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Commercial & Business Litigation

Detroit's Pitch for a Pension Pinch

By Devin Burke Hahn – November 21, 2013

Detroit’s bankruptcy case has shaken up the bond market. The writing is on the wall: Detroit will probably succeed in reducing its pension obligations. In hopes of restructuring its debt, Detroit filed a bankruptcy case under Chapter 9 of the Bankruptcy Code. Chapter 9 follows the familiar path of Chapter 11 in many ways, but Detroit will face several unique challenges as it attempts to apply some of the Bankruptcy Code’s hallmark provisions. See 11 U.S.C. § 901(a) (Chapter 9 borrows many provisions from Chapter 11). At each stage of its bankruptcy case, Detroit will meet serious objections based on the Michigan’s constitution.

Detroit’s pension pinch will face state constitutional challenges related to three major issues: eligibility, contract rejection, and the City’s ability to “cram down” a Chapter 9 plan. Detroit’s bankruptcy petition invoked the first of the Bankruptcy Code’s most powerful debtor protections, the section 362(a) automatic stay. 11 U.S.C. § 362. To keep the stay in effect, Detroit will face its first challenge in the form of an eligibility contest. Once it wins the eligibility contest, Detroit will face a dispute over whether it can use another very powerful bankruptcy provision, section 365(a), to reject its pension obligations. 11 U.S.C. § 365. After it wins its second contest, Detroit will face its third and toughest challenge when it attempts use section 1129(b)(1) to “cram down,” or confirm over creditor objections, a Chapter 9 plan that impairs the pensioners’ claims for pre-petition arrearages and breach damages resulting from the contract rejection. 11 U.S.C. § 1129. Whether Detroit will win all three of these disputes is the $9.2 billion question. See Nancy Kaffer et al., “Detroit Files for Bankruptcy Protection,” Detroit Free Press, July 18, 2013.

Eligibility: The Automatic Stay for the Automotive Capital
Detroit needs the automatic stay to stem the collections process for nearly $18 billion in debt. See Declaration of Kevyn D. Orr, ¶ 9, In re City of Detroit, Ch. 9 Case No. 13-53846 (SWR) (Bankr. E.D. Mich. July 18, 2013). The automatic stay under section 362(a) stays nearly all attempts to collect on debts against the bankruptcy debtor. The stay commences upon the Chapter 9 debtor’s petition for bankruptcy protection. With the stay in place, Detroit need not service its outstanding debt. This reprieve allows the City to marshal its revenues toward the restructuring process of case administration and plan confirmation. Meanwhile, creditors must wait to collect on any claims they have against Detroit. Accordingly, creditors seeking to collect debts owed by Detroit must prove that Detroit is ineligible for Chapter 9 bankruptcy and therefore does not qualify for the automatic stay.

The creditors’ argument contesting Detroit’s bankruptcy eligibility. To keep the stay in place, Detroit faces a legal battle unique to Chapter 9 debtors. Unlike most bankruptcy debtors, municipalities must fight for an order of relief under the Bankruptcy Code. In re City of Stockton (Stockton II), 493 B.R. 772, 776 (Bankr. E.D. Cal. 2013). Detroit proves the rule. Detroit’s creditors, including its two pension funds, have already objected to Detroit’s eligibility for an order of relief. See In re City of Detroit, Ch. 9 Case No. 13-53846 (SWR) (Bankr. E.D. Mich. Sept. 12, 2013) (First Amended Order Regarding Eligibility Objections Notices of Hearings and Certifications Pursuant to 28 U.S.C. § 2403(a) & (b)).

The objecting creditors’ strongest argument alleges that the state laws allowing Detroit to file a bankruptcy petition violate article IX, section 24, of the Michigan Constitution. See Mich. Const., art. IV, § 24; Mich. Comp. Laws § 141.1558(1); 2012 Mich. Pub. Acts 436, § 18(1). Section 24 states that a municipality may not impair its accrued pension obligations. Creditors argue that section 24 renders unconstitutional any state law allowing a municipality to enter bankruptcy and subsequently impair the pensions protected by the state constitution. For Detroit, eligibility for bankruptcy turns on distinguishing bankruptcy eligibility from the scope of section 24.

Detroit’s argument supporting bankruptcy eligibility. In Detroit’s fight for eligibility, it must prove that it complied with Bankruptcy Code section 109(c). Under section 109(c), an insolvent municipality may enter into Chapter 9 bankruptcy if the municipality can show, among other things, that it received authorization from the state before petitioning for bankruptcy. 11 U.S.C. § 109. Applying section 109(c), bankruptcy courts have distinguished state-law protection of the composition of a municipality’s indebtedness from a municipality’s authorization to file for bankruptcy. Those courts emphasized that the filing of a bankruptcy petition alone did not alter or impair debt. E.g., Stockton II, 493 B.R. at 776. Accord In re City of Stockton (Stockton I), 478 B.R. 8, 17 (Bankr. E.D. Cal. 2012) (stating that a municipal bankruptcy did not offend the contracts clause of the California constitution). As a preliminary matter, Detroit will show that the petition satisfies the two Michigan state-law requirements for a municipality to file for bankruptcy protection under Chapter 9: (1) Governor Snyder’s signed authorization and (2) Manager Orr’s recommendation to file for bankruptcy protection. To succeed in the eligibility contest, though, Detroit needs to show not only that it complied with the state-law requirements to file bankruptcy but also that the requirements were valid under the Michigan constitution.

The Michigan constitution’s supposed implicit bar against a municipal bankruptcy falls off the table in light of the fact that Detroit’s bankruptcy, in and of itself, does not impair its pension obligations. Like the Michigan constitution with its protections for pensions, many other state constitutions contain protections for contracts in general, similar to the United States Constitution’s Contracts Clause. For decades, municipalities have legally used Chapter 9 of the Bankruptcy Code to alter debts and contracts, often in contravention of state constitution contracts clauses. Bankruptcy courts have never refused a municipal debtor based solely on concerns of what debts a Chapter 9 plan might impair. Likewise, exactly what obligations Detroit might impair does not hinder its eligibility for bankruptcy.

Detroit will win the eligibility contest. Upon a favorable decision in the City’s eligibility contest, Detroit will maintain the protections afforded by the automatic stay and begin to restructure its creditor relationships through bankruptcy case administration.

Rejection and Renegotiation in the Renaissance City
When it filed for Chapter 9 bankruptcy, the City listed its pension arrearages as its two largest unsecured claims. See List of Creditors Holding 20 Largest Unsecured Claims, In re City of Detroit, Ch. 9 Case No. 13-53846 (SWR) (Bankr. E.D. Mich. July 18, 2013). Little surprise that the City intends to renegotiate these obligations. Accord Press Release, City of Detroit, Proposal for Creditors: Executive Summary (June 14, 2013). As part of the renegotiation process, a bankruptcy debtor’s ability to reject the underlying collective-bargaining agreements provides the ultimate leverage, leverage that Detroit will likely need.

The creditors’ argument contesting contract rejection. Once the City rejects its union contracts, Detroit’s pension obligations will represent only a claim in the bankruptcy case. The Bankruptcy Code deems the rejection a pre-petition breach, and the breach is subsequently reduced to monetary claims against the City. See 11 U.S.C. §§ 365(g)(1) & 502(g)(1). The process takes the retirement benefits and leaves only a liquidated claim in the bankruptcy estate. Obviously, pensioners would like to preserve their pensions and avoid seeing their retirement benefits severed and reduced to bankruptcy claims.

To protect their retirement benefits, pensioners will likely bring another objection premised on the previously mentioned provision in the Michigan constitution. Objections premised on the state constitution will cite 28 U.S.C. § 959(b)’s requirement that trustees abide by state law. 28 U.S.C. § 959. The argument will state that because the state constitution prohibits the impairment of Detroit’s pensions, section 959 prevents the City from rejecting the underlying collective-bargaining agreements in bankruptcy.

Detroit’s argument supporting contract rejection. To reject these contracts, Detroit will need to distinguish the restrictions of 28 U.S.C. § 959(b). Fortunately for Detroit, prior municipal bankruptcy decisions have already ruled that section 959(b) does not include municipal debtors in its scope. See In re Jefferson Cnty., Ala., 484 B.R. 427, 438–39 (Bankr. N.D. Ala. 2012). Accord In re Cnty. of Orange, Cal., 191 B.R. 1005, 1021 (Bankr. C.D. Cal. 1996) (asserting that states cannot “cherry pick” the application of the Bankruptcy Code to a municipal debtor; once a municipality is authorized to enter into bankruptcy protection, the debtor can restructure all of its debt, notwithstanding state laws that afford the state preferential treatment).

Once Detroit distinguishes 28 U.S.C. § 959(b), it will be free to use section 365(a) of the Bankruptcy Code to reject its collective-bargaining agreements. See In re City of Vallejo, 403 B.R. 72, 78 (Bank. E.D. Cal. 2009) (noting that the collective-bargaining agreement protections in section 1113 do not apply to Chapter 9 debtors). The Supreme Court has already clarified that collective-bargaining agreements constitute executory contracts under the Bankruptcy Code, so Detroit can focus on fulfilling the three Bildisco requirements for rejecting collective-bargaining agreements. See NLRB v. Bildisco & Bildisco, 465 U.S. 513, 521–23 (1984). As a preliminary matter, Detroit will need to show (1) that it took reasonable efforts to negotiate a voluntary modification of the contract; Detroit must then prove that (2) the collective-bargaining agreement burdens the estate and (3) equity favors the rejection of contract. Bildisco, 465 U.S. at 526.

In the contract rejection contest, Detroit will quickly show that the application of 28 U.S.C. § 959(b) fails as a matter of settled law. Turning to its burden of proof under section 365(a), Detroit can rely on its petition and factual testimony. Prior to bankruptcy, the City had already engaged in negotiations with creditors, including pensioners, for months. See Voluntary Petition for the City of Detroit, Michigan, at 3, Exhibit A, In re City of Detroit, No. 13-53846-SWR (Bankr. E.D. Mich. July 18, 2013). Under the second part of the Bildisco test, Detroit can prove that the collective-bargaining agreements burden the City. Indeed, the pensions amount to over $9.2 billion in unfunded liabilities for a city that currently cannot service its debt. The final part of the test, the equity of the case, supports Detroit as well. Bankruptcy policy is premised on the idea that deserving debtors should be able to restructure their debt and emerge with a fresh start. Accordingly, equity favors Detroit’s rejection of the collective-bargaining agreement because the contractual obligations make restructuring nearly impossible.

Detroit will win the contract rejection contest. The law favors Detroit in its second challenge. The City will successfully reject its pension obligations and reduce its outstanding obligations to a mere bankruptcy claim.

Will Motown Move On?
Once it rejects its pension contracts and reduces its breach to a liquidated claim, the City will likely attempt to “cram down” a plan that impairs the pensioners’ claims. In fact, Detroit must impair the pensioners’ claims if it intends to impair other unsecured claims against it. See 11 U.S.C. § 1129(b)(1) (allowing debtors to impair unsecured claims so long as the plan does not discriminate among creditors and the plan is fair to the impaired class), incorporated by 11 U.S.C. § 901(a).

The creditors’ argument contesting the cram down. When pensioners object to Detroit’s cram-down plan, they will have a strong argument. Their argument will repeat the state constitutional challenges alleged throughout the case, arguing that a cram-down plan violates article IX by impairing the pension obligations of the municipality. At this point in the case, the state constitutional challenge has real teeth. Two Bankruptcy Code sections require a municipal debtor’s Chapter 9 plan to comply with state law in the plan confirmation process. See 11 U.S.C. §§ 943(b)(4), 1129(a)(2), incorporated by 11 U.S.C. § 901(a). Violating the state constitution might cause a problem with both of these Bankruptcy Code sections.

In some respects, case law supports the pensioners’ objections. Repeatedly, courts insist that objections to a municipal debtor’s actions in bankruptcy should come at the time of plan confirmation. See Stockton II, 493 B.R. at 776 (Bankr. E.D. Cal. 2013). Whether the objections will persuade bankruptcy judges at the time of confirmation remains to be seen. Indeed, under the Bankruptcy Code, only one municipality has confirmed a plan that impaired pension benefits. See In re Cent. Falls, No. 11-13105 (Bankr. D.R.I. Sept. 11, 2012).

Detroit’s argument supporting the cram down. Detroit will need to provide a strong argument for the cram-down plan if it hopes to exit bankruptcy with a fresh start. Fortunately for the City, other municipal debtors have already blazed this trail. One of the few judicial doctrines to emerge in Chapter 9 bankruptcy stands for the proposition that a state cannot create preferential treatment for any creditor in the context of bankruptcy. The Supremacy Clause forbids such a power grab. See Mission Indep. Sch. Dist. v. State of Texas, 116 F.2d 175, 178 (5th Cir. 1940) (“The Bankruptcy Act as a law of Congress made in pursuance of the Constitution of the United States, is part of the supreme law. It makes no provision for separate or preferential treatment.”).

Recent cases support the power of the bankruptcy court to disregard state-law preferences in municipal bankruptcies. Some bankruptcy courts have implied that a municipal debtor may impair its obligations, even against state constitutional protections. See Stockton I, 478 B.R. at 16 (Bankr. E.D. Cal. 2012) (“The federal bankruptcy power also, by operation of the Supremacy Clause, trumps the similar contracts clause in the California state constitution.”). Another bankruptcy court in the same district has already confirmed a municipal plan that impairs contracts in spite of the California state constitutional protections afforded to contracts. See In re City of Vallejo, No. 08-26813-MSM (E.D. Cal. July 28, 2011). Just as the California state constitution could not proscribe a California municipality from confirming a cram-down plan that violated the state constitution contracts clause, Michigan’s constitution will not stop Detroit from confirming a cram-down plan that violates the pension protections in the state constitution.

Detroit will win the cram-down contest. In its final bankruptcy battle, Detroit will gain one more victory, completing the process of restructuring.

Rock City: The Restructured City?
Detroit, the city with more nicknames than perhaps any other, will likely survive the legal challenges to its bankruptcy. Whether it can survive the political and economic challenges it faces depends, in part, on the extent to which it can use the bankruptcy tools of sections 362(a), 365(a), and 1129(b)(1). As to Detroit taking on the new nickname of the “Restructured City,” the chances look slim, but a successful “cram down” might help.

Keywords: litigation, commercial, business, Detroit, automatic stay, bankruptcy, Chapter 9, pension, liquidated claim, cram down

Devin Burke Hahn is a judicial intern to the Honorable Stuart M. Bernstein of the U.S. Bankruptcy Court for the Southern District of New York. The author thanks Professor David G. Epstein.

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