As the once-proud city of Detroit humbles itself in bankruptcy court, its financial future may hinge on this key question: Is the city obliged to its past? Or can Detroit renege on its promises to thousands of retirees for the sake of its present city services?
The legal question at the heart of Detroit's bankruptcy filing has never definitively been answered by the nation's highest courts. But it could become increasingly important as cities from coast to coast are grappling with shortfalls in pension funds that left unchecked could force cutbacks to police, firefighters and other essential city services.
A federal judge overseeing Detroit's bankruptcy case is to hold his first hearing Wednesday, as Detroit spars with its employees over whether state lawsuits from pension beneficiaries can proceed.
Some cities, like Detroit, are located in states where pension benefits are guaranteed in full according to state constitutions, statutes or court precedent. Yet Detroit's emergency manager is asserting that those guarantees go away in federal bankruptcy court, leaving retirees in the same pool as numerous other creditors who may get mere cents for each dollar they are owed.
"There's not a lot of previous case law that tells us what's going to happen here," said Paul Secunda, a Marquette University law professor who specializes in labor and benefits issues.
"It's not just an issue of bankruptcy law and pension law, it's also an issue of federalism," Secunda said. "Can a federal bankruptcy court basically ignore a state constitutional provision and allow a city like Detroit to ignore its previous promises concerning public employee pensions?"
The question matters because pensions pose a major liability for states, counties, cities, schools and other local governmental entities. A report released earlier this year by the Pew Charitable Trusts found that the nation's largest cities had a combined pension shortfall of almost $100 billion and an even larger shortfall in retiree health-care benefits as the nation's financial crisis peaked in the 2009 fiscal year.
Although municipal finances generally have improved since then, many local retirement plans remain on an unsustainable path, the Pew organization said.
Michigan Gov. Rick Snyder and Detroit emergency manager Kevyn Orr contend that retiree benefits should be able to be trimmed along with other debts to restore the city's finances. Detroit has about 21,000 retired workers who are owed benefits, with underfunded obligations of about $3.5 billion for pensions and $5.7 billion for retiree health coverage.
"There have to be concessions," Orr said earlier this week.
A similar situation is unfolding in Stockton, Calif., which entered bankruptcy in April after its property tax revenues were hit hard by the housing crisis. Stockton owes the California Public Employees' Retirement System about $900 million to cover pension promises, by far the city's largest financial obligation. The city already has tried to save costs elsewhere by slashing employment, cutting health benefits for current workers and limiting its police force to responding only to emergencies in progress.
Bond insurers contend that pension cuts should be part of Stockton's debt reduction plan to be submitted to a bankruptcy judge in September. Attorneys for the creditors argue that employees who benefited when economic times were good should have to share the pain now that times are bad.
But union representatives contend retiree benefits already have been earned and shouldn't be part of the discussion in bankruptcy court.
"It's essentially similar to salary — you just don't reach inside somebody's savings account and take their pay back, nor should you reach inside their pension and deny them their pension benefits," said Steve Kreisberg, director of collective bargaining and pensions for the American Federation of State, County and Municipal Employees.
The legal arguments could center on two provisions of the U.S. Constitution — Article 6, which declares U.S. laws to be supreme; and the 10th Amendment, which reserves for states all powers not constitutionally delegated to the federal government.
Laws governing local public employee pensions are one of those areas left to state control.
Federal bankruptcy laws also require states to grant permission before their local governments can file Chapter 9 municipal bankruptcy cases. Only about half the states have authorized municipal bankruptcy filings, and many of those have done so only in limited circumstances.
The question for courts is whether a state's pension laws take greater precedence because of their 10th Amendment powers, or whether states have essentially waived that right by agreeing to let cities to participate in federal bankruptcy proceedings.
"The cases in Stockton and Detroit are similar in that they will answer the question on how far the U.S. Bankruptcy Code goes and whether that trumps state law," said Karol Denniston, a San Francisco attorney who specializes in municipal restructuring and monitors bankruptcies across the nation. "There are a lot of cities watching how this plays out."
Other recent municipal bankruptcies provide only limited guidance.
Rhode Island lacked a pension-guarantee law similar to Michigan's when the city of Central Falls filed for bankruptcy in 2011. Under a settlement approved last year by a federal bankruptcy judge, some retired Central Falls workers took pension cuts of more than 50 percent. But the state created a fund to help offset some of those lost benefits.
The city of Vallejo, Calif., which filed for bankruptcy in 2008, had threatened to stop paying pension benefits, but an out-of-court settlement was reached that set no precedent on the issue.
If a federal bankruptcy judge in Detroit or Stockton overrules state laws against pension reductions, "we would have a constitutional crisis at that point," said Hank Kim, the executive director of the National Conference on Public Employee Retirement, a trade association for public pension plans.
But it also could provide a path to financial stability for other troubled cities.
"It could potentially have a large impact in how these pension obligations get treated," Secunda said.