Detroit bankruptcy: Why judge's decision on city's fate will impact every American

FILE -- A street sign showing Detroit's city limits is shown near where a former Chrysler McGraw glass. (David Eggert/AP)

Will American cities in financial distress be given a legal precedent to use Chapter 9 bankruptcy protection to prioritize selected creditors, like pensioners, even if it violates bankruptcy law?

Has the bankruptcy process devolved into a political instrument, improperly influenced by public stakeholders? Or does it remain a legitimate legal process through which the justice system protects creditors equally?

[pullquote]

Should judges presiding over these cases help guide municipalities toward a path of fiscal stability and comprehensive restructuring, or simply allow political bargains to trump bankruptcy law and the municipality’s long-term sustainability?

The answers to these and other questions soon will be revealed as U.S. Bankruptcy Judge Steven Rhodes preparers to hear the case of Detroit’s collapse, the largest Chapter 9 bankruptcy in history.

Consider that one-third of America’s largest 61 cities face the threat of bankruptcy, and the national context of Judge Rhodes’ decisions becomes clear. It will have profound implications on precedent and case law.

Bankruptcy code stipulates similarly situated creditors must be treated similarly. So, if adjudicated with strict adherence to bankruptcy law, a ruling that places a premium on fairness will set the gold standard for future decisions. Creditors will risk capital and issue bonds with confidence that the system will treat them fairly should negative economic circumstances overwhelm a municipality.

However, under the classic battle lines of populist politics, bankruptcy proceedings invite predictable stereotypes. The struggling city and its legions of public worker retirees living on pensions are the victims, the good guys. Financial institutions, perceived to have accelerated their misery and demise, are the bad guys. This creates two classes of creditors, popular pensioners vs. unpopular lenders. This oversimplification creates a false impression of actual events.

Consider the multitude of governmental actions that got Detroit into its financial predicament. High taxes, crime, hostility toward business, excessive social welfare spending, political corruption and crony capitalism decimated the viability of America’s most industrious city. The result: $18 billion in debt.

Now, as part of a “Grand Bargain,” heavily informed by political interests, the city has proposed a plan that leaves pensions virtually untouched, increases hiring of public workers, and provides for $1.5 billion in new spending.

Meanwhile, the city neglects its obligations to politically unpopular creditors despite legal mandates to minimize creditor loses. The city maintains billions of dollars in assets, like the Detroit Institute of Arts (DIA), valuable real estate and other infrastructure, and should be compelled by law to use their value to finance liabilities to all creditors.

This plan presents the city with a “worst of all options” scenario since it essentially maintains an insolvent approach to pensions, neglects the law by preventing reasonable recoveries benefitting all creditors and turns the bankruptcy into a highly politicized process.

The Detroit's approach has been telling. Absent is the humility and sobriety of a city whose fate was sealed by decades of ineptitude and depravity from its political and municipal leaders. Instead, litigation has been the focus from day one, while the legal burden to maximize value for all creditors has been abdicated. With dogmatic rhetoric aimed at turning public opinion against certain creditors, a public relations campaign, rather than a legal case, has been built.

Salvation for the bankruptcy process, Detroit and municipalities across the nation can be achieved through the guidance of Judge Rhodes. He needs to support a deal that is fair to all creditors, gives Detroit its best chance to succeed, and creates sound legal precedent for future municipal bankruptcies.

Unless Judge Rhodes’ intervention produces a comprehensive settlement satisfying all creditors, the citizens of Detroit will not enjoy the benefits of a sound plan for recovery.