Detroit’s unprecedented bankruptcy filing highlights issues facing municipalities nationwide

Summary

The resolution of the City of Detroit’s bankruptcy proceeding may have wide-reaching implications regarding the treatment of general obligation bonds, underfunded pensions and health care obligations, as well as the use of bankruptcy to address issues facing municipalities nationwide.

Municipal bankruptcy filings are rare. While there were more than 1.2 million bankruptcies filed in 2012, only 276 municipal bankruptcies were filed between 1980 and 2012 – about eight a year. Nevertheless, the number of municipal filings is increasing. Thirty-six municipal cases have been filed since January 2010. Detroit is easily the largest municipality to file bankruptcy. With a population of more than 700,000, Detroit is twice the size of the next most populous municipal debtor, which was Stockton, California. Likewise, Detroit’s debt of more than $18 billion is by far the largest of all municipal bankruptcies.

In March 2013, a new state law enabled Michigan Governor Rick Snyder to declare a financial emergency in Detroit. The law also authorized Governor Snyder to appoint an emergency manager of the city. According to the law, the emergency manager would act in place of the mayor and city council. On March 28, Governor Snyder appointed Kevyn Orr, a seasoned bankruptcy attorney, as Detroit’s emergency manager. Upon his appointment, Orr immediately began developing a plan to reorganize the city’s finances, and on June 14, formally presented a proposal to the city’s creditors. A little over a month later, Orr concluded that negotiations with the city’s creditors were futile. On July 16, in a letter to Governor Snyder, Orr recommended that the city be authorized to file bankruptcy, and stated that “[g]iven the vast and fragmented pool of potential creditors, the City cannot practicably negotiate a consensual restructuring with all of its creditors outside of a court process.”

With Governor Snyder’s authorization, Orr filed Detroit’s bankruptcy petition on July 18. Later that afternoon, at the request of a series of pensioners, a Michigan state judge issued an order enjoining the city from filing bankruptcy. The next day, the same judge issued a declaratory judgment that the bankruptcy filing violated the Michigan Constitution and ordered that Governor Snyder direct that the bankruptcy filing be withdrawn. Within days, however, both the Michigan appellate court and the Bankruptcy Court stayed the state court’s orders.

On July 24, in the first hearing in Detroit’s bankruptcy case, Judge Steven Rhodes confirmed that the Bankruptcy Court has exclusive jurisdiction to determine Detroit’s eligibility to be a municipal debtor. He did not, however, rule on Detroit’s eligibility to be a municipal debtor. Instead, Judge Rhodes reserved ruling on the issue for a later date to allow it to be properly briefed and argued by the city and its creditors. Judge Rhodes accordingly has not yet ruled on any of the significant legal issues likely to arise in the case, including questions under both the Michigan and U.S. Constitutions, issues of federalism, and whether pensioners and/or bondholders rights may be impaired, among others.

Municipal bankruptcies are often lengthy, with the issue of the municipality’s eligibility to be a debtor frequently taking more than a year to resolve. Detroit, however, proposed an ambitious schedule for its case, which was approved by the Bankruptcy Court on August 2. Under the schedule, the trial on Detroit’s eligibility to be a municipal debtor will begin on October 23. If the city passes the eligibility hurdle, Orr has stated he hopes to complete the reorganization by September 2014. To this end, an attorney representing Detroit in the bankruptcy proceeding indicated that the city’s goal is to propose a restructuring plan by the end of 2013, explaining, “[o]ur view is that time is our enemy and that the facts are not going to change no matter how long we wait.”

Regardless of the length of Detroit’s bankruptcy case, investors in the $3.7 trillion municipal bond market will certainly be paying close attention. General obligation bond holders historically have expected to be paid in full in municipal bankruptcies. Detroit's proposed treatment of general obligation bonds may, however, result in only partial payment to bondholders. This would be a significant precedent that could cause investors and ratings agencies to reevaluate their risk and forecasting models, and cause borrowing costs for municipalities to rise. The effects would be most significant for distressed municipalities already dealing with low credit ratings.

Pensioners will be watching the Detroit case closely as well. Orr estimates that Detroit’s pension liabilities are underfunded by $3.5 billion. Underfunded pensions are a widespread problem for municipalities across the nation. In 2010, economists at the Kellogg School of Management at Northwestern University estimated that the nation's municipalities have underfunded pension liabilities of approximately $574 billion. If through its bankruptcy Detroit is permitted to modify its pension liabilities, bankruptcy may become more enticing to other municipalities with underfunded pension debt.

Detroit’s health care obligations are also underfunded. There is speculation that the city may attempt to shift some or all of its health care obligations to the health insurance exchanges being created in accordance with the Patient Protection and Affordable Care Act. If this occurs it will also be a significant new precedent and may also make bankruptcy more enticing to municipalities.

Some have suggested that Detroit, like General Motors and Chrysler, should receive a federal bailout to resolve some or all of its financial issues. This does not appear likely. According to Treasury Secretary Jack Lew, “when it comes to the questions between Detroit and its creditors, that’s really something that Detroit is going to have to work out with its creditors.”