Municipal Pensions and OPEB Liabilities in Chapter 9

>>Hello. I’m Beth Wiggins from
the Federal Judicial Center. When the Center held a workshop
on Chapter 9 bankruptcy, issues surrounding pension
and post-employment benefits were front and center
in the discussion. We’ve asked an expert
on that topic, Larry Larose, to guide us through
the important points judges need to understand
in handling these matters. Larry is a partner
in Norton Rose Fulbright
based in New York City and leads their municipal
restructuring practice. He’s played a major role
in nearly every significant Chapter 9 case
in recent memory, including Detroit,
Jefferson County, Alabama, Stockton, San Bernardino,
and Vallejo, and currently represents a major
creditor group in Puerto Rico. He’s been named a leading
lawyer in this area by the Legal 500 every year
for the past six years. Larry earlier walked us
through the intricacies of municipal financing, and that program
is on the Center’s intra and Internet sites.
I highly recommend it to you. But, for now,
welcome back, Larry, and thank you for being here
today to talk about pension and other post-employment
benefits.>>Well, thank you, Beth.
Nice to see you again.>>You, too. To start, can you explain
why pension issues are just so prominent
in Chapter 9 cases?>>Sure. Well, Beth,
as you know, municipalities are not
only governments, they’re also employers. And they’re major employers
in many cases. The employees in municipalities
provide all sorts of services to the citizens like police, fire, transportation
departments, teachers, and personnel in hospitals
and other parts of the system. Municipal employees participate
in a variety of pension plans and are entitled
to a variety of benefits. Usually, these pension plans are
called defined benefit plans, but they are also entitled to
other post-employment benefits sometimes called OPEB
such as healthcare, and all of these things
must be funded by the municipality
on a regular basis. Notably, most of the benefits
that are provided to these employees are under
collective bargaining agreements or CBAs between the municipality
and the labor unions. Employees subject to a CBA
are typically not eligible to participate in
Social Security or Medicare, and the public
pension plans themselves are exempt from ERISA
and the PBGC. So, employees and retiree costs
are typically a huge, if not the largest,
part of a municipal budget.>>So, why is this
such a big problem?>>Well, Beth, the magnitude
of these liabilities at both the state and local
level in this country is vast, and is growing exponentially. Economists have estimated
that looking at all state and municipal
pension obligations in the aggregate that
pension obligations alone are more than two
and a half times greater than the estimated
market value of the assets that are funding
these pension benefits. The unfunded portions
of the pension obligations are more than three times the
total outstanding public debt. When the city of Detroit,
for example, filed for bankruptcy
back in 2013, its pension plans were
underfunded by almost 70%. When Puerto Rico filed for
bankruptcy protection in 2017, its pension plan was underfunded
by almost 98%, and as we sit here today, all of its pension assets
have been depleted. It’s totally unfunded. So, currently, many large states
have enormous general obligation debt,
pension, and OPEB obligations, and when you combine them
all together, they’re more than 50%
of their annual revenues, and these are important states. Illinois, New Jersey, Hawaii,
Connecticut, Kentucky. So, unless states
and municipalities can get these liabilities
under control through either tax increases
or other means, it’s going to be inevitable that
they’ll have to cut services or going to need
a federal bailout. So, that’s why no matter
where we live these issues
are important to everyone. It’s literally
a ticking time bomb.>>Well, let’s step back
to something you said earlier. You said that
municipal employees typically participate
in defined benefit plans. What does this mean
and how does state law affect the status
of such plans?>>Sure. Well, as I said,
public pensions are typically
defined benefit plans. While these are increasingly
rare in the private sector, a defined benefit plan
is funded by municipal
contributions of assets into the plan and a promise
to an employee that he or she will be paid a set amount
of payments during retirement without regard to the actual
value of assets under the plan. It’s a fixed promise.
The legal status of these plans and those promises differ
under state law. Traditionally, most states
treated public pension plans as either gratuities or gifts.
That meant that the city or town could change the promise
at any time because those promises were not
vested and lawmakers could and did change them
on a regular basis. But currently only two states —
Indiana and Texas — continue to follow
that approach. Every other state either adopts
a contract approach or a property approach
to pension promises. Under the contract approach, pensions are considered to be
a contractual obligation between the employee
and the municipality. The only significant questions are when that contractual
obligation actually vests, and what are the terms. So, under this approach,
pension rights are protected under the Contracts Clause
of the U.S. Constitution and similar clauses
in state constitutions. Now, many states,
including Michigan, have incorporated
this contractual promise actually into their own
state constitutions. Six states interpret pension
promises a little different. They interpret them as creating
a vested property interest. Now, participants in plans
in these states can challenge any changes
and adjustments to the pension promises
under the Takings and Due Process clauses
of the U.S. Constitution.>>Okay. Well, so, is there any way
to adjust the obligations under such plans to get
under control the increasing, perhaps unsustainable,
magnitude of the liability?>>Well, giving the growing, and as you say perhaps
unsustainable burden, that these promises have placed
on states and municipalities, a number of them — most notably and unsuccessfully
Illinois recently — have attempted to adjust
their obligations through new state legislation. The general outcomes from
these attempts have been mixed. Under either the contract
or the property approach, accrued benefits really cannot be effectively altered
under state law. Different promises can be made
to new employees, but existing employee promises
generally have to remain intact. A few states and localities
have been successful in altering not yet accrued benefits
to existing employees, but these adjustments
are really relatively minor.>>Okay. So, what’s
the state law with respect to other post-employment
benefit plans? The same as for pension plans?>>Well, as I said, Beth, OPEB obligations are generally
created under CBAs and so therefore they’re contracts
with employment and are almost always unfunded. It’s very rare to find
a funded OPEB plan. While contractually-based, the contracts generally have
defined termination dates and thus lack the state
law protections afforded to pension plans
that we just discussed.>>Okay. Well,
that brings us to Chapter 9. Can you refresh our memory
before we get into the details about the basic legal framework
in play here?>>Oh, sure. So, as we’ve discussed,
well, previously, Chapter 9 is the provisions
of the Bankruptcy Code that are applicable
to municipalities. It does not apply to states. But the fundamental principle
supporting Chapter 9 is that municipalities
are creatures of the states, and the states themselves
are sovereign under federal law in the U.S. Constitution. So, a municipality cannot
file under Chapter 9 unless the state which created
it explicitly authorizes it to do so. About half of the states
have done this in one form or another.
So, under Chapter 9, the bankruptcy court
is prohibited from, in fact, interfering
with the municipality’s political
and governmental functions, and it cannot require
the municipality to raise taxes or cut its budget.
Notwithstanding this, the U.S. Constitution
does remain fully applicable in Chapter 9,
and it creates–and it states, I should say–in
the Supremacy Clause that the Constitution and
the laws of the United States shall be the supreme
law of the land. In addition, the Bankruptcy
Clause of the Constitution states that Congress shall not
have the power to establish–I’m sorry.
Congress shall have the power to establish
through uniform laws on the subject of bankruptcies
throughout the United States.>>Okay.>>Now, within this
legal framework, two bankruptcy courts have,
in fact, considered whether pension promises can
be restructured in Chapter 9.>>Okay. So, I think the two cases
are Detroit and Stockton, right?>>Right.>>So, can we start
with Detroit?>>Sure. Well, in Detroit — which is, of course,
in Michigan — the Michigan Constitution
expressly protects pensions, and it protects them
as contractual obligations and it says, quote, “These are contractual
obligations, “Which shall not be diminished
or impaired.”” So, retirees, unions, and others
in the case argued strongly from the beginning of the case that
the so-called Pension Clause in the Michigan Constitution
prohibited the bankruptcy court from impairing
any accrued pension benefits. Now, given
the severe underfunding of those stray pension plans —
as I mentioned earlier, they were underfunded
by over 70% — the potential liability
was huge — over $3.5 billion. And thus the question
of whether or not Detroit’s pensions
could be restructured and its liabilities reduced through Chapter 9
was a gating issue in the case. So, Judge Rhodes,
who overlooked the bankruptcy, in his opinion
on eligibility of Detroit to file under Chapter 9, expressly determined
that, quote, “The state
constitutional provisions prohibiting the impairment
of contracts and pensions impose no constraints
on the bankruptcy process.” He looked to
the Supremacy Clause and the Bankruptcy Clause
in the U.S. Constitution and held that those clauses
trump state law in this particular circumstance. So, thus, there is
no legal prohibition to impairing pensions
under Chapter 9. Judge Rhodes concluded that
impairing contractual rights is what the bankruptcy
process does.>>Okay. So, what happened
in the Stockton case?>>Well, in Stockton,
unlike Michigan, California does not have a constitutional
provision protecting pensions, but state statutory
and case law does in California. In that case, the California Public Employees
Retirement System — sometimes called CalPERS,
which administers many of the public employee
pension plans in California — argued that pension promises
could not be impaired in bankruptcy
under California state law and the Contracts Clause
of the U.S. Constitution and the California
Constitution. In his opinion
on plan confirmation, Judge Klein in the Stockton case rejected
all of CalPERS’ arguments citing the Supremacy Clause
and the Bankruptcy Clause as trumping state law. Judge Klein determined
that, quote, “First, the California statute forbidding rejection
of CalPERS’ contract in the Chapter 9 case
is constitutionally infirm in the face of the exclusive
power of Congress to enact uniform
bankruptcy laws. Second, the lien
granted to CalPERS via state statute is vulnerable
to avoidance in bankruptcy, and third, the Contracts Clauses
of the Federal and the State constitutions
do not preclude contract rejection
or modification in bankruptcy.” So, Judge Klein concluded
very clearly on this point. “Hence, as a matter of law,
the city’s pension administration contract
with CalPERS, as well as the city-sponsored
pensions themselves, may be adjusted as part
of a Chapter 9 plan.”>>Okay. Well, Michigan
and California both follow
the contract approach regarding the status
of public pensions, right? And so do you think
the outcome would be different in a state that followed
the property approach?>>Well, while both
Michigan and California do follow
a contract approach, and the bankruptcy
court analysis have followed from that, there is no case interpreting
the property approach. But I don’t believe the result would be any different
under that approach. Under the property approach,
the argument is that adjustment of vested pension obligations
under Chapter 9 without compensation results
in an unconstitutional taking of property
under the Fifth Amendment. But in Fifth Amendment cases,
the Supreme Court has made clear that it seeks to prevent
not all takings, but takings of property
to the extent of a claimants’ investment-backed
expectations in the property. Pension beneficiaries
in the states that we have seen appear
to have a solid argument that there’s a property
interested in funded portion
of their pension benefits. The question is whether
the property interest extends to the unfunded portion
as well. While it’s not free from doubt, I believe it’s unlikely that a
court would make that extension. A beneficiary of
a partially-funded pension plan is functionally no different than a partially-secured
creditor in bankruptcy. While property rights
attached to the extent of collateral
of a secured creditor. They don’t extend
to the deficiency claim, which is completely unsecured. It’s important to note
that pension plans do differ, however, from pledged collateral
in an important respect: there is no formal mechanism
like the UCC for perfecting a security
interest or property right in pension funds. If identifiable assets
have been set aside and segregated
from other public funds, it’s likely that a court
will conclude, though,
that pension beneficiaries have a protected property
interest in those assets and only the unfunded portion
of the pension obligation is subject to restructuring. That was the case in both
Detroit and Stockton. Now, in stark contrast,
you have Puerto Rico, which depleted virtually
all of its pension plan assets before filing for bankruptcy and has now totally unfunded
plans and unfunded claims.>>So, let’s jump back to OPEB
obligations. What have a bankruptcy courts
decided about their status?>>Well, as we discussed
previously, OPEB obligations generally
are created under CBAs. They’re totally unfunded
and they lack the same protections afforded to pensions
under state law. In the city of Vallejo
Chapter 9 case, which actually preceded
the Stockton case, the bankruptcy court
which was then upheld by the district court
on appeal applied a 1984 Supreme Court decision
called NLRB v. Bildisco to determine
whether a debtor — in this case Vallejo — could unilaterally assume
or reject a CBA in bankruptcy. In the Bildisco case,
the Supreme Court held that a debtor can subject
to a showing that
the agreement burdens the estate and that the equities balance
in favor of rejection. Application of the Bildisco
standard in Chapter 9 was and remains significant because
after Bildisco was decided, Congress enacted
Bankruptcy Code Sections 11.13 and 11.14 that set forth new
and higher standards and procedures
for rejecting CBAs and restructuring
benefits under Chapter 11. The Vallejo court held
that such provisions do not apply
at all in Chapter 9. So, both of the Stockton
and Detroit cases built on Vallejo reasoning,
and in Stockton, Judge Klein embraced Bildisco and used that standard
for CBA rejection and also denied a claim
that the rejection violated the Contracts Clause
of the U.S. and the California
constitutions. Judge Klein reasoned that the
Contracts Clause bars a state from making a law impairing
the obligations of contract, but it does not bar Congress
from doing so. And in Detroit, Judge Rhodes
endorsed Judge Klein’s analysis in all respects.>>Well, you’ve told us about
the legal reasoning the conclusions,
but can you tell us how the employees
actually faired in these cases?>>Yeah. That’s a really
good question because given the reasoning
that we’ve just walked through the way bankruptcy courts
have addressed these issues, many observers
have really expressed surprise at the actual treatment provided to claimants
under the plans of adjustment that were confirmed
in these cases. In Detroit, for example, pensions were impaired
by only 3% to 4%. But that also had
other adjustments to certain investment plans
about payments. But in contrast, unsecured
claimants in the Detroit case were impaired by 24% to 98%.
In both Stockton and Vallejo, pensions were completely
unimpaired while general unsecured claims
were severely impaired. But in all three cases,
OPEB obligations — primarily healthcare benefits — were treated as unsecured claims
and received minimal recoveries, resulting in hundreds
of millions of dollars of future benefits to
public employees being impaired.>>Well, certainly not
the outcomes one would expect. So, why these outcomes?>>Yeah, well, Beth, you know,
the reason for these outcomes is really inherent
in the process. While Chapter 9 is
a legal proceeding, of course, but there is a general consensus
that it’s also an inherently political process
which requires a careful balancing between
the powers of the court and the local government
and sovereigns involved. So, the court cannot
compel a government to seek to impair pensions
or OPEB obligations even if the government
may legally do so under the current standards. The only power
that the bankruptcy court can wield in this process is the power to confirm
or dismiss a Chapter 9 plan as proposed by the municipality. It’s important to understand,
I think, that while the legal standards
that must be met for a plan of adjustment to be confirmed are thorough
and bankruptcy courts take these standards seriously, there really is inherent leeway
in that process. While the Chapter 9 debtor must
show that the plan is feasible, that it’s in the best interest
of all creditors and contains no unfair
discrimination among creditors, the ultimate findings
on confirmation issues will be influenced by the
process undertaken in the case. For example, in Detroit, that process which involved
extensive mediation among the various
claimant groups resulted in a fully consensual
plan that was agreed to by all major creditor
constituencies and classes. In fact, because there were,
in fact, no objections to the proposed
plan, Judge Rhodes in Detroit had to engage
his own third-party expert to provide testimony
and analysis at the confirmation hearing on certain
confirmation standards. The outcome for pensions
in Detroit was really driven by what was called the so-called
Grand Bargain in that case, which saw hundreds of millions
of dollars of third-party contributions, mostly through
private foundations, effectively donated
to the pension plans to resolve that case. It’s a very sui generis
and I think it’s unlikely that we’d see that
in any other case. In Stockton, confirmation was
opposed by only one creditor, and Judge Klein easily found that when looking at employee
benefit impairment as a whole, including the OPEB impairment,
the plan did not unfairly discriminate against
unsecured creditors even if the pension plans
were left unimpaired.>>Okay. Well, I can’t help but ask
since you’ve been in Puerto Rico and are involved there. What do you think’s going
to happen in those cases?>>Well, the treatment
of employee benefits under any proposed
plan of adjustment proposed in the Puerto Rico case is really unknown and completely
unknowable at this time. But I think it can be observed
that the debtors in those cases can remember
it’s a federal control board that is technically the debtors. They have proposed a 10%
cut to vested pensions, but you must understand
that these pensions are currently 100% unfunded.
Okay? Even at this small cut of 10%
is being vigorously resisted by the Puerto Rico
Commonwealth government, highlighting the inherently
political nature of these types
of legal processes and the outcomes in that case
is, as said, unknowable.>>Okay. Well, so, Larry,
where does that leave us? What are the major points
you’d like to make now?>>I think we can sum up here by saying non-binding
bankruptcy case law and the general consensus of
the legal and academic community on these issues is that unfunded
pensions and OPEB obligations may be impaired through
a Chapter 9 plan of adjustment. But the legal issue
is not free from doubt, and constitutional
and state law issues including the constitutionality
of Chapter 9 itself are likely to be
vigorously contested if there is
a non-consensual attempt to impair these obligations
through Chapter 9. Indeed, I believe
the confirmation process in the Puerto Rico
Title III cases — which, remember,
incorporate or mirror most of the relative provisions
of Chapter 9 — could be just such a case, and the issues could go
all the way to the U.S. Supreme Court
at some point.>>Mm-hmm.>>The consensus also is that
a court cannot force a municipal debtor to impair pensions
or employee benefits if it is not inclined
to do so for political or any other reason.
The most that a court can do is fail to approve
a plan of adjustment proposed by the municipality
and dismiss the case. But experience really
does suggest that this outcome will be
a rare instance and courts will exercise
their discretion and flexibility in planned
confirmation proceedings to really encourage
consensual results. Thus, I think, Beth,
that we can conclude that Chapter 9 is really
not a silver bullet for curing municipal pension
and benefit woes, but it should be and is,
I believe, available as an option
to those municipalities with both the legal eligibility and the political
will to use it.>>Thank you, Larry,
for this fabulous overview on the state of the law,
and also thank you for the help you’ve given us
over the past two years in understanding
Chapter 9 issues generally.>>Thank you, Beth.
It’s been a pleasure.

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