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Detroit is Largest Municipality to File for Bankruptcy in US History

photo credit: chuckh6

photo credit: Charles Hildebrandt

Economic collapse, plummeting population and fiscal emergencies culminated in the city of Detroit filing for bankruptcy yesterday, the largest municipality in the country to ever go the bankruptcy route.

“The fiscal realities confronting Detroit have been ignored for too long,” Michigan Governor Rick Snyder said in a statement. “This is a difficult step, but the only viable option to address a problem that has been six decades in the making.”

The filing begins a long, painful odyssey for the city, which in the 1950s was actually the fourth-largest in the country with nearly 2 million inhabitants, but which has seen its population plummet to 700,000.  Middle-class residents — black and white —escaped to the suburbs to flee the city’s rising crime and deteriorating basic services.

One of the populations with the most at stake are retirees, whose pensions may be on the line now as the city begins the arduous process of negotiating with creditors.

This has been the case in other municipalities that filed for bankruptcy. After the nation’s financial meltdown in 2008, Vallejo, Calif., filed for Chapter 9 because it couldn’t pay its pension obligations. In November 2011, Jefferson County, Ala., which includes Birmingham, filed for bankruptcy after becoming mired in Wall Street’s problems.  Stockton, Calif., filed in June 2012 burdened by nearly $148 million in unfunded pension costs and more than $230 million in other debts. Stockton, with a population of 300,000, was the largest city to file before Detroit.

In an exclusive interview with the Michigan Chronicle, former federal bankruptcy judge Ray Reynolds Graves presented several scenarios of what could happen in bankruptcy negotiations.

“The fate of retirees has been a major issue in Chapter 9 whether or not the city cancels its retiree pension plan and force modification,”  Graves told the Chronicle. “In a Chapter 11 (bankruptcy) the parties must negotiate that and there is a process in Chapter 11 you must go through before you can make any changes in employee pension agreements that is not available in Chapter 9.”

Graves said under Chapter 9 the city can cancel pension benefits and the court can’t do anything about it.

“The retirees are going to take a cut in federal bankruptcy court. But how deep the cut is depends on how much money is left to pay creditors,” Graves said. “This is like a giant chess game.”

The bankruptcy filing comes just four months after Snyder appointed emergency manager Kevin Orr, a bankruptcy lawyer, to take over Detroit’s fiscal affairs. When Orr came in, he said the city had an estimated $17 billion in long-term debts and a $327 million annual budget deficit.

The city had already announced in July that it would stop making payments on about $2.5 billion in unsecured loans and had asked some of its creditors — bond issuers, unions and pensioners — to forfeit as much as 90 percent of what the city owed them to avoid bankruptcy. But in the end, it wasn’t enough.

The filing is an effort by the city to avoid lawsuits from creditors unwilling to take such a small percentage of what they are owed.

“It’s a very powerful, protective remedy for people who owe money,” John Pottow, a professor of bankruptcy and commercial law at the University of Michigan Law School, told Time magazine.

The city’s creditors will likely challenge the legality of the bankruptcy filing itself. The majority of bankruptcies in the U.S. fall under Chapter 11 reorganization or Chapter 7 liquidation, which apply to individuals and businesses.

But Chapter 9 bankruptcies allow for the reorganization of municipalities and differ significantly from other bankruptcies.

“A Chapter 9 bankruptcy is still a bankruptcy,” Pottow said. “Although it doesn’t have all the rules of Chapter 11.”

After the filing with a bankruptcy court, the debtor files a plan of reorganization that has to receive the approval of a bankruptcy judge. The debtor then reduces its debts by paying back a portion of what it owes.

While companies can be liquidated to pay off debts, that can’t happen to municipalities under Chapter 9 because it would violate the Constitution’s 10th Amendment that gives states “sovereignty over their internal affairs.”

But while a court can’t order a city to sell its assets, the city can sell off  what it chooses. While assets like police cars or school buses are vital to the functions of a city, there will be others that are not. In May, Orr raised the ire of the public when he reportedly contemplated selling the Detroit Institute of Art’s collection.

In Chapter 9 bankruptcies, cities also have difficulty getting out of contracts negotiated under a collective-bargaining agreement. Detroit must prove to the court that drastic  renegotiating is necessary for the survival of the city.

Orr has said more than 40 percent of Detroit’s revenues were spent on required payments such as pension checks, bond liabilities, health-care benefits and other dues—and those are estimated to grow to 65 percent of the city’s spending in the next four years.

“Certainly Detroit is something on the scale we’ve never seen before, both in terms of the quantity of the debt and also the concession they’re asking the creditors to take,” Pottow says.

While Orr’s reorganization plan will likely ask creditors to accept just 10 percent of what they are owed, in Vallejo creditors got between 5 cents and 20 cents on the dollar. In Jefferson County, some creditors received close to a third of what they were owed.

The statistics in Detroit are abysmally bad.

While Detroit had one of the highest per capita incomes in the country in the 1950s, when auto plants were booming, now it has the highest rate of violent crime among the nation’s big cities. The average police response time in Detroit is almost an hour, while nearly 80,000 buildings are abandoned or seriously blighted, and 40 percent of the city’s streetlights do not work.

Detroit’s jobless rate is above 18 percent, more than twice the national rate.

“The way Detroit is today can’t continue,” Douglas Bernstein, a bankruptcy lawyer in Bloomfield Hills, Mich., told Time. “At some point you’ve got to realize you’ve hit rock bottom, you wipe out the debt that you can’t afford and change the processes that got you in this situation to begin with. You clean up your balance sheets and you should only get stronger as time goes on.”

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