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March 6, 2014

Bankruptcy is about who is first in line among creditors. Secured creditors are first in line, one-upped only by “costs of administration” and creditors who by the terms of their agreements may be first in line of secured creditors. Definitions matter. Bankruptcy courts have enormous power to make findings that may totally rearrange standings of creditors to share in the bankrupt’s estate, especially under Chapter 11 of the bankruptcy code. Detroit’s bankruptcy is, of course, municipal, which comes under Chapter 9.
Detroit’s filing is the largest Chapter 9 filing ever and, as usual, creditors are lined up at the trough claiming preference (a word of art in bankruptcy lore). Bankruptcy Judge Steven Rhodes is in charge of the judicial determination of who gets what and how much and when. A state statute provides for the appointment of an emergency manager in Michigan and Republican Governor Snyder appointed Kevyn Orr to that position. Orr filed a Chapter 9 petition in bankruptcy for the City of Detroit. Orr is a partner of the international Jones Day law firm on leave while serving as emergency manager. Jones Day law firm is being paid 18 million dollars to represent the City of Detroit. The costs of Orr’s personal bodyguard and his downtown $4,200 a month condo at the Westin Book Cadillac are, of course, payable either as part of his compensation as emergency manager or as a cost of administration of the bankrupt’s estate. In either event, such expenses are likely and ultimately to be payable from the bankrupt’s estate.
Most of Detroit’s billions in debt are unsecured and such creditors will probably get pennies on the dollar, if anything, as they are last on the food (preference) chain. After costs of administration are paid, that leaves secured creditors, or are there yet other claims in front of theirs? There are. The lawyers have established their preferred status with claims under “costs of administration,” and now it’s the bankers’ turn to be paid in full under the terms of the following agreement (after a discussion of the terms of such agreement). Bankers and lawyers first; as for the rest – get in line. Guess who wrote the bankruptcy code which sets out priorities in preference? Hint – it wasn’t the unsecured creditors.
Detroit has had a population outflow and diminishing tax collections for many years, peaking in the 2008 catastrophe brought on by Wall Street banks. The city had a cash flow problem before that, and (even after layoffs and curtailed public services) was still in the red due to decreased tax revenues. In need of cash, the city entered into contracts with two investment banks in 2005 and 2006 for a $1.6 billion dollar loan which in and of itself was not a bad idea. What turned out to be bad was the way the loan was structured and how it panned out. The loan was made at a variable interest rate and then used as an interest-rate swap to convert $800 million of the loan to a fixed rate, which again was not a bad idea since locking in a fixed rate protected the city against exposure to long-term interest rate fluctuation. What was a bad idea was how the bankers framed the agreement and got away with it.
The agreement had three triggers; that if Detroit missed a payment on the loan, had its credit rating downgraded, or was placed under the control of an emergency manager, then all the interest due on the debt would have to be paid immediately. All three eventualities occurred, with a downgrade of its credit rating leading the pack. The city, already broke, then faced immediate due dates for payment of $250 million to $350 million dollars, making things worse, like not being able to meet its pension obligations, for instance (which cannot theoretically happen since the Michigan state constitution prohibits “impairment of public pensions”). So who says? Part II will discuss this. Stay tuned. GERALD E


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