Challengers to Detroit’s bankruptcy suffered a setback when a federal judge rejected an argument by public pension-fund officials that a state court must rule on the validity of the case before hearings can begin.
Kevyn Orr, the city’s emergency manager, rushed its $18 billion bankruptcy petition into federal court on July 18 just minutes before a state judge could stop him. His quick filing may forestall any state-court claims, said Peter Henning, a professor at Wayne State University Law School in Detroit.
“The usual rule of thumb in bankruptcy is that federal trumps state,” Henning said in a phone interview. “Winning the race to the courthouse is very important because of the automatic stay on lawsuits a bankruptcy filing delivers.”
Detroit sought bankruptcy protection after decades of population decline and dwindling factory jobs left it too poor to pay bondholders, retired cops and current city workers. U.S. Bankruptcy Judge Steven W. Rhodes has refused to delay the case and scheduled an initial hearing for tomorrow.
A municipality that has filed for bankruptcy is difficult to dislodge, especially when it has the governor’s backing, as is the case in Michigan, said Mark Schwartz, a former bond lawyer who unsuccessfully tried to help Harrisburg, Pennsylvania, restructure debt in bankruptcy.
Schwarz lost his battle after Pennsylvania’s governor, Harrisburg’s mayor and creditors lined up against him and the city council, which had authorized the petition under the U.S. Bankruptcy Code’s Chapter 9, which is reserved for municipalities. Schwarz said Detroit is different.
“Everybody is on the same side in Detroit,” he said. “In Pennsylvania, you didn’t have that. It’s a huge advantage.”
Schwartz, who was never paid for his work, was also the only lawyer for the city council. Detroit has a team of lawyers and financial advisers that includes the attorney who oversaw the 1994 bankruptcy of Orange County, California.
Three cases related to the Detroit bankruptcy are pending in state court in Ingham County, Michigan. Circuit Judge Rosemarie Aquilina in Lansing ruled on the first two, finding Detroit’s Chapter 9 filing violated the state’s constitution, which says public pension benefits are a contractual obligation that can’t be diminished or impaired. A hearing is set for July 29 to consider the third case, filed by two city pension funds.
“It would be inappropriate for us to comment because of the pending litigation at the state level,” said William Nowling, Orr’s spokesman.
Conflicts between state law and the federal bankruptcy code will arise as the case moves forward, said attorney James E. Spiotto, head of the bankruptcy group at Chapman & Cutler LLP in Chicago. Spiotto, who writes and lectures about Chapter 9, isn’t involved in the Detroit case.
Rhodes isn’t likely to cut short Detroit’s bankruptcy before going through the normal process of determining the city’s eligibility, Spiotto said. That can take months as each side gathers evidence, interviews witnesses and prepares for a trial.
In asking Rhodes for a delay, pension officials cited a July 19 ruling by Aquilina, who criticized republican Governor Rick Snyder for “overreaching” when he authorized Orr to rush the city into bankruptcy.
“We can’t just start carving out exceptions to the state constitution because it’s expedient,” Ronald King, a lawyer for the challengers, said in an interview yesterday. “We just need to let the Michigan courts decide.”
Aquilina ordered Snyder to withdraw the case, something the governor couldn’t do even if he wanted, said Kenneth Klee, the lawyer leading the bankruptcy restructuring of Jefferson County, Alabama. A federal judge would have to agree to dismiss it, he said.
Michigan Attorney General Bill Schuette has appealed Aquilina’s order, and the pensions have asked Rhodes to put Detroit’s first appearance in court on hold while the appeal goes forward. Larry Dubin, a professor at the University of Detroit Mercy School of Law, said the pensions shouldn’t expect their challenge to survive.
“While it will be more receptive than the federal bankruptcy court will be, the Michigan Court of Appeals would be reluctant to affirm that decision,” Dubin said.
Legal challenges to the process that led Snyder to appoint an emergency manager won favorable rulings from Ingham County judges, only to be rebuffed by the appellate court last year.
County Circuit Court Judge William Collette on March 20, 2012, ruled that his approval was required for implementation of any agreement between Detroit and a state financial review team to address the city’s financial crisis.
The court of appeals reversed him three days later, ordering Collette to “take no further actions,” including holding hearings, in the case. Two months later, the appeals court reversed Collette’s decision that the Detroit financial review board is required to hold open meetings.
A second Ingham County judge, Joyce Draganchuk, issued a temporary restraining order in April 2012 barring the review team from meeting after a union official claimed its term of office had expired the prior month. The appeals court reversed two days later and ordered Draganchuk to dismiss the suit.
This time, the appeals court may avoid making decisions altogether, Dubin said. “The court may sit tight and see what the federal bankruptcy judge does.”
By the time Rhodes holds a hearing on whether the city can remain in bankruptcy, the pensions may be able to argue that Orr’s quick filing shows the city didn’t negotiate in good faith as required under Chapter 9, Spiotto said.
A reversal of Aquilina’s order by the appeals court may not be the end of the retirees’ claim that the state constitution bars cutting pensions, it just may mean that the federal judge will decide the issue, Henning said.
“This is all a fight over who’s going to decide the fight,” he said.
The case is City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).