When detective Gabi Versado investigates the mutilation and murder of a teenage African-American in the novel
, she does so against the background of Broken Monsters Detroit‘s ruins – much like Ryan Gosling, who sets his directorial debut in a fictional suburb of Lost River Detroit.
Detroit‘s problems are more than fiction. Imagine France selling the Mona Lisa to pay off debt obligations to the EU. Unimaginable, yet Detroit may well have to sell its Rembrandts to pay its creditors. How was this possible for a city that was one of America’s largest in the 1950s and home to the hallmark of its prosperity, the automotive industry? Two forces stand out.
The first was a massive population loss due to people moving into suburbia – ironically supported by the ever more affordable car and ever more extensive highway system. In 1950, the city had 1.8 million inhabitants; in 2012, only 700,000 remained, a 60% decline. This sent property values tumbling, and dramatically reduced the city’s property tax revenues.
Second, the dominant automotive manufacturing hub faced severe job losses due to more efficient production processes, international competitors and cheaper domestic labor, mostly in southern states like Alabama. The challenge of adjusting public expenditure in the face of severe population and job losses should not be underestimated. Municipal services such as public safety and infrastructure maintenance entail large fixed costs, which make it difficult to quickly downsize when usage declines. Detroit did not succeed in making the necessary cuts.
Detroit’s biggest single mistake was the failure to rein in rising legacy costs – pension contributions and health-care benefits THE NAIL IN THE COFFIN
Its biggest single mistake was the failure to rein in rising “legacy costs” – pension contributions and health-care benefits for public employees. It did not move to a contributed benefit scheme when the state of Michigan did so in the mid-1990s. It also offered unfunded health-care benefits on generous terms especially for coverage of dependents such as spouses. This put the city’s budget under increasing pressure in the 2000s when health care costs soared.
The city’s pension system also made voluntary distributions for several years, which were not warranted by underlying investment returns and effectively increased the level of unfunded liabilities by an estimated $1.9 billion. In 2005 and 2006, to plug the pension gap without running into a debt ceiling set by the state of Michigan, the city administration, together with investment banks, devised complex financial transactions. At the time, the so-called “certificates of participation” (COPs) were hailed as an ingenious way of funding pensions. However, they turned out to be the proverbial nail in the coffin when the city faced potentially large upfront termination fees for associated interest rate swaps, triggered by rating downgrades.
Municipal bankruptcies are very rare compared to corporate ones and so the outcome for specific claims against Detroit are far from clear PANDORA’S BOX
Detroit’s bankruptcy, filed by its state appointed emergency manager on July 18, 2013, opened a Pandora’s box of thorny legal issues. Municipal bankruptcies are very rare compared to corporate ones and so the outcome for specific claims against Detroit are far from clear and as of writing, they still hang in the balance.
Likely the biggest issue is the inclusion of (accrued) unfunded public pension claims. The federal bankruptcy judge decided that public pension claims can be part of the bankruptcy procedure and thus could be impaired in general. However, retiree and employee organizations as well as the state’s attorney general argued that public pensions should be protected, based on clauses in the Michigan state constitution. Several appeals are pending. Since constitutions in other states like Illinois and New York contain similar clauses this issue has attracted countrywide attention.
The city’s proposed treatment of its bondholders also faces legal challenges. In an unexpected move, the city proposed to treat parts of its “general obligation bonds” as unsecured claims. While general obligation bonds do not pose the biggest claim on Detroit, there are hundreds of billions of these bonds issued by other US municipalities.
In particular, the suggested impairment of unlimited tax general obligations (ULTGO) caught investors by surprise. They saw the bonds as “secured” by both an unlimited and voter-approved pledge to levy property taxes in whatever amount necessary as well as the promise to set aside the revenues necessary for paying back the bonds before using it for other purposes.
Planning to treat ULTGO bonds on par with unsecured claims sent ripples through the municipal bond market. Several Michigan municipalities postponed new debt issues fearing higher interest rates required by investors, and affected bondholders have objected to the city’s proposal before the bankruptcy court.
Detroit’s emergency manager is now also questioning the legality of the COPs, arguing that the whole transaction, including the incurred debt, was void from its beginning because it violated state set debt limits. Of course, the holders of the COPs – to a large part European banks – disagree.
As for assets available for satisfying claims, the biggest battleground is the Detroit Institute of Art (DIA), which is owned by the city and not by a non-profit foundation like many other civic museums. This means any debt adjustment proposal by the city that does not attempt to use this asset (read “sell”) to ease the losses of creditors could be deemed “not in the best interest of creditors.
In terms of Chapter 9 in the Federal bankruptcy code, the settlement plan must result in a better outcome for creditors than the rejection. However, the code also stipulates that the plan be “feasible, that is, the municipality must be able to make the promised payments under the plan and still offer public services at an appropriate level.
If these conditions are not met, the bankruptcy judge cannot confirm the city’s restructuring proposal. The non-profit organization running the museum’s operations as well as the state’s attorney general argue that the DIA holds the collection in trust for the Michigan public and cannot sell off pieces to satisfy creditors of the city. In addition, many of its pieces were donated with provisions that prohibit selling.
NEGOTIATIONS DRAW FLAK
The months after the bankruptcy filing saw intense negotiations between the city, its creditors and other stakeholders such as the state of Michigan. In terms of Chapter 9, the bankruptcy court will decide who loses more and on what scale.
The initial proposals by the city drew flak from both pension claimants as well as bondholders. While the proposed cuts favored pensions over bondholders,they still amounted to an average 34% cut to pensions for general public employees. Additionally, future inflation adjustments would be eliminated.
Finally, the large unfunded health-care retiree benefits were to be severely cut by setting up an independent health-care trust with a one-time payment and otherwise completely freeing the city from health-care obligations.
The proposed cuts met with heavy public resistance and countrywide media coverage. While pensioners’ annual pensions averaged between $20,000 and $30,000, banks were demanding swap payments related to COP transactions in the hundreds of millions of dollars and ULTGO bondholders wanted to be paid back in full.
Chapter nine bankruptcy
According to chapter nine of the US federal bankruptcy code, a municipal debtor must provide a plan of debt adjustment that details cuts to creditors. The plan is confirmed or rejected by a bankruptcy judge. To confirm the plan the judge needs to deem it “in the best interest of creditors” and “feasible”. Under chapter nine, “the best interest of creditors” is measured against the hypothetical outcome of an uncoordinated non-bankruptcy foreclosure. In other words, the plan’s confirmation must result in a better outcome for creditors than its rejection. “Feasible” means that the municipality must be able to make the promised payments under the plan and still offer public services at an appropriate level. Additionally, at least one impaired creditor (class) must have agreed to the plan. The judge may then impose the plan on dissenting creditors if he deems it fair, equitable and not unfairly discriminating. This means unsecured creditors are not all treated equally.
Pensioner representatives expected that over time the cuts would push close to 20% of retirees below the federal poverty line. Bondholders and banks on the other hand argued that they were either protected by special pledges on city revenues, were entitled to be treated on par with other unsecured creditors (read “pension claims”) or that they had legally valid claims since the city knew what it signed-up for.
The battle now is centered on the DIA settlement. Some of the DIA collection had been acquired at least partially with city funds (among them paintings by Breughel, Rembrandt and van Gogh bought in the automotive heydays of the 1920s and 1930s). At one point retiree representatives and financial creditors were allegedly close to striking a potential 50-50 deal on the revenues of a potential DIA sale.
However, in a surprise move, another proposal was mediated: In exchange for the transfer of the ownership of the DIA collection to the museum, several charities, the state of Michigan and the museum agreed to come up with an aggregated $816 million of outside funding to be used exclusively to limit pension cuts.
Bondholders balked at the idea of being sent away empty handed. One legal expert dubbed the proposal “Detroit’s clever and likely illegal art-for-pension deal”, based on the Chapter 9 requirement of not “discriminating unfairly” between creditors. To prove a higher value the bondholders have solicited outside bids for the complete collection, which tentatively reaches up to $2 billion.
LESSONS TO BE LEARNT
At the time of writing, the tussle over the DIA and the morally fraught task of balancing bondholder claims against the needs of retirees continues to make legal history in the US. In the meantime, the case is showcasing lessons for all the parties involved.
First, pension claimants should be aware that their claims are only as good as the assets backing them. The defined benefit claim will be in doubt if it is not adequately funded and/or the employer’s future finances are not too rosy and the claim is not backed by a third party.
Municipal bondholders need to be aware that a debtor’s obligations are not described by its outstanding bonds alone but also by its (unfunded) pension promises. In a bankruptcy case they are probably in for some bad press.
Finally, both pension claimants and bondholders must be aware that public entities like municipalities are usually not liquidated to go out of business, but need to become attractive enough to pull in new (tax-paying) residents and businesses in the long run. For this they need to have sufficient funds left to provide public services. Or as one municipal bankruptcy expert puts it: “You have to find a way to make sure that next 911 call is dealt with.” So, holding on to that Rembrandt and the DIA might be a good idea after all.
This article was originally published in July 2014, before Detroit’s restructuring proposal was confirmed by a bankruptcy judge.