The Trial in the Motor City Begins…

September 2, 2014
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Getting Ready for Confirmation. With Detroit’s trial on whether U.S. Bankruptcy Judge Steven Rhodes will sign off on the Motor City’s sixth version of its proposed plan of adjustment to address its nearly $18 billion in debt amongst its more than 100,000 creditors is scheduled to open bright and early this morning, determining the fate of Detroit’s future. The largest municipal bankruptcy in the nation’s history will determine whether the court finds Emergency Manager Kevyn Orr’s plan to eliminate more than $7 billion of the Motor City’s estimated $18 billion in debts―and to invest about $1.5 billion into his proposed plans to create a sustainable fiscal future meets the so-called “Rhodes test”—measuring, in effect, whether the rhythm guitar player of the Indubitable Equivalents finds the city’s proposal to be equitable, feasible, and in the best interest of creditors. Under Detroit’s proposed plan of adjustment, Detroit’s more than 100,000 creditors would get a wide range of returns on their claims. Investors who bought $1.4 billion of certificates the city issued in 2005, to raise money for its pension system, could come away nearly empty-handed, since Detroit now calls the borrowing a sham transaction that should be voided entirely. By contrast, investors who bought a type of general obligation bond that was backed by a special, dedicated tax are slated to recover 74 cents on the dollar. Under the plan the city hopes Judge Rhodes will confirm, Detroit’s more than 100,000 creditors would receive a wide range of returns on their claims. Investors who bought $1.4 billion of certificates the city issued in 2005, to raise money for its pension system, could come away nearly empty-handed, since Detroit now calls the borrowing a sham transaction that should be voided entirely; in contrast, investors who bought a type of general obligation bond that was backed by a special, dedicated tax are slated to recover 74 cents on the dollar.
The trial will both test the State of Michigan’s constitutional promise of full protection of the city’s employees’ post-retirement and health care benefits versus an equitable distribution of “haircuts” amongst its myriad of creditors. Most importantly, it will challenge whether the city has balanced those equities in a way that ensures the city a future—not simply bought time and another fiscal collapse down the road. , Judge Rhodes will send significant messages beyond Detroit about the rarely tested powers and limits of municipal bankruptcy, at a time when many cities are struggling with underfunded pensions, neglected infrastructure and declining industries.

For state and local leaders, how Judge Rhodes reacts to the proposed allocation or divvying up of the city’s assets amongst its more than 100,000 creditors will involve unique and unprecedented federalism decisions. Judge Rhodes, in finding Detroit eligible for municipal bankruptcy protection, has already ruled that the federal municipal bankruptcy law, chapter 9, preempts the State of Michigan’s constitution, which bars cities and counties from cutting post-retirement health care or pension benefits, will face an even more difficult teeter-totter issue: how will he react to Detroit’s plan for the city’s post-Emergency Manager future? Unlike corporate bankruptcies, where one option is to dissolve the corporation and divvy up what’s left equitably among its creditors, municipal bankruptcy was enacted to ensure continuity of essential public services—with the process beginning this morning to not just determine which services are essential, but also whether the plan will ensure their continuity. The so-called “Rhodes Test” will measure whether a municipality can virtually repudiate some of its debts to certain creditors—and whether the Motor city—by means of the unique state-foundation partnership—can avoid selling off valuable assets, such as the world famous Detroit Institute of Arts—in order to have an economic anchor for its future.
Over the next month or so—complicated by the right of the Detroit City Council to terminate Emergency Manager Kevyn Orr’s tenure effective October 1st—Judge Rhodes will examine hundreds of exhibits and hear testimony from nearly 100 witnesses—with the trial expected to run at least six weeks. Mayhap one of the most critical tests will involve the challenge from the city’s two largest holdout creditors, Syncora and Financial Guaranty Insurance Co. (FGIC), to the lynchpin of Detroit’s and Michigan Governor Rick Snyder and bipartisan leaders of the legislature to the grand bargain, the complex and unprecedented package which would provide $816 million to Detroit over the next two decades to ensure no retiree falls under the federal poverty level, convert the Detroit Institute of Arts to a foundation, allow the city to accept the equivalent of $816 million over 20 years from the State of Michigan, and provide a strict state oversight structure of Detroit. The two objecting creditors will urge Judge Rhodes to find the bargain to be illegal—and, perhaps more critically—that it would constitute unfair discrimination in favor of the city’s retirees. The two will also argue that it is unacceptable for the Motor City to claim it is providing equitable treatment to creditors when it is proposing to simply eliminate some $1.4 billion in debt insured by the two creditors.

During the trial, Mr. Orr’s team expects to rely on as many as 26 witnesses, including Mr. Orr himself, Detroit Mayor Mike Duggan, Detroit billionaire Dan Gilbert, City Council President Brenda Jones, Miller Buckfire investment banker Ken Buckfire, and Annmarie Erickson, the Executive Vice President and COO of the Detroit Institute of Arts, and Martha E. M. Kopacz, who will be queried about her finding that Detroit’s plan of adjustment is feasible. In addition, with over 600 individuals who have filed official objections to the plan, Judge Rhodes could anticipate a bevy of diverse objection. In voting on the proposed plan Judge Rhodes will decide upon, majorities of six classes of the city’s creditors cast ballots in favor of the city’s plan in recent months, but five other voting classes rejected it. Some opponents, including the bond insurers Syncora and Financial Guaranty, have vehemently fought the plan, saying it improperly favors some creditors over others, and uses a questionable transaction to put the riches of the art collection beyond the creditors’ reach. Creditors slated to get little or no funds from the grand bargain hope to persuade Judge Rhodes that he should not approve the plan, because it discriminates unfairly and is not in the best interests of creditors. In voting that is part of the bankruptcy process, majorities of six classes of the city’s creditors cast ballots in favor of the city’s plan in recent months, but five other voting classes rejected it. Some opponents, including the bond insurers Syncora and Financial Guaranty, have vehemently fought the plan, saying it improperly favors some creditors over others, and uses a questionable transaction to put the riches of the art collection beyond the creditors’ reach.

The Rhodes’ Test. Some believe Detroit’s future Detroit’s future depends on the so called Rhodes test—a test referencing back to a hearing late last month when Syncora attorney Stephen Hackney asked Judge Rhodes to identify which of two well-established bankruptcy tests gauging the fairness of a restructuring plan the judge expects to use. Instead of opting for either, Judge Rhodes responded: “There is a third alternative.” Mr. Hackney paused, then asked: “The Rhodes test?” The judge nodded slowly, without saying anything.

Detroit’s Future. Whatever the “Rhodes’ Test” is, by the end of the trial, Judge Rhodes’ decisions will be critical to the future of the Motor City. That is, the Judge must grapple not just with what is fair and equitable in the allocation of debt among more than 100,000 creditors, but also the larger, essential questions about Detroit’s fate and future. Does the plan offer the right formula and governance to provide the city a secure future: will it provide enough fortitude to prevent the city from backtracking down the road, because it has too much empty land and is insufficiently competitive with other cities around the nation? Does the plan meet the gruel test of demonstrating the plan will begin rebuilding Detroit’s tax base, financial stability, and population, which has fallen below 700,000? Does Mr. Orr’s plan propose enough new investment in Detroit’s future to eliminate the blight that scars the city and restore city services? If, at the end of the trial, Judge Rhodes determines the city’s proposed plan of adjustment does not meet his test, it is not clear what options the city would have. Judge Rhodes—having invested well over a year in this process—would be likely to offer suggestions of how the plan would have to be modified—and to invite alternative plans—but only the city—and, in this instance, likely a post Kevyn Orr city, can submit a proposed plan of adjustment to the federal court.

For state and local leaders, how Judge Rhodes reacts to the proposed allocation or divvying up of the city’s assets amongst its more than 100,000 creditors will involve unique and unprecedented federalism decisions. Judge Rhodes, in finding Detroit eligible for municipal bankruptcy protection, has already ruled that the federal municipal bankruptcy law, chapter 9, preempts the State of Michigan’s constitution, which bars cities and counties from cutting post-retirement health care or pension benefits, will face an even more difficult teeter-totter issue: how will he react to Detroit’s plan for the city’s post-Emergency Manager future? Unlike corporate bankruptcies, where one option is to dissolve the corporation and divvy up what’s left equitably among its creditors, municipal bankruptcy was enacted to ensure continuity of essential public services—with the process beginning this morning to not just determine which services are essential, but also whether the plan will ensure their continuity.

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