Detroit Bankruptcy Potential Precedent-Setter on Pensions

The case could set precedents for public workers' pensions nationwide.

Detroit may have particularly large fiscal problems to face, but it is not alone.
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With a federal judge quashing legal challenges that could have held up the Detroit bankruptcy, the process rolls on. Now might be time for public employees nationwide to take notice.

Among the lawsuits that U.S. Bankruptcy Judge Steven Rhodes ruled on this week was a challenge filed by city employees about pension cuts. That suit will be decided in federal court. The Michigan state constitution, however, explicitly prohibits cutting employees' accrued pension benefits. But since seven other state constitutions have similar language and plenty of other cities face fiscal difficulties ahead, bankruptcy experts say Detroit will be the case to watch in determining how future bankruptcies might play out.

"It may be the most important bankruptcy ruling in the history of bankruptcy law." says Robert Novy-Marx, a public pensions expert and associate professor of finance at the University of Rochester's Simon School of Business.

[READ: Judge Sets First Hearing for Detroit Bankruptcy]

"If Detroit is able to impair these pension plans from workers' point of view, despite the fact that there's constitutional language preventing this, it basically is going to let workers everywhere know that they're only protected up to the assets that are set aside," he adds.

In his June restructuring plan for the city, emergency manager Kevyn Orr estimated Detroit's unfunded current and future liabilities at nearly $3.5 billion, meaning they make up nearly one-fifth of the city's total debt.

City employees have responded vigorously to the prospect of those liabilities being restructured. One local union of public employees has organized a rally scheduled for Thursday afternoon, where members will protest potential pension benefit cuts, alongside other demands, like a call for federal funds.


Sharon Levine, an attorney representing AFSCME, the union that represents Detroit city workers, told the Associated Press that cutting pensions will make hard economic times even harder for many recipients.

"Our members who participate at most are at or below $19,000 a year. There is no safety net," she said. The local AFSCME council also says the city did not try to bargain with unions before filing for bankruptcy, as the Wall Street Journal reports.

Detroit may have particularly large fiscal problems to face, but it is not alone. One 2011 paper from California based think tank The Milken Institute showed Chicago, New York City, San Francisco, and Boston had even more unfunded pension liabilities per household than Detroit, and Novy-Marx says those unfunded liabilities persist in many large cities. A rash of medium- to large-sized cities have also been filing for bankruptcy in recent years, including Vallejo, Calif., in 2008; Harrisburg, Pa., in 2011; and both Stockton and San Bernardino, Calif. in 2012. As more municipalities fall victim to bankruptcy, the decisions in the Detroit case could be all the more important on a national scale.

[PHOTOS: Portrait of a Bankrupt City]

"If Detroit can make at least modest adjustments to its pensions, and restructure its other obligations as well, the city and other municipalities in dire financial straits may have a fighting chance. If not, the downward financial spiral of too many American cities is likely to continue," said David Skeel, a professor of bankruptcy law at the University of Pennsylvania Law School, in a Wednesday Wall Street Journal opinion piece.

Detroit's bankruptcy is the largest municipal bankruptcy in U.S. history, and because of both the size and the legal question of cutting pensions, it could mean a battle in a much higher federal court.

"It would be a significant ruling, and one given the stakes involved would likely find its way to the Supreme Court, because a proceeding in a federal court would presumably be overriding a provision of a state constitution, raising the question of the ability of a federal bankruptcy court to intrude on the sovereignty of a state," says Paul Maco, a partner at Bracewell & Giuliani LLP, and a former director of the SEC's Office of Municipal Securities.