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UPDATE 1-Detroit eligible for bankruptcy protection -U.S. judge

Joseph Lichterman and Bernie Woodall
Tuesday, 3 Dec 2013 | 12:32 PM ET

DETROIT, Dec 3 (Reuters) - Detroit is eligible for the biggest municipal bankruptcy in U.S. history because the city is broke and negotiations with its thousands of creditors were unfeasible, a federal judge said on Tuesday in a wide-ranging ruling that also said the city could cut retiree pensions.

The ruling by U.S. Judge Steven Rhodes marks a watershed in the history of Detroit, once the cradle of the U.S. auto industry and now a symbol of urban decay and mismanagement.

Detroit's state-appointed emergency manager, Kevyn Orr, had painted bankruptcy as Detroit's best bet for a return to financial stability, and Rhodes' ruling will now give Orr and other civic leaders an opportunity to test that argument.

"It is indeed a momentous day," Rhodes said as he read aloud for more than an hour from a written statement in a packed courtroom. "We have here a judicial finding that this once-proud and prosperous city cannot pay its debts. It's insolvent. It's eligible for bankruptcy. At the same time it has an opportunity for a fresh start."

Detroit's labor unions, retirees and pension funds, all of which likely will bear the brunt of austerity measures Orr plans to impose, had argued against the city's bankruptcy in a nine-day eligibility trial. Orr has said he plans to impose a restructuring plan by the end of the year.

Rhodes also said that the city could cut pensions as part of the restructuring, despite the argument that Michigan's constitution protects them from being slashed. However, Rhodes warned he will not rubber-stamp any pension cuts.

"Nobody should interpret this holding, that pension rights are contract rights, to mean that this court will necessarily confirm any plan of adjustment to impair pensions. It will not casually or lightly exercise the power under federal bankruptcy law to impair pensions," Rhodes said.

He declined to stay the bankruptcy proceedings as potential appeals proceed through the courts. He also turned down an effort to allow any appeals of his ruling to go directly to the 6th Circuit U.S. Court of Appeals. Rhodes declared that motions to appeal the case must first be filed in bankruptcy court. Rhodes previously stayed all state court action in the case.

The American Federation of State, County and Municipal Employees Council 25 filed a notice of appeal of Rhodes' ruling in the bankruptcy court.

In his lead-up to the ruling, Rhodes went through key arguments made by the city's labor unions, retirees and pension funds opposed to the bankruptcy. He found that Chapter 9 of the federal bankruptcy code is constitutional and while Michigan's constitution protects public pension benefits as contracts, those contracts can be impaired in a municipal bankruptcy.

The judge also found that the 2012 Michigan law that allowed the city to file for bankruptcy with the governor's authorization was constitutional.

Tuesday's ruling begins a new chapter in the case that first arrived in federal court with Detroit's July 18 bankruptcy petition. As emergency manager Orr works toward submitting a plan to readjust Detroit's more than $18 billion in debt - to be accomplished chiefly by forcing creditors to take a discount on what the city owes them - an appeals process will begin in the federal courts.

STRUGGLING CITY

Detroit is burdened by $18.5 billion in debt as it struggles to provide even the most basic services to the city's 700,000 residents. About 40 percent of the city's streetlights do not work and about 78,000 abandoned buildings litter the city, whose population peaked at 1.8 million in 1950.

In order to meet federal eligibility requirements, Detroit had to prove that it is insolvent, it was authorized to file for bankruptcy and that it negotiated with creditors in good faith or that negotiations were impractical.

City unions, retirees and pension funds had objected in court to Detroit's filing, contending during a nine-day trial in November that Orr did not negotiate in good faith and drove the city into bankruptcy court instead. Orr, a former bankruptcy lawyer, was appointed in March by Michigan Governor Rick Snyder, a Republican.

Opponents also argued that Michigan's constitution protects pensions from being slashed and that the city has other assets it can sell to pay down its debts, including the works of the Detroit Institute of Arts. Orr has brought in auction house Christie's to place a value on some pieces in the museum's collection.

In June, Orr put forward an initial proposal on how Detroit should deal with its $18.5 billion in debt and liabilities that offered unsecured creditors only pennies on the dollar to settle their claims. Orr raised eyebrows by declaring that holders of most of Detroit's general obligation bonds would be treated as unsecured creditors who would be part of a group that would receive pro-rata shares of $2 billion in notes to settle their $11.5 billion in claims.

Detroit says about half its liabilities stem from retiree benefits, with $5.7 billion in liabilities relating to retiree healthcare and another $3.5 billion from pensions.

Likely cuts to retiree pensions and changes in healthcare benefits have been at the heart of the objections from the city's unions, pension funds and retirees. Orr drew pointed questions from Rhodes over possible cuts during his time on the witness stand in the eligibility trial last month.

"The state and the EM have had a lot of time to steer the course and plot the direction they're going in," said Brendan Milewski, a 34-year-old retired Detroit firefighter who was paralyzed in 2010 while battling a fire.

In some respects the Detroit Institute of Arts has become symbolic of the costs of allowing Detroit to fall into bankruptcy. Last week, a group of the largest creditors asked Rhodes to order an independent valuation of the museum's 66,000-piece collection. One of the city's most prized cultural assets, the museum includes paintings by Vincent van Gogh and Henri Matisse, an original cast of Auguste Rodin's "The Thinker," and a fresco mural by Mexican artist Diego Rivera. Christie's has not yet issued its valuation of the museum's collection.

Bill Nowling, Orr's spokesman, said in an email last week that the city disagrees with the creditors' filing, but the move helps "illustrate the lengths they are willing to go to ensure they receive payment."