Detroit’s Final Bankruptcy Hearing: What to Watch For

The City of Detroit’s groundbreaking bankruptcy proceeding enters what may be its final phase this week. The court will conduct hearings over the next month or so to decide whether to approve the plan for exiting bankruptcy presented by the emergency appointed by the Michigan Governor under the state's draconian municipal take over law. And, as of September 27th, the city's elected officials are entitled under the law to reclaim at least some semblance of governance from the emergency manager. In large measure, the debate points have been set out and the hearings will determine the final outcome.

As these events unfold, here are the major items to look for.

• The largest and most complex municipal bankruptcy in history has made it clear that the claims of the creditors of a large city must be resolved on a case by case basis. Unlike a corporate bankruptcy, claims in a municipal bankruptcy involve nuances of policy. They cannot be placed in a single basket and treated the same. Judge Rhodes appears to be disposed to move in this direction, but this is largely unprecedented and may have to be revisited on appeal.
• It remains to be seen whether the “Grand Bargain” will survive. This is the deal brokered by the court among a number of foundations with an interest in Detroit and the governor to avoid selling off the city magnificent art collection and to limit the damage done to public employee pensioners. It requires the foundations and the state to kick in substantial sums of money. But the conservative State Legislature is always a wild card, so watch this space.
• A large portion of the purported $18 billion legacy obligations of the city is the $1.4 billion claimed on “certificates of participation” issued during the mayoralty of Kwame Kilpatrick, currently serving time for corruption, to fund a deposit to the city's public employee pension funds. This transaction was a Rube Goldberg-esque structure designed to avoid legal limitations on city debt. As Demos pointed out in our report on the bankruptcy, there is substantial doubt whether the structure was permitted under state law. Finally, after the report came out, the Emergency Manager challenged the validity of the deal in court and this remains to be resolved. The court could rule on the issue or alternatively some settlement for a much-reduced payment could be approved by the Bankruptcy Court.
• Another large portion of the purported city debt is the $5.8 billion of water and sewerage bonds. The water and sewerage system serves a region that includes 40% of Michigan’s population but is operated by the City of Detroit's water and sewerage department. As set forth in our report, it was misleading to categorize this as city's debt. Nonetheless, this is what the Emergency Manager did. There was a recent tender offer—an offer to certain bondholders to exchange their bonds for lower interest rate bonds blessed by the bankruptcy court—that reportedly met with success. Lowering the cost of this debt is a good thing for the residents of the city and the entire region, so further steps may be taken along these lines. However, the emergency manager has suggested either a permanent takeover of the operation by a new joint state and regional entity, which would increase the governor’s influence over this important enterprise, or even a partial privatization. This broad reorganization can be seen as an effort to eliminate the system’s public employee union rights and should not be in the final plan, even as part of a comprehensive refinancing.
• A related question involves the shutoff of service to thousands of Detroit households and businesses that are served by the water and sewerage system for non-payment of usage charges. The implementation of this shutoff plan during the summer brought protestors into the streets and became a story of international import. Judge Rhodes intervened, seeing that this could derail the bankruptcy proceedings and (hopefully) that it was just plain unfair. A thirty day moratorium was put in place, but that has expired just as the final hearings commence. A renewal of shutoffs affecting people who cannot pay as well as those who are cheating could affect the entire process.
• In 2012, the City Water and Sewerage Department made a termination payment of around $540 million to banks that were counterparties to interest rate swaps connected to water and sewerage bond issues to avoid default because of credit rating downgrades, as described in the Demos report. This was similar to the swap termination agreement from July associated with the pension certificates of participation that the Report successfully urged the court to reject. Although this occurred almost two years ago, many of the issues parallel the pension swaps. It is conceivable that the water and sewerage swaps may be reopened either in the bankruptcy proceedings or outside of it.
• Finally, the plan proposed by the emergency manager eviscerates the health care coverage for city employees. As with the other numbers in the purported legacy expenses, the city's exposure to health care expenses was greatly overstated. As described in our report, the emergency manager used calculations that assumed long term increases in health care costs that are much higher than current conditions would support. In the period since our report came out, the moderating health care costs resulting from the Affordable Care Act have become much clearer, as described in a recent article by Paul Krugman. Although this has not to date been fully explored by the court or debated in the press, it would be appropriate for discussion in the hearings on the plan.