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July 22, 2013


The practice of capitalism involves risk. You, your company or partnership may make or lose money. It follows that others who extend such businesses credit in goods and services are also taking a risk. Risk is involved all along the spectrum from beginning to end, and lenders, whether shareholders, bondholders or those who provide inventory and other forms of credit, whatever their degree of sophistication in investing or extension of credit, understand that they may lose part or all of their investment(s) or that their goods may be sold and their billings may go unpaid in whole or in part as the particular corporation takes Chapter 11, goes into receivership or involuntary bankruptcy on a petition brought by creditor(s).

The same general guidelines apply to Chapter 9 (as with Detroit) except that Chapter 9 has application to only a narrow band of governmental entities. Governments are not designed to make profits; they are involved in providing services to their citizens and others within their jurisdiction (police, fire, streets and roads etc.). Their “income” is derived from taxes and fees.

Unlike ordinary corporations, whether privately or publicly held, they “provide” rather than “sell” services to the general public, in return for which those who consume such services pay taxes and fees. When, as in Detroit, the tax and fee base is drastically reduced by out-migration of people and loss of industrial base to the Orient and elsewhere (among other reasons), there results an inability to pay such creditors with the further result that the vultures start lining up at the Chapter 9 feeding stations, each noisily proclaiming a right to first priority to the court’s ultimate distribution of the bankrupt’s assets.

There is a large target to shoot at – Detroit is 18 billion dollars in debt – and the battle in court will be between bondholders on one side and public employees and pensioners on the other. (We can be thankful there are no shareholders in the upcoming brawl.) With a Chapter 9 statute whose terms case law has not entirely fleshed out yet, and with Detroit as the biggest entity to ever file in Chapter 9, I think (as I suggested in Part I of this essay), that there may be new and novel interpretations of some of the applicable portions of the Act that will be subject to appeal. The Emergency Manager Kevyn Orr has stated that he expects to have this matter wound up by the end of 2014. Given the size and complexity of this case along with the time involved in likely appeals, I think that PR estimate unrealistic.

Aside from the likely horrendous losses to bondholders and layoffs and reduced pensions to retirees, there are ripples elsewhere from Detroit’s Chapter 9 filing. The threats have started rolling in. Angry public employees in Detroit, with little to lose, are mum on questions of whether they are thinking strike. The Securities Industry and Financial Markets Association wrote a letter to the governor and state treasurer of Michigan warning that if bondholders are mistreated in this bankruptcy proceeding, it will affect how other municipalities in the state are treated by bond investors (i.e., if we don’t get our way in the Detroit bankruptcy matter, we will hit the other municipalities in your state with increased costs for their bonding requirements, which will impact their borrowing costs). Expect more threats from others marginally involved, but most will come from the two with the most to lose – bondholders and public employees/retirees.

Some optimistic commentators are comparing this Chapter 9 filing with that of Orange County, California, which was in and out of a Chapter 9 proceeding in 1994 in less than a year and had a Triple-A bond rating by 2003 (thus significantly reducing its bonding costs). The situations the Chapter 9 filings were designed to correct (as between Orange County and Detroit) are totally different. Detroit is not into “cleaning up a balance sheet” and reducing bonding costs. Detroit has massive debt that band-aid fixes could not correct in its march to Chapter 9 and indeed its filing has to do with municipal survival as a viable municipality rather than a calculated and transparent means of reducing bonding costs. Orange County’s tax base and out-migration were not factors in its filing, unlike Detroit, where it not only has an 18 billion dollar debt, but a declining ability to pay for it due to such circumstances.

I am not a fan of Governor Snyder nor of the state statute which permits appointment of “emergency managers” for municipalities within the state. However, I think Chapter 9 was and is necessary in the case of Detroit, and I hope he and the emergency manager will resist the threats of the bonding industry in doing what is best for the public employees and retirees of the city. From a narrow political point of view, the governor (who is up for reelection) will (I should think) remember that people in Detroit will vote in the next election – and that flacks who write threatening letters do not.

Finally, I have serious reservations about a state statute that permits the appointment of a state czar to totally take over the affairs of a municipality. The democratic process calls for election of a mayor and council to run cities888. If they do a poor job, they can be replaced in the next election since their performance in re bonding debt, how they treat public employees and balance budgets responsibly are certainly subjects for political campaigns.

As for filings of Chapter 9 petitions and the like, a mayor and council have city attorneys and CPAs at their beck and call; they do not need some czar to come in, take over, and make such decisions. He or she was not elected; nor was the governor elected mayor. One might inquire of the governor and the legislature who passed this emergency manager bill how they would like it if our federal government decided that the State of Michigan was in financial trouble and the president appointed an emergency manager to come in and replace the governor and legislature and, perhaps, filed a Chapter 9 petition.

As for Detroit and other such municipalities who may be in financial trouble, there is enough blame to go around, both in Detroit and Lansing. With this filing, we are beyond the issues of human error in how we got here; the point is that we ARE here – so now what?

I come down on the side of public employees and retirees as the least of those who should be penalized for the mistakes of others, and while bondholders are not chargeable with the mistakes of politicians at any level of government, they are very sophisticated investors and must understand that part of the interest they were paid on Detroit’s bonds to date was for the risk they took in issuing such bonds. Their threats to the contrary notwithstanding, you win some and you lose some, as the old saying goes. This is one bondholders should lose when the court is apportioning the meager remains of Detroit’s assets. To the extent that the Act allows discretion in making such findings, I would hope the court would exercise such discretion in its decision. If not, I think the Act should be amended to allow the court to exercise such discretion in its findings. Chapter 9 has not been totally fleshed out by case law to date, thus my use of the phrase “uncertain territory” in the topic of this essay. We will know the governor’s position in this case when Orr files his reorganization plan, which I await with great interest. Stay tuned.  GERALD  E


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