B-Day in Motown. U.S. Bankruptcy Judge Steven Rhodes this morning determined the city of Detroit is officially eligible for Chapter 9 bankruptcy, and that the case “should not be dismissed…Certainly the court must conclude that the bankruptcy filing was a foregone conclusion, at least in 2013.” Judge Rhodes, in his oral summary, stated it was impracticable for Detroit to negotiate with 100,000 creditors before deciding to file bankruptcy last July 18th, a key element Detroit needed to secure his approval of the city’s eligibility for federal chapter 9 municipal bankruptcy protection, noting that “This situation has proved unworkable,” Judge Rhodes stated: “The city’s debt and cash flow insolvency is causing the city’s 700,000 residents to suffer hardship,” finding that the city met the criteria necessary to enter into Chapter 9, including proving insolvency and the impracticability of good-faith negotiations―as well as determining that the State of Michigan’s constitutional protection of pensions does not apply in federal court: “Pensions are not entitled to any extraordinary protection.”
The creditors fighting the city’s eligibility, which includes unions and pension systems but no bondholders or insurers, have already said they will appeal the eligibility ruling and now, likely the pension ruling as well. They are expected to appeal directly to the U.S. Court of Appeals for the Sixth Circuit, bypassing the U.S. District Court Eastern District of Michigan; however, the city’s bankruptcy Plan of Adjustment process will now proceed while the appeal is filed and considered, setting off a new round of negotiations with the municipality’s 100,000 plus creditors to try to reach agreements with enough of its creditors so that the Motor City it can file a reasonable plan of adjustment—seeking to gain approval from a class of creditors who make up two-thirds of the amount of debt and over half by number. Appeals in the case will be made first to either the U.S. District Court, Eastern District of Michigan, or the bankruptcy appeals court in Michigan, then on to the U.S. Court of Appeals for the Sixth Circuit, and the U.S. Supreme Court. Judge Rhodes will post his 140-page written decision on the federal bankruptcy court web site today.
Insolvency. In his opening, Judge Rhodes described the state of Detroit: “Crime case closure rates “are substantially below those of comparable municipalities nationally and surrounding communities…The number of employed Detroit residents fell from 353,000 in 2000 to 280,000 in 2012…If the city had not deferred these payments, it would have run out of cash by June 30 of 2013.” With regard to the disputed level of the Motor City’s pension obligations, the Judge told the court: “If the city had not deferred these payments, it would have run out of cash by June 30, 2013.” He said the state of the city’s finances were reaching desperation levels: “The city projects it would have negative cash flow of $376 million by 2017,” thereby making clear the city has met the criteria of insolvency. Judge Rhodes recounted the details of more than fifty individuals who protested the city’s bankruptcy filing at the September 19th hearing, noting they were: “moving, compassionate, compelling, and well-articulated” arguments.
Federalism. Judge Rhodes affirmed that the U.S. Bankruptcy Court has the authority to determine the constitutionality of chapter 9 and Michigan’s Emergency Manager law, noting: “The court finds now that these issues are ripe for decision…Resolving this issue now will likely expedite the resolution of this bankruptcy case.”
Constitutionality of Michigan’s Emergency Manager Law. In his decision, Judge Rhodes said that Detroit met the legal criteria of obtaining the state’s authorization, even as he noted that while there was “certainly was some credible evidence in support of the assertion” that the Michigan Legislature attached a spending provision to the emergency manager law to prevent it from being overturned by referendum, that would not stop him from ruling the emergency manager law was constitutional. Judge Rhodes said the city meets the legal criteria of obtaining the state’s authorization, making clear that in his opinion Gov. Rick Snyder did the right thing by refusing to attach a contingency to the city’s bankruptcy filing: “Any such contingency in the governor’s authorization letter may have rendered the authorization itself invalid,” in effect building a legal case that Michigan’s emergency manager law is constitutional. Judge Rhodes rejected the argument that the federal Chapter 9 provisions allowing for contract cuts makes it unconstitutional: “The court concludes that Chapter 9 satisfies the uniformity requirement of the United States Constitution,” telling the courtroom Chapter 9 “does exactly” what the Supreme Court dictated it should: “It has long been understood that bankruptcy law entails the impairment of contracts…If the 10th amendment prohibits (cuts) of pension benefits in this case, then it would also” prevent other debt cuts…”Chapter 9 is limited to voluntary proceedings,” because the U.S. government cannot force cities to file. Only states can authorize cities filing for bankruptcy: “Nothing distinguishes pension debts from other municipal debts, notwithstanding the state constitution,” he said, referring to Michigan’s state constitution: “There is no functional difference or meaning between ‘impair’ versus ‘impair or diminish.’” Noting that Michigan’s state constitution protects pension rights as “contractual rights (like California’s state constitution),” Judge Rhodes noted that U.S. municipal bankruptcy law permits a debtor municipality to impair contracts. Nevertheless, sounding a warning, Judge Rhodes warned the city that just because pension rights can be impaired, that does not mean he will approve a plan with steep cuts: “[W]here―as here―the state consents, that impairment does not violate the 10th amendment.” Nevertheless, Judge Rhodes made clear he would not approve any plan of adjustment by the city unless he found the plan to be fair and equitable.
Eligibility: Judge Rhodes told the court: “The city needs help”: it is facing “mounting crime rates, spreading blight and a deteriorating quality of life…The city no longer has the resources to provide its residents with basic police, fire and services.” Addressing the unfunded pension liability dispute, he stated; “The court concludes that it is not necessary to resolve this issue at this time…Except for the unfunded pension liability,” the parties do not dispute the debt. With regard to Detroit’s other debts and liabilities, estimated at more than $18 billion, Judge Rhodes noted: “This has led to decaying infrastructure…and a deteriorating quality of life,” in his eligibility summary, telling the court that the city, which once boasted a population of 1.85 million residents and which was “building half of the world’s cars,” that there is enough evidence to prove Detroit is insolvent: “The city bears the burden to establish by a preponderance of the evidence each of the elements of eligibility: The city cannot legally increase its tax revenues nor can it further reduce its expenses without further endangering health and safety…The court finds that the city does desire to effect a plan” to reduce its debts― one of the key requirements of Chapter 9 bankruptcy. Judge Rhodes noted that witnesses for city proved that a sale of assets would not have solved financial crisis, only delayed it. Judge Rhodes state that the testimony of Chief Craig established that the city is in a state of ‘service delivery insolvency:’” “The court finds that the city of Detroit was and is insolvent….The court finds that the city was generally not paying its debts as they became due.” Further, he found that one-time infusions of cash would not fix things, specifically noting the Detroit Institute of the Arts, finding that the city established that “sales of city assets … would not address the long-term” issues of the city.
Pension Obligations. On the disputed issue of the city’s “complex and confusing” pension obligation certificates of participation, Judge Rhodes stated that “During 2012, 39% of the city’s revenue was used to service legacy liabilities,” noting: “The city lost on the swaps bet. Actually, it lost catastrophically on the swaps bet.” The city borrowed about $1.4 billion in 2005 through the controversial pension certificates to eliminate its unfunded pension liabilities. Then it “entered into a wager,” — the swaps, which provided a steady interest rate on the pension certificates.
Good Faith. Judge Rhodes scolded the city for rushing through negotiations, noting that allowing only a month to negotiate was not enough: “This calendar was very tight and did not request counter proposals,” noting that creditors only had 30 days to offer a counter: “That amount of time is simply far to short that such a vague proposal of creditors…Charitably stated, the proposal is very summary in nature…The creditors cannot be faulted for failing to offer counter proposals when they did not have enough information to evaluate the city’s initial vague proposal.” Nevertheless, Judge Rhodes found that that negotiating in good faith was “impracticable.” Thus, even though the Judge found the city did not meet good faith requirements, (“negotiations were impracticable”) he told the court: “The totality of the circumstances” demonstrated that the city filed for bankruptcy in good faith.
Judge Rhodes’ ruling gives the green light for Kevyn Orr to commence what will be – by far – the more critical challenge of unspooling the largest municipal bankruptcy in American history, achieving consensus on a recovery plan; the process of negotiating such a plan with 100,000 plus creditors would be an exceptional challenge. But, in this case, it is almost less achieving a compromise on a plan to gain the support of a majority of the city’s creditors; rather it is fashioning a plan that will actually provide for a viable economic future for Detroit. Moreover, because what happens in Detroit is likely to have ramifications for any city or county in the United States confronting severe fiscal distress, the next stages for the Motor City are expected to set national precedents for lenders, bondholders, unions, and pension funds. That is, this next stage poses a far more complex and critical challenge than any confronting Congress. Detroit would not have expended millions of its taxpayer dollars getting to this point were it easy to work out a compromise—thus there is little likelihood of achieving widespread consensus on any recovery plan. A restructuring or adjustment plan, after all, is intended to adjust — not eliminate — Detroit’s debts, so that none of the parties who have fought so hard against the bankruptcy can emerge from the process with everything it wants―and all the parties are far poorer than when the process began because of the enormous drain on resources already extracted to date. The real challenge will be not to simply patch over a broken fiscal process, but rather to fashion a plan that actually creates a viable fiscal and economic future for the city—a critical distinction from simply achieving a balanced budget.