It's feds vs. state as Detroit heads to bankruptcy hearing

Downtown Detroit
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Downtown Detroit

Detroit's largest-ever municipal bankruptcy could make even more history on Wednesday when a federal judge is expected to rule on whether U.S. law trumps Michigan's constitutional protections to preserve the pensions of city workers. The judge's decision could impact dozens of other states and cities facing financial stress for years to come.

The hearing will be the latest legal skirmish pitting the city's state-appointed emergency manager against more than 100,000 creditors, including pensioners, as lawyers for all sides are clearly sailing in uncharted waters.

"You have go back to the 19th century when states repudiated their Civil War debts to see anything like this," said John Tuohy, Arlington County, Va.'s deputy treasurer, who chairs the pension committee of the Government Finance Officers Association. "This will be studied in law schools for the next 30 years."

The case took another twist Tuesday when Michigan's appeals court halted all ongoing challenges to the constitutionality of the bankruptcy filing pending in state court. The appellate court asked for additional briefs before deciding the next step, according to Morgan Cole, a law clerk for Ingham County Circuit Judge Rosemarie Aquilina, who has scheduled a Monday hearing on those challenges.

"(The order) stops the proceeding until they make a decision whether to send it back to trial court, whether they're going to keep it, or whether they're going to send it up to the Supreme Court of Michigan," said Cole.

The main event in the legal wrangling comes Wednesday morning, when a federal bankruptcy court judge in Michigan is expected to rule on whether U.S. law trumps the state's constitutional protection against rescinding retired city workers' pensions. Bond holders who have relied for centuries on a government's "full faith and credit" to repay their investments will also be there to argue their case.

And the legal precedent the case sets will be watched closely by dozens of other states and cities grappling with under-funded pension promises.

"I can guarantee every county and city attorney in the U.S. has been watching this with great interest," said Tuohy.

Union lawyers who opposed last week's historic Chapter 9 bankruptcy filing are expected to make a last ditch argument that the law which granted the city's emergency manager, Kevyn Orr, the authority to make the bankruptcy filing violates the state's constitution.

Bankruptcy lawyers say that argument faces an uphill legal battle because federal courts typically have the power to interpret state constitutions.

"It's a cardinal principal of law that every federal court has the ability to determine its own jurisdiction," said Bruce Zirinksy, a bankruptcy lawyer with Greenberg Traurig in New York. "The federal court is also able to enjoin any state court action which will interfere with its jurisdiction."

But opponents of the Detroit's bankruptcy will be armed with a ruling handed down Friday by Judge Aquilina, who agreed with their argument that Detroit violated the Michigan Constitution.

(Read more: Detroit bankruptcy could hit millions of retirees)

Appearing Wednesday before U.S. Bankruptcy Court Judge Steven Rhodes, opponents of the bankruptcy filing will argue that the question is solely a state matter, placing it outside the reach of federal courts, a doctrine known as "independent and adequate state grounds," according to Aquilina law clerk Cole.

"Generally, federally courts will deny discretion to review an issue it if it rests solely on state grounds," she said.

Regardless of tomorrow's ruling, bankruptcy law experts say,the case could involve multiple appeals to both state and federal courts – with little legal precedent to shape the outcome. Most of the several hundred cases that have been filed since the modern Chapter 9 code was amended in 1978 involve small municipal entities like water or sewer districts.

Only a handful of cities and counties have used the law to restructure debts, and none with anything close to the 100,000 creditors and more than $18 billion in debt owed by Detroit.

With such a long list of creditors lining up armies of attorneys, Orr's office is assembling his own team of lawyers, consultants and financial advisors. And he doesn't need court approval to pay their salaries.

Bankruptcy experts say the case could take years—and could prove to be very costly for the city.

"Bankruptcies are expensive," said Andrew Gottfried, a bankruptcy lawyer with Morgan Lewis. "You're going to see staggering bills that Detroit is going to have to pay if this case drags on."

(Read more: Detroit's bankruptcy battle likely to be long and painful)

Detroit city workers and retirees are digging in for a long fight. Union officials argue that the city has mismanaged their pension fund andhasn't done all it can to collect back taxes to cover its debts. They also argue that the city's bid to cut retiree pensions violates state law.

"They want to rape and plunder the city of Detroit without any real voice of the city workers or the citizens," Albert Garrett, president of AFSCME Council 25, which present city workers, told NBCNews.

Union lawyers also plan to argue that the city has not tried hard enough to negotiate voluntary concessions. In the weeks before last week'sfilling, Orr conducted a series of whirlwind talks in which he reportedly offered as little as ten cents on the dollar toward the city's obligations.

But, in an interview Monday with NPR, Orr said it's not clear yet just how deeply pensions would be cut.

"There's a lot of talk about how there's going to be no pensions and that's not true," he said. We're just talking about adjusting them to today's realities… We just don't know how deep."

As city retirees and creditors fight it out in court, thecase is expected to have a wide impact on other municipalities struggling under the financial weight of years of underfunded pensions. Most funds were hit hardby the financial market collapse of 2008 and have only recently to recover some of those losses.

The average funding ratio of the largest 100 public pension plans continued to fall in the latest year, according to an analysis by Pensions& Investments, a trade publication. Those top 100 plans had combined unfunded liabilities of $793 billion as of their latest valuation date - up 4.1 percent from the previous year. Of the 94 plans that had filed fiscal 2011 reports, only three funds had funding ratios above 100 percent, according to P&I.

Many of those fund have made changes since 2008 to get back on track, from increased contributions to cuts in future benefits. But if Detroit succeeds in cutting its pension payments with its bankruptcy, it could prompt other cities to use the process to fix their pension funding shortfalls.(States are barred by law from filing for bankruptcy.)

Zirinksy notes that bankruptcy filings among privatecorporations were rare until the stigma was broken in the 1970s and 80s.

"People use to say no one would ever fly on a bankruptairline," he said. "But we've seen every major airline in the country go througha bankruptcy. I don't expect there to be a rash of filings by municipalities,but I think there will be more because there are clearly other potentialcandidates out there."

Paradoxically, the bankruptcy process could help Detroit begin rebuilding by restoring its ability to borrow, an option it lost when rating agencies slashed its credit to junk status. Much like what's known as debtor-in-possession financing in corporate bankruptcy, new investors would be given special status outside the bankruptcy proceeding.

"To the extent we have increased cash flow, we're already seeing some lenders come in and talk to us about possible other funding," Orr told NPR "Lenders are remarkably rational. If you can pay your bills and you're rehabilitated, they want to make sure that they—that's business. That's good business and that's what we're aiming for."

But any financing extended after a corporate bankruptcy filing is typically secured with equity in the company or other hard assets. It's not clear what kind of collateral Detroit could pledge. That's where the state or federal government could play a role, providing a financial backstop short of an actual cash bailout to help the city attract desperately needed new investment.

"The government's going to have to be very careful, though,because there are going to be a lot of other states and cities with their hands out," said Zirinksy.

So far, the White House has been cool to any suggestion of a Detroit bailout, saying the city has to show that it can to stabilize its red ink first.

Still, after Washington threw a bailout lifeline in 2008 to private sector retirees at Motor City employers GM and Chrysler, there will likely be ongoing political pressure on state and federal officials to offer some kind of assistance to the financially beleaguered city and its workers.

"We are people that sacrifice our lives," Detroit firefighter Dennis Hunter told NBC News. "We may not come home one day. So to look at us is a spreadsheet is to me un-American."

—By CNBC's John W. Schoen. Follow him on Twitter @johnwschoen.

This story has been updated to reflect that GM and Chrysler received a bailout from the U.S. government in 2008.