Two important and very different decisions regarding public pensions were recently issued by the Supreme Court of Illinois and the Supreme Court of New Jersey. These decisions are significant not only for the workers and taxpayers in these States, but also for the owners and insurers of municipal bonds issued in these States.

ILLINOIS

The Supreme Court of Illinois held that Illinois's constitutional provision barring the impairment of pension obligations is absolute and may not be overridden by the State's reserved police power to protect the health and welfare of its citizens. While the exercise of the police power may under certain circumstances justify the impairment of contracts and override the Contract Clause of the Constitution, the Supreme Court held that the constitutional provision protecting pensions may not be overridden. In effect, obligations to pay pensions under Illinois law are super-contracts that may not be impaired under any circumstances.

This decision limits Illinois’s options in addressing the State’s overall fiscal crisis. It also limits the options of its municipalities, like Chicago, with huge unfunded pension liabilities. It puts more stress on the need to cut other operating expenses and raise revenue, which may ultimately redound to the detriment of the State’s citizenry – especially its taxpayers. Ultimately, if these steps are implemented but are still insufficient to address the fiscal crisis, it could place stress on the ability and willingness of the State of Illinois, the City of Chicago, or other municipalities in the State, to pay the debt service owed on municipal bonds.

Municipal bonds under Illinois law do not have special constitutional protections like those afforded to public pensions. Over the next few years, bondholders thus face the risk, absent a robust economic recovery – and especially in the event of a severe economic downturn – that Illinois may attempt to use its police power to impose a payment moratorium on bond debt of Illinois, Chicago, or other municipalities of the State. The State may even attempt to impair, i.e.slash the principal owed on, such bond debt. To be justified, any moratorium or impairment would have to meet the requirements of the police power – it must be necessary for a vital public purpose, and it must be reasonably imposed in the least burdensome manner under the circumstances. It would also likely face a challenge under the Takings Clause of the Constitution, and the State would have to establish that the moratorium or impairment was not a taking of property without just compensation. Undoubtedly, any such action would be a last resort, but bondholders should be aware that it is conceivable that a moratorium or an impairment could be upheld under both Illinois and federal constitutional law, depending on the facts and circumstances at the time.

For municipalities in Illinois, there could be another option. Currently, Illinois municipalities do not have statutory authority to file for bankruptcy under Chapter 9 of the Bankruptcy Code. If the Illinois legislature passed legislation authorizing its municipalities to file under Chapter 9, then filing for bankruptcy would be a legal possibility.  In Chapter 9, the federal Bankruptcy Code would trump the Illinois Constitution, permitting an Illinois municipality to impair its pension obligations. Decisions in the Detroit and Stockton bankruptcy cases support this view, and it is also consistent with the Bankruptcy Clause and the Supremacy Clause of the United States Constitution, as well as decisions of the United States Supreme Court interpreting those provisions.

However, while Chapter 9 could be a tool for impairing municipal pensions, this does not mean that bond debt will be saved. To the contrary, the lesson learned from recent municipal bankruptcies is that cities that cut pensions may also feel compelled, for political reasons, to impair bond debt – perhaps even more dramatically than pensions.  We saw this in Detroit, and are likely to see it in other cities. Thus, Chapter 9 may be a negative option for municipal bondholders as well as pensioners.

NEW JERSEY

While the recent Illinois decision addressed a State constitutional provision aimed at protecting pensions, the recent New Jersey decision involved the failure of the executive and legislative branches to implement a statute mandating a specific level of payments each fiscal year to the State pension fund. The Supreme Court of New Jersey upheld an executive order by the Governor and a budget passed by the legislature (and approved by the Governor) that will reduce payments to the State pension fund below statutorily mandated amounts. The Supreme Court determined that the amount of the statutorily required payments would violate the debt limit provisions of the New Jersey Constitution and, therefore, the law requiring those payments was unenforceable. The Supreme Court made clear that while the pension liabilities had to be paid, mandating specified payments in future fiscal years in amounts that may exceed the debt limit, without a vote of the State’s citizenry, violated the New Jersey Constitution.

While this decision provides relief for New Jersey in the short run, it allows the State to continue to “kick the can down the road” in terms of addressing its unfunded pension liabilities. As in Illinois, absent a robust economy recovery or in the event of a severe economic downturn, New Jersey faces a serious fiscal crisis which ultimately could impact bondholders.

This decision could also have implications for other States and for municipalities. Under the New Jersey Supreme Court’s rationale, a State's debt limit for itself and for its municipalities places a limit on any law mandating a pay down of unfunded pension liabilities that would exceed the debt limit.  If this proposition is applied in States that require a vote of the people for the issuance of debt over a specified limit, the State will be prohibited from passing a law mandating payments to a pension fund in future years.

Whether or not the New Jersey reasoning will be applied by courts in other States will be influenced by the State's definition of debt for purposes of its constitutional debt limit. Pension obligations would be considered debt for purposes of the debt limit in some, but not all States.