Not so fast in applying Detroit bankruptcy precedent — at least in California

Harvey Leiderman
Harvey L. Leiderman is a San Francisco-based partner with the international law firm Reed Smith LLP. He serves as general, fiduciary, litigation and investment counsel for the California Public Employees' Retirement System, California State Teachers' Retirement System and other California city and county retirement systems as well as investment counsel to the South Carolina Retirement System Investment Commission. Among his work, he was fiduciary counsel to the Orange County Employees' Retirement System during that county's Chapter 9 bankruptcy proceeding, filed in 1994. Mr. Leiderman's comments are his own, and not necessarily those of his firm or any of its clients.

Lest California cities in, or considering, bankruptcy get too euphoric over the mileage they might get from the Detroit ruling on public employee pension rights (“Detroit ruling reverberates with pension funds around country,” Pensions & Investments Dec. 9), a check under the hood might be useful.

Fifty years ago, Michigan changed its constitution to grant public employees contract rights to their pensions in retirement. The state's employees thought that this would be an ironclad way to protect their pensions against impairment, given the added state and federal constitutional protections afforded contracts. Instead, Michigan inadvertently exposed their public servants' pensions to the chop shop of federal bankruptcy courts, which are in the business of doing just what employees fear — impairing contracts. And Michigan declined to go further in protecting pension plan participants' rights. Indeed, as U.S. Bankruptcy Court Judge Steven W. Rhodes said in his Detroit ruling Dec. 3, Michigan could have added additional protections for retirees. “It could even have explicitly required the state to guarantee pension benefits. But it did none of these.” For that reason, it was pretty easy for Mr. Rhodes to conclude that since the only rights pension plan participants had were contract rights, “they are subject to impairment in a federal bankruptcy proceeding.”

But here is where California's vehicle for delivering pension benefits has a few options that might give its public pension plan participants better mileage in the long run. In California, retirees do not have a contract with their former public employers. They are not “creditors” of the municipalities for whom they once worked and they don't have “claims” against those municipalities. What's more, the unfunded liabilities on the books of the retirement fund are not even a “debt,” according to the California Court of Appeals.

The obligations owed to California retirees to pay their retirement benefits are owed by an independent public agency — the retirement trust fund — not by their former employer. That's by statutory design, not by contract. And the obligation owed by the employer to the pension trust fund is also not one of contract, but of statute. It was the exercise of the state of California of its governmental powers that created these statutory obligations, independent of any contractual rights and obligations between the employer and employee while in the employment relationship.

As a result, there can be no “contract” between a California retiree and a former employer that is in danger of “impairment.” And the federal bankruptcy courts may not interfere with the exercise of state political and governmental powers, under the 10th Amendment of the U.S. Constitution and Section 903 of the Bankruptcy Code.

The following diagram might be helpful in understanding these relationships:

Only while the employee is working for the employer is there a contract that can be rejected (a la the Vallejo city bankruptcy proceedings) or impaired by a bankruptcy court. Once in retirement, the retiree looks to the pension trust fund for a monthly benefit check, and the trust fund looks to the employer for full funding. This is the statutory framework in California. In contrast, the Detroit bankruptcy judge was stuck with a Michigan law that only described the contractual relationship of two of the parties, down the right side of the diagram. California law, however, presents the full picture, with all the vehicles' retirement features protected by statute. Call it the California “lemon law” for pensioners.

Detroit's pension guzzler cannot compare with the California hybrid. The California model includes the optional equipment employees in Michigan never got — an explicit guarantee of their pension benefits. California state, county and city pension laws all require full funding of retiree benefits by statutory mandate, not contract, expressly written into the Public Employees' Retirement Law, the State Teachers' Retirement Law, the County Employees Retirement Law, and in virtually every other city charter and municipal code. That's the left side of the diagram. As a result, public agency retirees in California have a statutory engine powering their rights, and need not fear that a bankruptcy court will run them off the road.

So let's be careful when we assume all vehicles for delivering pension promises might run out of gas in federal bankruptcy court. At least in California, your mileage might differ.

Harvey L. Leiderman is a San Francisco-based partner with the international law firm Reed Smith LLP. He serves as general, fiduciary, litigation and investment counsel for the California Public Employees' Retirement System, California State Teachers' Retirement System and other California city and county retirement systems as well as investment counsel to the South Carolina Retirement System Investment Commission. Among his work, he was fiduciary counsel to the Orange County Employees' Retirement System during that county's Chapter 9 bankruptcy proceeding, filed in 1994. Mr. Leiderman's comments are his own, and not necessarily those of his firm or any of its clients.