Detroit Immunity Ruling Opens Way for Eligibility Fight

Detroit obtained federal protection from lawsuits while in bankruptcy, opening the way for a hearing near the end of the year over whether Michigan’s biggest city belongs in bankruptcy court in the first place.

U.S. Bankruptcy Judge Steven Rhodes in Detroit yesterday blocked lawsuits by public employee unions and pension funds that said the state overreached in seeking court protection from creditors. He also shielded Republican Governor Rick Snyder from litigation related to the biggest U.S. municipal bankruptcy.

The ruling gives Detroit breathing room it says it needs to address $18 billion in debts. To stay in bankruptcy, the city must now convince the judge that it can’t pay in full and that it tried in good faith to reach a deal with creditors. Ron Oliner, a lawyer for a police union that fought to get Vallejo, California’s bankruptcy case thrown out, said that process can be costly.

“In Vallejo, the unions challenged eligibility unsuccessfully,” Oliner, a partner at Duane Morris LLP in San Francisco, said in an interview. “Doing so delayed the case for a great period of time and cost the unions and the city many millions of dollars.”

After losing the eligibility fight, the police union hired Oliner to represent it during the rest of the case as the city worked out a plan to adjust its debts.

Stockton Proof

It took Stockton, California, months to prove it was eligible to remain in bankruptcy, while San Bernardino, California, won’t get a hearing on the issue until next month, about a year after it sought court protection.

Harrisburg, Pennsylvania, also tried to restructure debt using Chapter 9 of the U.S. Bankruptcy Code, which covers municipalities. Its case was thrown out in November 2011 after a federal bankruptcy judge found the filing wasn’t authorized under state law.

Kevyn Orr, Detroit’s emergency manager, filed his Chapter 9 petition July 18 at Snyder’s direction, saying six decades of economic decline had left the city unable to both provide residents necessary services and pay creditors, including retired city workers, all they are owed.

Orr, 55, has proposed giving creditors until the end of August to object to eligibility. After that, the two sides would exchange information and interview witnesses, submitting final written arguments in November. The eligibility hearing would happen sometime after that.

Michigan Constitution

City unions and pension officials claim Snyder, 54, violated Michigan law by authorizing the bankruptcy. Pension funds sued in state court to have the filing declared illegal, contending the Michigan constitution bars any government in the state from reducing pension benefits. Rhodes said such disputes belong before a federal court.

Michael Artz, a lawyer for the American Federation of State, County & Municipal Employees, part of the AFL-CIO, said after yesterday’s hearing that while the question of the constitutionality of the Chapter 9 filing belonged in state court, the union “will fight whatever court we’re in.”

The bankruptcy came amid negotiations between Orr and creditors including bondholders, public workers and retirees. Before the filing, Orr proposed canceling about $2 billion in bond debt and reducing $3.5 billion in unfunded pension liabilities. Those debts would be replaced with about $2 billion in new notes, forcing bondholders and the pension systems to accept less than what they are owed.

Bond Prices

Prices on Detroit’s general-obligation bonds moved in both directions after yesterday’s ruling, indicating that investors are still debating the debt’s fate in bankruptcy. No municipality has used Chapter 9 to force holders of such bonds to take a cut in principal.

Detroit general obligation bonds maturing in April 2028 traded after the decision at as little as 82 cents on the dollar, the lowest since March 2011, data compiled by Bloomberg show. Similar debt due in April 2025 traded at 94 cents on the dollar following the ruling, up from 91 cents earlier this week.

Unlike companies, municipalities don’t need to ask the bankruptcy judge for permission to pay any bills they ran up before filing for court protection, including wages, utilities and rents.

That means creditors can’t put as much pressure on a city over its spending habits as they can on companies in bankruptcy. Chapter 9 creditors also can’t offer their own reorganization plan and aren’t entitled to form an official committee with legal fees paid by the municipality. Unsecured creditors typically have those rights under Chapter 11, which companies use to try to stay in business and reorganize.

Rhodes, 64, may name a fellow jurist to oversee mediation between the city and its creditors. On the agenda he posted for an Aug. 2 hearing, Rhodes included a proposal to appoint Gerald Rosen to mediate. As chief judge of the U.S. District Court in Detroit, Rosen, 61, oversees Rhodes and the other bankruptcy judges in the district.

The case is City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).

To contact the reporters on this story: Steven Church in federal court in Detroit at schurch3@bloomberg.net; Erik Larson in federal court in Detroit at elarson4@bloomberg.net

To contact the editor responsible for this story: Andrew Dunn at adunn8@bloomberg.net

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