On Saturday morning, Providence Mayor Angel Taveras will convene a meeting of the city’s retirees to ask them to accept reductions in their pension benefits to help the capital avoid filing for bankruptcy, as nearby Central Falls did last August. What happens if they don’t come to an agreement?

David Skeel is a professor at the University of Pennsylvania Law School in Philadelphia and a nationally known expert on bankruptcy and Chapter 9. We spoke on Thursday about what bankruptcy would mean for Providence’s pension system, how Central Falls has changed the legal landscape, and why he doesn’t buy the case for Rhode Island’s bondholders-first law. The transcript has been lightly edited for length and clarity.

I was fascinated by the argument in your working paper that government employees’ and retirees’ property rights cover the pension fund but not the pension promises. Could you explain that?

The question is if a city or a state makes a pension promise, but does not fund the promises – which has been true in many states in recent years – what exactly is protected in the event of a default or of bankruptcy? A lot of people assume that what’s protected is the full promise, even if there’s no funding behind it.

Although this is certainly not free from doubt – this is unchartered territory in many respects – my view is that there’s a good argument that what’s protected is the amount of money that’s been set aside. Pension obligations are a form of what we refer to in the law as a property right, and other kinds of property rights are protected up to the value of the property that’s set aside for them. So if somebody has collateral for a transaction, we treat that promise as sacrosanct up to the value of the collateral.

For a layman, that sounds like the difference between a secured claim and an unsecured claim.

It is analogizing to that distinction. And there is some historical evidence that this is the way that pensions are treated. In the Studebaker case, which is a very important case about 50 years ago now, that was essentially the way the courts handled that. They treated the Studebaker employees as being protected up to the extent that there are actually funds. So what was protected was the amount funded, exactly.

That sort of makes sense. If we save money for your pension, we can’t just raid it. But if we didn’t save enough money, there’s no dedicated funds to take from you. Money would have to be found.

Absolutely. It makes perfect sense. It’s counterintuitive to many people in the pension context – a lot of people start with the assumption that what is protected is the promise, and that even if the company or the city is unable to pay, many people assume that they’re still obligated to the extent of the promise. My view is there are a lot of areas where we don’t operate that way. It’s easy to understand why you would be protected up to the extent that money is actually set aside for you; it’s a little bit more of a stretch to say you should be protected even if nobody set any money aside.

We’re talking on the eve of a huge meeting Saturday morning here in Providence where the mayor is going to ask for voluntary concessions. In Providence’s case, there was $1.32 billion in pension promises but only $362 million saved as of June 30. In that case, then, your argument is the $362 million would be protected to pay retirees but not the whole $1.32 billion promised.

One way you could look at it is it would be protected up to the $362 million, and then with the rest you would treat that equivalently to other unfunded promises. The city would make an arrangement to pay some of it, but they wouldn’t necessarily guarantee all of it.

So it’s not so much that you write off everything and they take a total loss on everything above $362 million, but you’d restructure it.

That’s right. You’d treat the rest of it as if it were an unsecured claim. If Providence were to use Chapter 9 and if they were to go this route, that would likely mean they would offer to pay some of it but not pay all of it. And what they would pay would be comparable to the way they treated other general creditors.

The question in a sense is, what’s the minimum a city or a state could pay? That doesn’t necessarily mean that they would have to do that. In many Chapter 9s – almost all of them, until Central Falls – pensions were protected. The city just didn’t want to go after pensions for a variety of reasons: the uncertainty, the concern about the effect of reducing pensions. So what we’re talking about is if the city were to play hardball, what’s the most aggressive thing it could do with pensions? This is not to say they necessarily want to do that.

I’ve covered pensions and Chapter 9 for more than a year, but this was a new argument to me. How far out there are you in terms of your legal theory here? I know Chapter 9 is sort of an unsettled part of the law anyway.

This is an aggressive interpretation of what a city can do to restructure its pensions. It is not a slam-dunk interpretation. If Providence or Central Falls were to try this, if their deal were to fall apart and they were to try this and it were to go to a court, I could not say with 100% accuracy that a court would uphold this. But I think that it is far more than 0% accuracy, and I think I’d go so far as to say a little bit more than 50% accuracy.

So the question is, why don’t you see other people saying this? A couple answers.

One is the uncertainty. It’s not clear whether you can do it. The other is just the realpolitik of it. Pensions have been treated as sacrosanct, as something that is simply untouchable. And so the idea that they might not be legally untouchable – it’s kind of beyond what people are willing to consider or are comfortable considering. I think that’s a big part of it. And I think that’s one of the reasons why Central Falls is so important.

I was going to ask – you’ve said a number of times that the tentative deal between the city and retirees to cut pensions in Central Falls could have a huge impact on the legal landscape when it comes to pensions and Chapter 9.

Oh, it’s hugely important. It does have the distinction that this is a voluntary deal – this is not something that is imposed through a vote in the bankruptcy process. But the idea that you can restructure your pensions is an enormously significant idea. There’s only one other case I’m aware of, which was Pritchard, Alabama, where this appears to have been done.

And in that case I believe the fund had literally run out – there was literally no money.

Right, I think there was literally just no money. So this is a very significant case, and it really is in my view potentially a game-changer. There’s been this sort of meme that pensions were off the table, that this is just not something that you could restructure. And in a number of municipalities, it’s one of the biggest obligations and if you can’t restructure it, you can’t really do anything.

That’s what the officials say in Providence.

And I think San Diego is in a similar position, though I think they’re not quite as precarious financially. Whether that’s on the table or not on the table is just incredibly important, and I think Central Falls is moving the needle on that.

There’s a heated debate about whether there could come a point where it would be better for Providence to just file for Chapter 9 – that if the city can’t find ways to deal with its financial problems outside of bankruptcy, it’s better to bite the bullet rather than have the issue drag on and on. But obviously there are huge worries about what that would mean for Rhode Island, with it being our capital and a huge economic engine. Where do you come down on that?

I think it’s a really hard question to answer in the abstract. The question is the more important issue. There are a set of trade-offs that you have. If you’re the capital city, this is not a step you want to be taking. You want to take it only if there is absolutely not an alternative. But on the other side of it, at some point you’re not doing anybody any favors by making it impossible to climb out of your financial predicament. Promises that you can’t realistically pay are a huge drag on municipal finances, and over a long period of time, year after year, if you’re just completely hamstrung by these promises and you either can’t pay them or paying them leaves you completely crippled, I think you have to consider the possibility of restructuring on the view that that will facilitate growth going forward.

It’s even possible that the people who are restructured will be better off, because if I’m a retiree I’d like to keep getting 100 cents on the dollar, but if the city just collapses I’m not going to get my 100 cents on the dollar – I’m going to be Pritchard, Alabama. I may be better off getting 70 or 80 cents on the dollar and having a healthier city going forward.

It’s a really tough trade-off. These promises were made to these pensioners, many of them worked in expectation of getting the pensions – you don’t want to back away from those kinds of promises. On the other hand, there comes a point where sticking with the direction that you’ve been going in is even worse than restructuring.

The other thing I wanted to ask you about was our “bondholders-first” law here in Rhode Island, which says bondholders get first priority for repayment at the expense of other creditors, primarily pensioners. You’ve said that may violate the Contracts Clause of the U.S. Constitution and could potentially wind up before the U.S. Supreme Court.

It’s a hugely important issue. The best case to go up to the Supreme Court is a case where there’s a conflict in the courts, and since this is new there at this point isn’t a conflict in the courts really. There’s been a lot going on with the Contracts Clause in the courts, and I would not be at all surprised if a Contracts Clause case goes up to the Supreme Court in the near future, and this is one that could be it.

You’ve also said you don’t think the bondholders law is necessarily fair, to protect one group of creditors over another. The argument I always hear back here is that Rhode Island governments can’t operate without being able to borrow money, and that without this protection we could be cut off from the bond markets. What do you make of that argument?

I disagree with the assumptions underlying the argument, which is that if you don’t completely protect bondholders all possibility of borrowing will disappear. I just don’t think there’s evidence of that. The bond market view tends to be if you do anything that prevents us from getting 100 cents on the dollar, the world is going to come to an end. And my view is, there’s just no evidence of that. The evidence is really to the contrary – healthy municipalities will pay less and have better access to the bond markets than sick ones, and the restructuring of one city is a lot less likely to have contagion effects on other cities in those states than people in the bond market tend to believe.

I just don’t find these kinds of arguments compelling. For instance, Greece is restructuring its bond markets severely right now – the bond markets have not shut down in Europe.

The response here will be, well, Rhode Island is so small that the bond market can just write the whole state off without losing much business if things get dicey.

I still don’t find that persuasive. With respect to a city that restructures a bond – the city itself, whether it’s Providence or Central Falls – you might be a little worried about that city because they’ve restructured their bonds. On the other hand, their debt situation is better after they restructure their bonds, so in that sense they’re a better credit risk than they were before the restructuring.

If you look at countries that have had trouble with their bonds, the evidence shows that in countries that default and restructure, they’ve been able to go back to the bond markets fairly quickly. So I’m of the view that claims that markets would be completely shut down are seriously exaggerated.

We all hope you’re right.

If the bond market cuts off Rhode Island, well, if Rhode Island is in better shape then than it is today, then it’s kind of a mistake for the bond markets to cut them off. And someone I think is going to want to fill the vacuum.

Maybe we’ll call you and ask to borrow $20.

[Laughs] The bottom line on the bond stuff is they throw around contagion and “nobody will ever be able to borrow again,” and there’s really just no evidence of it. The bond market effects seem to me to have been considerably exaggerated.

(photo: University of Pennsylvania Law)