On January 18, 2022, Microsoft announced a $68.7B purchase of the video gaming firm Activision Blizzard.  This is a very interesting tale of negotiation for two reasons.  First, in its SEC filing, Activision Blizzard gives us a peak into the negotiation that led to the sale.  Second, as of the writing of this post, the purchase is not completed because it has not yet received regulatory approval.  As a result, the deal could still be altered or even vetoed.  In today’s post, DiscussingTerms looks at the Activision Blizzard acquisition.

Acquisition as a Negotiation

Acquisition is a two-party negotiation (buyer and seller).  In the case of the Activision Blizzard, there are a number of parties not present at the negotiation table (stock holders, customers (users), and government regulators) who have the ability to affect the outcome of the deal.  Most acquisitions are adversarial or competitive negotiations.  Over time a zone of possible agreement is explored and, ultimately, a sale price established.  Representation is common with one or both sides represented by firms specialized in mergers and acquisitions.  (In the Activision Blizzard deal, Goldman Sachs provided financial advice to Microsoft, Allen & Company provided financial advice to Activision Blizzard, and Skadden provided legal advice to Microsoft.)

Activision Blizzard

Activision Blizzard is a company with many positive attributes.  Leading characteristics making the company an attractive takeover target include:

• Intellectual property:  Activision Blizzard’s stable of products includes some of the most well-known video games in the world:  Call of Duty, Guitar Hero, World of Warcraft, Overwatch, Candy Crush Saga, and others.
• Worldwide appeal:  Many cultural products have limited appeal around the world.  Activision Blizzard video games have transcended their point of origin, capturing 370 million users in hundreds of countries.

But, the company has had two significant problems:

• Corporate culture:  In July, 2021, the California Department of Fair Employment and Housing filed suit against the company, alleging sexual harassment and employment discrimination.  The scandal acted as a drag on the company’s stock price as investors manifested concern whether the company’s management could navigate past the legal crisis.
• Competition:  Activision Blizzard’s net revenue has grown in a steady linear fashion for more than 15 years, starting at about $1B in 2006 and reaching almost $9B in 2021.  However, the video game market is tremendously competitive.  As the third largest gaming company behind Tencent and Sony, Activision Blizzard faced major challenges, particularly in the areas of data analytics and machine learning.

Every corporation has two plans.  Plan A is to grow the business.  Plan B is to sell the business.  The five common motivations for a sale of a business unit or a company are:

1. To sell off non-core businesses
2. To flip an asset (in the case of private equity)
3. Insufficient capital to compete
4. Business (particularly small or medium) in which some faction of the owners do not wish to continue to own the business—the classic family business sale
5. Any business in which the current management team is not perceived to be able to maximize the value of the asset

Given the challenges faced by Activision Blizzard in the fall of 2021, the company fell into category 5).  We will see how this situation developed into a negotiation for sale in the discussion below.

Microsoft

Since 2012, Microsoft has experienced exponential growth, a remarkable decade-long record of success:

Microsoft’s cloud services business Azure has played an important role in this growth.  Though the tech sector, and the overall economy took a hit in 2022, growth is expected to continue once anxiety around inflation and concern about the situation in Eastern Europe subside.

The strategic question for Microsoft management is how can the company continue to fuel growth in the coming years?  Management’s answer was the $68.7B acquisition of Activision Blizzard.  The deal represents slightly less than 4% of Microsoft’s 2022 market capitalization.  There are several strategic motivations behind the acquisition:

• Stock price:  Activision Blizzard had led the 2022 fall off in tech stock prices by two quarters, making it an attractive acquisition target.
• Strategic technologies:  Activision Blizzard intellectual property has driven consistent high revenue.
• Synergy and growth:  Microsoft receives significant revenue from gaming.  Addition of Activision Blizzard’s $9B net revenue from 190 countries will increase Microsoft in both breadth and depth.  There is the possibility that the Activision Blizzard acquisition, coming on the heels of Microsoft’s acquisition of Bethesda Softworks, could lead to advances for Microsoft in the so-far ill-defined “metaverse,” allowing Microsoft to better compete versus Meta.
• Spoiling:  By completing this acquisition, Microsoft prevents any of its competitors from obtaining this value for themselves.

This purchase does come with some significant risks:

• Large acquisition risk:  Often large acquisitions underperform due to many complex and some poorly understood factors.  Strategic fit and employee retention are two major factors that if not present can tank a large deal.
• Regulatory risk:  Large corporate mergers and acquisitions are the subject of international regulatory interest.  Regulators could demand that Microsoft alter some aspects of the deal or even scotch the entire acquisition.

Negotiation for the Sale

Negotiation of a sale is a highly ritualized activity.  It begins with a Board of Directors decision to seek a sale, and proceeds through selection of an investment bank, preparation of supporting documentation, and development of a list of possible purchasers.  This leads to an approach to possible purchasers, provision of an information memorandum, an offer expressed in a letter of intent (LOI), due diligence, contract negotiations, a purchase agreement, and closing.

Fortunately for us, some of the important details of the negotiation for the sale are included in a filing with the Securities and Exchange Commission supporting the sale [1].  It is worth noting that Activision Blizzard and Microsoft have worked together for decades on gaming, so it is not unusual that senior executives would be meeting at the time the story in the SEC filing begins:

• On November 19, 2021, Bobby Kotick, chief executive officer of Activision Blizzard, and Phil Spencer, the chief executive officer of Microsoft Gaming, were meeting (following a Wall Street Journal article three days earlier which had alleged that Kotick had known for years about sexual misconduct at his company—the WSJ article is not mentioned in the SEC filing, of course).  One can imagine that the discussion between the two companies was probably tense following the WSJ article, given that the public scandal which had started over the summer of 2021 did not seem to be abating.  In that meeting “Spencer raised that Microsoft was interested in discussing strategic opportunities between Activision Blizzard and Microsoft and asked whether it would be possible to have a call with Mr. Nadella the following day.”  In this version of the story, Microsoft made the approach.
• On November 26, 2021, Microsoft made an all-cash offer of $80 per share.  ATVI had opened the week at $60.62 which meant that the Microsoft offer contained a $20 premium.  Activision Blizzard refused the offer, pointing out that the company had traded above $90 before the California DFEH suit.  Activision Blizzard was essentially arguing that its pre-scandal stock price should be used as a comparable for its current valuation.
• On November 28, 2021, Activision Blizzard countered with a range of $90 to $105.  I have always shied away from offering a range—it seems to me that by offering a range you are actually offering one number at the high or low end (depending on whether you are acting as buyer or seller).  Initially, Microsoft attempted to apply this interpretation, accepting the range on November 29 while noting that it would be more comfortable at the low end.
• However, the range seems to have been a good negotiation strategy on the part of Activision Blizzard.  Over the next two weeks, offers and counter offers at the ends of the range were exchanged.  Just prior to December 16, 2021, Kotick informed Nadella that Activision’s floor was now $95, an offer which was ultimately accepted by Microsoft.  In the end, the range became a device that allowed Activision to move the offer up from $90 to $95.

Looking through the SEC filing, it is fascinating to see the negotiation proceeding, almost as if one was a fly on the wall.  But, the bargaining between Activision Blizzard and Microsoft was not the only action going on.  In the SEC filing, it becomes clear that Activision Blizzard did have other suitors (referred to as “Company A,” “Company B,” up to “Company E” in the filing).  It may have been the discussions with the other possible purchasers that gave Kotick the confidence to establish at $95 floor in mid-December.

Applying cash flow analysis, rather than comparables, the sale price of $68.7B seems reasonable.  At $9B of net revenue annually (assuming that Microsoft only maintains revenue, rather than growing it) pays off the purchase price in a little over 7 years.  Of course, Microsoft expects synergies to significantly grow the value of this purchase.  Given that IT companies have historically been traded at valuations that cannot be justified by cash flow, this case is reassuring.

Regulatory Concerns

The Microsoft/Activision Blizzard deal is scheduled to close in 2023, provided that regulatory review proceeds successfully.  The result of the acquisition would be a new Microsoft division Activision Blizzard to go with Microsoft’s Xbox Game Studios, both divisions to be housed inside Microsoft Gaming and headed by Phil Spencer.

For regulators, there is a significant amount of grist for their mill:

• Wages:  Consolidation in the gaming industry represents fewer distinct workplaces and can depress wages for workers.  Microsoft has attempted to be out front on this issue by promising not to interrupt unionization efforts at Activision Blizzard.
• Vertical Integration:  Following Microsoft’s recent Bethesda Softworks acquisition, the games Starfield and Redfall were made exclusive to Xbox.  Regulators have traditionally opposed this type of vertical integration in which an advantage in one area is used as a lever in another related area.  These types of concerns harken back to the “bundling” of Internet Explorer with the Microsoft operating system which occurred in the 1990s and led to United States Justice Department Action

Numerous regulatory agencies around the world are looking at the acquisition, but it is the US Federal Trade Commission, along with the European Commission and the UK Competition and Markets Authority, that have the most power to block the deal.  It was this combination of three agencies that prevented the $40B sale of the chip maker ARM from the Japanese SoftBank Group to the US software and chip maker Nvidia in 2022.

On December 8, 2022, the US Federal Trade Commission filed suit to stop the Activision Blizzard acquisition, citing the anti-competitive nature of the transaction.  However, the suit is not a slam dunk.  In the case of Nvidia, both ARM and Nvidia do business in the small area of chip manufacture.  ARM intellectual property is used in Google, Microsoft, and Qualcomm chips.  In contrast, Microsoft and Activision Blizzard operate in different business areas of gaming (hardware versus software)—so making charges of monopolization stick may be more difficult.

Microsoft began making moves in December to blunt some of the criticism of the deal—signing a deal to ensure that Call of Duty will be on Nintendo consoles for the next decade.  At the current moment, it is unclear if the FTC has filed suit in order to go the distance in court or perhaps to increase its bargaining power and force concessions from Microsoft.

[1] Activision Blizzard, Inc.  Schedule 14a filed with the United States Securities and Exchange Commission.

Disclaimer:  DiscussingTerms^TM provides commentary on topics related to negotiation.  The content on this website does not constitute strategic, legal, or financial advice.  Consult an appropriately skilled professional, such as a corporate board member, lawyer, or investment counselor, prior to undertaking any action related to the topics discussed on DiscussingTerms.com.

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In today’s post, DiscussingTerms addresses how patent litigation is settled—using the example of biosimilar pharmaceuticals.  Biosimilars are the generic versions of expensive injectable medications like Remicade, Enbrel, and Humira.  Biologics and biosimilars are a rapidly growing segment of pharmaceuticals, so there is a lot at stake financially and medically.  The focus of this post is on how settlements are valued and how a zone of possible agreement between the parties involved in patent litigation can be established.

Background

Here is a quick introduction to biosimilar litigation:

• In 2009, the Biologics Price Competition and Innovation Act (BPCIA) was passed into law to create an approval pathway for generic versions of biological drugs (“biosimilars;” generic versions of medicines like Remicade, Enbrel, and Humira).  The reason that a separate approval process was required is that biological drugs are much more complicated to manufacture than small molecule drugs (like antihypertensives and antibiotics).
• Within the BPCIA are provisions which require the “patent dance”—disclosure of the biosimilar drug manufacturing process by the biosimilar manufacturer to the initial manufacturer (“innovator”).  This allows the innovator to consider whether any patents held by the innovator have been violated by the biosimilar drug manufacturer.  The reason it is called a “dance” is that there are several rounds of communication back and forth (like a dance).  If any areas of dispute cannot be resolved, litigation may follow.

This form of negotiation is a classic adversarial or competitive negotiation.  Demands, threats, and the use of power (through the courts) are expected in this negotiation.  The goal for each side is a “win”—the innovator wants to block the biosimilar from entering the market, and the biosimilar manufacturer wants to launch their drug as soon as possible to take market share from the innovator.

In these negotiations, accommodative behavior may rarely come into play (if by chance the two companies involved have other projects that they are working on together and want to preserve their relationship as a way of maximizing the return from the other activities that involve them); however, the norm in this type of negotiation is competition.

Assessing Risk, Cost, and Profit

Many business processes such as litigation [1] and option pricing [2] involve some degree of risk combined with possible costs or profits.  Such processes can be represented as trees of probability and value.  As an example, consider this tree describing the possible outcomes of BPCIA patent litigation over pegfilgrastim in 2020:

This tree structure considers the possibility that a purely hypothetical pegfilgrastim patent case was brought in 2020.  Though the tree is hypothetical, the values in the tree were estimated using real market and litigation data, as will be seen below.  Consider the following aspects of the tree:

• Structure:  The tree structure assumes that a case is brought by a plaintiff (i.e., innovator pharmaceutical company) against a defendant (i.e., biosimilar pharmaceutical company) for patent infringement in manufacture of pegfilgrastim.  The possible outcomes of this litigation are a verdict for the plaintiff or for the defendant (the two lefthand branches of the tree), and if the verdict is for the plaintiff, a range of possible penalties may apply (the two righthand branches of the tree).
• Probabilities and Penalties for Defendant:  To be as realistic as possible using publicly available data, DiscussingTerms developed a database of US district court BPCIA litigation [3].  In the database, ten cases were pursued all the way to a trial outcome, with seven determinations for the defendant and three for the plaintiff.  Using this data, the chance of a verdict for the plaintiff is 30% (versus 70% for the defendant).  In the case of a verdict for the plaintiff, 3 cases provided example penalties (two cases for patent infringement of Enbrel resulted in 9-year delays to the market when patent protection was upheld, and one case for patent infringement of Epogen resulted in a $70M penalty).  Assessing what the penalties might be imposed is case specific, these values from cases other than pegfilgrastim were used in the tree structure above purely as examples.  Of course, each litigation team would spend time creating a tree specific to their case.

• Rewards for Defendant:  Having considered the possible penalties, what about the rewards?  Pegfilgrastim is a biologic used primarily in supportive care of chemotherapy patients to boost their immune cell level.  Market projections for North America starting in 2020 are shown above [4].  Assuming that early entry into this market would lead to 50% market share and late entry would lead to 10% market share, the revenues for these two scenarios are shown in 4^th and 6^th columns.  The net present value (NPV) in 2020 for an early entry can be calculated at $4.7B (a late entry would yield $931M in value).  In the tree above, a late entry was assumed, so value for a verdict to the defendant is shown in the tree as $931M. (Note: Back in the day, entry date was part of the negotiation between a pharmaceutical innovator and a generic. The FTC now guards against such “pay for delay” agreements. The reason to consider early versus late entry here is that clinical and CMC considerations limit how quickly a biosimilar makes it to the market. It is worth examining whether and how entry date affects this type of negotiation. See the table of expected outcomes below for a comparison.)
• Value to the Defendant:  The value to the defendant is the weighted average of the possible outcomes:  (30% x 67% x $0)+ (30% x 33% x ($931M-$70M))+ (70% x $931M) which equals $737M.  This value exists as a purely theoretical amount—if the litigation is pressed to conclusion, the biosimilar company will receive one specific value ($0, $861M, or $931) depending on the verdict.  The ultimate value hangs in the air like the fate of Schrödinger’s cat.

• Value to the Plaintiff:  The tree looks different to the plaintiff (see 2^nd tree shown just above).  The probabilities of this 2^nd tree remain the same as those in the 1^st tree, but the outcome values differ.  If the defendant prevails, then the plaintiff receives nothing, so that branch is valued at $0.  A verdict for the plaintiff contains a 33% chance of a $70M judgement to the defendant.  A 9-year delay (67% change if there is a verdict for plaintiff) takes the defendant out of the North American market for pegfilgrastim, so the innovator may receive the value that would have been provided to the biosimilar company ($931M) if the innovative product is able to capture those sales.  The weighted average for this tree is:  (30% x 67% x $931M)+ (30% x 33% x ($70M))+ (70% x $0) which equals $194M.

The Negotiation

Litigation under BPCIA is an example of a multiparty negotiation (involving innovator company, biosimilar company, legislature, courts, insurance companies, doctors, and patients).  However, there are three parties with the most immediate sway in this type of negotiation (the two pharmaceutical companies and the courts).  Their positions are as follows:

• Courts:  The courts enforce guardrails on the negotiation.  The BPCIA mandates the patent dance, and both companies are required to negotiate in good faith during this process.  Failure to abide by the patent dance process can lead to penalties.  Also, the courts have found that certain types of settlements are anticompetitive and violate antitrust principles (see:  FTC v. Actavis, Inc., 570 U.S. 136 (2013)).  So-called “pay-for-delay” agreements, in which the innovator pays a generic or biosimilar company to stay out of the market, can be challenged by the FTC under these principles.
• Defendant:  The biosimilar company’s primary goal is to avoid achieving a $0 value.  To prevent this disastrous outcome, they would be willing to concede some value, but how much?  We’ll see below.
• Plaintiff:  The innovator faces a decline in revenue due to erosion of the price for pegfilgrastim and the entry of competitors taking market share.  Through this negotiation process, the innovator hopes to salvage some revenue from this product line which is reaching the end of its product lifetime for the innovator.  How much value might they be looking for?  Again, we’ll see below.

The zone of possible agreement (ZOPA) is a range of settlement values that satisfy both parties.  In this case, the settlement involves direct cash payments or a share of future revenue, but it cannot involve a pay for delay agreement.  What range might satisfy both parties?  Consider the following table:

In this table, the case of late entry into the North American market (10% share) is shown at the top of each entry; the case of early entry (50% share) is shown at the bottom of each entry in parentheses.  Both parties wish to avoid their worst outcome.  In each case (late entry and early entry), if the biosimilar company is willing to concede the difference between its best outcome and its expected outcome, the freed cash satisfies the innovator’s expected outcome.

Other factors will also come into play:  the relative strength or weakness of the patent infringement case, the bargaining position of the biosimilar company (are they short of cash or deep pocketed), the number other biosimilar products and their expected launch dates, etc.  However, this analysis does indicate that a zone of possible agreement between the two parties may exist.

Conclusions

Creation of a case-specific model of value which builds in the most relevant data on risk and potential cost and profit can be a useful tool of negotiation preparation.  These types of models help the negotiation team think several moves ahead in the bargaining process, as well as allowing the team to put themselves in the place of their adversary.

Some other issues to bear in mind include:

• Framing:  Whether a particular outcome is framed as gain or loss has strong psychological effect on humans.  Craver goes into this topic in some detail [1].  In considering a settlement, the litigant is well advised to consider emotional factors which influence their point of view.
• Hidden Costs:  It is important to consider all of the costs within this type of negotiation:  litigation costs, impact of the litigation on public perception (does the uncertainty of litigation frighten potential business partners or investors?), opportunity costs (do the rigors of preparation for a trial distract from other business activities?), etc..

All of these issues come into the decision of when and how to settle; however, as some wise person once said, “There’s always a number.”

[1] Craver, C.  Effective Legal Negotiation and Settlement, Carolina Academic Press (2020).

[2] Metrick, A.  Venture Capital and the Finance of Innovation, John Wiley & Sons, New York (2010).

[3] US District Court BPCIA Litigation, DiscussingTerms, December (2022):

[4] Research and Markets.  Global $4,037 Million Pegfilgrastim Biosimilars Markets, Analysis & Forecasts, 2015-2020, 2025F, 2030F, www.globenewswire.com/fr/news-release/2022/03/16/2404168/28124/en/Global-4-037-Million-Pegfilgrastim-Biosimilars-Markets-Analysis-Forecasts-2015-2020-2025F-2030F.html

Disclaimer:  DiscussingTerms^TM provides commentary on topics related to negotiation.  The content on this website does not constitute strategic, legal, or financial advice.  Consult an appropriately skilled professional, such as a corporate board member, lawyer, or investment counselor, prior to undertaking any action related to the topics discussed on DiscussingTerms.com.

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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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