Bankrupt Detroit can cut pensions; implications big for California

12/03/2013 9:13 AM

10/22/2014 1:55 PM

It was a gold-plated promise: A career in government meant a safe and sound pension, no matter what.

All that may have changed Tuesday. In a case with major implications for California, a judge in Michigan ruled that the bankrupt city of Detroit can impose cuts to its municipal pension plans.

The ruling comes as a bankrupt California city, San Bernardino, edges closer to a possible legal showdown with CalPERS over the sanctity of public employee pensions. Although the decision in Detroit doesn’t directly affect what happens in San Bernardino, legal experts said it will strengthen the California city’s hand as it tries to reduce its multimillion-dollar pension obligations.

In any event, the Detroit ruling was a milestone. Experts long suspected that cities could use bankruptcy to force reductions in their pension expenses, but until now they’ve never had a court’s blessing. Other cities that filed for bankruptcy protection – notably Vallejo and Stockton – have shied away from a confrontation over the issue, choosing instead to continue making all their pension contributions.

Now U.S. Bankruptcy Judge Steven Rhodes has said cities in bankruptcy protection can go after pensions. For San Bernardino – openly chafing over its $24 million-a-year CalPERS bill – that could represent a big victory. The judge hearing the San Bernardino case isn’t obligated to follow the Michigan ruling, but is likely to look to it for guidance, said James Spiotto, a bankruptcy lawyer in Chicago who’s following both cases.

Bottom line: It’s no longer realistic to assume public pensions are inviolable.

“It’s a wake-up call to everyone who’s been saying this is sacred and you can’t touch it,” said Karol Denniston, a San Francisco bankruptcy lawyer.

Aside from the legal consequences, the ruling could alter the political climate surrounding public pensions in California. Denniston has advised San Jose Mayor Chuck Reed, who’s promoting a statewide ballot initiative that would give municipalities greater freedom to cut pension costs.

Reed seized on the ruling, issuing a statement that said “most struggling cities will not be able to truly pull themselves out of trouble without addressing these unsustainable retirement costs.” He said his initiative would keep cities out of bankruptcy and allow them to fix their problems less painfully.

On the other hand, labor unions opposing Reed will likely “redouble their efforts” now that the threat of reduced pensions has become more real, said political scientist Jack Pitney of Claremont McKenna College.

Added Sacramento political strategist Steve Maviglio, a spokesman for public employee unions: “In California, teachers, firefighters, police officers and other public employees are fully prepared to resist being scapegoated for the financial mismanagement of elected officials.”

The Detroit ruling capped a nine-day trial last month in which unions and retiree groups argued that the city’s Chapter 9 bankruptcy filing should be dismissed. Rhodes not only declared that the city, buried under $18 billion in debt, was eligible for bankruptcy, he went a giant step further. He said pension promises made to employees can be treated essentially the same as any other business contract. That means they can be “impaired” – bankruptcy lingo for reduced.

“It has long been understood that bankruptcy law entails the impairment of contracts,” he said, according to the Detroit News.

The city hasn’t submitted an actual plan to reduce pension costs, but months ago floated the idea of slashing benefits by about 85 percent. The judge, however, warned the city against making draconian cuts.

Spiotto, the expert from Chicago, said the rule of thumb is that expense cuts in bankruptcy must be “the least drastic.” Retirees can expect to receive “everything that can be paid practically,” he said. The average Detroit pension pays around $19,000 a year.

Detroit city workers protested outside the courthouse, and a lawyer for the unions filed an appeal. It could be months before it’s clear if Detroit – or any other city in bankruptcy – can reduce pensions.

“If I’m an official of San Bernardino, I don’t conclude that the game is over and I’ve won. But it’s a strong signal that pensions can be restructured. That certainly reinforces the position that San Bernardino has taken,” said David Skeel, a bankruptcy law expert at the University of Pennsylvania.

Dale Ginter, a Sacramento lawyer who represented retirees in Vallejo’s bankruptcy case, agreed that Tuesday’s ruling is influential but not necessarily the final word.

“Pension liabilities of cities can probably be altered in bankruptcy,” Ginter said. “It hasn’t happened yet.”

CalPERS, the nation’s largest public pension fund, said the Detroit ruling doesn’t apply to a statewide entity like the California Public Employees’ Retirement System. The pension fund said employees’ and retirees’ pension rights are still protected by the California Constitution.

“The ruling is short-sighted and does not take into account the promises made in exchange for the financial and physical investments that public employees and retirees make in our communities,” CalPERS added. “CalPERS will continue to protect and champion the public employees and retirees who serve California every day.”

San Bernardino, unlike Vallejo and Stockton, has fought CalPERS over costs. After filing for bankruptcy last year, it suspended its monthly pension payments. It’s resumed paying but still owes CalPERS about $14 million in overdue contributions. For its part, CalPERS has tried unsuccessfully to get San Bernardino’s bankruptcy case thrown out of court.

The San Bernardino City Council in October tentatively approved a bankruptcy reorganization plan that lays out how each creditor would be treated, including CalPERS. The plan remains confidential while the parties undergo court-supervised mediation, but city officials have spoken openly about wanting to cut pension costs. Mayor Pat Morris recently described the city’s payments to CalPERS as “the giant whale in the general fund deficit that eats the city’s services and destroys the city’s financial viability.”

Officials with San Bernardino couldn’t be reached for comment Tuesday.

Denniston said the Detroit ruling could also affect the Stockton bankruptcy. Even though Stockton left its CalPERS payments untouched and made debt-restructuring deals with most of its other creditors in October, the city still hasn’t reached agreement with one major lender, Franklin Templeton. The Detroit decision could give the Franklin firm an opening to demand that Stockton officials treat CalPERS like every other creditor, according to Denniston.

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