The Meaning of Detroit
On July 18, 2013, the city of Detroit, Michigan, filed for bankruptcy. Other major cities had come close. At the height of its financial crisis in 1975, New York City considered bankruptcy. President Gerald Ford initially refused to provide federal financial help — the most famous of the headlines at the time read "Ford to City: Drop Dead!" — and briefly advocated a new set of bankruptcy provisions for large cities, with New York in mind. (Ultimately, Ford backed down and gave New York a massive bailout loan.) In the years that followed, Cleveland, Washington, and Philadelphia faced close calls. But no major American city ever declared bankruptcy — until Detroit.
For much of the 20th century, cities were viewed as irreducibly public, and market forces as antithetical to municipal operations. This perception was always a little odd, given that cities historically have been structured as corporations, but it was deeply held. In the second half of the 20th century, market-oriented innovations such as privatization and neighborhood-based services began to destabilize the distinction between public and private. Detroit's bankruptcy is a dramatic step further in this direction. Detroit used the same general process that has been used to restructure corporations since the mid-19th century to pare away $7 billion of its estimated $18 billion of debt.
The Detroit case had its peculiarities. The bankruptcy judge and his chosen mediator were powerful personalities, known for taking a firm hand in their cases. The Motor City case was flavored by the recent bankruptcy, federal bailout, and restructuring of GM and Chrysler. The city's water authority was in shambles, and the holdings of the city's art museum were up for grabs as an asset that might be liquidated. After more than a year of behind-the-scenes mediation and ugly public fights, Detroit now has a plan to get back on track, but it may be years before the fate of the city becomes clear.
In the meantime, despite all the particulars of the case, Detroit's bankruptcy does provide clear answers to several key questions that are of immediate interest to other floundering municipalities: Is bankruptcy a viable solution to the problem of unsustainable public pension obligations? What does it mean for a city to use bankruptcy to restructure itself? And how well does municipal bankruptcy work?
The short answer to the first question is that bankruptcy does provide a potential solution to the problem of unsustainable pension obligations, at least for some cities. The verdict on the bankruptcy process itself is more mixed. The Detroit bankruptcy raised concerns about transparency and adherence to rule-of-law principles, as well as concerns about judges overstepping their role. Oddly enough, giving bankruptcy judges more power in municipal bankruptcy, not less, may be the best response to these problems. To see why this is so, and to understand the remarkable intersection of public and private governance techniques in the Detroit case, we need to take a closer look at some of the major players and controversies of the case.
DECADES OF DEBT
The roots of Detroit's recent troubles go back to the 1940s. In 1943, as part of an effort to stabilize the economy during World War II and control inflation, President Franklin Roosevelt implemented a nationwide wage freeze. In response, the National War Labor Board declared that the wage freeze did not cover benefits, so, to increase compensation when the labor supply was tight, major businesses around the country added or increased health and other benefits for their employees. As the strength of organized labor grew, so did the impetus to expand workplace benefits. In 1950, General Motors and the United Auto Workers signed an agreement, soon dubbed "the Treaty of Detroit," that promised regular salary increases and some of the best benefits in the country. The agreement included a defined-benefit pension plan for GM's workers.
Though the benefits trend started in the private sector, it soon swept through public city and state offices, too. In 1958, New York City mayor Robert Wagner issued an executive order authorizing the city's public employees to engage in collective bargaining, which is often identified as the starting point of public-employee unions. In Michigan, collective bargaining dated back to legislation enacted in 1947, but public workers' rights were limited until Michigan lawmakers amended the legislation to significantly expand collective-bargaining rights in 1965.
Traditionally, when a city or state promised to give pension benefits to its employees, these promises were deemed to be "gratuities" under the law, so a city or state's promise of a pension was not legally binding. In 1963, Michigan ratified a new state constitution, and, in one of Michigan public employees' most notable achievements, it included a provision that made benefit promises into binding contractual obligations of the state. Several other states made similar amendments to their constitutions around this time. The Michigan provision, Section 24 of Article IX of their constitution, states that the "accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby."
Public-employee unions are controversial now, but they did serve an important purpose in the 1960s. Many public employees, including the vast majority of school teachers, were women, whose status was especially vulnerable given that teaching and nursing were among the few occupations that were open to women at the time, and unionization significantly enhanced their bargaining power. The problem is that, unlike with private unions, which can serve as a necessary counterweight against powerful managers, the interests of public unions are often closely aligned with those of the governmental officials who sit on the other side of the bargaining table. The Detroit mayor and city council are part of the same pension system as other public employees, for instance, and they often ride to office on the public-employee vote. The public employees were their coworkers, not their counterweights. And the problem is not limited to politicians on the left. A recent article by Sarah Anzia and Terry Moe shows both Democrats and Republicans supported enhanced state pension benefits from 1999 to 2008.
Although Detroit's public-employee pensions are not outlandish by national standards, they have been fraught with other problems. Like cities and states throughout the country, Detroit made highly optimistic assumptions about the returns its pension funds would receive on their assets, thus radically understating the city's future liabilities. But Detroit's pension system also engaged in several other highly dubious practices that exacerbated the problem. The General Retirement System, Detroit's pension fund for employees other than police and firefighters, handed out nearly $1 billion in "13th checks" to its workers and retirees between 1985 and 2008. These 13th checks were bonuses distributed to workers and retirees if pension assets exceeded the targeted return in a given year. The trouble was that, while public workers got the extra check if returns were good, no one was asked to give anything back or pay any extra when returns were bad. The GRS also offered many workers an annuity as part of their retirement benefits that guaranteed them extravagant, no-lose returns — as high as 7.9% in early 2014.
Another major problem was the shrinking population: As Detroit's population and tax base shrank from 1.8 million in 1950 to less than 700,000 today due to a confluence of tragic developments (which have been chronicled by historian Thomas Sugrue), its pension and other benefit costs — such as health care — became increasingly unsustainable. There were a few bright spots for the city's budget. In the late 1970s, Mayor Coleman Young balanced Detroit's budget, and in the 1990s, a renaissance seemed to be on the horizon for the city under Mayor Dennis Archer. But Detroit overextended: Despite the city's falling population, Archer hired a substantial number of employees during the economic boom of the late 1990s.
To make matters much worse, Detroit declined to follow the lead of the state of Michigan, as the state shifted from defined-benefit to defined-contribution pensions for its public employees in 1997. Such a defined-contribution pension removes the risk of underfunding, since the state simply sets aside its contributions for employees, and the employees themselves decide how the funds are invested. With a defined-benefit plan, the state or other employer promises to pay a specified amount to the employee during his retirement. Instead of adopting the more sustainable option, Detroit stuck with its costly defined-benefit pensions and continued to underfund them.
In less than a decade, the city's pension gap was becoming a crisis. In 2005, Mayor Kwame Kilpatrick oversaw the sale of $1.4 billion in bonds known as Certificates of Participation to shrink the hole. The interest rate on the original bonds would rise or fall as interest rates changed. To guard against the risk that interest rates would rise, the Kilpatrick administration arranged for a financial contract known as a "swap" with two major international banks to lock in a single, fixed interest rate for Detroit. Under the terms of the swap, Detroit would pay a set interest rate, and the bank counterparties would pay Detroit the variable interest rate. It seemed like a brilliant idea at the time. The Bond Buyer, a municipal-bond newspaper, gave Kilpatrick a special award at its Deal of the Year celebration in 2005.
Thanks to the long period of extremely low interest rates, however, the swap transaction proved disastrous for Detroit. By 2009, Detroit was technically in default, and a sex and perjury scandal had forced Kilpatrick from office. To pacify its bank creditors, Detroit agreed to give the banks the revenues from its casinos as collateral to secure Detroit's payment obligations under the swaps. Detroit's obligations to the banks had ballooned to $288 million as of July 18, 2013, the date of its bankruptcy filing.
Even absent the stagnation that followed the Great Recession of 2007 to 2009, Detroit was almost certainly headed for default. But the recession removed any doubt. Detroit couldn't even fund basic services; its shriveled police force took nearly an hour to respond to an urgent 911 call. Absent a radical intervention like bankruptcy, there was no way for Detroit to reduce its crushing pension and benefit costs or other major obligations. At some point, the city would simply collapse.
LAWYERS AND JUDGES
Something had to be done. In March 2013, Detroit's municipal government was replaced by an emergency manager appointed by Michigan governor Rick Snyder. This intervention — a coup, as many Detroiters saw it — was nearly as radical a step as the bankruptcy itself. Indeed, Detroit never would have filed for bankruptcy without it, since Dave Bing, the former NBA basketball star who was mayor at the time, and the city council both stoutly opposed bankruptcy.
In preparation for the state takeover and Detroit's eventual bankruptcy, Michigan lawmakers in 2011 vastly expanded the state's power to intervene when a city or town falls into financial distress. Under the new provisions, an emergency manager not only assumes all of the powers of the mayor and city council, he also has the authority to terminate collective-bargaining agreements and other contracts. Both Snyder and a majority of the Michigan legislature were Republicans, while Michigan's most distressed cities were run by Democrats, which made the state-takeover statute highly controversial, and Michigan voters repealed the provisions by referendum in November 2012. Governor Snyder and the legislature immediately reinstated them, albeit in revised form.
The man the governor chose as emergency manager was Kevyn Orr. A graduate of the University of Michigan Law School, Orr was at the time a bankruptcy lawyer in the Washington office of the enormous Jones Day law firm and had been one of the principal partners overseeing the Chrysler bankruptcy. He also is African American, like then-mayor Bing, most of the city council, and a substantial majority of Detroit residents. Given his résumé, there was little doubt about Snyder's expectations.
After meeting with a number of Detroit stakeholders and documenting Detroit's woes in an extensive report, Orr asked Snyder for and received the authority to put Detroit into bankruptcy under Chapter 9 — the bankruptcy provisions for cities and other municipalities — in July 2013.
Municipal bankruptcies have a special set of rules. When a corporation like Chrysler or General Motors files for bankruptcy, the bankruptcy judge is assigned through a random process known as the "bankruptcy wheel." Not so with a city. Because Congress believed that cities are different than other bankruptcy debtors and should have the best available judge, the chief judge of the federal court of appeals must handpick a judge to oversee a municipal bankruptcy. Not surprisingly, this process involved a great deal of backstage maneuvering. Judge Gerald Rosen, the chief judge of the federal district court — the court that oversees the bankruptcy court — lobbied for the appointment of Judge Steven Rhodes. "I have worked extensively with Judge Rhodes when he was chief judge of the bankruptcy court," Judge Rosen wrote to the chief judge of the court of appeals, "and he has outstanding administrative and management skills, which of course will be necessary in handling a case of this magnitude." A longtime Detroiter and well-respected bankruptcy judge, Judge Rhodes was certainly the logical choice. But Judge Rosen's entreaty seemed a little odd.
Things soon became odder still. After Judge Rhodes was assigned to the case, he invited Judge Rosen to serve as chief mediator in the case. He thus asked a judge who had advocated his appointment, and who (as the chief judge of the district court) is in a sense his boss, to serve as the mediator. It was an alarming display of mutual back-scratching.
The mediator's role is to serve as a catalyst, bringing major parties together and facilitating their negotiations and encouraging them to settle disputes that might otherwise require time-consuming litigation. Mediation is not uncommon in big bankruptcy cases, but its scope in the Detroit case was extraordinary. "After consultation with the parties involved," Rhodes's mediation order states, "the Court may order the parties to engage in any mediation that the Court refers in this case." Judge Rhodes submitted so many disputes to mediation that Judge Rosen needed to assemble a team of mediators to handle all of the issues. By order of Judge Rhodes, the mediation also was conducted under conditions of extreme secrecy: "All proceedings, discussions, negotiation, and writings incident to mediation shall be privileged and confidential, and shall not be disclosed, filed or placed in evidence." So little was revealed about issues under mediation that parties were unaware of even the status of negotiations unless they were directly involved.
Both the bankruptcy judge and his boss-turned-mediator viewed the Detroit case as their judicial legacy, and each pushed the boundaries of his role. The boundary stretching was to some extent inevitable, given the judges' personalities. Judge Rhodes is well known for tightly controlling the cases in his court. Judge Rosen, the mediator, is something of a political fixer; an unsuccessful candidate for Congress before becoming a judge, he is highly connected in Republican politics in Michigan and has developed a reputation for being one of the few people who can get things done in Detroit.
The focus of much of their attention — and the source of much of the drama — was two groups of very large creditors: Detroit's current and retired employees with claims to pensions and the city's bondholders. At the outset of the case, both thought that they were entitled to be paid in full and that bankruptcy could not be used to reduce Detroit's obligations to them. Both were wrong.
THE PENSIONS
The Detroit bankruptcy would have ended even before it began if Detroit's public-employee unions had had their way. Pointing to the pension provision in Michigan's constitution, the unions and Detroit's two principal pension funds asked Judge Rosemarie Aquilina, a state court judge in Lansing, to halt the case. Because the bankruptcy would be used to reduce the pensions, they argued, it would violate the Michigan constitution. Judge Aquilina agreed and issued a flurry of orders barring Governor Snyder and the emergency manager from pursuing the case, announcing in court that bankruptcy would dishonor the 2009 bailouts of Chrysler and General Motors. On one of the orders, she jotted a handwritten instruction to forward a copy of the order to President Obama.
Unfortunately for the public employees, Detroit had already filed for bankruptcy before the orders were issued. The emergency manager had seen them coming and got to court first. As Judge Rhodes pointed out several days later, the municipal bankruptcy laws explicitly forbid interference with the activities of state and local officials, as part of the "automatic stay."
The public-employee unions continued to push, however, and, in his December 2013 opinion upholding Detroit's eligibility to file for bankruptcy, Judge Rhodes officially rejected the argument that the Michigan constitution prohibits any restructuring of pensions. He was right to do so: The 1963 constitutional provision was designed to convert pension promises into contractual obligations so that a city like Detroit cannot arbitrarily decide to renege on them. There is no evidence, however, that Michigan lawmakers intended to give pension promises a higher status than other contracts in the event a city did not have enough assets to pay all of its obligations. In fact, Detroit mayor Frank Murphy, who later became governor and then a Supreme Court justice, was one of the staunchest advocates of the original federal municipal bankruptcy law in the 1930s, testifying in support of it on several different occasions. And since 1939, Michigan has explicitly authorized its municipalities to file for bankruptcy. The principal purpose of the municipal bankruptcy laws that Michigan has consistently endorsed is to enable troubled municipalities to restructure their contractual obligations.
Furthermore, even if the Michigan constitution did intend to treat pension obligations differently than other obligations, it would not matter because municipal bankruptcy is a federal law. The federal bankruptcy law, which clearly does permit the restructuring of the unfunded portion of a pension, trumps state law — even state constitutional law — because of the supremacy clause of the U.S. Constitution.
The unions' strongest argument against adjusting their pensions was their much more radical claim that the entire municipal bankruptcy statute is unconstitutional. Under the contracts clause of the United States Constitution, which says that no state can take actions "impairing the Obligation of Contracts," municipalities and states are forbidden from altering existing contracts. By giving a city the power to alter its contracts, the unions argued, the municipal bankruptcy laws facilitate a violation of the contracts clause. According to this reasoning, Congress cannot authorize a city to alter a contract that the city could not alter on its own. The unions also argued that municipal bankruptcy interferes with the sovereignty of a state and its municipalities, thus violating the Tenth Amendment's protection of state sovereignty. The unions acknowledged that Chapter 9 prohibits a city from filing for bankruptcy unless the state authorizes the filing, but they insisted that this safeguard of state sovereignty does not suffice; municipal bankruptcy is inherently inconsistent with maintaining the separate spheres of federal and state oversight.
Back in 1936, the U.S. Supreme Court struck down the original municipal bankruptcy law on precisely these grounds in a case called Ashton v. Cameron Water Improvement District No. 1. Congress quickly enacted a new municipal bankruptcy law, and two years later the Supreme Court upheld municipal bankruptcy in United States v. Bekins. The principal explanation for the change in outcome seems to have been timing. Although the new municipal bankruptcy law made only minor adjustments to its predecessor, the Supreme Court justices had undergone a dramatic shift in perspective — known as the "switch in time" — in 1937 during the debate over President Roosevelt's infamous "court packing scheme." (Under the scheme, a new justice would be added to the court for every existing justice over the age of seventy years and six months.) Prior to 1937, the Court had struck down many New Deal legislative efforts; that year, the Court started upholding them. The jurisprudential support for municipal bankruptcy is thus somewhat shaky. The federal government was sufficiently worried about the public employees' constitutional challenge that the U.S. Department of Justice filed a brief in the Detroit case defending the constitutionality of municipal bankruptcy.
When Judge Rhodes issued a 150-page opinion in December rejecting the objections to Detroit's bankruptcy filing, only a handful of pages directly addressed the question of whether pensions can be restructured in bankruptcy despite the pension protection in the Michigan constitution. But those pages were by far the most widely discussed portion of the opinion. Judge Rhodes might easily have postponed the pension issue for a later date, declining to decide so early in the case whether the pensions could be restructured. But he explicitly rejected the unions' arguments and ruled that pensions can indeed be restructured, effectively telling the unions that pensions were inarguably up for discussion.
Of course, if Detroit's pensions had been properly funded, this skirmishing would have been irrelevant, since only the unfunded portion of the pension could be restructured. To the extent that funds were properly set aside, these funds are held in trust for the pension beneficiaries. Detroit and its creditors do not have any interest in the funds. But the pensions had been massively underfunded for years, and $3.5 billion in unfunded pension liabilities were on the table.
THE BONDS
Given this huge dollar amount and the constitutional issues at stake, the question of whether Detroit's pensions could be restructured was the single most important issue in the case. But Detroit also needed to significantly reduce its bond debt, and it was on this issue that Judge Rhodes intervened most dramatically.
Judge Rhodes was skeptical from the outset about the elaborate interest-rate transaction that originally had garnered so much praise for then-Mayor Kilpatrick. After rejecting a settlement that would have given the bank counterparties a $230 million claim (thus reducing their original $288 million claim by $58 million), Judge Rhodes sent the parties to mediation. After weeks of wrangling, mediator Judge Rosen announced that the banks had agreed to reduce their claim to $165 million. For the only time in the case, Judge Rhodes rejected his mediator's handiwork, telling the parties that the banks' claimed interest in Detroit's casino revenues was too dubious to justify such a relatively minor reduction. The parties later renegotiated dramatically steeper cuts that left the banks with only an $85 million claim.
Judge Rhodes also questioned the too-clever design of the bonds underlying the interest-rate swaps — the Certificates of Participation whose proceeds had been used to buttress Detroit's pensions. As cities have done for decades, Detroit used creative structures and clever design to evade the city debt limit: Rather than issuing the COPs directly, Detroit created new, separate entities, and those entities were the ones who borrowed the money — not Detroit. Seemingly prompted by Judge Rhodes's skepticism, Detroit questioned whether the holders of COPs were entitled to any claim at all and offered to give them only up to 10% of what they were owed.
COPs were not the only bonds Detroit had sold to cover its debts, however, and the city could not be nearly as tough on bonds whose legitimacy was not in doubt. Chief among these were a variety of bonds known as General Obligation bonds. GO bonds usually require voter approval and are backed by the city's promise to use its "full faith and credit" to make sure that the bonds are repaid. Many of Detroit's GO bondholders thought that these protections would give them special status in a bankruptcy case. Prior to the city's bankruptcy filing, as two investment experts at Cumberland Advisors wrote, "the general-obligation pledge was still considered a secured claim and 'sacrosanct' — senior to all other claims against a debtor, requiring the debtor to raise taxes to repay bondholders." The bondholders quickly learned that this was mistaken. For the GO bonds that did not have any specific collateral, Detroit offered 10 to 13 cents on the dollar, a far greater reduction than most had expected at the outset of the bankruptcy. (The payout to some classes of bondholders was eventually increased to 41 cents.) Everyone expected special protection at the outset, and neither pension holders nor bondholders were as safe as they expected.
THE ASSETS: WATER AND ART
Detroit's water authority is perhaps the city's most significant asset. Detroit provides water not just for the city's metropolitan area, but for four surrounding counties as well, serving roughly 40% of all Michigan residents. So another major issue in the bankruptcy was the restructuring of Detroit's water authority. Creating a new regional water authority was a key feature of emergency manager Kevyn Orr's vision for the restructuring of Detroit.
As always, Judge Rhodes submitted the negotiations to mediation. Whether he had the formal authority to require the outside counties to participate was subject to doubt, but Detroit agreed late in the case to lease its water and sewage departments to a new Great Lakes Water Authority for 40 years. The authority will pay Detroit $50 million per year to be used for refurbishing the infrastructure of the system.
While the negotiations were taking place, the current water and sewer authority caught nationwide attention by cutting off the water at the residences of hundreds of Detroiters who had not paid their water bills. Judge Rhodes told the citizens and their lawyers that he did not have the authority to require Detroit to restore water, while also making clear his frustration with the decision to cut off water at residences after many years of inaction when residents failed to pay their bills. Detroit has worked with residents to maintain their access to water, while defending the action as evidence that the city is putting its services on a sounder financial footing.
Sorting out the problems with the water authority was a vital part of solving Detroit's financial crisis. But the biggest wildcard in the case was the Detroit Institute of Arts. The DIA is the sixth most prestigious comprehensive art museum in the United States, after the flagship art museums in New York, Washington, Chicago, Philadelphia, and Los Angeles. Its most famous room contains an enormous series of Diego Rivera murals satirizing — ironically, given Detroit's current predicament — the world wrought by Henry Ford and Detroit's auto industry in its heyday. The museum's holdings also include masterpieces by Bruegel, Matisse, and many others.
Since Detroit does not have many valuable assets, the art museum quickly became a center of attention in the bankruptcy case. Most art museums are owned by non-profit foundations that are entirely separate from the city itself, so in New York, Chicago, and nearly every other city, the question of whether the city's creditors are entitled to the value of the museum's art would never even come up. But Detroit is different. Although the art was originally held by a separate foundation, Detroit acquired the museum and its art in 1919, when the city was riding high with the rise of the auto industry. "With the wealth of Detroit," as the museum's current president puts it, the transfer "was seen as giving the museum security."
So even before Detroit filed for bankruptcy, Michigan's attorney general Bill Schuette drew a line in the sand by releasing a report stating that "[t]he art collection of the Detroit Institute of Arts is held by the City of Detroit in charitable trust for the people of Michigan, and no piece in the collection may thus be sold, conveyed, or transferred to satisfy City debts or obligations." But because Detroit clearly does own the museum and at least some of its art, Schuette was forced to devise creative arguments to defend his position that the art could not be sold. He pointed out that many of the artworks were purchased by others, not by Detroit, or were subject to restrictions, and he claimed (rather heroically) that all of it really belonged not to Detroit but to the people of Michigan.
Although it seemed quite clear that Detroit could sell some of the art if it wished, its creditors could not force Detroit to sell it. One of the peculiarities of municipal bankruptcy law is that only the city itself can sell assets or propose a plan for the adjustment of its debts. Even the bankruptcy court must defer to the city's decision whether or not to sell an asset. Because Congress was worried about interfering with the sovereignty of state and local decision-makers — since the intrusion could violate the Tenth Amendment of the U.S. Constitution — the municipal bankruptcy law forbids the bankruptcy court from usurping "any of the political or governmental powers" or "the property or revenues" of the city. These protections supplement the rule that a city cannot file for bankruptcy unless its state consents.
Detroit did face one important constraint: The bankruptcy court could not approve Detroit's restructuring plan unless it was "feasible" and "in the best interests of creditors." To satisfy the "best interests" requirement, the restructuring plan must give creditors as much as they would have been likely to receive if Detroit had never filed for bankruptcy. This gave creditors a very powerful lever to push the city to sell at least some of the art. Unless Detroit tapped the value of the art to pay its creditors, they argued, the creditors' recovery was likely to be less than they would have received if they had pursued their legal rights against Detroit outside of bankruptcy.
For the arts community, keeping Detroit's art in Detroit was the single most pressing issue in the case. But their scramble to prevent even a single piece of Detroit's art from being sold created a bit of a controversy. At an October 2013 panel event in New York City to discuss the Detroit art, Frank Robinson, a former director of several university museums, noted that "the median income of our adult visitors...in some [museums] is in the six figures," whereas the circumstances of at least one group of Detroit's creditors — the city's pension beneficiaries — are far more humble. To some, the wealthy arts community seemed more concerned about art than about the predicament of Detroit pensioners who are barely scraping by. "How can we equate a few pieces of canvas with paint on them," as Robinson put it in the letter to the New York Times, "with the pensions of thousands of firefighters, nurses, police officers, teachers and other civil servants?"
In late 2013, a remarkable strategy for solving this dilemma emerged. Under the "Grand Bargain," as the proposal soon came to be known, Detroit would transfer all of its art to a new non-profit organization in return for $816 million: $366 million of it would come from Kresge, Ford, and other foundations; $350 million from the state of Michigan; and $100 million from fundraising by the Detroit Institute of Arts itself. The new organization would legally commit itself to keeping the art and the museum in Detroit forever.
Crucially, rather than distributing the proceeds among all of its creditors, Detroit would give every penny to the pension beneficiaries. By linking the protection of Detroit's art to a new source of funding for Detroit's pension beneficiaries, the Grand Bargain turned the embarrassing conflict between the interests of the arts community and Detroit's current and retired workers into a strategy that benefitted both parties. It was a brilliant solution for everyone — except for the Detroit bondholders and other creditors who suddenly found themselves on the outside looking in.
The two most vociferous objectors in the case — Syncora Guarantee, Inc., and Financial Guaranty Insurance Co., which had insured the $1.4 billion of Certificate of Participation bonds — attacked the Grand Bargain as obtaining far less than Detroit could for its art. Syncora identified four different bidders, each of whom would pay more than $816 million to Detroit, either for a portion of the art or as proceeds of a loan secured by the art. The bond insurers also secured an appraisal of Detroit's art that assessed its value at as much as $8.6 billion, far more than the $454 million to $867 million price tag Christie's had put on a selection of the art earlier in the case. But Detroit refused to budge.
For bankruptcy experts who had followed the Chrysler and General Motors bailouts in 2008 and 2009, the Grand Bargain was déjà vu all over again. In both Chrysler and General Motors, the government orchestrated a sham sale of the company's assets to a new entity, and made it nearly impossible for anyone other than the favored recipient to make a competing bid. In the Chrysler case, the "purchaser" (known as "New Chrysler") paid $2 billion for Chrysler's assets, which appeared to be far less than the company was worth, while also agreeing to pay Chrysler's retirees essentially in full. After the smoke cleared, Chrysler's secured bondholders received only 29% of what they were owed, while the retirees and other favored creditors were protected. The Grand Bargain and car-bailout strategies are therefore almost identical: Each relied on a sham sale that was insulated from competing bids, and each was used to favor one group of creditors at the expense of other, financial-market creditors.
It is tempting to assume that Jones Day, the law firm that handled both the Chrysler and Detroit cases, simply dusted off its Chrysler strategy and re-employed it in Detroit. And it seems highly unlikely that the Grand Bargain ever would have been attempted if Chrysler had not paved the way. But Judge Rosen has suggested that he devised the framework, attributing its origins to a chance encounter with Miriam Noland, the president of the Community Foundation for Southeastern Michigan, in a Detroit deli in fall 2013. "Well, two days later she was in my office," Judge Rosen said later, and "Eugene [Driker, a mediator working with Judge Rosen and the husband of a former Detroit Institute of Arts board member] and I sort of spun out this idea, and when she picked herself up off the floor she said, well, let's think about that! And, within three weeks we had 13 foundation leaders." Rosen vigorously lobbied the foundations. He also circulated among Michigan politicians, nudging them to vote in favor of the $350 million contribution from the state.
It is important to recognize that, of the city's creditors, Detroit's pensioners were the most vulnerable. For Detroit to ignore their predicament would have been indefensible from both a humanitarian and an economic perspective. But the gulf between the payout promised to the pension beneficiaries — at least 60% of the unfunded portion of their pensions (in addition to the funded portion), and possibly much higher, depending on the calculations — and Detroit's bond creditors — less than 10% for the COPs — was enormous. Syncora and FGIC objected to the differential as "unfair discrimination." The team of lawyers for Syncora even filed an objection with the court, describing Rosen and Eugene Driker as "agenda-driven, conflicted mediators who colluded with certain interested parties," and claiming that, because Driker's wife had been a longtime member of the board of directors for the Detroit Institute of Arts, Driker should never have been involved with this aspect of the mediation. Judge Rhodes dismissed the lawyers' complaints, since the possible conflict of interest had been properly disclosed, but the case had become personal and ugly.
In early September 2014, at the outset of the big trial to determine whether Detroit's restructuring plan would be approved, Syncora and FGIC signaled that they would attack Detroit's plan as unfair discrimination and as failing to give them as much as they would have received outside of bankruptcy. Given the strength of their objections, it promised to be a dramatic trial. But on September 15, Syncora struck a deal with Detroit, after Detroit offered the company long-term leases to operate a parking garage and the tunnel between Detroit and Canada. James Sprayregen, the lead lawyer for Syncora, even issued a fulsome apology for Syncora's harsh criticism of the mediators: "We are deeply sorry for the mistake we made [suggesting that Eugene Driker's wife's DIA ties had not been disclosed]," he said, "and for any unfounded aspersions it may have cast on Chief Judge Rosen and the Drikers." FGIC held out for a month longer, but in the end it reached a somewhat similar deal. Detroit gave FGIC a contract to develop the area around the Joe Louis Arena, current home of the Detroit Red Wings hockey team, after Detroit demolishes the arena and the Red Wings relocate.
By pacifying the two major creditors, Detroit removed the most compelling objection to its plan. A plan that provides much better treatment for some creditors than others cannot be said to "unfairly discriminate" if the creditors who receive less agree to their treatment. The unfair-discrimination objection did not disappear altogether; two smaller classes continued to object, but the most robust opposition had been defanged.
On November 7, 2014, Judge Rhodes formally approved Detroit's proposed plan. Reading an oral opinion from the bench, he praised the participants in the case and extolled the treatment of Detroit's pensioners as "border[ing] on the miraculous." Judge Rhodes briefly considered and rejected each of the remaining objections. His most surprising statement came when he reached the "unfair discrimination" concern. Rather than adopting an objective standard, he stated that "determining fairness is a matter of relying upon the judgment of [the Court's — that is, his own] conscience." The special treatment of pensions was justified, he concluded, because they are central to Detroit's mission, whereas the disfavored creditors, in his view, are not. Judge Rhodes also concluded that the proposed plan is "feasible," another key prerequisite to approving a restructuring plan: "[T]he City of Detroit, after the confirmation of the Plan of Adjustment, will be able to sustainably provide basic municipal services to the citizens of Detroit and to meet the obligations contemplated in the Plan without the significant probability of a default."
The mood in Detroit is surprisingly optimistic as the city emerges from bankruptcy. Warren Buffett recently assured a Detroit audience that "[w]e would buy a company in Detroit today and we'd be happy to have the headquarters here." Detroit will be cutting $7 billion of its estimated $18 billion of debt, and thus will have a considerably improved balance sheet in the short run. The rehabilitation provides for over $1 billion in blight removal and development (although much of it is not yet funded), and the deals with Syncora and FGIC will spur additional development.
Whether Detroit eliminated enough of its debt is less clear. Protecting its retirees and cutting deals with many potential objectors prevented Detroit from making the far deeper cuts that some thought were necessary. But given the speed of the bankruptcy and the number of stakeholders involved, the bankruptcy achieved a great deal.
SOLUTIONS FOR OTHER CITIES
Although Detroit's cuts to its pensions were relatively small in the end, the court's conclusion that pensions can be restructured makes bankruptcy a meaningful new option for cities in financial distress, whose pension obligations are rapidly squeezing out their ability to provide even basic services to their citizens. Detroit was not the first municipality to restructure its pensions; Central Falls, Rhode Island, did it several years ago, but because the town's retirees agreed to the cuts, the bankruptcy court did not have to issue a judicial opinion upholding the right to restructure pensions. Judge Rhodes was thus the first judge to formally rule that pensions can be restructured in bankruptcy. For cities facing the fact that they cannot plausibly fulfill their pension promises, the rule makes clear that the obligations can be renegotiated in bankruptcy.
The ruling has another benefit as well: It is a rare example of a legal ruling that can help to reshape a dysfunctional political process. Now that unions and other interested parties know that underfunded pensions could eventually be restructured in bankruptcy, they have much stronger incentives to ensure that their city fully funds its obligations and to consider whether their promised benefits are realistic. The looming possibility of a bankruptcy restructuring will have a beneficial effect even if the city in question never actually files for bankruptcy.
The Detroit ruling is especially important given that Stockton and San Bernardino, two California cities that also have been in bankruptcy, both decided to keep their pension plans intact rather challenge CalPERS, California's massive public pension fund. The judge in Stockton's bankruptcy case had made clear that Stockton had the legal power to alter its pension obligations if it wished, but the city declined to do so. San Bernardino initially halted its pension contributions and announced that it intended to restructure the obligations, but it has backed off in the face of relentless pressure from CalPERS.
Although the Detroit case did not break new ground in upholding the restructuring of general-obligation bonds, this too should be seen as a benefit of the bankruptcy case. The bond markets have tended to assume that municipal bonds will never default, because the state will step in with a bailout if necessary. As a result, municipal-bond prices have long been artificially high. Detroit's bankruptcy has made clear that bailouts are not inevitable, which should reduce the bailout subsidy that had inflated prices.
Detroit did not restructure nearly as much, or in as many ways, as it might have. In a report on the feasibility of Detroit's bankruptcy plan that Judge Rhodes relied upon heavily for his own conclusion that the plan is feasible, restructuring expert Martha Kopacz pointed out that Detroit adjusted its balance sheet but still has not fixed its operational problems. "This bankruptcy has been largely focused on deleveraging the City," she noted, "often to the exclusion of fixing the City's broken operations." As a result, "the operational restructuring that often occurs with commercial reorganizations will be left largely to Mayor Duggan and his managers for the post confirmation period."
New York University law professor Clayton Gillette and I point out in a new law-journal article that municipal bankruptcy also could be used to restructure a city's governance. Dysfunctional governance arrangements often cause or exacerbate a city's fiscal woes. Detroit has a variety of structures that might easily have been reformed. One striking example is the selection of Detroit's police chief. Although the mayor nominally selects the chief, he is required to choose from a list presented by an elected board of police commissioners. Since the board of police commissioners is largely composed of former police officers, police officers essentially control the selection of their chief. This makes meaningful police reform extremely difficult. Given that effective control of crime is one of the best predictors of a city's future vitality — consider the contrast between high crime Newark or Detroit and lower crime New York in recent decades — failure to more fully reform Detroit's municipal governance is a major missed opportunity.
The Michigan legislature did enact legislation that will provide oversight of Detroit's finances for 13 years after its bankruptcy. But Detroit could have attended more directly to some of the governance flaws that contributed to its distress. Gillette and I argue that a bankruptcy judge could facilitate such reforms by refusing to certify that a proposed debt-adjustment plan is "feasible" if it fails to address obvious municipal-governance dysfunction.
Detroit's bankruptcy judge and mediators did manage to maneuver an extremely thorny case to completion in just over a year, and made significant progress in addressing some of Detroit's problems. Judge Rhodes also deftly handled the concern that only creditors have a formal vote in bankruptcy — ordinary citizens do not — by giving Detroiters regular opportunities to participate and by making clear that he would not approve a plan unless Detroit demonstrated its ability to provide basic services for its citizens. But the process also raised serious concerns about transparency and the judicial role.
In theory, the bankruptcy judge serves solely as a neutral arbiter. In fact, when Congress enacted the current bankruptcy laws in 1978, limiting the judge's role to this function was one of the principal objectives. Prior to 1978, bankruptcy judges were actively involved in the administration of cases. The judge often met with the parties, and he selected the professionals who would serve as trustees or as lawyers for the trustees in an ordinary bankruptcy case. This judicial involvement, however, led to accusations that judges were involved in "bankruptcy rings," in which insiders benefited from access to lucrative patronage appointments. The current bankruptcy law is intended to leave the administrative features of the case to others — such as the office of the United States trustee — and to limit the bankruptcy judge's role to resolving judicial issues. But Judge Rhodes actively intervened in the Detroit case at many key junctures.
The mediation process was even more problematic. The submission of nearly every major issue in the case to mediation, and the insistence on complete secrecy, meant that the bankruptcy process was highly opaque, as University of North Carolina law professor Melissa Jacoby has pointed out in several recent law-journal articles. This raises concerns not just about the Grand Bargain at the heart of the case, but also about the many other deals reached by the mediator and his team. Perhaps the creditors believed that the deals they agreed to were completely fair, but they may also have concluded they did not really have a choice.
These concerns about the level of judicial control in the Detroit bankruptcy case may sound inconsistent with the suggestion that bankruptcy judges should insist that cities adopt operational or governance reforms, rather than just restructuring their balance sheets. But the two conclusions are not inconsistent at all: The problem in the Detroit case was the absence of transparency and concerns about whether rule-of-law principles were being honored, not the amount of power wielded by the judge. A bankruptcy judge that focused on operational and governance issues might have even more power, in a sense, but it would be less problematic if the process were fully transparent rather than shrouded in secrecy.
Will other troubled cities be able to replicate Detroit's successful reworking of its pensions, and perhaps make more complete use of the market-oriented restructuring process provided by Chapter 9? Quite possibly yes, but several looming obstacles could interfere with a bankruptcy filing by another troubled major city.
The first is that a city cannot file for bankruptcy unless state law expressly allows municipalities to do so. Nearly half of all states currently do not allow cities that option. The city also must demonstrate that it is incapable of paying its debts as they come due. Many financially distressed cities would find it quite difficult to show that they are actually incapable of paying their current debts. Chicago is the most obvious example. Chicago's public pensions are underfunded by roughly $30 billion, and the Illinois Supreme Court has suggested that even minor adjustments to the pensions of retirees and current employees are likely to violate the Illinois constitution. Yet even if Chicago's situation worsens, it probably would not be able to show that it is unable to pay its debts as they come due. Because most of Chicago's pension liabilities are future expenses, not current ones, the city may be able to postpone an inevitable collapse for years. In the meantime, the pensions will crowd out services and other city priorities.
The simple solution to this predicament would be to make entrance requirements for municipal bankruptcy more reasonable. In its 2010 financial reforms, the U.S. Congress gave regulators the authority to take over a giant financial institution if it is "in default or in danger of default." This standard would also make sense for municipal bankruptcy. A more ambitious Congress might go further and expand the municipal bankruptcy laws to include Puerto Rico, whose municipalities are inexplicably excluded. Better yet, it would permit states to file for bankruptcy, as Jeb Bush and others advocated a few years ago — an option that Illinois, which has massive unfunded pension and retiree healthcare liabilities, may soon need.
In the meantime, the coming months will provide additional perspective on what bankruptcy means for Detroit itself. Now that the emergency manager's term has ended, his job is over. The mayor's office and the city council have assumed nearly all of the authority they had before the emergency manager was put in place. The future of Detroit is in their hands.