December 12, 2013
Bankruptcy Judge Steven Rhodes delivered a seismic ruling on December 3, holding that the City of Detroit is eligible to proceed with its Chapter 9 bankruptcy filing. Detroit’s bankruptcy arose in large part due to the $3.5 billion that it owes to public pension holders, amounting to nearly 20% of its total debt. The City filed for bankruptcy to alleviate this burden, seeking to pay as little as pennies on retired employees’ pension dollars. Judge Rhodes chastised City officials for failing to negotiate with creditors in good faith, but nonetheless permitted Detroit to reduce its estimated $18 billion of debt. Several parties, including Detroit’s two pension funds, have asked Judge Rhodes to permit them to appeal the decision directly to the Sixth Circuit federal appeals court.
Federal Law Preempts Michigan’s Constitution
The ruling addressed tension between federal and state law. The Bankruptcy Code allows insolvent cities to reduce their debt; however, Michigan’s Constitution (like California’s) protects both contracts and pensions from modification. Judge Rhodes concluded that bankruptcy law trumps state law, allowing Detroit to ‘restructure’ what it owes to pension funds in Chapter 9 bankruptcy.
The court considered several arguments. To begin, the pension funds argued that the bankruptcy intruded on the state’s ability to manage its own finances. The court disagreed, noting that state officials chose to file for bankruptcy. Judge Rhodes also refused to give greater protections to pensions than ordinary debt. While state law prevents Michigan itself from reducing pensions, a bankruptcy court can do so. According to Judge Rhodes, public pensions are no different than contracts; bankruptcy at its core reduces debt and “impairs” contracts. This does not change if the debtor is a city, rather than an insolvent corporation or person.
Good Faith Negotiations Impracticable
The court also stressed that cities filing for bankruptcy must negotiate with their creditors in good faith. Judge Rhodes criticized city officials for providing woefully incomplete information to creditors, regarding the extent of its financial distress. However, circumstances made ‘good faith negotiations’ impracticable. For instance, Detroit faces over 100,000 creditors; it has leveraged itself 33 to 1 (debt-to-net-assets ratio), taking $8.5 billion in loans to pay for basic city utilities and services. The court concluded that negotiations were “unfathomable” in light of these facts, permitting Detroit to proceed in bankruptcy.
This ruling will inevitably have a major impact in California, as insolvent municipalities seek to reduce their pension obligations in bankruptcy. Additionally, we expect this ruling to be appealed to the Sixth Circuit Court of Appeals, and ultimately the United States Supreme Court.
The authors wish to thank Eric Riss, Law Clerk, who assisted with the drafting of this Alert.
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