Analysis: Constitutional, good faith arguments unlikely to halt Detroit bankruptcy

By Nick Carey

Tue Aug 20, 2013 2:26am EDT

(Reuters) - The key to eligibility for U.S. Chapter 9 bankruptcy protection for Detroit, as it is for any municipality, lies in proving the city is insolvent and has negotiated in good faith with creditors.

Few could disagree that the city is in woeful financial shape. It has long-term debts of $18.5 billion and has seen its population decline to 700,000 from a peak of 1.8 million in 1950, a loss of tax base that would cause trouble for any city.

Even in that diminished state, Detroit's July 18 filing for bankruptcy protection was by far the largest in U.S. history.

The court fight is likely to be protracted and costly, with creditors facing steep losses and fears over potential loss of benefits for more than 9,000 workers and over 23,000 retirees.

In filings Monday, unions representing workers have focused on whether state-appointed emergency manager Kevyn Orr's team has negotiated in good faith.

However, the bulk of their arguments boiled down to whether the city's bankruptcy filing contravened worker benefit protections enshrined in Michigan's state constitution. A separate, surprise argument claimed that Chapter 9 of the U.S. bankruptcy code itself violates the U.S. constitution.

Unions representing Detroit's police and firefighters went a step further, arguing "one of the City's express purposes... is to attempt to use these Chapter 9 proceedings to illegally impair the constitutionally protected pension rights" of employees and retirees.

Both the "good faith" and constitutional arguments will likely face an uphill battle in an October hearing in front of presiding federal bankruptcy judge Steven Rhodes, bankruptcy experts said Monday.

The most unorthodox argument put forward was the states' rights argument by the American Federation of State, County and Municipal Employees. The union representing Detroit city workers in essence is challenging decades of legal proceedings in which courts have found that federal bankruptcy law trumps state laws.

According to Sharon Levine of law firm Lowenstein Sandler LLP, counsel for the union American Federation of State, County and Municipal Employees (AFSCME), the union "firmly believes that a decision of this constitutional magnitude is not properly within the jurisdiction of any bankruptcy court."

Chapter 9, she added, breaches Michigan's constitution and the U.S. constitution "because it attempts to permit impermissible federal encroachment on the states' rights."

But that argument is a tricky one to make in court, not least of all because no one has challenged the constitutionality of Chapter 9 since the Supreme Court upheld it in 1938. Even a major revision of the bankruptcy code in 1976 did not invite any new challenge.

"We bankruptcy lawyers take the constitutionality of municipal bankruptcy as gospel because the Supreme Court decided it was constitutional," said Marc Levinson, a bankruptcy lawyer who represented Stockton and Vallejo in California.

RULE ANOTHER DAY

The issue of Michigan's constitution and its provision specifically preventing the impairment of worker and retiree benefits is more complicated than the federal argument.

In its objections filed Monday, the United Auto Workers described the city's Chapter 9 filing as a deliberate ploy by Michigan's Republican Governor Rick Snyder and the state-appointed emergency manager Kevyn Orr to use the proceedings as a "blunt instrument" to "to force retirees and pension-vested workers into negotiating away their benefits, despite the protection afforded those benefits by the Michigan Constitution.

"The lawful exercise of federal municipal bankruptcy power is critically dependent upon the municipality's adherence to state law," the UAW argued.

According to Douglas Bernstein, a bankruptcy attorney with Plunkett Cooney in the Detroit suburb of Bloomfield Hills, the UAW may find its constitutional argument difficult to make in an eligibility hearing.

Among the reasons is that while Orr provided a rough settlement proposal for creditors on June 14, he has not provided a specific restructuring plan yet - making it difficult for the union to prove that Orr intends to impair pension benefits.

"It's a problematic argument to make because there is a settlement proposal but not the plan itself," Bernstein said.

Michael Sweet, a bankruptcy attorney with Fox Rothschild who helped the city of Richmond, CA to restructure its finances in a successful effort to avoid bankruptcy, said the argument over Michigan's constitution could well fall outside the key considerations Judge Rhodes will apply in Detroit's eligibility hearing: is the city solvent and has it negotiated in good faith?

"I think he is going to view this quite narrowly in terms of eligibility," Sweet said. "The question of constitutionality is something that will happen in the future. It is not something in front of the judge right now."

Sweet added, though, that as Michigan's constitution is an important issue for Detroit's bankruptcy case, the unions could be sending the judge a message that constitutionality will need to be addressed at some point.

"If Judge Rhodes ultimately decides that Detroit is eligible, I am confident he will do so noting that he has not ruled out a subsequent ruling on the issue of constitutionality," he said. "There will almost certainly be a ruling at some point because this is a very important issue."

GOOD FAITH THRESHOLD

Bankruptcy experts say the strongest argument made by the unions on Monday concerns allegations over whether Orr has negotiated with unions in good faith.

The objections filed Monday by the unions representing Detroit's police officers and firefighters allege that "there were no negotiations" in the weeks leading up to the city's bankruptcy filing.

"Contrary to the City's claimed efforts to negotiate in good faith... the City has consistently sought to block... (police and firefighter unions') efforts to negotiate terms and conditions of employment," the unions argued.

Chapter 11 corporate restructurings are relatively commonplace, but there has been a relative paucity of Chapter 9 filings, so Judge Rhodes will have few precedents to draw on in making rulings on the good faith arguments.

"There is no discernible standard for what constitutes good faith," said Pat O'Keefe, president of O'Keefe and Associates, a turnaround firm based in the Detroit suburbs.

Negotiations still would take place as part of the Chapter 9 process, so the judge may decide to approve Detroit's bankrupt status and let talks proceed from there.

"The judge may rule that negotiations are a perfunctory task," he said. "Honestly, I don't see how the city gets healthier outside of Chapter 9."

Plunkett Cooney's Bernstein said the police and firefighter unions' claims of a lack of effort on Orr's part "deserves scrutiny."

"If it's a close call the tendency in such cases is to err on the side of the city and give them a chance to restructure and reorganize," Bernstein said. "But that doesn't mean the city won't have to make a strong case," he added.