Bankruptcy in Detroit, and new precedents may be set

Reuters News
Posted: Jul 18, 2013 6:06 PM
Bankruptcy in Detroit, and new precedents may be set

By Cate Long

The emergency manager of Detroit, Kevyn Orr, with the blessing of the Governor of Michigan Rick Snyder, has gone to the federal courthouse and filed a petition for Chapter 9 municipal bankruptcy The most important dimension of this filing is that it shields the city from lawsuits that are being filed against it. Already Detroit's public pension funds and workers have filed state-level lawsuits against Orr and Snyder to halt them from filing for bankruptcy. Undoubtedly a legal judgment was made about the validity of those suits and whether seeking the protection of the federal bankruptcy court was necessary.

It took the municipal market and public by surprise when the filing happened today. The publisher of the Bond Buyer, Mike Stanton, said on Twitter:

"The fact will stand up: Speed of filing took bond creditors by surprise. Yesterday, one investor's atty forecast September"

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Although similar to other chapters in some respects, chapter 9 is significantly different in that there is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors. Such a liquidation or dissolution would violate the Tenth Amendment to the Constitution and the reservation to the states of sovereignty over their internal affairs. Indeed, due to the severe limitations placed upon the power of the bankruptcy court in chapter 9 cases, the bankruptcy court generally is not as active in managing a case as it is in corporate reorganizations under chapter 11. The functions of the bankruptcy court in chapter 9 cases are limited to approving the petition, confirming a plan of debt adjustment, and ensuring implementation of the plan.

There have been few municipal bankruptcies in the U.S. and none yet the size of Detroit. Prior cases in Central Falls, Rhode Island and Vallejo, California treated bondholders carefully. They still needed to maintain access to the bond markets for short and long-term funding. But the bankruptcy of Jefferson County, Alabama, where bondholders are taking between 20 and 85 percent haircuts, has changed the rules for municipal bondholders. Now the blood has begun to flow.

Detroit has been in desperate financial shape for nearly 20 years. Corruption, violence, uncollected property taxes, borrowing to fund deficits and flawed city management doomed the city years ago. For two decades, Detroit's administration should have been shrinking. That process only began under the current mayor Dave Bing.

The process of restructuring liabilities began with the bankruptcy filing today. This process may last up to two years and involve a lot of litigation. New precedents about the treatment of bondholders, swaps counterparties, employees and pensioners will likely be developed. Conflicts will arise between the Michigan Constitution and federal bankruptcy law. The fights and protests may be vicious. But in the end, Detroit may be reborn with finances it can sustain and public services that should make the city livable.