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Detroit’s Bankruptcy. Is it a real bankruptcy?

Detroit’s Bankruptcy. Is it a real bankruptcy?

Detroit in USA’s largest municipal bankruptcy, but it is not a typical liquidation.

In July, the city of Detroit’s bankruptcy was big news, also making the headlines in Dutch newspapers, announcing the ‘bankruptcy’ (‘faillissement’) of Detroit. Although the poor financial situation of the city had existed for decades and the severe consequences will be felt by holders of unsecured bonds and ordinary people, such as retirees, the question I raise is whether it is a ‘bankruptcy’ in the classical sense of the word. There are several reasons to doubt this.

Since 1937 – after the Great Depression in the USA – the US Bankruptcy Code contains a Chapter 9, which provides for specific rules for the reorganisation of municipalities, which includes cities and towns, as well as villages or school districts. Since then around 500 municipal bankruptcy petitions have been filed, including Orange County (1994), Stockton (2008) and San Bernardino (2010). Jefferson County was one of the thirteen municipalities that filed for Chapter 9 in 2011 while twelve other ones followed in 2012. The purpose of Chapter 9 is to provide a financially distressed municipality protection from its creditors while it develops and negotiates a plan to adjust its debts. Such an adjustment of debt is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, and refinancing the debt by obtaining a new loan. In the case of Detroit the plan will certainly include the elimination of debt. Detroit’s staggering debts (over $18 billion) make its filing by far the largest ever. Jefferson County was the previous record holder. It listed debts of approximately $4.2 billion when it sought Chapter 9 protection. Early in August, an Alabama federal judge gave the green light to Jefferson County to seek approval of its plans to emerge from Chapter 9, the latest step for the county in tackling its debt.

Chapter 9 differs significantly from bankruptcy liquidation. Let me list just a few of those differences. First of all (i) 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 would violate the Tenth Amendment to the Constitution and the reservation to the states of sovereignty over their internal affairs. As a result (ii) the bankruptcy court has a rather passive role, generally limited to approving the municipality’s petition, confirming a plan of debt adjustment, and ensuring implementation of the plan. In addition, (iii) the court cannot appoint a trustee (there is no property of the estate and thus no estate to administer). The municipality’s day-to-day activities are not subject to court approval and (iv) as a debtor Detroit may borrow money without court authority. The municipal debtor (v) has broad powers to use its property, raise taxes and make expenditures as it sees fit. Therefore it has been suggested that Detroit would consider selling real estate (Red Wings hockey stadium), its art (several Van Goghs) and its zoo, all the city’s property (anyone interested in an elephant!). It is (vi) also permitted to adjust burdensome non-debt contractual relationships under the power to reject executory contracts and unexpired leases, subject to court approval. Municipalities (vii) may also reject collective bargaining agreements and retiree benefit plans without going through the usual procedures as they are known in business reorganisation in Chapter 11 cases. The judge appointed (viii) is not the first one available on the roster, but the chief judge of the court of appeals for the circuit embracing the district in which the case is commenced. This rule should de-politicise the case. The court (ix) cannot convert the case to liquidation proceedings. Furthermore (x), a municipality must voluntarily seek protection under the Bankruptcy Code, it cannot be forced to do so, whilst (xi) the rules for notifying creditors differ, and (xii) the role of creditors is more limited in Chapter 9 than in other cases, as there is no first meeting of creditors, and creditors may not propose competing plans. If (xiii) certain requirements are met, the debtor’s plan is binding on dissenting creditors.

Apart from the foregoing, the consequences will be felt sharply: bitter legal battles will take place concerning the funds which pay for police and fire basic services, and on health benefits paid to retired city workers. These account for around 20,000 people, where Detroit currently has around 10,000 city employees. Mr Orr, the emergency manager, has not been able to negotiate a deal with creditors and employees. ‘Detroit’ will certainly become a test case for constitutional questions and for other (future) municipal bankruptcies. The case is City of Detroit, 13-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).

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