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Detroit to Learn If Crisis to Be Handled in Bankruptcy

State-appointed Emergency Manager Kevyn Orr
State-appointed Emergency Manager Kevyn Orr has said the changes are needed to stabilize Detroit's finances and allow it to provide basic services for its 685,000 residents. Photographer: Jeff Kowalsky/Bloomberg

Detroit officials will learn today whether Michigan’s largest city can stay in bankruptcy, allowing a federal judge to referee all of its battles with creditors owed about $18 billion.

“The city needs help,” U.S. Bankruptcy Judge Steven Rhodes said at a hearing today in Detroit as he began reading his ruling on the city’s request to remain under court protection. Without it, Detroit may be forced to defend a wave of lawsuits in multiple courts over the gap between the city’s revenue and the amount it owes.

If Detroit stays in bankruptcy, creditors will be limited in legal actions they could take to collect from the city or to interfere with pension cuts and other changes pushed by its state-appointed emergency manager, Kevyn Orr. Orr has said the changes are needed to stabilize Detroit’s finances and allow it to provide basic services for its 685,000 residents.

“Whether they stay in or not, they need to resolve their issues with creditors,” said James Spiotto, a partner with Chapman & Cutler LLP in Chicago who has written journal articles about Chapter 9 of the U.S. Bankruptcy Code, which covers municipalities. “There is no way of avoiding it.”

Losing Chapter 9 protection would allow Detroit’s pension funds and municipal unions to revive state-court lawsuits seeking to bar Orr and Republican Governor Rick Snyder from cutting retiree benefits. Investors who hold defaulted bonds or interest swaps that have paid them $50 million annually also could sue to seize city property.

Judge’s Findings

Detroit filed for the largest-ever municipal bankruptcy on July 18, saying decades of economic decline had left it without enough money to pay creditors and still provide services. Rhodes said last week that he would rule today on the city’s eligibility for bankruptcy.

To find that Detroit is eligible, Rhodes must conclude that the city either tried to reach a deal with creditors before filing or that talks were impractical.

The city must also convince Rhodes that it is insolvent, desires to implement a plan to adjust its debts and that Michigan law authorizes it to be in bankruptcy.

Union and retiree lawyers challenged the city’s claim that it met those tests during about 10 days of testimony and argument in October and November. They accused Orr and Snyder of failing to negotiate in good faith and of pursuing the bankruptcy filing to get around pension protections enshrined in the Michigan Constitution.

Governor’s Testimony

Both men testified at the trial about why they chose bankruptcy instead of continued negotiations. Snyder’s court appearance was the first time a sitting governor had ever been forced to take the witness stand to justify his authorization of a bankruptcy filing.

Investors didn’t challenge the city’s eligibility for bankruptcy. Instead, they will probably attack any plan that seeks to impose losses on them. Bond insurers have already sued the city, asking Rhodes to find that certain defaulted general obligation bonds cannot be cut under the state’s constitution.

Before the bankruptcy, Orr proposed canceling $3.5 billion in future pension obligations and at least $1.4 billion in unsecured bonds. The debts would be replaced with a $2 billion note paying 1.5 percent interest.

Cash Cushion

The city’s cash cushion had fallen to $7 million on an annual budget of more than $1 billion, investment banker Kenneth Buckfire said during the trial. To avoid running out of money for basic services, the city moved cash around, canceled payments to its pension funds and defaulted on debt, according to Gaurav Malhotra, a partner at Ernst & Young LLP who began advising the city in May 2011.

Should Rhodes allow Detroit to remain in bankruptcy, the city will need to focus on revitalizing its economy as well as cutting debt, said Spiotto, who isn’t involved in the case. Creditors, taxpayers and city workers have no reason to agree to any debt-cutting proposal without seeing a credible recovery plan, he said.

Detroit must ask “what is necessary to invest to attract business?” Spiotto said in a phone interview. “If you don’t solve the systemic problem, you are just going to repeat it.”

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

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