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Detroit Bankruptcy Plan Approved and It’s Interesting How the Sausage Was Made

detroit photoWhen anyone – including a great city like Detroit – “successfully” emerges from bankruptcy, no one is usually happy how it turned out. This is clearly the case with the city of Detroit’s Chapter 9 municipal bankruptcy, following Judge Steven W. Rhodes’ approval of the reorganization plan on November 7, 2014.

When Detroit sought bankruptcy protection in July 2013, it was up to its eyeballs in debt and other unfunded financial obligations. The run-up to the Motor City’s bankruptcy unfolded over decades, but can be boiled down to this simple formula: not enough money coming in and too much money going out. At jeopardy, among other essential city services like, say, police and fire protection, were the pension plans of the municipality’s retired and current employees, as well as the fate of the significant art collection held by the Detroit Institute of Arts (the “DIA”), whose works could arguably be sold and the funds applied to the city’s debt obligations.

Early in the case, Judge Rhodes appointed Chief U.S. District Judge Gerald Rosen to act as mediator. A seasoned attorney and judge with savvy political skills, Judge Rosen approached the task with a relentless zeal and determination to succeed. Over the past 16 months, Judge Rosen negotiated what’s become known as the “grand bargain” among the city’s disparate stakeholders, which include the State of Michigan (including its Republican governor and the Legislature, who resented “bailing out” Motown yet again), the financiers, bondholders and secured creditors, the city’s current employees and its pensioners, the unions, the thousands of unsecured creditors – and the DIA.

Judge Rosen’s grand bargain is as sophisticated as it is unorthodox. The deal calls for many of the country’s largest charitable foundations – most of which have no vested interest in Detroit – to pony up gargantuan pledges to save the city’s pension fund and art museum, and in fact, the city of Detroit itself. To facilitate the grand bargain, the State of Michigan (through its Republican governor and Legislature) and the DIA agreed to kick in significant investment, to have some ‘skin in the game’.

One of the obstacles to consensus was the labor unions and the pensions they administer. Detroit, as the one-time center of the country’s automotive industry, has strong union ties with stakeholders including the United Auto Workers, Police and Fire Retirement System, the American Federation of State, County and Municipal Workers and the Detroit Retired City Employees Association. Based on the Michigan constitution and decades of assumptions, the unions (and of course, the individuals they represent, whose current or future pension funds are at stake) believed these pensions were sacrosanct and immune from the reach of bankruptcy law. Consequently, the unions saw no need to ‘come to the table,’ since their pension funds were exempt from the clutches of bankruptcy.

But in a single ruling, Bankruptcy Judge Rhodes paved the way to consensus for the grand bargain by establishing that the city’s unions and its pension funds are not inviolate, despite their apparent state constitutional protections. “Pension rights are contract rights under the Michigan constitution,” Rhodes said from the bench, declaring the city insolvent and eligible for bankruptcy. “It has long been understood that bankruptcy law entails the impairment of contracts.”

This concept is fundamental to U.S. bankruptcy law, and it was naïve of the unions to assume otherwise. Moreover, the Michigan constitution could not have been clearer: “The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof and shall not be diminished or impaired thereby,” reads Section 24 of Article 9 of the state constitution.

The Socialist Workers Party is not happy about this development.

Judge Rhodes’ judicial dagger brought the unions to the table. Now, Judge Rosen, the mediator, could take the position that the assembled cash (pledged from the charitable foundations, the DIA and the State) provides a credible alternative to a forced settlement, the dreaded “cramdown” that could be imposed by the judge. This provided the unions a powerful motivation to get a deal done.

Judge Rhodes delivered his decision approving the reorganization plan on November 3, 2014, in a nearly two-hour ruling from the bench. Judge Rhodes expressed sympathy for residents of the insolvent city and strong praise for the plan to shed $7 billion in debt, shield the city’s art collection and minimize cuts to retiree pensions. In the approved plan, even the banks and financiers weren’t totally hosed, as they obtained rights to purchase choice land in currently-blighted areas of the Motor City, and the city’s art collection has been saved from the auction block, and transferred to a new charitable foundation no longer owned by Detroit.

But Detroit is not out of danger.

Martha E.M. Kopacz, the fiscal expert Judge Rhodes hired to assist in determining whether the grand bargain was feasible, expressed many reservations, especially about underlying actuarial assumptions as well as the continuing unfunded future liabilities of the pensions.

“The city must be continually mindful that a root cause of the financial troubles it now experiences is the failure to properly address future pension obligations,” she said in her report, with which Judge Rhodes agreed. Unless ‘business as usual’ in Detroit changes, the grand bargain simply forestalls the day of reckoning for MoTown.

Judge Rhodes noted that the state, which is putting $195 million into the grand bargain pot, would have to serve a tougher pension watchdog role. In exchange for the Michigan’s participation in the grand bargain, Detroit’s retirees are releasing the state from any liability under its constitutional clause barring public pension cuts.

Judge Rhodes found that settlement reasonable, but his misgivings were clear. “History will judge the correctness of this finding,” he said. Michigan must “assure that the municipalities in this state adequately fund their pension obligation. If the state fails, history will judge that this court’s approval of that settlement was a massive mistake.”