Guest Post: Jonathan Lipson on the Mess in Detroit

Lipson_WebPhotoSorry to interrupt the symposium, but this is in the way of a breaking law-news update.  I asked Jonathan Lipson (Temple), a former guest blogger here and all-around bankruptcy superstar, to offer our readers some thoughts on the recent decision out of the Detroit bankruptcy.  Here are his views:

Detroit: Kicking the Federalism Question Down the Rhodes

Yesterday, Bankruptcy Judge Steven Rhodes stayed a state court suit to derail Detroit’s chapter 9 bankruptcy.  While Judge Rhodes may ultimately dismiss the bankruptcy petition on his own, the decision forestalls one of the harder questions underlying the filing: To what extent may an Article I bankruptcy judge approve a bankruptcy plan that (may) conflict with state constitutional protections for municipal union members?

The answer will be difficult for several reasons, mostly having to do with the recursive interactions between federal and state law in this context. Bankruptcy Code § 943(b)(4) permits a bankruptcy judge to approve a “plan of adjustment” (as it is called) if the “debtor is not prohibited by law from taking any action necessary to carry out the plan.”

While chapter 9 case-law is sparse, one court has interpreted this to mean that it could not approve a plan that altered state-law priority-protections for bondholders. In re Sanitary & Improv. Dist. #7, 98 B.R. 970 (Bankr. D. Neb. 1989). Municipal union members may cite this, and then point to Michigan’s constitution, which provides:  “The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.” Mich. Const. Article IX, § 24.

Because the plan proposed by Detroit’s emergency financial manager, Kevyn Orr, apparently reduces accrued benefits significantly, retirees would argue that the plan would diminish and impair their contractual rights.

But Orr may respond in three ways. First, he may cite the recent City of Stockton case, and argue that state law cannot prevent a municipal debtor from “adjusting” (i.e., reducing) debts, because federal law is supreme.  See In re City of Stockton, 478 B.R. 8, 16 (Bank. E.D. Cal. 2012).  Of course, if the federal law in question (the Bankruptcy Code) defers to conflicting state law, this argument doesn’t get him very far.

So, his second move may be to argue that a plan that diminished accrued contractual benefits would not violate the law, because it has long been accepted that the Bankruptcy Power is far greater with respect to contract rights than property rights.

As I (and others) have explained elsewhere, this distinction seems foundational.  Michigan’s constitution may protect municipal union members’ contract rights, in other words, but that’s all they are: contract claims, subject to “adjustment” under federal bankruptcy law.  If municipal retirees had really wanted solid protection, Michigan’s constitution should have characterized their accrued benefits as “property,” not “contract,” rights.

Third, and most instrumentally, the Michigan constitution does not appear to prevent Orr from exiting current agreements prospectively.  Bankruptcy Code section 365 would give Detroit the power to reject such contracts if they are burdensome (there are actually a couple different rejection standards, but it seems likely he could meet them).  Even if Orr’s hands are tied as to accrued obligations, the argument would go, he could terminate large numbers of current employees, some of whom he may rehire at lower wages.  If municipal employees want their jobs back, they (or their unions) would have to compromise accrued benefits claims.

This would in effect pit current employees against former ones (retirees).  Like those who have successfully reorganized mass-tort, Orr may be able to use this tension to extract concessions from the unions.  Or, the unions may be able to use this same tension to get a better deal than the one that’s on the table.

Either way, setting up these sorts of bargains is, in my view, one of the most important federal interests here.  I have argued in the context of the Catholic Church bankruptcies, for example, that that should be the system’s overarching goal, especially in normatively difficult cases.

Yet, further confounding the analysis are the mixed signals the Supreme Court has sent on the interaction between Congress’ Article I powers (especially bankruptcy court power, in cases such as Stern v. Marshall) and “states’ rights.”  On one hand, cases such as Seminole Tribe and Alden (and, indirectly, Stern) suggest that the Court takes state sovereignty seriously:  the federal government has limited powers to intrude into states’ affairs, which may include interpreting their constitutions (okay, let’s ignore Bush v. Gore).  On the other hand, cases such as Hood and Katz suggest that the Court will make an exception for bankruptcy, discharging state claims and permitting suits against states to recover preferential transfers, respectively (okay, let’s ignore Stern).  Perhaps Judge Rhodes will have a relatively free hand here.

How this will unwind in Detroit is difficult to predict, but seems likely to matter to the outcome. In the meantime, we will have to wait for Judge Rhodes to decide whether to permit Detroit’s case to go forward at all.  Bankruptcy Code section 921(c) provides that the bankruptcy “order for relief” cannot be entered until resolving objections to the petition.  This can include an objection that the filing “does not meet the requirements of this title.”

The unions are likely to argue that Detroit’s bankruptcy petition flunks because Orr’s plan would violate the state constitution, as “incorporated” by Bankruptcy Code section 943(b)(4).  Orr would respond by arguing the supremacy of federal bankruptcy law, perhaps along the lines noted above . . . . And so on.

Given these complexities, it would be understandable if Judge Rhodes wanted to kick the federalism question further down the road, in the hope that all major stakeholders—e.g., bondholders and employees—can avoid the costs of litigating these questions, and settle them in a plan they agree on.

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