Detroit’s Bankruptcy

Stuart R. Gallant, MD, PhD

Today’s post takes on Detroit’s 2013 bankruptcy.  Bankruptcy is a classic type of multiparty negotiation.  From the point of view of scope, Detroit’s bankruptcy settlement is fascinating, with billions of dollars at stake, negotiated in the glare of national media.  Most remarkably, the negotiation was successful.  The parties were able to come to terms in which every creditor agreed to the deal.

Background

Detroit is located on the shores of Lake St. Clair and the Detroit River, across from Windsor Canada.  Historically, it has been a major manufacturing center for the United States.  However, over a period of 6 decades, from the 1950s to the early 2000s, Detroit fell on increasingly hard times, leading ultimately to bankruptcy in 2013.  Detroit’s bankruptcy did not have just one cause, it had many.  Some of the causes of bankruptcy included:

• Growth of Suburbs:  In the Post World War 2 era, many Americans moved out of crowded cities to suburbs.  This population movement can be summarized in the following table.  From 1950 to 1980, Detroit City loses 0.7 million people, as the metro region gains 1.0 million people.  This represents a loss of some of Detroit’s best educated and most talented workers.

• Loss of Employment:  As population shifted to suburbs, businesses moved from Detroit to the surrounding suburbs, reducing the tax base.
• Shrinking Tax Base:  At the time of the bankruptcy (2013), Detroit had four sources of tax revenue [1]:  1) Property taxes peaked in dollar value at about $1B in the late 1950s.  Even though tax rates had increased since the late 1950s, the absolute yield of property tax dollars had shrunk to less than $250M.  The causes of the loss in revenue were movement of businesses out of Detroit City and degradation of the housing stock within the city.  2) An income tax was initiated in 1962 to capture revenue from workers who commuted into the city.  In 2000, the income tax brought in about $500M, but it shrunk over the following years, bringing in only half that amount in 2012.  3) A utility tax brought in a small amount of revenue (less than $100M).  4) A tax on gambling brought in about $250M at the time of the bankruptcy—without this tax, the budget simply would not balance.
• Poor Management and Outright Corruption:  Mayor Coleman Young, who held office for two decades starting in 1974, recognized that Detroit’s government needed to shrink in line with its reduced population and tax revenue.  His administration cut jobs and programs, allowing Detroit’s debt to drop from $3.3B in 1974 to $1.4B in 1985.  But, starting in 1985, Detroit’s debt increased in an exponential fashion.  The following table lists the level of debt at the end of each mayoral administration.  Clearly, debt was becoming a serious problem in the Archer administration.  Instead, of addressing the problem, the Kilpatrick administration used a shell corporation structure to add $1.44B of debt [1]:

By 2012, it was clear something needed to be done.  The city’s debt had ballooned to $18.5B (more than double what it was at the end of the Kilpatrick administration).  Clearly, Detroit was no longer in control of its debt—the debt was in control of Detroit.  83% of the budget was devoted to police, fire, retiree healthcare, pension contributions, and debt service.  Only 17% of the budget was available for all the other functions of government. Of the $204M budgeted for discretionary items in 2012, $121M was deficit spending, piling more debt onto the city.

Multiparty Negotiations

Bankruptcy is an example of a multiparty negotiation.  Often a multiparty negotiation is conceptualized using a Venn diagram:

Each party is envisioned as possessing a circle within which it will be satisfied by the outcome of the negotiation.  In the simplest representation of this idea, negotiation consists of finding the area in which all parties are satisfied by the outcome (i.e., the red hatched region).  However, several aspects of multiparty negotiations make them unique and risky:

• Initial Marker:  From the point of view of a mediator, it may be tempting to set a marker for one party at a time.  The multiparty negotiation then becomes a succession of two-party negotiations between individual parties and the mediator.  The disadvantage of this approach is that the mediator may not be familiar with the zone of satisfaction for each party.  Because of this lack of knowledge, the mediator may set an initial marker outside the zone of possible agreement (e.g., the red dot in the diagram below).  If that happens, the mediator is stuck with two bad options:  1) go back to the first party to extract additional concessions or 2) face the possibility that some of the parties will not sign onto the final agreement willingly.

• Coalitions:  In a multiparty negotiation, groups of parties may find it strategically advantageous to band together to attempt to extract concessions from the mediator or from the other parties.
• Zone of Possible Agreement:  The Venn diagrams above are depicted with a red hatched area in which it is possible to satisfy all the parties (i.e., the zone of possible agreement).  However, it is possible that such a zone does not exist.  It may only be possible to satisfy a portion of the parties with any practical solution.
• Information Sharing:  In a multiparty negotiation, it is likely that some parties will share information with certain parties while excluding other parties from that information.  Similarly, side negotiations and trade-offs are possible.

Municipal Bankruptcy

In any negotiation, it is important to ask, “What are the rules of this negotiation?” because the rules shape the zone of possible agreement often as much as the needs and desires of the parties shape it.  In the case of municipal bankruptcy, the laws implicitly recognize that people who live within a municipality are entirely dependent on the government for services like police, fire protection, schooling, and public transportation.  Chapter 9 bankruptcy looks to preserve viable local government at the same time it tries to protect the rights of creditors.

Governmental bankruptcies are rare events in the United States.  On average, two or three municipalities declare Chapter 9 bankruptcy each year.  These are usually cities and towns, not larger entities (Orange County, California’s 1994 bankruptcy and Jefferson County, Alabama’s 2011 bankruptcy being exceptions).  The procedures for Chapter 9 bankruptcy include:

• State Law:  To file for bankruptcy, a municipality must exist within a state that authorizes government entities to access Chapter 9.  Many states either fail to authorize municipal bankruptcy or create conditions too restrictive to make it practical.
• Insolvency:  A municipality must demonstrate insolvency (i.e., that its debts are larger than it resources to pay).
• Good Faith Bargaining:  A municipality must have attempted to resolve its debts with its creditors prior to filing for bankruptcy.
• Authority Under Bankruptcy:  Chapter 9 (municipal) bankruptcy is different that Chapter 11 (corporate) bankruptcy.  In corporate bankruptcy, the court’s powers are broad and substantial.  If a corporation is found insolvent, the owners of the company may be left with nothing.  In contrast, Chapter 9 preserves the operational powers for the municipality (or the emergency manager empowered to act in the elected officials’ place).  Even while inside bankruptcy, the city or county can continue to maintain its roads, pay its employees, and undertake new contracts.
• Plan of Adjustment:  To exit bankruptcy, the municipality (not the creditors) must develop a “plan of adjustment” which is presented to the responsible judge.  For the plan to be approved, it must be legal (i.e., comply with relevant state and federal law), be in the best interests of the creditors, not discriminate unfairly between the creditors, and be feasible to implement.

The Negotiation

Judge Steven Rhodes was appointed to oversee Detroit’s bankruptcy.  Broadly speaking, there were five parties involved in Detroit’s bankruptcy negotiations:

• The Government of the City of Detroit:  With strong statutory powers, the state-appointed emergency manager Kevyn Orr was given control of Detroit’s budget and had the ability to set aside labor contracts and sell assets.  Orr recognized that Detroit needed to be able to protect its citizens with fire and police, pave and light its streets, plow snow in the winter, and perform a host of services that would make people want to live in Detroit, rather than abandon it.  So, in addition to solving the city’s debt problem, Orr wanted $1.7B of new spending over 10 years to fix things like streetlights and computer systems, purchase buses, and provide wage increases to workers whose pay had stagnated during the years of budgetary crisis.
• Current Detroit City Workers:  The policemen, firemen, and other city workers were in a difficult position, particularly if they had put substantial time toward their city pension.  It was hard for many of them to walk away, but not all of them needed to walk away to tip the city into an ungovernable mess.  If a significant percent of the city workers took jobs in Detroit suburbs or moved to other cities, the city could grind to a halt.  Throughout the negotiations, the unions representing the city’s workers were visible and vocal advocates for their members, reminding everyone who would listen of the important services they provided.
• Retirees Receiving Healthcare and Pensions from Detroit:  The retirees were perhaps the most vulnerable in this negotiation.  Many were entirely dependent on their pensions because, as city workers, they had not paid into Social Security.  If they took a significant hit in the negotiation, many would not be able to pay their rent or buy groceries.  But, in a way, this was also a strength of their bargaining position.  It would be extremely difficult for the bankruptcy judge to endorse a plan that put tens of thousands of retirees on the street.  And, they had one other card to play, Michigan state law said that pensions could not be reduced in municipal bankruptcy.  (On the other hand, federal law allowed pensions to be reduced in bankruptcy, so the law was unclear.)  If the retirees felt that they got unfair treatment, they could attempt to litigate against the plan of adjustment.
• Unsecured Creditors of Detroit:  Secured creditors held debt tied to specific streams of revenue (for example the revenue of the city’s water and sewer system)—they stood to recover 100% of their capital.  But, unsecured creditors were not so lucky—what they recovered was the subject of negotiation within the bankruptcy.  These creditors had little leverage in the negotiation.  They could express their dismay at the “haircut” they were to receive, and they could refuse to sign onto the plan of adjustment.  Ultimately, they could appeal the plan if they felt that they had grounds, perhaps delaying or casting a shadow over the plan.
• Bankruptcy Mediator:  Judge Gerald Rosen was appointed to act as a bankruptcy mediator, working with the parties to narrow differences and flesh out possible terms.  However, Rosen acted as more than an honest broker.  He developed a mechanism to bring additional funds into the settlement.  Detroit had authority over the works in the collection of the Detroit Museum of Art.  Rosen realized that these works of art would become targets of liquidation in bankruptcy, leaving the city with a huge cultural vacuum.  Rosen created a deal in which private foundations and the Michigan state government were solicited for funds to protect the Detroit Museum of Art, and the funds were then used to protect the city’s pensioners.  In effect, the donations were a pass through to the retirees which had the effect of protecting the city’s art in perpetuity:

The negotiations proceeded from July 18,2013 when the city filed for Chapter 9 to November 7, 2014 when Judge Steven Rhodes accepted the plan of adjustment.  Some significant milestones in the negotiation were [2]:

• Kevyn Orr had a vision for the city with the people of Detroit at the center of his vision, but he was no cupcake.  Shortly after filing for bankruptcy, Orr made his first offer to pensioners with 50% reductions to retirement benefits and major cuts to healthcare coverage.  This and other early offers to unsecured creditors had the effect of sobering all the parties in the proceeding.  This was in effect a low ball first offer.
• Orr used his powers to put other markers down.  For instance, he named a new chief of police, James Craig, who came from the Cincinnati police force.  Craig would work to restore morale, reduce response times, and improve documentation systems.  By naming the new police chief and supporting the police force, Orr wanted to signal that Detroit was still open for business.
• Both Bank of America Merrill Lynch and UBS held significant debt from Detroit.  They attempted to settle with the city early in the bankruptcy process.  First, they cut a deal for 75¢ to 87¢ on the dollar.  Then, they and the city cut a more modest payout for the banks in a second deal.  Both times, Judge Rhodes nixed the deal, indicating that he would not tolerate side deals that might make the overall settlement impossible or might burden the city with too much debt imperiling its financial health after emerging from bankruptcy.
• Two of the last holdouts on the plan were bond insurers Syncora and Financial Guaranty Insurance Company (FGIC).  They stood to lose a lot in the bankruptcy—Syncora would receive $25M on a $400M claim.  As financial institutions, they did not have the public sympathy that either the pensioners or the city workers received.  But, they had one thing on their side—if the city ruined them, then the reputation of Detroit in financial deals would suffer.  Both Syncora and FGIC were able to cut sweetheart real estate side deals with the city that did not make them whole but offered the opportunity that over time they could make good some of their losses in the bankruptcy.  With Syncora and FGIC signing on, essentially all the large unsecured creditors were inside the bankruptcy deal.
• The cost of the bankruptcy in terms of fees to lawyers and financial professionals was $170M to Detroit, an index of the Herculean effort required to put Detroit’s financial house in order.  Of course, the savings in forgiven debt was many times that figure.  Ultimately $7B was removed from Detroit’s books, leaving Detroit with somewhat more debt in November 2014 than it had at the end of the Kilpatrick administration.

Conclusions

Multiparty negotations are often difficult and time consuming, as was the case in Detroit’s 16 month bankruptcy.  Two significant features of this negotiation were:

• An iterative approach to the negotiation in which early offers to the pensioners, the unions, and the financial institutions were revised, sometimes significantly, until a zone of satisfaction was located.
• Creative enlargement of the pie was critical to drafting the final plan of adjustment.  The most impressive addition to the plan was the $800M added to preserve the art held by the Detroit Museum of Art and to protect the retiree pensions.  And, the sweetheart real estate deals with Syncora and FGIC were critical to bringing those creditors into the plan.  The latter is an example of the strategy of “is there something that would cost little to one party and would mean a lot to another party?”

It’s a credit to emergency manager Kevyn Orr, bankruptcy judge Steven Rhodes, and mediator Gerald Rosen that they were able to resolve the financial crisis and return the city to democratic administration.  As Eminem rapped, “You only get one shot, do not miss your chance to blow.  This opportunity comes once in a lifetime.”

[1] Bomey, N. and Gallagher J.  “How Detroit went broke: The answers may surprise you – and don’t blame Coleman Young,” Detroit Free Press, Sept. 15 (2013).  All dollar values adjusted to 2013 dollars.

[2] Bomey, N.  Detroit Resurrected:  To Bankruptcy and Back, W.W. Norton and Company (2017).

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