if it were otherwise, then public employees' pensions would have less protection than private sector employees' defined benefit plans. That's a result that makes no sense, not least because of the vulnerability of public employees in bankruptcy, when they are accused of being the holdouts preventing the city from getting back on its feet. 

There are important questions about the role of state law in Chapter 9 bankruptcy, but seeing Chapter 9 as an interaction between co-equal federal and state sovereigns that acknowledges the role of state law is hardly going to bring about the parade of horribles envisioned by the WSJ. 

 

Comments

[Tom]

The move from treating public pensions as gratuities to guarantees happened in the 60s and 70s. So while there were no public pensions with today's legal protections when Chapter IX was created, there certainly were during the revisions in the 1970s.

More recently, the Central Falls, RI bankruptcy resulted in pensioners agreeing to take huge haircuts because of a state law passed just before filing that gave GO bonds secured status in municipal bankruptcy. Granted, those weren't forced haircuts, and Rhode Island also doesn’t offer the same protection of public pension benefits that can be found in Michigan, California, and Illinois, for example.

But that's another problem with the article - not all states prohibit meaningful unilateral modifications of public pensions *outside* of bankruptcy. In almost all states you can alter unearned benefits outside of bankruptcy (including Michigan), and in some there are pension features that have a large impact on the cash-flow funding of pensions that can be altered outside of bankruptcy (for example, cost of living adjustments).

There is also the fact that more than a handful of states grant GO bondholders statutory liens on municipal tax receipts specifically for the purpose of making them secured creditors in bankruptcy.

All that said, pension underfunding is a huge issue, and some really important precedents will be set in the municipal bankruptcy cases pending in CA and MI. But I have a hard time seeing how they would result in a stampede of municipalities into bankruptcy, given the law and municipal balance sheets.

[Adam]

Hi Tom,

It's not clear to me how much protection the Contracts Clause of the federal constitution provides for municipal pensions outside of bankruptcy. There are obviously limits to the Contracts Clause (e.g., Blaisdell v. Home Loan Building Ass'n), but I would have thought that it would shield pensions from anything other than limited temporary changes. COLA changes I would think wouldn't be a problem to the extent a particular COLA formula isn't part of the pension agreement.

[Tom]

Adam,

First, thanks for covering the public pension issue, especially with regards to muni bankruptcy.

With regards to contracts clause prohibition of prospective benefits decreases, the source of the contract here is state law, so it is rare that the federal contracts clause would bind states prospectively. Certainly it would protect public pension benefits that were already earned, but often there is states did not explicitly express their intent to be bound prospectively to public pension benefit formulas, which is a requirement to read statutes as prospectively binding contracts. Amy Monahan has some great work on this (and other public pension) topics.

Regarding COLAs - they actually are treated as part of the protected pension promise in some states. Colorado (Justus v. Colorado) and MN (Swanson v. Minnesota) most recently litigated the COLA issue, with a MN district court deciding that there was a contractual right to a COLA, but not a specific one (so it could be lowered), and a CO appellate court deciding that retirees have a contractual right to at least the COLA in place when they retired. As a side note, many states have made public pension COLAs nominal escalators instead of using a CPI or PCE adjustment, which results in them constantly over- or under- adjusting.

[Knute Rife]

Once again the Wall Street Journal demonstrates it doesn't really understand how gummint works, it's jist agin' it. Let's look at the two states where I'm a bar member, Washington and Utah. The public pension plans are not creatures of local ordinance or CBAs but of state law. The municipalities are collectors and contributors, just as private employers are for unemployment and workers' comp. State law prohibits opting out. Allowing Chapter 9 pension restructurings where nonbankruptcy law (i.e. state pension law) would leave the state holding the bag for any shortfalls. I don't see that happening.