Detroit uses stick and carrot to sell bankruptcy plan

Reuters News
Posted: Feb 26, 2014 4:45 PM

By Karen Pierog and Tom Hals

(Reuters) - In his effort to keep Detroit on a fast track to end its historic bankruptcy, the city's emergency manager has cobbled together a plan to cajole or even threaten key creditors to accept cuts he laid out in federal court filings last week, or else face even deeper losses if they do not cooperate.

Kevyn Orr has every incentive to keep the parties in line. If he wins broad agreement with creditors, the city will gain access to some $815 million pledged by foundations and others to ease the bankruptcy blow on city retirees. Even so, his plan for dealing with Detroit's $18 billion of debt may drive a wedge between city workers and retirees and their unions and pension funds.

As Orr's strategy plays out, this landmark bankruptcy case could set legal precedents with repercussions for other municipalities. As just one example: Orr's plan, filed in federal court last Friday, could open the door to the first use of a so-called cramdown of settlement terms in a major municipal bankruptcy. If court-mandated mediation sessions fail to produce results over the next several weeks, Orr is reserving the right to force uncooperative counterparties to accept his terms.

Orr's plan presents city workers and retirees with a stark choice. Cuts to pension checks would only total about 4 percent for police and fire retirees and 26 percent for other retirees if there is a "timely settlement." If not, those cuts could balloon to 10 percent and 34 percent, respectively, or even more, depending on what measures are needed to keep the city's two retirement systems funded at a minimum of 80 percent of their obligations.

"To the pensions they are dangling a carrot and a stick, where they are offering less of a reduction if they can get a negotiated settlement," said Matthew Sweet, a bankruptcy attorney with Fox Rothschild in San Francisco.

In a conference call with reporters on Friday, Orr said he anticipates reaching a settlement with the funds.

"I would think a reasonable person would sit down and say 'Boy, you know, a bird in the hand is worth whatever's in the bush. Let's get this done,'" Orr said.

But Detroit's general and police and fire retirement systems and a court-created committee representing the city's retirees on Friday dismissed the plan as premature and debilitating to retired workers. They said they would continue court-mandated mediation, though it was not certain how long they can hold out while knowing they are risking the loss of the pledged money if they do not reach a settlement.

"It remains to be seen if the pensioners are willing to give up $815 million by rejecting this plan to pursue litigation which is not likely to succeed," said Laura Bartell, a law professor at Wayne State University in Detroit. "That is a very high-risk strategy."

Besides, Bartell noted, the loss of the pledged money would force Detroit to propose a new plan that is "far less favorable to the pensioners," and one that Judge Steven Rhodes is apt to approve.


As Orr negotiates over his plan, he is facing divisions even within the ranks of certain groups. Individual city creditors may want to settle, but the pension funds and unions that are negotiating with the city on their behalf may oppose a settlement over fears that Detroit's bankruptcy could set unwanted precedents that could weaken their negotiating leverage in other bankruptcy cases.

"The cops in Detroit want to see Detroit come back and be better because they will do better, their community will do better and they will feel safer on the job," Sweet said. "But the union may want to take a harder stand because they are not only worried about Detroit but other pension issues in other jurisdictions."

Orr's plan calls for a $1.5 billion program to improve essential services and public safety over 10 years, with up to $500 million earmarked for blight removal - moves that may ease the city's high crime rate.

Ultimately, Detroit must convince Judge Rhodes, who has scheduled a June trial to consider whether Orr's plan is fair and equitable. The city also must prove its plan does not discriminate unfairly among unsecured creditors.

Legal experts said it could be vulnerable on that second test because retirees have been offered something bondholders have not: the $815 million if they accept the plan.

The money was pledged by philanthropic foundations, the Detroit Institute of Arts and by Michigan Governor Rick Snyder, who has asked the state legislature to approve $350 million for the city. The money is earmarked exclusively to city retirees, and foundations and the DIA agreed to contribute in an effort to avoid a fire sale of city-owned art to raise cash.

The state and foundation money would make it possible for Orr to impose relatively smaller cuts on retirees while demanding the investors in unsecured bonds take an 80 percent loss on their investment. The unprecedented disparity between classes seems certain to raise fairness questions in the June trial, lawyers said.

"Why do the pensioners get so much more? Not unfairly discriminate does not mean not discriminate at all, but this is really where the Detroit bankruptcy is precedent-setting," said Juliet Moringiello, a professor at Widener Law School in Harrisburg, Pennsylvania.

Should Rhodes rule that pensions can be paid more than bondholders, it would rattle the $3.7 trillion U.S. municipal bond market, Moringiello said.

Detroit's plan allows it to force some creditors to accept steep cuts once other creditors agree via a cramdown. Under Chapter 9 of the federal bankruptcy code, a judge may approve a city's plan to impose terms on other impaired classes of creditors once a single class agrees to terms and if the plan does not discriminate unfairly and is fair and equitable. The city contends its plan meets those tests.

"We have no doubt that there will be at least one impaired accepting class. We expect there will be many," Bruce Bennett, Detroit's attorney at law firm Jones Day, told reporters in a conference call on Friday.

(Reporting by Karen Pierog in Chicago and Tom Hals in Wilmington, Del.; editing by Matthew Lewis)