The chapter 9 bankruptcy case of the City of Detroit has been as complex and litigious as anticipated. Nevertheless, Emergency Manager Kevyn Orr has kept plodding forward, and last week filed a proposed plan of adjustment, the road map for the Motor City to emerge from bankruptcy. There are two key components to the plan. The first is that it will seek to inflict somewhat less pain on retired employees than on bondholders. The second is that it will direct approximately $1.5 billion towards Detroit’s future rather than to the payment of creditors.
While the plan raises numerous issues on top of the thorny disputes with which Detroit and its creditors are already grappling, these components of the plan raise two fundamental questions that go to the heart of what municipal bankruptcy may be able to accomplish: how much disparate treatment of different creditor classes can be tolerated, and to what extent can the city invest in its own future, rather than pay back creditors? The plan will be the subject of intense negotiations over the next few months, and is almost certain to be revised substantially. However, if Mr. Orr cannot reach deals with the City’s retirees and bondholders, these questions will be at the forefront of the issues that Judge Steven Rhodes will need to adjudicate.
The Bankruptcy Code provides that a plan may not “unfairly discriminate” among classes of creditors holding claims of equal priority. So what level of discrimination is fair? The Detroit plan proposes to pay police and fire retirees approximately 90% and general retirees approximately 70% of their earned pensions (in both cases after elimination of cost of living allowances). The holders of general obligation bonds, on the other hand, are slated to receive approximately a 20% recovery. Emergency Manager Orr will contend that such discriminatory treatment is not “unfair”, given the competing equities between the retirees and the bondholders arising from the probable hardships that retirees will face from pension reductions. The bondholders are likely to have a different view.
The plan must also be “in the best interests of creditors”. In a corporate bankruptcy, satisfying this requirement is fairly straight-forward: creditors must receive more under a reorganization than if the debtor were to be liquidated. A municipal debtor, however, cannot be liquidated, so the determination of what constitutes the “best interests of creditors” in a chapter 9 case is much more nebulous. The Detroit plan contemplates spending $1.5 billion over ten years on essential infrastructure spending and on fostering growth and redevelopment. Detroit has seen impressive private sector growth over the last several years, but its ability to once again be a thriving municipality (albeit on a far smaller scale than in its heyday) depends on its ability to emerge from the chapter 9 process with a debt structure that fits its reduced size, and with sufficient free cash to support at least a minimum threshold of functionality. It’s a noble vision; however, it may not be one that can be deemed to be “in the best interests of creditors”, who will argue that the City’s future should not be funded on their backs.
There are numerous other hurdles for the Detroit plan. A deal on the termination of certain interest rate swap obligations that would free up crucial casino revenues must be reached. Bondholders will additionally argue against the proposal that seeks to monetize the collection of the Detroit Institute of Art and use the proceeds to shore up the City’s pension funds. The retirees, notwithstanding their proposed favorable treatment, have not yet agreed to any reductions in their pensions, and are appealing the ruling of Judge Rhodes late last year that not only found Detroit eligible for chapter 9 protection, but also held that the City’s pension obligations could be impaired in a federal bankruptcy proceeding.
These are fascinating and complex issues in their own right. However, it is the resolution of the two overarching questions that will largely determine the extent to which Detroit’s chapter 9 case can ultimately provide a model for future municipal bankruptcy cases.