8.19.13

Detroit’s Bankruptcy Filing Deadline. Midnight is the deadline in Motown, by which time unions, creditors, and retirees are expected to file formal objections to Detroit’s eligibility for federal bankruptcy protection. In order to be eligible, Detroit will have to convince the U.S. Bankruptcy Court that the city is insolvent—and must demonstrate that it received state authorization to seek bankruptcy protection, and that it made a good-faith effort to reach a deal with creditors before seeking bankruptcy. Thus, to obtain U.S. Bankruptcy Judge Steven Rhodes’ blessing to move forward, Detroit must prove it negotiated in good faith with creditors and other stakeholders, that it was insolvent at the time of the filing and that it met legal requirements to file for bankruptcy. It is not an inconsiderable bar: of the 63 Chapter 9 filings for municipalities since 1953, only 34 cleared the bar of eligibility. The test of insolvency in a Chapter 9 is on a cash-flow basis—that is, the court will not require the city to bounce a check to prove its insolvency. U. S. Bankruptcy Judge Steven Rhodes will hold a mini-trial on the issue of eligibility, commencing on Oct. 23, where creditors and the city will call witnesses to try to make their case. Judge Rhodes also has set aside Oct. 24-25, 28-29 and Nov. 4-8 to continue the trial if necessary.

Detroit’s fire and police retirement system, which supports 8,500 retirees, has made clear it will file today, claiming that Gov. Rick Snyder did not have the authority to approve Detroit’s bankruptcy filing last month because the decision infringed on Michigan’s constitutional protections for pensions. Michigan Attorney General Bill Schuette has raised the same issue; Mr. Schuette last month announced he would defend retirees in the proceedings despite the governor’s support for bankruptcy. With as much as $3.5 billion in unfunded pensions at risk, the constitutional dispute is expected to be critical in the eligibility trial. In court documents, Emergency Manager Orr said that unions declined to bargain on behalf of the 21,000 municipal retirees and that multiple lawsuits filed against him and the governor proved resistance from some creditors.  The pension funds and unions are likely to ask that Judge Rhodes rule on whether Michigan’s state constitutional protection of earned pension benefits shields them from cuts in bankruptcy. The unions and retirees also are expected to contend the city’s claim of $3.5 billion in unfunded pension liabilities is inflated and based on a consultant’s incomplete actuarial analysis: they will likely claim that Mr. Orr did not negotiate in good faith as evidenced by the city’s rush to file on July 18 to avoid a state court’s planned injunction against Governor Snyder’s authorization of the filing.

In addition to complex legal arguments from unions and pension funds, Judge Rhodes will also have to sort through bankruptcy eligibility objections from citizens and retirees who began submit objections to the court on Friday. Motown resident Regina G. Bryant filed two personal objections, hand writing “creditor” under her typed name and signature. Her first related to her alleged wrongful termination from the city’s water and sewerage department in February 2010. The other focused on her quality of life on the city’s east side: “I believe the City of Detroit filing Chapter 9 would hamper all services and do a disservice to the citizens of Detroit.”

A Long & Expensive Process. Detroit’s legal struggle to prove eligibility for federal bankruptcy protection is almost certain to be a long and expensive process with no guarantee of success. Over the next two months, creditors can interview city officials and experts to try to demonstrate to the court that Detroit does not meet the multi-part test for eligibility. Stockton, Ca., overcame objections by methodically laying out the dire state of their finances in hearings and documenting efforts to negotiate in good faith with creditors. In Central Falls, R.I., the city was able to exit bankruptcy quickly after retirees withdrew their objections to proposed cuts. But in Harrisburg, Pennsylvania, the federal bankruptcy judge dismissed Harrisburg’s case just weeks after it filed in October 2011, citing a state law that barred some cities from seeking bankruptcy protection. That is to say: the eligibility test can be a critical struggle—and an expensive one in terms of costs of time and resources. Creditors will likely depose numerous city officials, advisers, consultants, and, likely, state officials, seeking emails and other records as they try to build their case. In Detroit’s case, the stakes could be higher: retirees and pension fund officials have signaled their intent to fight the bankruptcy on the grounds that proposed pension cuts violate the state Constitution.

Consider a case with similarities to Detroit: Stockton, Ca., which, prior to Detroit, was the largest U.S. city to file for court protection. Stockton filed for chapter 9 in June of 2012; it was deemed eligible last April. U.S. Bankruptcy Judge Christopher Klein presided over a three-day trial on the issue, and now the city is moving toward an exit from municipal bankruptcy. Judge Klein described the eligibility hearing as “much like a qualifying heat in a race or sporting event, in that it merely determines whether we’re going to go forward and have some of the conversations that are ultimately involved” in the bankruptcy process. Each side was given 700 minutes of court time to make its case. And the trial came in the wake of creditors deposing the entire senior staff of the city, the vice mayor, the police chief, and city consultants. The city was required to turn over thousands of emails and documents.

One of Stockton’s attorneys in the process, Mark Levinson, described the goal of the eligibility hearing to be one in which the creditors seek to gain bargaining leverage if the case proceeds: “It’s about causing the city pain in an attempt to gain bargaining leverage come plan of adjustment time, which they know is inevitable. Nothing else makes sense.” (Once a city is granted eligibility, its next step is offering a “plan of adjustment” that serves as a roadmap for its restructuring.) Judge Klein, in approving Stockton’s eligibility for chapter 9, noted that crime was spiraling out of control and that police had been cut to the bone. In his decision, he wrote” “City management before the Great Recession deserves some of the blame…City accounts were in such disarray that it has taken literally years to unscramble them.” Other municipalities that successfully surpassed the eligibility test were able to win concessions from creditors and retirees at the beginning of the process. Jefferson County cleared the bar for bankruptcy in November 2011, citing more than $4 billion in debt, largely from a troubled sewer project. Nearly two years later, the county is now nearing an exit from bankruptcy—nearly a year and a half after a judge ruled it was eligible to file in March 2012. The county has sold assets, continued layoffs, and closed a county hospital. Under an agreement announced last June, Jefferson County has agreed to spend the next 40 years repaying much of the debt it owes—and that after creditors agreed to forgive a significant amount. Central Falls, R.I., was able restructure in bankruptcy last year after retirees withdrew their objection to the filing. The city exited bankruptcy in 2012 in a plan that mostly hurt retired employees and fully repaid bondholders. The city of nearly 20,000 cut its work force by about a third, cut pensions by as much as half, closed a community center, and imposed annual 4 percent property tax hikes over five years. The state passed a law giving bondholders preference in a bid to ensure the state’s credit rating did not decline. Central Falls was declared eligible for filing for municipal bankruptcy after a group of 100 retirees withdrew its objection without demanding a hearing—helping to facilitate the city’s exit out of bankruptcy in less than a year. But San Bernardino, Ca. is still trying to prove it is eligible for federal bankruptcy protection. Judge Meredith Jury has scheduled a hearing for a week from Wednesday in which she could decide on San Bernardino’s eligibility. The city filed for bankruptcy on last year on August 1st. For more than a year, the has contended with the California Public Employees Retirement System (CalPERS), which has objected to the filing and is fighting for documents, claiming the city is operating as a “black box” and not disclosing financial information. While San Bernardino waits for the green light, more than 25% of its estimated 1,200 municipal employees have left, and it has cut city services. Crime is up, the city says, and crime-fighters are down — to 260 police officers in January, from 356 in 2009.

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