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More Bankruptcies, Please

Detroit shows the way.

Aug 5, 2013, Vol. 18, No. 44 • By DAVID SKEEL
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Although Detroit’s bankruptcy is only a few days old, it already has become clear that it could bring answers to two very important questions: whether municipal bankruptcy law is a plausible alternative to either bailouts or decades of fiscal malaise for large cities that are sagging under unsustainable debt, and whether it is time for Congress to enact a bankruptcy law for states too. So far, the answer to both questions looks like yes.

Detroit

For many years, Chapter 9—the rules that govern the bankruptcy of cities and other municipalities—was viewed as a legal backwater, an option that might make sense for a local sewer or water district, but would never work for cities of any size. Critics of municipal bankruptcy loved to point out that, of the 600 or so municipal bankruptcies since the 1930s, only a handful involved substantial cities or counties. Not any longer. The signs that things have changed have been multiplying ever since Vallejo, California, filed for bankruptcy in 2008. After Vallejo came Jefferson County, Alabama (home of Birmingham), and the California cities of Stockton and San Bernardino. Detroit’s filing puts an exclamation point on this trend.

Why the sudden spate of filings? One reason is simply that the unfamiliarity and—as Warren Buffett pointed out last year—the stigma of filing for Chapter 9 are declining as more cities use it. But there are larger factors as well. Many cities and states made unsustainably generous pension promises to public employees for decades, often financing them by selling bonds to investors who either paid little attention to the risk or assumed they could count on a bailout. These promises are now coming home to roost, and in the wake of the 2008 financial crisis, Congress and the states are less willing and less able to step in with bailouts.

Much of this writing was already on the wall in late 2010 when a number of lawmakers flirted with the idea of proposing a federal bankruptcy law for states. After a flurry of attention, the state bankruptcy idea was quickly shot down. Officials in California and New York insisted that no state would ever actually file for bankruptcy and that merely mentioning the word would have a devastating effect on the bond markets. These warnings were echoed by bond market participants and by conservative critics of state bankruptcy. Liberal critics suspected that state bankruptcy was a ploy to whack public employee unions, and insisted there was no need to alter collective bargaining agreements or pensions.

Detroit’s bankruptcy filing has called all of these objections into question. If a major city is willing to file for bankruptcy, it is certainly possible that a state in dire financial distress might do the same if there were no good alternative. To be sure, the situation in Detroit was unusual. Mayor Dave Bing and the Detroit city council were not the ones who decided to file for bankruptcy. The initial recommendation was made by Kevyn Orr, a bankruptcy lawyer who was brought in to run Detroit under a controversial Michigan law that permits the governor to appoint an emergency manager when a city is deeply distressed. But the ultimate decision to permit Detroit to file for bankruptcy rested with the governor, Rick Snyder. In June 2011, Snyder had said (much as the California and New York officials did) that he would never permit Detroit to file for bankruptcy. But given Detroit’s predicament, he quite properly changed his mind. Snyder’s willingness to face the flack suggests that a governor also might be willing to file for state bankruptcy if the state’s financial condition were sufficiently dire.

Detroit’s bankruptcy filing also undercuts claims that enacting a state bankruptcy framework would cripple the state bond markets. Similar claims were made about municipal bankruptcy when the predecessor to Chapter 9 was enacted in the 1930s, but none of the dire predictions came true. Only if bond markets are incapable of distinguishing between profligate cities or states and fiscally responsible ones would the mere enactment of a state bankruptcy law roil the markets for every state, not just the troubled ones. The market’s reaction to the Detroit filing suggests the bond markets know the difference. Although a few pundits warned of disaster, there was very little change in municipal bond prices, even the day after Detroit’s filing.

As for liberal critics’ complaints about the implications of bankruptcy for collective bargaining agreements and pensions, they are right that public employees should not be expected to bear all of the consequences of a city’s or state’s financial distress but wrong when they suggest there is no need to make adjustments. Last month, Orr, the emergency manager, issued a comprehensive report that makes clear Detroit’s only hope for a renaissance (not just a Renaissance Center) lies in $1.25 billion in infrastructure investment together with a restructuring of the city’s major obligations—including roughly $1.43 billion in “certificates of participation,” $1.01 billion of general obligation bond debt, and $3.5 billion or more in unfunded pension liabilities.

The question of whether pensions can be restructured has become the first major flashpoint in the case. Because the Michigan state constitution says that pensions cannot be diminished or impaired, retirees and their representatives have insisted that every nickel must be paid in full. Retirees have made similar arguments in the bankruptcies of San Bernardino and Stockton. 

Although no court has explicitly ruled on the issue—one of the bankruptcy judges in these cases will almost certainly be the first—it seems very likely that pensions can be restructured. Under ordinary bankruptcy law, pensions would be fully protected up to the amount of funding that has been set aside for them, but any unfunded portion would be subject to adjustment. Because federal bankruptcy law takes precedence over conflicting state law in accordance with the supremacy clause in Article VI of the U.S. Constitution, the bankruptcy treatment should prevail.

The importance of the pension issue cannot be overstated. If Detroit—and by extension any other big city whose financial distress spirals out of control—is permitted to adjust its pensions and other major obligations, its bankruptcy filing could help bring an end to its decades of decline. What is true for Detroit is also true for states. The single biggest reason for the financial travails of the states that are currently in financial distress is woefully underfunded pensions. Under the laws of many states, there is almost no way to adjust the states’ obligations to retirees, no matter how extravagant or underfunded the pensions are. Much as with Chapter 9, state bankruptcy could provide an escape if it were simply impossible to pay all the obligations in full.

The existence of a state bankruptcy law could have a beneficial effect even before any state actually filed for bankruptcy. Illinois is the most obvious case. Although Illinois’s pensions are radically underfunded—by $97 billion under the state’s own estimates and twice that under more realistic assumptions—the Illinois legislature has rejected proposals to try seriously to close the gap. If unsustainable pensions were subject to restructuring in bankruptcy, pension beneficiaries would surely put far more pressure on legislators to make sure the pensions are adequately funded.

It is, of course, far too early to tell what Detroit’s bankruptcy will bring. But if bankruptcy works for Detroit, it surely will work elsewhere. New evidence of the potential benefits of a state bankruptcy law could well be the next great idea to come out of the Motor City.

David Skeel, a visiting professor at New York University School of Law, is the author, among other books, of Debt’s Dominion: A History of Bankruptcy Law in America.

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