When the City Goes Broke: Pensions, Retirees, and Municipal Bankruptcies

When the City Goes Broke: Pensions, Retirees, and Municipal Bankruptcies

Legal Sidebari

When the City Goes Broke: Pensions, Retirees,
and Municipal Bankruptcies
April 10, 2018
In recent years, a significant number of cities, towns, and other municipalities in the United States have
found themselves increasingly unable to pay their debts. In order to offer municipalities relief from many
types of debts they cannot repay, Chapter 9 of the Bankruptcy Code authorizes certain municipalities to
file for bankruptcy. However, filing for bankruptcy may adversely affect the municipality’s creditors,
especially beneficiaries of underfunded municipal retirement plans (who, along with bondholders, often
hold “the lion’s share” of a municipality’s financial obligations). Because a number of municipalities face
a “dramatic and growing shortfall in public pension funds,” many “firefighters, teachers, police officers,
and other public employees” who purportedly have “a right to pension benefits at retirement” face a
significant risk that their pensions will ultimately not be fully repaid. The fact that public pensions, unlike
their private counterparts, are neither subject to the “vesting and funding rules imposed by” the Employee
Retirement Income Security Act of 1974 nor “protected by the federal pension guarantee program
operated by the Pension Benefit Guaranty Corporation” could, according to some commentators, further
exacerbate that risk. Moreover, because courts presiding over municipal bankruptcy cases have generally
been “amenable to modifying pension debt in bankruptcy,” retirees’ pension benefits may potentially be
significantly curtailed when a municipality declares bankruptcy. Although many Chapter 9 debtors have
ultimately opted not to cut pensions “for political or practical reasons,” courts and commentators
generally accept that, under certain circumstances, municipalities “have the legal ability to shed pension
debt” in bankruptcy if they so choose.
This Sidebar first explains how, under current bankruptcy law, Chapter 9 debtors have significant freedom
to modify their outstanding pension obligations through the bankruptcy process. The Sidebar then
explores proposals to alter the legal principles governing the adjustment of municipal pensions in
bankruptcy.
Background on Municipal Bankruptcy
Chapter 9 of the Bankruptcy Code authorizes municipalities to file for bankruptcy if they satisfy certain
eligibility requirements. A Chapter 9 case is designed to culminate in “a plan for the adjustment of the
debtor’s debts” that alters the financial relationships between the municipality and its creditors. Chapter 9
thereby affords a subset of municipal debtors relief from many types of burdensome debts so that they
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may continue to provide certain services that have been viewed as “essential” to their residents, like
police protection, fire protection, and garbage removal.
Filing for bankruptcy under Chapter 9 confers many benefits upon a municipal debtor. Most relevantly,
Section 365 of the Bankruptcy Code generally gives a Chapter 9 debtor the power to reject an “executory
contract”—that is, a contract that the parties have yet to fully perform—subject to the bankruptcy court’s
approval. Rejecting a contract under Section 365 effectively constitutes “a court authorized breach” of the
agreement that generally “free[s] [the debtor] from future performance under the rejected contract.” “The
claims arising from this breach” are then generally “subject to compromise in bankruptcy” pursuant to a
Chapter 9 plan that modifies the debtor’s obligation to pay those claims. This authority to reject executory
contracts “is a particularly powerful tool” because it allows the debtor to effectively “disavow” certain
contracts “that it no longer wishes to maintain.” One such contract could be a municipality’s
commitments to provide pension benefits to its employees.
Pensions in Municipal Bankruptcy
As noted above, “many municipal debtors” face “overwhelming and seemingly unassailable pension
obligations.” However, several bankruptcy courts presiding over high-profile municipal bankruptcies
(such as the Chapter 9 cases filed by the City of Detroit and the City of Stockton) have agreed that a
municipality’s pension obligations “may be adjusted as part of a chapter 9 plan” by using Section 365’s
rejection power described above. As a result, filing for bankruptcy under Chapter 9 thereby “provide[s] a
means of reducing the unfunded liability portion of a municipality’s pension obligation or otherwise
compromising a municipality’s pension debt.”
That is not to say that “public pensions can be rejected or unilaterally modified willy-nilly,” however.
Some bankruptcy courts, most notably the court presiding over the City of Stockton’s Chapter 9 case,
have stated that a court must “balance the interests of the affected parties—debtors, creditors and
employees”—to determine whether a debtor may permissibly “us[e] chapter 9 to force changes in
municipal pension plans.” Specifically, the bankruptcy court “must consider the consequences of the
alternatives” to adjusting the municipality’s pension obligations “on the debtor, on the value of creditors’
claims and any ensuing hardship and the impact on employees. The court also must consider the degree of
hardship faced by each party and must consider any qualitative differences between the types of hardship
each may face.”
Moreover, even when a bankruptcy court might otherwise be inclined to permit a municipality to adjust
its pension obligations, “political or practical” concerns may nonetheless deter municipalities from using
Chapter 9 to adjust their pension obligations. “For example, it may be politically unpopular to treat debts
owed to public workers in the same manner as sophisticated commercial lenders, or it may be difficult to
continue the essential work of the city if employees feel that their employer’s promises cannot be
trusted.” The fact remains, however, that municipalities potentially “have the legal ability to shed pension
debt.”
Possible Considerations for Congress
Given that multiple bankruptcy courts have concluded that the Bankruptcy Code gives Chapter 9 debtors
significant (albeit not unlimited) power to modify their pension obligations, commentators have debated
whether current bankruptcy law correctly balances the competing interests of debtors, retirees, and other
creditors. Some have argued that municipalities presently enjoy too much freedom “to set aside collective
bargaining agreements and retiree protections” to the detriment of workers “who have devoted their lives
to public service.” Others, by contrast, have cautioned that affording pensioners favorable treatment in
municipal bankruptcy cases could make lenders—who often “battle [with] retirees over the municipality’s

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scarce resources” in Chapter 9 cases—“more wary about loaning money to struggling cities,” which
could, in turn, “increase borrowing costs for cities already in debt.”
Responding to this debate, some Members of the 115th Congress have introduced bills that would change
how pensions are treated in municipal bankruptcy cases. For instance, the Protecting Employees and
Retirees in Municipal Bankruptcies Act of 2017 (H.R. 139) aims to “strengthen[] protection for
employees and retirees under chapter 9 municipality cases” by (among other things) (1) making it harder
for debtors to modify pensions and other retiree benefits over the objection of retirees and employees; and
(2) imposing stricter eligibility requirements upon would-be Chapter 9 debtors, thereby narrowing the
universe of municipalities that are eligible to modify their pension obligations through the bankruptcy
process. As of the date of this publication, the bill is pending before the House Judiciary Committee’s
Subcommittee on Regulatory Reform, Commercial & Antitrust Law.

Author Information

Kevin M. Lewis

Legislative Attorney

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