Detroit, once the symbol of U.S. manufacturing muscle, was given the authority to try to pare billions in debt and slash employee pensions in a federal court ruling that may have implications for distressed cities across the U.S.
U.S. Bankruptcy Judge Steven Rhodes, in a decision announced today in Detroit, ruled that the city had properly sought bankruptcy protection on July 18, the largest ever for a municipality, rejecting arguments by unions that pension cuts are barred by Michigan’s constitution.
The decision means Detroit can now write a plan to restructure its $18 billion of debt and trim pension benefits under the protections of Chapter 9 of the U.S. Bankruptcy Code. That code limits what creditors of municipalities, including bondholders and labor groups, can do to impede restructuring efforts.
“This once proud and prosperous city cannot pay its debts,” Rhodes said, in finding that the city was insolvent. Detroit “has the opportunity for a fresh start.”
While unions moved to appeal Rhodes’s ruling, Detroit expects to file a debt adjustment plan with the court in the first week of January, after creditors have seen it, Kevyn Orr, the city’s emergency manager, said at a press conference after today’s hearing.
Detroit, the country’s 18th-largest city, has said it doesn’t have the money to pay bondholders, retirees and employees everything it owes them while still providing its 700,000 residents basic city services, such as ambulances and streetlights.
“There’s going to be pain for a lot of different people,” Mayor Dave Bing said at the same press conference. “In the long run, the future for the city will be bright.” Bing said the mayor-elect, Mike Duggan, will have a clean balance sheet to work with to improve city services as debt is cut.
Rhodes found that the city was insolvent and had sought bankruptcy protection in good faith, two requirements of the law. Municipal unions had asserted the city always intended to file for bankruptcy and had refused to negotiate with creditors before filing.
Unions and retirement systems also claimed that because Michigan’s constitution protects pensions, Republican Governor Rick Snyder shouldn’t have authorized the city to file bankruptcy. They also argued that the U.S. Constitution protected the right of the states to prevent pension cuts in Chapter 9.
In ruling that pensions are not protected, Rhodes may have undermined union claims in other distressed municipalities, said attorney Ken Klee, who represented Jefferson County, Alabama, in its bankruptcy.
“The pension people around the country have positioned themselves around that argument,” Klee said. “They really put themselves in a box.”
Klee helped rewrite Chapter 9 in the 1970s while working as a lawyer for Congress. His client, Jefferson County, officially ended its bankruptcy today with the closing of a bond issue to raise money to pay creditors.
Investors are fighting the bankruptcy of Stockton, California, in part because the city has proposed paying its pension obligations in full and while cutting other debt.
In its bankruptcy, San Bernardino, California, is battling the California Public Employees’ Retirement System over pension contributions payments that city failed to make. Calpers has argued that state law protects it from cuts in bankruptcy court.
“To us, it was good enough to hear him say that nothing is off the table, including the pensions,” said Rafael Costas, who oversees about $72.5 billion of local debt as co-director of municipal debt at Franklin Advisers Inc. in San Mateo, California.
Protecting pensions “would obviously leave a lot less money for the rest of the people who are lined up,” he said.
Detroit’s debt-adjustment plan must treat similar creditors equally, which means if unsecured bondholders take losses, retirees should lose by the same percentage, according to Dale Ginter, a bankruptcy lawyer who is not involved in the case.
Before Detroit’s bankruptcy, Orr, the emergency manager, proposed canceling $3.5 billion in future obligations to the pension system and $1.4 billion in unsecured bonds the city issued in 2005 and 2006 to fill a hole in its retirement system.
Orr offered to replace those debts with a $2 billion note paying 1.5 percent interest, which would give bondholders, the pension system and other unsecured creditors pennies on the dollar.
Orr said he expects an appraisal of the Detroit Institute of Arts collection by Christie’s Inc. as early as this week. He also said he may try to create an agency to run Detroit’s water system and pay the city a fee.
Orr has said he must move quickly to get a debt-adjustment plan approved before his term in office can be ended by the city council in September.
Within moments of the decision, the American Federation of State, County and Municipal Employees, which represents city workers, filed a notice of appeal.
“We are very concerned about how this ruling may affect retired city employees,” Sharon L. Levine, an attorney for the union, said before today’s hearing.
Rhodes cautioned lawyers on both sides today not to assume his statement on pension cuts means he would approve such a proposal. Any plan would have to meet bankruptcy code standards, and he would take into consideration how cuts would affect creditors, including retirees, the judge said.
The judge said that under the bankruptcy code the case can’t be halted while creditors appeal.
After the bankruptcy was filed in July, Rhodes ordered the city and its creditors into confidential mediation sessions overseen by the chief judge of the U.S. District Court in Detroit, Gerald Rosen.
Mediation may yield a proposal to cut debt by the end of the year.
Should talks fail, the city would need to persuade Rhodes to approve the plan of adjustment over creditor objections.
Trading in Detroit municipal securities has slowed since the weeks following the city’s bankruptcy filing, according to data compiled by Bloomberg.
About $20,000 of Detroit general obligation bonds maturing in April 2020 changed hands today at an average yield of 7.29 percent, or 89 cents on the dollar, data compiled by Bloomberg show. The securities are insured by National Public Finance Guarantee Corp.
Some Detroit sewer bonds due in July 2016 traded today before the ruling for the first time since Nov. 8, at an average yield of 5.21 percent, the lowest since October, according to data compiled by Bloomberg. The debt is also backed by National.
Orr has said the city is going to honor water and sewer securities.
The case is City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).