Detroit's historic bankruptcy trial has its first day in court

Detroit’s bankruptcy finally entered the courtroom Tuesday, beginning the final phase of a trial to determine if the city can emerge from under the weight of $18 billion in debt.

It has taken Detroit 14 months of mediation, legal wrangling, and behind-closed-door negotiations with creditors and pension groups to bring the city to the courtroom of U.S. Bankruptcy Judge Steven Rhodes.

The five-week trial will, in the words of Judge Rhodes, “determine the future of the city of Detroit.”

The legal battle is not a slam dunk for the city. Not only is Detroit’s Chapter 9 bankruptcy the largest-ever for a U.S. municipality, many aspects of its proposed plan are unprecedented.That includes a so-called “grand bargain” to preserve retiree pensions and protect the city’s art collection, outlined in the city’s plan of adjustment, which cannot proceed without Rhodes’ approval.

Watchers of the unfolding saga say the bargain involves a unique collaboration between nonprofit foundations, the state, and big labor. If approved, it could create a blueprint for other cities facing similar crises, they say. But not everyone is looking on in admiration: Two creditors plan to challenge the plan in court on grounds of fairness.

“This has never been done before,” says Douglas Bernstein, a bankruptcy attorney in Bloomfield Hills, a Detroit suburb. “Every city circumstance is different in how they propose getting funding, but to get funding from an unexpected force like a charitable foundation – that is very unique.”

Under the plan, the city would raise $816 million earmarked for pension benefits over 20 years through the Detroit Institute of Art (DIA) collection. The plan involves spinning off the collection into an independent trust made possible through $366 million pledged by a dozen philanthropic groups such as the Ford Foundation and the Andrew W. Mellon Foundation, $100 million raised by the DIA, and $350 million made available by the state.

The proposal has drawn fire from Syncora Guarantee Inc. and Financial Guaranty Insurance Co., two creditors who are owed $1.4 billion from the city. They say the agreement is designed to benefit city pensioners and therefore violates key tenets of Chapter 9 bankruptcy law, which requires bankrupt municipalities to negotiate in good faith and to treat all parties fairly.

According to the city’s calculations, the pensioners would get six times more money than the bond insurers.

In a pre-trial hearing Tuesday, attorneys for both companies argued that the city has not proven that pensioners are under severe hardship, which would have justified what the attorneys described as more preferential treatment under the plan.

But in his opening statement, city attorney Bruce Bennett defended the plan, saying that it “provides creditors with all the city can provide them [and] that creditors are permitted to reach.”

For his part, Rhodes suggested that finding a legal precedent may not prove a simple matter.

“There’s probably not any case law on this one way or another,” he said.

Despite the unprecedented debt load of this bankruptcy, legal experts say that the 14-month time period it took for the city to make it to trial is far shorter than other municipalities in similar circumstances. For example, the city of San Bernardino, Calif., filed for Chapter 9 bankruptcy in July 2012 and has yet to reach the trial phase.

Complicating matters further, state-appointed emergency financial manager Kevyn Orr’s term ends Sept. 27 – before the expected October end date of the trial.

His reinstatement would need approval from the city council and Mayor Mike Duggan. If Mr. Orr leaves before the trial is over, it could bring the proceedings to a halt, Bernstein says.

Bernstein says that, for that reason, it is likely that Rhodes will try to persuade the city to allow Orr to remain until the trial reaches a conclusion.

“Bringing someone up to speed would be time consuming and would likely affect continuity,” Bernstein says. “I think everybody realizes that it would be awkward and problematic if it happened before the trial was completed.”