Originally posted at Public Sector Inc.
By Steve Eide.

Significant, but perhaps less so than developments in Illinois and California. Nothing that happens in federal bankruptcy court can change the fact that pension reform is mostly a matter of state law.

In addition to being the largest municipal bankruptcy in US history, Detroit is also commonly held to be the most complex. Many questions admit of no easy resolution, either because of the legal principles involved, or simply because stakes are so high.

Or, that’s the perception. Judge Steven Rhodes is determined to keep proceedings on track, and prove that all issues can be resolved both fairly and expeditiously.

It seems to be Rhodes’ view that, from a purely legal perspective, whether a city can cut pensions in bankruptcy is an open-and-shut case of a debtor’s ability to break contracts in bankruptcy. He writes in his opinion on Detroit’s eligibility for bankruptcy:

The state constitutional provisions prohibiting the impairment of contracts and pensions impose no constraint on the bankruptcy process. The Bankruptcy Clause of the United States Constitution, and the bankruptcy code enacted pursuant thereto, explicitly empower the bankruptcy court to impair contracts and to impair contractual rights relating to accrued vested pension benefits. Impairing contracts is what the bankruptcy process does…While bankruptcy law endeavors to provide a system of orderly, predictable rules for treatment of parties whose contracts are impaired, that does not change the starring role of contract impairment in bankruptcy.

Yes, Michigan protects “accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions” (Article IX, Section 24). But, according to Rhodes’ reading of the historical record, the intent behind the state’s constitutional pension guarantee was just to give pensions the status of contracts instead of “gratuities”: “At common law, before the adoption of the Michigan Constitution in 1963, public pensions in Michigan were viewed as gratuitous allowances that could be revoked at will, because a retiree lacked any vested right in their continuation.”

Simply stated, under Michigan law, a pension is a contract, and, while contractual obligations cannot be impaired under state law, they certainly can in federal bankruptcy court.

Leverage is what other governments will gain from Rhodes’ ruling, assuming it holds up. Future bankruptcy judges will refer back to Rhodes, just as he refers to rulings from Stockton, Orange County, and elsewhere. Knowledge that not even a state constitutional guarantee can prevent cuts to accrued benefits in the context of bankruptcy could make unions more amenable to pension reform, and encourage California cities to take on CalPERS.

But cities can only wield this new leverage if the threat of bankruptcy itself is real. Federal law establishes high entry barriers to Chapter Nine. On many occasions, cities’ bankruptcy petitions have been rejected.

Going forward, municipal bankruptcy will probably remain rare, meaning that nearly all pension reform efforts will have to take place within the framework of state law. That’s why litigation over the Illinois pension reform and Chuck Reed’s pension initiative could well prove more consequential than pension cuts in Detroit.

In Illinois, pressure from the bond market clearly drove fiscal reform. The state put off pension reform for years, despite having the worst-funded system in the nation (SERS, tied dead last with Kentucky’s in this survey), and the lowest bond rating of all 50 states. “…pension funding pressure…has helped trigger five Illinois downgrades since early 2009.”

An Act concerning public employee benefits,” signed into law last week by Gov. Pat Quinn, reduces cost-of-living increases for all current and future retirees. The previously automatic 3% annual COLAs will now be available only to benefits below a threshold based on years of service. Future retirees will also be required to forfeit at least one, and as many as five annual COLA increases in retirement.

The bill also imposes a cap on pensionable earnings and raises the retirement age for workers 45 and younger. All these modification to benefits for current workers and retirees set the Illinois pension reform on a collision course with Article XIII, Section 5 of the state Constitution: “Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

The issue is less what’s being cut (COLAs have been reduced before, in Colorado, Minnesota, New Jersey and South Dakota) than reformers’ strategy in addressing the contract issue.According to the Chicago Tribune, state lawmakers believe the reform gave due “consideration” to Article XIII, Section 5 by offsetting the COLA cuts with a one-percentage point reduction in required employee contributions, a binding commitment to fund pensions, subject to enforcement by giving state retirement systems the right to go to the Illinois Supreme Court if lawmakers failed to make required payments, and giving workers a 401(k)-style plan option.

No one believes that the Illinois pension reform balances out on a strict dollar-for-dollar basis–which would be pointless since there would be no savings–nor do unions claim to expect perfect parity. But they do believe the state has not offered enough in exchange for the cuts, and plan to litigate on grounds that the reform is unconstitutional.

But if Illinois’ reform withstands legal challenge, it could open the door to similar reforms in other states such as New York that also have constitutional pension guarantees.

San Jose mayor Chuck Reed’s “Pension Reform Act of 2014” would impose no pension reductions, but rather give governments in California the ability to negotiate changes in benefits on a going forward basis. Governments now lack this power, due to the so-called “California Rule.” Workers may be fired, given furloughs and pay cuts, face increased healthcare contributions, but the structure of pension benefits in place on the day they are hired cannot be modified. If Reed succeeds, pensions will become more like any other form of compensation.

Reed intends to place his proposal on the November 2014 ballot. He has faced some tough early sledding. Late last month, 25 local officials in California came out against the proposal, which must have hurt, given that empowering local management is a key selling point. What Reed still has going for him is that it is a fundamentally reasonable idea to allow governments to restructure benefits on a going forward basis, subject to collective bargaining, and his success last summer in San Jose.

Has Detroit changed Reed’s chances, or those of Illinois legislators? Through making bankruptcy available to cities, and other measures, the federal government may play an indirect role in pension reform, but only that. There’s no federal remedy for a lack of political will at the state and local level.