October 23, 2013
The coverage of the legal battles surrounding how Detroit’s pensions would be treated in bankruptcy have generally treated the guarantee of public employee pensions in the Michigan state constitution as somewhat of a joke that needs to be cast aside given Detroit’s dire circumstances. The basis for the humor is less than obvious.
When the state of Michigan put a guarantee into its constitution it was presumably sending a message to both its public sector workers and its potential creditors. The pensions would have a prior claim on state and local government assets before other creditors. Workers put in their time with this understanding and presumably creditors made loans to Detroit’s city government with the same understanding.
The question now is often posed as to whether this priority can carry over into federal bankruptcy court, which does not award pensions complete priority over other creditors. (In other words, bondholders do not have to allow pensions to be paid in full before they can get partial collection.) The argument presented in the media is that federal law trumps state law or a state constitution, therefore the bankruptcy judge is free to cut pensions to partially payoff other creditors.
However, there is a prior issue. If public employee pensions cannot be guaranteed protection in federal bankruptcy court, can the city of Detroit declare bankruptcy? The city is a creation of the state. (This is especially true at present with Detroit being run by a city manager appointed by the governor.) Certainly the state of Michigan can’t embark on a course of action that would lead it to violate its own constitution, so how can a city within the state?
There are entities that do not have the option of filing for bankruptcy in federal court, like state governments. It is possible that Detroit may also not have this option if it could result in a violation of the state’s constitution.
Okay, that’s enough playing at lawyer for the day. It just doesn’t seem like the issue of protecting pensions is so obviously crazy and informed investors should have known about this clause in the Michigan constitution when they decided to lend the city money.
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