by James E. Spiotto

As children, we learned the stove was hot either by burning ourselves or by watching a sibling do so. We quickly realized touching the stove wasn’t worth the effort. Similarly, the Detroit bankruptcy (while certainly a challenge for Detroit’s citizens and creditors) may serve a greater social benefit. Participants in the Detroit bankruptcy are presently considering the legal and metaphysical question of whether a state constitutional provision can mandate that, unlike other contracts, unfunded pension obligations must be paid in a municipal bankruptcy without any impairment or reduction. Unfortunately, bankruptcy is the land of broken promises and impaired contracts but, regardless of the outcome of the legal debate, there may be practical answers emanating from the case for all those who are watching Detroit.

In the first half of the 20th century, public workers’ pensions were treated as gratuities – as pay-as-you-go obligations that would be paid if the municipality had sufficient funds and desired to make the payment. During the second half of the 20th century, workers and their representatives desired greater assurance that pension obligations would be paid; they requested enactment of statutes and constitutional provisions defining those obligations as contracts to be protected under the Contract Clause and not subject to impairment or reduction.

However, just like any other contract, the Federal Bankruptcy Code allows pension obligations to be impaired when it is necessary for the rehabilitation of the debtor. Also, the law recognizes that contracts can be impaired for a higher public purpose, such as the health, safety and welfare of citizens; in other words, for the continuation of the municipality. While some may argue that pensions are different and must be paid no matter what, the price of this legal debate may not be worth the effort because there is realistically only one simple answer.

Some Basic Truths

There are some truths about pension obligations and municipalities that we all know. Pensions are long-term obligations. As we are presently seeing, the failure to fund them today can lead to insurmountable problems tomorrow. The municipality’s ability to adequately fund pensions is inextricably intertwined with its ability both to have funds to pay the pensions and also to meet the necessary costs to govern effectively and survive. Municipalities cannot pay that which they have no revenues to fund.

When obligations become so overwhelming to a municipality as to crowd out necessary expenses for essential governmental services and infrastructure, the consequences can be devastating and lead to the meltdown of the municipality (as Detroit has amply demonstrated). From Bridgeport, Connecticut in 1991, we learned a truth applicable here: if a municipality is required by state law to balance its budget and consequently cuts expenses for essential services and raises taxes, the net result is fewer citizens, fewer corporate and individual taxpayers, and the subsequent lowering of revenues. If the municipality attempts to correct for this by raising taxes and/or cutting expenses and services, meltdown continues and the death spiral will begin.

It appears self-evident that if a municipality (such as Detroit) is required to first and foremost pay everything it owes on its pensions now, it will not be able to succeed because it cannot afford such payment in full. Consequently, the municipality will not be able to develop a recovery plan to stimulate and encourage business with the accompanying creation of jobs that are sorely needed in the community. In such a situation, funds necessary for essential governmental services (such as public safety, education of future workers and infrastructure improvements necessary to move goods, services and workers through the community) will not be there.

In reality, the future of pension funding, workers’ continued employment, and the recovery plan for Detroit is dependent upon determining what costs and expenses are sustainable and affordable. This would include determining what amount of pension obligations can be paid that is reasonable, prudent, and feasible. Such determination must take into account the necessity of sufficient funding for a recovery plan whereby essential governmental services can be raised to an acceptable level and infrastructure provided to encourage, stimulate and ensure business growth and expansion, with its accompanying creation of good new jobs, especially for the young citizens of Detroit. This will ensure not only Detroit’s short-term recovery but also its long-term success.

Less is More!

The famous architect, Mies Ludwig van der Rohe, once said that “less is more” in the context of architectural design. Clearly, the architecture of a municipal recovery plan is to reduce expenses (including pension payments) to a level that is sustainable and affordable not only so that the municipality recovers and grows but also so that pensions can and will be paid. With a true recovery comes increased tax revenues, and thus more funding can be available to share among competing obligations and programs.

If we were honest with ourselves, we would all admit that there is a simple answer to this controversy. Workers (current and retired) who have labored hard and especially those who are necessary for the recovery and success of a municipality deserve to be paid for past efforts. As much as can be paid should be paid to meet these obligations as promised. Likewise, workers and retirees rely on the continued success and growth of the municipality for continued employment and pension payments. If the municipality continues to erode and does not succeed with its attempted recovery, there will be less not more to fund pensions and to keep workers employed.

It is truly unfortunate that some promises made to public employees may not have been attainable, may not have been realistic, and may not have been founded on any prudent notion of governance. However, that is an analysis best left to historians and is not currently critical to the question of how municipalities can grow and survive.

Can the Answer Be this Simple?

Fortunately, the answer to all of this is that simple.

Rather than positioning and fighting among ourselves as to what can be paid, what cannot be paid, and what must be paid, it is in the best interests of all parties working on the recovery and success of the municipality to recognize and determine what is sustainable and affordable. Acknowledging the resulting adjustments is simply a recognition of reality. In the long run, this approach will pay more than the best litigation strategy.

Pension obligations can be appropriately adjusted to what is sustainable and affordable, allowing the municipality to invest in that which will help it to recover and grow.

During the 1800’s, railroads had fallen on difficult financial times and needed to find a method of restructuring debts and obligations. The railroads’ then current cash flow was insufficient to pay their debts in full. As a result, the railroads wisely restructured their debt by setting an affordable fixed payment of a portion of the debt that would be guaranteed to be paid annually and a contingent payment of the remaining portion of debt that would only be paid if there were increased revenues based on future success of the recovery. The same basic model can be used for pension obligations.

Pension obligations can be appropriately adjusted to what is sustainable and affordable, allowing the municipality to invest in that which will help it to recover and grow. There would be determined affordable fixed payments that would be guaranteed by a dedicated annual payment source and contingent payments that would only be paid if there were increased revenues created by the success of the recovery plan. If the municipality’s finances improve, there will be more funding. Pensions are not impaired or diminished because, realistically, all that can be paid is being paid. Pension plan beneficiaries have improved expectations that the municipality operating under a realistic recovery plan will make future payments to fund their pensions based upon the anticipated recovery and success of the municipality. Also there could be periodic adjustments to the fixed and contingent payments based on actual results of the recovery and what is affordable. Many pension obligations are long-term obligations; this approach provides a more secure promise of future payments to younger workers who might otherwise be worse off than any of the other workers/retirees.

Why Don’t We Do It?

The reason this approach has not been followed to date in Detroit or in other situations is because we are presently playing the game of blink. Everyone believes that the other side should give in and blink. However, sometimes the wisest person is the one who blinks first.

From the standpoint of workers and retirees, they can achieve a resolution that is better than what can be obtained in the best fought litigation or under any other mechanism by working together and recognizing that together with the municipality they must (1) determine what is sustainable and affordable to allow recovery and growth for the municipality and (2) develop how the municipality can stimulate and attract business and new jobs to the community. In that way, workers and retirees can advocate for (and, hopefully, can participate in) a share of the new tax revenues to be used in fulfilling their future pension funding needs. In doing so, the solution to underfunding can be obtained. Namely, the price for the adjustment to what is sustainable and affordable is the hardwiring of pension funding going forward.

We all have the capacity to change, and now is the time. Detroit is the perfect lesson.

The municipality must identify and dedicate a sustainable and sufficient revenue source for the funding of pension obligations so that we will never again repeat the unfortunate scenario that to balance budgets we forego pension contributions and promise future pension benefits that are not sustainable and affordable. Instead, we fund on an agreed upon ongoing basis from an agreed upon source what we are obligated to fund to ensure the payment of the pensions. Thus, we do not put that burden on our children and grandchildren or underfund pension obligations to the detriment of the workers, especially the youngest.

What is required to achieve this realistic solution is everyone coming together as we have always done in times of crisis in the past. All concerned must work together in a selfless way to achieve the recovery of the municipality first, and hopefully, the increased revenues second, all premised upon a restructured debt that will allow this realistic resolution to happen.

Yes, We Can Change?

We all have the capacity to change, and now is the time. Detroit is the perfect lesson. It may not be too late for Detroit but if it is, it should not be too late for all the other situations.

Over the years, in restructuring corporations and municipal debt obligations, in times when such controversies were quietly done, when there was an impasse and no one wanted to move, the story was told about how monkeys were caught in Australia. In Australia, in order to catch a monkey, a wooden box is chained to a tree and a hole is drilled in it just big enough for the monkey to put its hand in. A nut is placed in the box and soon after the trap is set, a monkey comes, sees the box, smells the nut, reaches in, grabs the nut and makes a fist, and while refusing to let go of the nut, the monkey can’t extract his hand from the box because the hole is not big enough for the fist to fit through. Now they have found monkeys who have died of starvation, still clutching the nut, while just five feet or so away are water and food. The monkey would not let go of the nut in order to save itself. No one in the current controversies over unfunded pension obligations should want to be traced back to that monkey.

Now is the time to make the change and gain more even though some might say it is less.

About the Author

James Spiotto, a co-owner of MuniNet, is a partner in the Chicago law office of Chapman and Cutler, LLP. Head of Chapman and Cutler’s Special Litigation, Bankruptcy and Workout Group, he has represented banks, insurance companies, institutional investors, funds, indenture trustees and bondholders in litigation or workouts for more than 400 troubled debt financings in over 35 states and 10 foreign countries.

He has testified before governmental bodies regarding troubled debt financing, including appearances before the United States Congress in 1988, 1992, 1995, and 2011 with regard to amendments to the Bankruptcy Code.

The National Association of Bond Lawyers presented him with the Carlson Prize in 1995 for best scholarly article for his work on municipal bankruptcy. In 1992 the National Federation of Municipal Analysts presented him with the Municipal Industry Contribution Award.