NCBJ 2022: Gradually, Then Suddenly. The Bankruptcy of Detroit

This program looked at the bankruptcy of the City of Detroit through the lens of a documentary filmmaker. I thought it was a clever way to look at one of the most consequential bankruptcies of our time through the eyes of someone who was not a bankruptcy lawyer or judge. While filmmaker Sam Katz is not part of the bankruptcy profession, he did have substantial experience in municipal finance, having served as Chair of the Fiscal Oversight Board in Philadelphia in the 1990s. It took him six years to make the film compared to the fourteen months that Detroit was in bankruptcy. I have included a link to a website about the film at the end.

Much of the story of the City of Detroit focuses on the conflict between the Republican Gov. Snyder and the Democratic officials in Detroit. In 2010, the Michigan legislature passed an emergency management law allowing the State to  basically take over city.  In the view of the White Michigan, Detroit was a management problem and they could fix it. If the elected officials were unable to protect life, liberty and the pursuit of happiness, someone has to do it. When a house is burning, you don't say you didn't give me enough time. You have to react. 

When the state decided to use the emergency management law, the big issue was picking the right person. Kevyn Orr was a partner at Jones Day and was African-American. He asked why he would accept such a  difficult job. His wife told him it was  time to put up or shut up. He held the emergency manager job for 18 months. 

The statute assigned the emergency manager extraordinary powers. He could sell assets. throw the elected council and mayor out and reject contracts. It was a controversial position and he was widely hated. However, the City's problems could not be solved by the elected leaders. When you have to make hard choices, you are not going to make them because you want to get reelected. How are you going to do that and have a political career? The emergency manager didn't have that problem.

Enter Bankruptcy

When Kevyn Orr used his powers to put Detroit into bankruptcy, Judge Steven Rhodes held a hearing on eligibility.  On the one hand, there was a sea of suits with their binders stacked up and media from the New York Times, Wall Street Journal, wire services and local media. Into the maelstrom, Judge Rhodes allowed ordinary citizens to come in and express themselves. 

It was hard for some people to accept just how bad the City's situation was. Every constituency screamed for 100% recovery. Protesters were chanting and protesting in the streets that paying even a dime to the banks was too much. Ordinary citizens gave their stories about how bad things were. One citizen testified that a body lay in street for five hours because of cutbacks in the coroner's office. Things were so bad in fire stations that they didn't have alarms. They would put a pop can on the fax machine to let them know when a call came in. Judge Rhodes concluded that the City of Detroit was eligible to be a debtor under chapter 9. 

The filmmaker said that he was not sure anyone had a sense what it was like to be in chapter 9.  FDR had suggested a system of municipal bankruptcy during the Great Depression. He turned to the Mayor of Detroit, Frank Murphy, to help him design the system. The Supreme Court found FDR's municipal bankruptcy law to be unconstitutional but it was later enacted as part of the Bankruptcy Code. However, Chapter 9 was not used that often. There had only been 230 or 240 chapter 9s, most of which were special purpose districts.  When Judge Rhodes allowed ordinary people to testify, Detroiters started to take notice. 

The Great Conflict

As I mentioned above, Detroit's problems posed a conflict between the White, Republican state government and the people of Detroit.  The idea that the Republicans would take over the city was unacceptable to citizens of Detroit. Gov. Snyder's support in Detroit went down from 8% to 4%. The filmmaker expressed his opinion that Gov. Snyder didn't have a political motive to hurt the Democrats in Detroit. Instead, he was afraid that the city would collapse and the state would be called upon to pay its debts. Michigan could not kick Detroit out of the State. If the city collapsed, Detroit's problems would become Michigan's problems. The State constitution said that pensions could not be impaired. As a result, Detroit's unfunded pension obligations of $3.5 billion could potentially become an obligation of the state. 

The Unfunded Pension Liabilities

Could the pensions be touched? In bankruptcy, there are two types of creditors, secured and unsecured. The pensions were unsecured debts which made them a long way from sacrosanct. While the State Constitution promised that they could not be diminished or impaired, they were still just contract debts. There was a very strong emotional reaction to telling retirees that their pension rights might be impaired in the bankruptcy process. It was a classic case of kicking the can down the road. The union leadership had not been honest with its members. They learned that when you go into bankruptcy, your pension rights might not be protected. 

The actuaries had said that the unfunded liability was $1.5 billion. However, they had used a discount rate of 9%. When a more realistic discount rate of 6% was used, the unfunded balance went to $3.5 billion. The key variable was the discount rate. 

Art to the Rescue

The thing that saved Detroit was that it owned an art museum. When formulating a plan, the options are to raise new revenue, borrow new money or find an asset to sell. Many years before, the wealthy citizens of Detroit decided that they needed a jewel of an art museum. Collections were donated to the City and other major works were bought with city funds. 

However, the museum asset raised the issue of how to evaluate 60,000 works of art in a matter of months.  There was a concern that the appraisers and investment bankers were coming in like Visigoths to take over museum.  In the end, the City decided that if Christie's wanted to appraise the collection, they could pay their 8 bucks and walk around with their note pads. 

There were two valuations: Christie's and the investment bankers that represented the insurance companies. Christie's said it was worth $500-800 million, while the investment bankers said it was worth $8 billion. 

The emergency manager figured out how much was needed to make the reorganization work and got an appraisal to support that number. The plan was based on raising funds to keep the art museum intact. Judge Rhodes later said he would never have approved sale of art.  The value of the art would have been discounted by quantity of art being dumped on the market so that keeping it intact made sense.

There wasn't enough cash in the systems to plug the hole. The plan was to put the art in a trust and give the money to the pensioners. The City would need for the foundation community to kickstart the process.  In the end, the foundations came through and the State ended up matching the foundation grant. This was a great deal for the state. If the City had failed and the State had been forced to cover the unfunded pension liability under the State Constitution, it could have been liable for $3.5 billion. They ended up paying $169 million.

There is a lot that I didn't cover in this summary. One facet I wanted to end with was that early on in the case, Judge Rhodes was presented with a compromise that would have gotten the City out of bankruptcy without solving its problems. He rejected it on the basis that there had been too many instances where the City had made deals which simply kicked the can down the road. In the view of the filmmaker, Judge Rhodes protected the interest of the unsecured creditors but also protected the citizens of the City.

Take-Aways

My takeaway from this film was being impressed with just how versatile the bankruptcy system can be. It took many decades of neglect for the City to be forced to file bankruptcy. Once it did file, it didn't fit the mold for a normal bankruptcy. In a typical bankruptcy, there are assets and cash flow which can be used to satisfy creditors and if that is not sufficient, the debtor can liquidate under chapter 7. However, a city cannot liquidate. There are people who live there who need city services in order to survive. The fact that the State could have been liable for the unfunded pension debt made the case a ticking time bomb for the White, Republican leadership. As judge, Steven Rhodes had to balance the interests of the bondholders, the pensioners and the city residents. By all accounts, many things went right. The Governor obtained the legislation to appoint an emergency manager who could take the drastic actions that city leaders could not. The emergency manager, Keyvn Orr turned out to be the right man for the job. The judge turned out to be a hero. "Old" Detroit represented by the foundations stepped in to save the art museum and fund the plan. It really is an amazing story of disaster averted through the hard work of the bankruptcy system.

To see more about the film, click here.