Detroit's bankruptcy battle begins

DETROIT - Detroit's historic Chapter 9 bankruptcy will culminate in a high-stakes court battle starting Tuesday that will determine the fate of the city's sweeping plan that would pay pensioners more than financial creditors, preserve the Detroit Institute of Arts and slash more than $7 billion in debt while reinvesting in services.

With the fate of pensioners' pocketbooks, the museum and financial creditors on the line, the city is facing extraordinary pressure to prove that the grand bargain to resolve the bankruptcy and reinvest $1.4 billion over 10 years in services is fair.

The power to approve Detroit's plan of adjustment or force the city to start over rests with Bankruptcy Judge Steven Rhodes, who will examine hundreds of exhibits and hear testimony from potentially more than 80 witnesses during a trial that could stretch through Oct. 17.

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As Rhodes put it, the proceeding - called a 'plan confirmation hearing' - will determine 'the future of the city of Detroit.'

The city's bitter feud with its holdout financial creditors will take center stage - with the powerful bond insurers bidding to prove the plan of adjustment is a disaster that must be rejected.

'This is the dramatic finale - like when you're watching a movie, this is the big final battle,' said John Pottow, University of Michigan bankruptcy law professor. 'There's going to be fireworks flying.'

Winning the judge's approval won't be easy.

Is grand bargain fair?

This is the dramatic finale - like when you're watching a movie, this is the big final battle.

John Pottow, University of Michigan bankruptcy law professor

The cornerstone of Detroit's restructuring plan is called the grand bargain, which would allow the city to accept the equivalent of $816 million over 20 years from the state of Michigan, non-profit foundations and Detroit Institute of Arts donors to reduce pension cuts and transfer the museum to a charitable trust.

But the city's most vociferous opponents - bond insurers Syncora and Financial Guaranty Insurance Co. (FGIC) - argue that the grand bargain is illegal and amounts to unfair discrimination in favor of pensioners.

When taking into account the grand bargain cash, Detroit pensioners are getting about six times more than the insurers, according to the city's financial calculations.

Syncora and FGIC also contend that Detroit emergency manager Kevyn Orr is frittering away the museum for billions less than it's worth.

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But the city's Jones Day lawyers argue that the deal is fair in part because grand bargain funding was never intended for financial giants.

In addition, unequal doesn't necessarily mean unfair. The city is expected to argue that Detroit pensioners deserve better treatment in part because they are relinquishing their right to sue the state and city over pension cuts. U.S. bankruptcy law allows different unsecured creditors to be treated differently if there's justification to do so.

Still, Rhodes recently reminded the city that it must justify its plan to obliterate the $1.4 billion in city debt insured by FGIC and Syncora.

'I don't think it's a slam dunk,' said Melissa Jacoby, a University of North Carolina Chapel Hill professor who has been closely tracking the case. 'It's possible it can be justified. There's no rubber stamp here.'

During the trial, the city is expected to call as many as 26 witnesses, including Orr, Mayor Mike Duggan, Detroit billionaire Dan Gilbert and Detroit Institute of Arts Executive Vice President and COO Annmarie Erickson. Syncora and FGIC will counter with their own evidence and witnesses in a bid to undercut the credibility of the city's plan.

Are pension cuts fair?

The proposed settlement with the DIA is novel, hasn't been tested anywhere else, is groundbreaking, and that's going to be the focus.

Doug Bernstein, a bankruptcy lawyer representing the foundations that pledged cash for the grand bargain

The valuation of the city-owned museum's property is in dispute and will be a significant issue during the trial.

On paper, the museum's prized collection of more than 66,000 pieces is worth $4.6 billion to $8.1 billion based on valuations conducted by a city-hired expert and FGIC-hired expert, respectively.

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'In essence, you're taking a massive asset of the City of Detroit and taking it away from the citizens of Detroit - and the creditors also,' said James Sprayregen, the lead attorney for Syncora, in an interview. 'Something that could be worth billions of dollars is no longer going to be valuable to the citizens of Detroit. We don't just think this is a bad deal for Syncora; we think this is a bad deal for the City of Detroit.'

But the city's adviser, Artvest Partners, concluded that a fire sale would fetch only up to $1.8 billion. The city says it's not clear whether the museum's art can legally be sold - and municipal bankruptcy law doesn't require the city to sell assets.

'We believe the plan is fair,' Orr spokesman Bill Nowling said, 'and we're going to defend that strongly in court.'

Doug Bernstein, a bankruptcy lawyer representing the foundations that pledged cash for the grand bargain, said the deal is legally unique.

'Let's face it,' he said. 'The proposed settlement with the DIA is novel, hasn't been tested anywhere else, is groundbreaking, and that's going to be the focus.'

Syncora and FGIC will have few allies during the trial.

More than 600 individuals also filed official objections to the plan but for vastly different reasons. Most are angry about pension cuts.

But after an intense series of confidential mediation talks led by Chief District Judge Gerald Rosen - the lead mediator in the case - Detroit reached settlements with all major retiree groups representing more than 30,000 pensioners.

Civil retirees voted overwhelmingly to accept 4.5% cuts to their monthly pension checks, the elimination of cost-of-living-adjustment (COLA) increases and a clawback in excessive annuity payments from 2003-13. Police and fire retirees voted to accept a reduction in COLA from 2.25% to 1%.

U.S. Bankruptcy Judge Steven Rhodes is overseeing Detroit's bankruptcy trial which begins Tuesday, Sept. 2, 2014, in Detroit.(Photo: John Meiu, Detroit Legal News Publishing LLC/file)

Altogether, pensioners are getting about 60% of their unfunded liabilities, while Syncora and FGIC are getting up to 10%.

'Each class of retirees did vote to approve the plan, so it's at a point where we're relying on the city to present and prove its case,' said Ryan Plecha, an attorney for the two Detroit retiree associations that helped negotiate a pension settlement.

The cuts were significantly lower than what Orr originally proposed.

But how will Rhodes decide whether the cuts to pensioners and financial creditors are fair?

In an Aug. 21 hearing, Syncora attorney Stephen Hackney asked the judge to identify which of two well-established bankruptcy tests gauging the fairness of a restructuring plan the judge expects to use.

'There is a third alternative,' Rhodes said, crossing his arms.

Hackney paused. 'The Rhodes test?' he asked.

The judge nodded slowly, without saying anything.

Detroit's future depends on the Rhodes test.

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