What's at Stake in Detroit's Historic Bankruptcy Trial

Story by Bloomberg
Written by Karen Weise

Today is scheduled to be yet another milestone in Detroit’s historic bankruptcy. It’s the opening day of the trial where federal bankruptcy judge Steven Rhodes must decide if he should approved a proposed and highly contentious settlement plan to let the city restructure its debts and emerge from bankruptcy. To get a big picture look at what’s to come, I spoke with Melissa Jacoby, a law professor at the University of North Carolina at Chapel Hill who’s been following the case closely.

The proposed settlement. The so-called grand bargain involves a series of gives-and-takes, where some creditors would be made completely whole while others would recoup little or none of what’s owed. It also transfers the city’s crown jewel, the Detroit Institute of Arts, to a charitable trust, supported by the state and foundations, to protect its valuable collection from creditors.

The Detroit Free Press has a (slightly outdated) yet handy breakdown of who gets what in the proposed settlement, but two groups are most important to keep in mind: bond insurers and the city’s pensioners. The grand bargain is supported by the city’s pensioners, who would take a reduction of as much as 4.5 percent in their monthly payouts, a reduced cost-of-living adjustment, and a 90 percent cut in health-care benefits. The settlement is fiercely opposed by bond insurers, which are on the hook to pay the shortfall in payments on the city’s pension obligation bonds. The insurers would face near-total losses, able to recoup at most 10 percent of some outstanding debts under the grand bargain.

Is the grand bargain feasible? The plan only works if the city can prove the settlement gives post-bankruptcy Detroit a stronger footing. Jacoby says Rhodes must determine if the city will be able to honor its restructured debts while improving municipal services. “It’s not a successful case if the city isn’t able to have a better police response time, to have the streetlights on,” she says. At the same time, she says, “they have to to be able to service their debt. A quick default would not be good.”

Predicting the future debts and revenue of the city is tricky. “That will be a big issue in this case: Whose opinions can be trusted?” says Jacoby. The city has forecasts that go out as far as four decades, which creditors say is based on too many assumptions. “There is the fight about whose models work better for predicting what the city is going to look like and what are they based on, when there has never been a city of this size in bankruptcy before,” Jacoby says. The judge hired his own feasibility expert, whose expertise the creditors are challenging.

Is the grand bargain fair? The judge must decide on two intertwined, critical issues: whether the settlement was negotiated in good faith and whether it unfairly discriminates against certain creditors. The mediator was active in directly soliciting foundations to support the museum, which in turn freed up more money to minimize the pension cuts. The insurers and other creditors accuse the mediator who negotiated the settlement of unfairly favoring the retirees. “It is not a surprise that creditors who don’t have a piece of that are perplexed,” Jacoby says. “Why do retirees get it? Why did they choose the amount they chose?”

The pensioners and the city say the mediators were neutral, and when the health-care cuts are included, pensioners didn’t make out much better than other creditors. Jacoby says combining the pension and health-care cuts “is a dangerous road to go down,” because not all people who had pensions also had health care and vice versa. But the city could use the two issues to showed a shared sacrifice. “To me, that is a sign that the plan was put together in good faith,” she says.

The logistics. The trial schedule allocates 170 hours for testimony split between supporters and objectors. Rhodes has already decided to allow about two dozen residents (PDF), mostly city employees or retirees, present evidence and cross-examine witnesses. It’s part of the judge’s long-running effort to involve local citizens in the case. He’s heard from residents in the past and asked the city to respond to questions they’ve raised. Jacoby says this is one of the unique procedural steps where she thinks the Detroit bankruptcy may set the strongest precedent for future cases. “It is important for this process not just to be fair,” she says, “but to seem fair.”