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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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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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