When cities and other municipalities file for bankruptcy, it is typically a staid affair. At least by bankruptcy standards.
Because of our constitutional structure, a federal bankruptcy judge has limited power in a municipal bankruptcy case. There are no shareholders who can lose control of the case, as in Chapter 11, and no trustee who could be appointed to replace existing management. The elected leadership of the city remains in place; any change must take place through the ballot box or through the oversight of the state government.
But the judge does have the ultimate power to reject a Chapter 9 plan. Thus the municipality can’t be totally unreasonable, or the court will simply tell it to “go away.â€
What is the purpose of Chapter 9 then? After all, it might seem that most of what Chapter 9 does could be arranged by agreement, like Greece or any other workout.
Chapter 9’s existence is the result of hard fought battles during the New Deal, when the Supreme Court rejected the first attempt at municipal bankruptcy. The New Dealers refused to give up, given the sorry state of so many municipalities during the Great Depression. There must have been something worth fighting for.
The key is the basic point at the heart of all restructuring statues: muting the power of holdouts. With municipal bankruptcy, the debtor avoids the fate of Argentina and countless other debtors that have attempted to solve their problems out of court.
But because the municipal debtor has to avoid having its case dismissed, and often wants to return to the debt markets sooner rather than later, a subtle dynamic has developed.
The typical municipal bankruptcy case has involved slight losses to creditors. Sure, creditors have experienced losses related to the time value of having their money tied up with the debtor longer than expected, and maybe some bondholders have not received all the return they expected, but in the end the bondholders usually received at least their original investment back.
That might change in a big way with Detroit. Unlike other municipal debtors that have overextended themselves or made poor financial choices, Detroit is in much deeper trouble. In particular, the city has and is undergoing such fundamental changes that a simple delay in repaying its bonds won’t quite do it.
Instead, Detroit needs to fundamentally revamp itself. And doing so means hard choices, and the hard task of making a wide range of constituents face up to this new reality.
All of which is likely to make Detroit something of a trailblazer in Chapter 9 terms. A honor it certainly wished to avoid.
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
