Detroit Update

On Friday of last week, Detroit Emergency Manager Kevyn Orr released his bankruptcy plan of adjustment detailing how the city will emerge from bankruptcy. This is a key step in the city’s bankruptcy process as it lays the groundwork for how the city’s finances will look after negotiations among stakeholders. A Chapter 9 municipal bankruptcy plan’s purpose is to detail the haircuts, restructurings, and new investments in city services that will have to occur in order to realign the city’s expense base with its current financial resources. The element which distinguishes this case from other forms of bankruptcy is “the new investments” part of the plan, which ensures that the bankruptcy will not only satisfy the claims of creditors but also meet the needs of city residents by providing improvements in city services, with the goal of making the city an inhabitable place again.

The marketplace has labeled the plan as “controversial” for its treatment of general-obligation bondholders as unsecured creditors. The muni market has long viewed the general-obligation pledge as a “senior and secured” pledge which compels an issuer to use its “full faith and credit” to repay the bonds by raising taxes – before paying other creditors. The plan contains no tax increases and instead proposes haircuts of 80% on GO bondholders, greater than the 70%-80% cuts for pension beneficiaries, effectively subordinating GO debt to claims of pension beneficiaries. Bond insurers, who have insured $641 million of general-obligation debt, have argued in mediation that under state statute and existing case law, general-obligation unlimited tax bondholders should receive preferential treatment over other creditors because of their secured status. Not so in this case. The emergency manager’s viewpoint is that the city’s residents have paid a hefty price in the years leading up to bankruptcy in the form of reduced health and public services, high crime, and urban blight. As is, with 30% of its residents living below the poverty line, Detroit is the second-highest-taxed city in the state of Michigan; thus the capacity for further tax increases to repay bondholders is limited.

Other post-employment benefit (OPEB) beneficiaries will likely receive 10% of original value, and holders of Certificates of Participation or COPS (see Detroit Bites Again) are offered a low settlement with drastic haircuts typically not seen in Chapter 9 bankruptcy cases. The plan also addresses Detroit Water and Sewerage Department debt, classifying it as bankruptcy-eligible and thus subject to automatic stay provisions – a questionable interpretation, as Chapter 9 states that special revenue debt is not legally direct debt of a bankrupt entity. Instead, it is self-supported by a dedicated revenue stream as part of a bankrupt entity’s ongoing operations. In this case, Detroit water and sewer bonds are impaired by an exchange for notes in a new authority and subordination of debt service payments to payments back to the city.

The plan will have far-reaching consequences for how municipal bond investors perceive risk and return in the marketplace. Spreads on general-obligation debt are likely to differ by state based on statutory authority to raise taxes, and the market’s perception of “safe-haven asset” may switch from general-obligation debt to self-supporting debt not subject to automatic stay. Detroit’s emergence from bankruptcy will likely be a long, litigated process that could take years, with high direct and indirect costs. We will follow closely and keep readers apprised of new developments.

BY David R. Kotok