On July 18, 2013, the City of Detroit, Michigan became the largest city to file for rehabilitation under Chapter 9 of the United States Bankruptcy case. Detroit, through its financial manager, is seeking to restructure approximately $18 billion in accrued liabilities, including unsecured debt and other liabilities of $11.5 billion, and secured obligations—including swap obligations—of $7.3 billion. A summary of the City’s obligations is as follows:
|General Obligation Bonds/Notes||$641 million|
|Unfunded Pension liabilities||$3.500 billion|
|Unfunded Other Post-Employment Benefits (“OPEB”) liabilities||$5.700 billion|
|Other unsecured obligations||$300 million|
|Water and Sewer Bonds||$5.800 billion|
|State Revolving Loans Relating to Water & Sewer||$530 million|
|Secured General Obligation Bonds (State Aid)||$440 million|
|Swap Obligations||$344 million|
|Other secured obligations||$97 million|
Prior to causing the City to file its chapter 9 petition, the state-appointed emergency financial manager for the City gave its major creditors a restructuring proposal that proposed a write-down of 80%-90% on the City’s unsecured claims (including the City’s general obligation bonds, its unfunded pension liabilities and unfunded OBEP). Under the proposal, the City offered to pay unsecured creditors a pro rata distribution of $2 billion in principal amount of interest-only, limited-recourse participation notes.
Prior to commencing its bankruptcy case, the emergency manager was able to reach an agreement with only one group of creditors—the swap providers. Thus, judging from the litigation that was commenced both before and immediately following the chapter 9 petition, it appears this bankruptcy case is likely to be long and protracted.
Now that the City has filed its chapter 9 petition, the next step is for the bankruptcy court to determine whether the City actually is eligible to be a debtor in a bankruptcy case. Before allowing the bankruptcy case to proceed, the bankruptcy court must first determine that the chapter 9 petition by the city satisfies the statutory requirements. (This requirement is unique to chapter 9 cases; a corporate debtor who files a voluntary chapter 11 petition does not need to go through these proceedings.) The chapter 9 requirements include:
- The City must be expressly and directly authorized to file for bankruptcy by the state;
- It must be insolvent;
- Its bankruptcy petition must have been filed in good faith;
- It has or wants to develop and implement a plan to adjust its debts; and
- It must demonstrate that it has tried and failed to negotiate a debt readjustment for all of its major obligations (including pension and other OPEB liabilities and financial debt obligations) or that such negotiations are impracticable.
These proceedings are often heavily contested by creditors, requiring the court to conduct an evidentiary hearing over many days. Here, bondholders, the unions, retirees and other creditors are objecting to eligibility on grounds that, among other matters, the petition was not filed in good faith or that the City did not make efforts to negotiate a debt readjustment before filing its chapter 9 petition.
Signaling that the bankruptcy court intends for this case to be resolved as quickly as possible, the bankruptcy court has imposed a very aggressive schedule for the determination of the City’s eligibility to be a chapter 9 debtor. By order dated July 30, 2013, the bankruptcy court set the following dates and deadlines.
- Deadline to file objection to eligibility (August 19th)
- Deadline to submit pretrial briefs and proposed joint final pretrial order (October 17th)
- Pretrial conference (October 21st)
- Eligibility trial (commencing October 23rd)
- Deadline for City to file its plan of rehabilitation (March 1, 2014)
By motion filed on July 24, 2013, the City requested the bankruptcy court to authorize it to assume a forbearance agreement that the City entered into with its swap providers relating to interest rate swap agreements that the City entered into in connection with the City’s issuance of its $800 million 2006 Pension Obligation Certificates (the COPS). The swap agreements were entered into in order to hedge against its variable interest rate exposures on the COPS. The City’s obligations to the swap providers are secured by a pledge by the City of certain casino revenues, including payments from the developer’s of the City’s casinos and taxes upon each casino’s gross receipts. The casino revenues are deposited into a collateral account held with U.S. Bank, N.A., as collateral agent. After depositing certain of the casino revenues into an account held for the benefit of the swap providers, U.S. Bank, as collateral agent, releases the balance of the casino revenues to the City, approximately $170 to 180 million annually over the next ten years.
Because of various defaults and early termination events under the swap agreements, the swap counterparties have the right to terminate the swap agreements and require the City to make termination payments, which the City estimates could be approximately $300 million. Under the forbearance agreement, the swap providers agreed to forbear, during the term of the forbearance agreement, from exercising their rights to terminate the swap agreements. The City also negotiated the right to cause the swap providers to terminate the swap agreements. The City may terminate the swap agreements and pay the swap counterparties 75% of the mid-market value of the swap agreements if the option is exercised through October 31, 2013; 77% if exercised between November 1 and November 15; and 82% if exercised between November 16, 2013 and March 13, 2014. The City also will pay any unpaid amounts then owing under the swap agreements. The City indicated in the motion to approve the forbearance agreement that the City entered into the forbearance agreement in order to obtain access to the casino revenues, which were desperately needed for the City’s operations. Several parties, including the sureties of the COPS, have filed objections to the City’s motion and the Court has referred the City and those parties who filed objections to the motion to mediation before Judge Rosen, as described below.
A few of the major issues affecting Detroit (to be determined after the bankruptcy court determines the City’s eligibility to be a chapter 9 debtor) are the following:
- Treatment of holders of the City’s general obligation bonds. Generally, general obligation bonds are treated under the Bankruptcy Code as general unsecured claims, entitling the distressed municipality to suspend interest and principal payments during the pendency of the bankruptcy proceedings. The question for the City and for investors in the City’s bonds is whether holders of general obligation bonds are entitled to a preference under the City’s plan of adjustment over other unsecured claims, including pension obligations. What about the state’s constitutional or statutory protection for bond debt? Are those provisions effective in a chapter 9 bankruptcy proceeding?
- Treatment of the City’s revenue bonds, such as the water and sewer bonds. Generally, holders of revenue bonds are entitled to be paid from the revenues generated by the assets that they financed, after deducting the operating expenses of that enterprise. Holders of these bonds generally are not expected to suffer substantial losses—the City proposes to treat these obligations as secured obligations. The City will cause a newly formed authority (the Metropolitan Area Water and Sewer Authority) to issue new notes, the proceeds of which will be used to pay the existing water and sewer bonds. The City also indicated in its proposal to creditors that it intended the restructured notes (perhaps in connection with a concession for or lease of the Detroit Water & Sewer Department), the City would receive a monthly transaction payment to cover certain of the legacy benefit obligations.
- Treatment and priority of the City’s pension obligations and other OBEP liabilities. Generally, pension obligations are general unsecured claims entitled to no priority in a bankruptcy case. What about the state’s constitutional or statutory protection for pension obligations? Do these protections, if any, extend to the City’s OBEP’s? The emergency manager has lumped the pension and OBEP liabilities with the City’s general obligation bonds and other unsecured claims.
Most of these issues are issues of first impression—Judge Rhodes, the judge presiding over the City’s bankruptcy case, will be determining these issues with limited precedent. Recognizing the likelihood for protracted litigation, by order dated August 13, 2013, Judge Rhodes appointed Chief District Judge Gerald Rosen as a mediator to facilitate negotiations amongst the various parties.