The Contract Clause, which prohibits states from making laws impairing the obligation of contracts, is commonly used to challenge state and local public pension reform efforts. Courts in California, and in other states following California’s example, follow a particularly strict rule: they hold not only that public employees are entitled to the pension they’ve accrued by their work so far, but also that they’re entitled to keep earning a pension (as long they continue in their job) according to rules that are at least as generous. Thus, in states where the California rule applies, one can’t constitutionally increase employee contribution rates or reduce cost-of-living allowances.
This rule is properly viewed either as an application of the federal Contract Clause, which usually defers to state law on the threshold question of whether there’s a contract and what it covers, or as an application of a more generous state Contract Clause. Thus, there’s nothing legally invalid about the California rule. But the rule is unsound as a policy matter, insofar as it locks governments and public employees into compensation structures different than what they would otherwise negotiate, and makes it harder for states to reform their pension systems.

I’ll be serial-blogging this paper over the coming days. Read the whole thing! But here’s the first part of it below.

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In 1996, Anne Arundel County, Maryland, modified its Police Service Retirement Plan. The main change to the plan was that the maximum cost-of-living adjustment (COLAs) would now be lower: while previously COLAs had been capped at 4%, they would now be capped at 2½% for benefits earned after the bill’s effective date.

Police officers sued the county, asserting, among other claims, that the bill violated the U.S. Constitution’s Contract Clause—“No State shall . . . pass any . . . Law impairing the Obligation of Contracts.” The district court agreed with the plaintiffs that “the retirement plans of state and local governments give rise to contractual rights within the scope of the Contract Clause,” but denied that the Contract Clause was violated. The key aspect of the county’s modification was that the COLA change was purely prospective; any benefits already earned would still be subject to COLAs calculated under the previous formula. And because the change didn’t apply “retroactively to vested benefits,” there was no impairment of contract rights.

But that was Maryland. Consider an analogous case from California. In 1982, charter amendment H in the city of Los Angeles placed a 3% cap on COLAs for police and firefighter pensions. (COLAs had been introduced, with a 2% cap, in 1966; then the cap had been removed in 1971.)

Police and firefighter unions challenged the amendment under the federal and California Contract Clauses. The California Court of Appeal took the opposite approach from the Maryland district court: the COLA cap impaired the state’s contractual obligations. That the cap was purely prospective was immaterial: “upon acceptance of public employment [one] acquire[s] a vested right to a pension based on the system then in effect.” (And if pension rules become more generous in the future, one then becomes entitled to the continuation of those more generous rules.) Changing the COLAs for the future deprives employees of currently vested pension rights. Not that the COLAs can never be changed—contractual impairments can sometimes be justified—but the changes must be reasonable, meaning that they “must bear some material relation to the theory of a pension system and its successful operation,” and any disadvantages to the employees “should be accompanied by comparable new advantages.” The court recognized Maryland’s approach but noted that it was “contrary to California law.”

This is the “California rule,” now adopted by twelve states (representing over a quarter of the U.S. by population). As state and local governments seek to resolve their unfunded public pension problems, the California rule, by freezing public-employee pension benefits in place, deprives governments of the flexibility to alter some of the future conditions of public employment.

If the government really promised its employees that its pension rules would be at least as generous for the duration of their employment, such a promise should be enforced—governments can’t take property without paying just compensation, even in the face of a fiscal crisis; why should they be able to do so with contract rights? But there is no such explicit promise. And guaranteeing particular pension rules is a strange thing to suppose governments have implicitly promised, given that they don’t promise other, more important prospective benefits: one’s tenure in one’s job, one’s future salary, or any other aspects of compensation. The state of California is free to repeal any civil service laws or other protections it may have for government employment; the Constitution isn’t implicated. It may fire entire departments and slash public-sector salaries, if it so chooses. But God forbid it chooses to lower COLAs: that’s unconstitutional.

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In the original Constitution, before the adoption of the Bill of Rights, the Contract Clause was one of the few provisions to apply against states, together with such rules as the prohibition against states’ entering into treaties, coining money, or passing bills of attainder and ex post facto laws. During the 19th century, it “was the most litigated provision in the Constitution and was the chief restriction on state authority.” The Marshall Court applied the clause “to tax-exemption agreements, grants of corporate charters, land grants, agreements between states, and state insolvency laws. In so doing the Court affirmed the sanctity of contracts and encouraged the rise of a market economy.”

Things are different now, as different as California is from Maryland. Starting in the mid-to-late 19th century, the Supreme Court made it easier for governments to abrogate their own contracts via eminent domain or the police power; and in the early 20th century, the Supreme Court likewise retreated from aggressive protection of private contracts. In 1934, the Court gave the Clause a “near-fatal punch” when it upheld a state’s two-year mortgage foreclosure moratorium in Home Building & Loan Ass’n v. Blaisdell.

But the Clause isn’t dead yet: in 1977, in U.S. Trust Co. of New York v. New Jersey, the Supreme Court reaffirmed that some limits remain on state abrogation of contracts, and that in fact the limits are stricter when the state seeks to abrogate its own (public) contracts, since then its own “self-interest is at stake.” The current test is whether the challenged state law “substantial[ly] impair[s] a contractual relationship” and whether the impairment is “reasonable and necessary to serve an important public purpose.”

So far, this is all federal law; but state law also shows up in Contract Clause analysis, in two ways. In the first place, most state constitutions have their own contract clauses, which are usually interpreted similarly to the federal Contract Clause; California is one of them.

In the second place, even in federal doctrine, state law plays a role in the threshold question of whether a contract exists. After all, to answer whether a state law substantially impairs a contractual relationship, one must first identify the contract and what it covers. This turns out to be tricky when it comes to pensions. The government usually doesn’t enter into explicit contracts on this point; rather, the legislature generally just enacts a statute defining pension benefits for public employees. And according to the Supreme Court, a statute isn’t treated as a contract unless “the language and circumstances evince a legislative intent to create private rights of a contractual nature enforceable against the State.”

So do these pension statutes create contractual obligations? Do the language and circumstances evince the necessary intent? On this threshold question, federal doctrine defers to state law, within limits. Ultimately it’s a question of federal law; otherwise, states—whether their legislatures or their courts—could define contract rights out of existence, making the Contract Clause “a dead letter.” Federal courts’ willingness to use their own independent judgment also extends in the other direction, denying protection to arrangements that fall short of contracts even if a state court is willing to call them contracts. But within these broad bounds, federal courts “accord special consideration and great weight to the views” of state supreme courts, and thus will usually accept state law determinations of whether a contract has been formed.

Thus, in Dodge v. Board of Education of City of Chicago (1937), the Supreme Court examined the language of an Illinois statute granting public teachers pension benefits and concluded that the statute didn’t create a contract, but this was against the background of longstanding caselaw of the Illinois Supreme Court. Dodge needn’t be read as supporting the traditional view that pensions are gratuities, revocable at will and not subject to the Contracts Clause: all it shows is that this was the state of Illinois law in 1937. Since most states have now held that public pensions are contractually protected, courts would now defer to state law in those states and grant federal Contract Clause protection, even with Dodge still on the books.

The California rule should be understood in this context. It might represent a state-law rule of contract recognition—when does a statute create a contractual obligation?—which may be within the bounds of deference for purposes of federal Contract Clause doctrine. Prospective changes to employment conditions may not usually implicate the federal Contract Clause, but that’s because state law usually says so, and California law on pensions is a limited exception. Or, to the extent the California rule is out of federal bounds, it could be interpreted as part of California’s own Contract Clause doctrine, which is more protective of public employee pensions than the federal doctrine.

But before trying to resolve the question, let’s look at what exactly California courts say about public employee pensions. That’s what we’ll do in tomorrow’s post.