I. Chapter 9 Bankruptcy
The academic literature on Chapter 95 bankruptcy is sparse.6 Because it is rarely invoked — fewer than a thousand Chapter 9 cases have been decided since Chapter 9 was made a part of the Bankruptcy Code in 19347 — few academic articles have been devoted to the subject.8 To the extent that Chapter 9 has been explored, the focus has been on the concept as an adjunct to a broader discussion of constitutional law, specifically the Tenth Amendment to the Constitution.9
Prior to the inclusion of Chapter 9 in the Bankruptcy Code, debt adjustment at the local level often fell into disarray.10 There was not an orderly and sanctioned forum to deal with municipal default.11 Nor was there a way to mandate that creditors work to resolve issues with their claims.12 Even in the case where a majority of creditors reached a settlement with the municipal debtor, there was not a way to put the plan into effect.13 The Great Depression increased the need for a forum to carry out debt adjustment. Municipal bond defaults increased from 678 in 1932 to 1,729 in 1934.14 In response, in 1934, Congress enacted Chapter 9 as part of the Bankruptcy Code.15
The law was struck down in Ashton v. Cameron County Water Improvement District16 when the Supreme Court determined that the law conflicted with the Tenth Amendment17 and interfered with state power.18 Congress enacted a second version of the law that mirrored the first.19 Upon a second review undertaken in U.S. v. Bekins,20 the Supreme Court upheld the law.21 The reason for the different result reached by the Supreme Court in 1936 versus 1938 is in part attributable to differences in the composition of the Supreme Court, which had acquired two new members between cases.22
Today, Chapter 9 offers municipalities an opportunity to effect a plan of adjustment.23 The plan of adjustment is a settlement to restructure debt filed by the debtor in Bankruptcy Court. Upon the acceptance of the plan of adjustment by a majority of creditors and the federal bankruptcy judge, a municipality’s debts are either refinanced under better terms or reduced.24
Under Chapter 9, the federal bankruptcy judge’s authority is most powerfully exerted at the points of entry and exit.25 A municipality must be determined eligible under the statute before it can restructure its debt, a determination made by the federal bankruptcy judge. In turn, exit from Chapter 9 bankruptcy is dependent upon the federal bankruptcy judge’s decision to either approve or reject the plan of adjustment, or dismiss the case entirely.26
In the interim, the federal bankruptcy judge serves chiefly as a mediator, whose purpose is to adjudicate creditors’ claims, property subject to a lien, and the acceptance or rejection of contracts by the municipal debtor. The day-to-day operations of the municipal debtor remain under the control of its elected leaders. The Bankruptcy Code’s § 904 strictly limits the federal bankruptcy judge’s ability to interfere in the political process:
Notwithstanding any power of the court, unless the debtor consents or the plan so provides, the court may not, by any stay, order, or decree, in the case or otherwise interfere with:
- any of the political or governmental powers of the debtor
- any of the property or revenues of the debtor or
- the debtor’s use or enjoyment of any income-producing property27
Further interference by the Bankruptcy Court into local matters, or an attempt by the federal bankruptcy judge to force a municipal debtor to sell public assets would be in direct conflict with the Supreme Court’s decision in Bekins — for the very reason Chapter 9 was first invalidated in Ashton. The limitations placed on the federal bankruptcy judge are included to ensure respect for state power since municipalities are creatures of the state.
Compared to Chapters 7, 11, and 13 of the Bankruptcy Code, which refer to individual and commercial bankruptcy, Chapter 9 does not offer the option of liquidation.28 Nor do debtors under Chapter 9 come under the auspices of a bankruptcy trustee, a court-appointed receiver, who ordinarily would oversee the estate of the debtor. Municipalities are also further empowered to reject contracts with labor unions in a way that commercial debtors are not under Chapters 7 and 11.29
Overall, debtors under Chapter 9 hold more power than creditors compared to other chapters of the Bankruptcy Code.30 However, the barriers to entry for debtors to file for Chapter 9 bankruptcy, listed in § 109(c), are more difficult to overcome. A debtor must testify that it:
- is a municipality
- is specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under such chapter
- is insolvent
- desires to effect a plan to adjust such debts and
(A) has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter
(B) has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter
(C) is unable to negotiate with creditors because such negotiation is impracticable or
(D) reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under section 547 of this title.31
The standards for entry into Bankruptcy Court differ chapter by chapter, but Chapter 9 is peculiar in two respects. One, it requires negotiations to have taken place outside of the Bankruptcy Court prior to a petition for debt adjustment, and two, it requires that the debtor be insolvent at the time it files.32
Notably, the issue of insolvency illustrates the de-emphasis of public assets in Chapter 9. Insolvency is an inability to service debt. There are multiple ways to determine insolvency, and different methods are applied in different chapters of the Bankruptcy Code.33 Under Chapters 7, 11, and 13, a debtor’s liabilities must exceed its assets before they can be deemed insolvent. For municipalities insolvency is a test of whether or not the municipality can payout what is owed on time, or, in other words, whether or not there is cash on hand to “pay debts as they become due.”
To reiterate an earlier point, while the complete liquidation of assets in order to satisfy creditors is an option for individual and commercial debtors, complete liquidation of assets to satisfy creditors is not available for municipal debtors.34 It follows, therefore, that public assets are unimportant to the Bankruptcy Court’s assessment of a municipal debtor’s financial condition, because the municipal debtor is not expected to liquidate or dissolve in order to satisfy creditors — a conclusion that lends itself to further discussion of insolvency.
In a sense, insolvency is a choice for the municipality. Theoretically, municipalities wield the near inexhaustible ability to increase taxes in order to obtain more revenue; that is, in fact, a part of the assumed safety of municipal bonds.35 Elected officials ‘choose’ to provide services in excess of revenue, and ‘choose’ to levy taxes inadequate to cover the cost of public services. Save for statutory and charter limits on local taxation, situations of financial distress can theoretically be solved with tax increases. Certainly it is true that a tax increase could turn into a Pyrrhic victory, whereby revenue increases initially, but then plummets as citizens leave in search of more affordable jurisdictions,36 but the fact remains, the municipality has access to additional funds.
Because insolvency can be construed as a choice, courts presented with petitions for debt adjustment under Chapter 9 have taken into consideration the options available to municipal debtors. Municipal debtors have been denied access to Bankruptcy Court because under the determination of the court the municipal debtor was not insolvent.37 Bridgeport, Connecticut was denied access to Bankruptcy Court in 1991 after the court said that calamity would not strike in the immediate fiscal year, and therefore the city had time to correct its budget imbalances with bond proceeds held in a special fund.38 In another example, Boise County, Idaho, which filed for bankruptcy in 2011, had its case dismissed after the court determined that the county still had the ability to issue warrants.39 Yet, despite these cases, it is not an absolute rule to reject a petition for debt adjustment because of a failure on the part of the municipal debtor to increase taxes.40 Nor has the failure to monetize assets been considered cause to reject a municipal debtor’s petition for debt adjustment.41
II. Insolvency and the Detroit Institute of Art
Detroit was declared insolvent and able to adjust its debts under Chapter 9 on December 3, 2013.42 Due to the enormity of Detroit’s liabilities — $18 billion — and the pricey valuations attached to the DIA, if there was ever a case for new precedent to be set on the vulnerability of public assets in Chapter 9 bankruptcy it would be this case.43 Kevyn Orr, the Emergency Manager appointed to oversee Detroit’s finances by Governor Rick Snyder of Michigan, commissioned the auction house Christie’s to appraise the art owned by the city in the DIA.44 Founded in 1885, the DIA has a collection of 66,000 works, and is the cultural jewel of the city.45 The art collection is so broad it has been called “encyclopedic” by many, and includes works by Henry Matisse, Paul Cezanne, and Claude Monet. The most valuable artwork, “The Wedding Dance,” painted by Pieter Bruegel the Elder in 1566, was valued by Christie’s in 2013 between $100 million and $200 million.46
Christie’s appraisal of the art collection ranged between $454 million to $867 million, but was limited by the stipulation that only the portion of the art collection that was either paid for by city funds in whole, or in part, be valued.47 Out of the DIA’s art collection of 66,000, only 2,781 pieces of art were valued. That number dwindled to 1,741 with the realization that only a small portion of the art collection accounted for the total estimated value. Just a handful of pieces accounted for 75% of the value of the appraised art. The final report by the auction house was delivered on December 17, 2013. Financial Guaranty and Syncora Guarantee, demanded an alternative assessment, one broader in scope.48
The city received four offers from private investors that had been presented by Financial Guaranty.49 Catalyst Acquisitions, LLC, and Marc Bell Capital Partners, LLC, offered to purchase the entire art collection for $1.75 billion. Poly International Auction Co. Ltd, offered to purchase all of the art made by Chinese artists on behalf of an unnamed client for $1 billion. Yuan Management Hong Kong Limited, offered on behalf of interested investment companies to purchase 116 pieces of art for $895 million to $1.47 billion. Art Capital Group offered to provide $2 billion in funds with the art collection posted as collateral.50
In order to absolve itself of the criticism that it had obtained a limited appraisal from Christie’s to reduce pressure to selloff the art collection, the city contracted with Artvest Partners, an investment firm, to conduct the second and more expansive appraisal that Financial Guaranty and Syncora Guarantee had demanded.51 In a report released on July 8th, 2014, the art collection was valued at $2.7 billion to $4.6 billion. A noted condition of the report was the caution held for how the artwork would sell on the open market. The art collection could have fetched much less than its maximum total estimated value said the report, mostly because the open market would be flooded with so much art at one time.52
On June 20th, 2014, the Governor and State Legislature enacted two laws which added $195 million in state funds to $366 million private donations to be paid to pensioners over 20 years, and $100 million from the DIA.53 This was part of a scheme known as the “Grand Bargain” in the media.54 The deal saved the city’s artwork from liquidation, and transferred ownership of the art collection from the city to a nonprofit entity, DIA Corp., to hold the art in charitable trust forever in city limits. The $195 million in state funds was but a down payment for contributions that will total $350 million. Collectively, the deal will raise $816 million. The funds were used both to shield the DIA, and to reduce the cuts that would have otherwise been made to city pensions.55 Yet, the project would not become a success until affirmation of the city’s plan of adjustment by a majority of creditors and the federal bankruptcy judge.
The deal mollified city retirees, but raised the ire of other creditors who would see low recovery rates. Financial Guaranty and Syncora Guarantee, two creditors that insured some of the city’s debt persisted still. A third appraisal of the art collection commissioned by Financial Guaranty, issued on July 28th, 2014 by Victor Wiener Associates, an art appraisal company, said the artwork was worth $8.5 billion.56 In response to this new valuation, Art Capital Group, which had offered to finance the city’s exit from Bankruptcy Court increased its offer on August 26, 2014.57 The company offered to lend the city $4 billion with the art collection used to securitize the loan.58 This was much more than the $275 million loan the city obtained from Barclays Capital on August 28, 2014.59 That money was used for what is termed an exit facility in the Bankruptcy Code. By the end of the case, which ended on December 11, 2014, the art collection remained in the DIA, the city settled with Financial Guaranty and Syncora Guarantee, and the “Grand Bargain” went into effect.60
In an interview with the Emergency Manager in which the DIA’s valuation and threat of monetization were discussed,61 the DIA’s art collection was cited as the city’s chief unencumbered asset, i.e. an asset without a lien or other creditor claim attached to it. Municipal debtors are able to use, sell, or lease assets without approval from the Bankruptcy Court, unless that property is encumbered by a lien or other lawfully obtained security interest in the property in question. Because the art collection was unencumbered, Detroit was free to sell the art collection and use the proceeds to repay creditors without interference from other actors, had it chosen to do so.
In testimony from the case, the Emergency Manager revealed the objections raised by patrons who had donated pieces to the DIA. In the words of Emergency Manager, “The DIA said it would fight and litigate every piece of art that the city would sell. The intent was that they would make it a very lengthy and painful piece of litigation.”62 Donors to the DIA did not have a lien on the art, but whether or not another claim to the art could have been made is uncertain. In any case, while the art collection was officially unencumbered, lawsuits by donors could have forestalled an auction and ultimately the payment of creditors.
III. Bondholders, Fieri Facias & Public Assets
A discussion about the remedies available to creditors to recoup investments necessarily must start with those remedies that are unavailable to municipal creditors. Garnishment of income is an option to recoup investments available to creditors when the delinquent borrower is a person, but is unavailable for municipal debtors. Creditors can file suit and petition the courts to have a portion of the delinquent borrower’s future income partitioned for debt payment or their funds seized, but are denied the ability to dip into public treasuries to secure repayment.63
However, creditors via court order can compel municipal debtors to increase taxes for the purpose of repayment.64 Called a writ of mandamus, a creditor may petition a court with jurisdiction to order a municipality to use its full faith and credit, or in other words taxing power, to make good on a claim.65 Still, these efforts can be undermined in a number of ways. The writ of mandamus cannot interfere with state law, so, in the case where the state has limited the level of local taxation, the writ could not compel a municipality to break the law.66 And, because such orders are rendered to elected leaders, those leaders can leave office in order to abdicate their responsibility to increase taxes.67
Furthermore, creditors typically cannot obtain a writ of fieri facias, an order from a court to foreclose on property.68 In a majority of states, statute prohibits the seizure of public assets to compel the payment of debt, or to satisfy the debt itself.69 For example, in documents from the bankruptcies of Vallejo and Stockton, a similar refrain is used in reference to public assets: “California law does not permit the levy on or sale of a city’s assets in order to satisfy a court judgment.”70 The same is true in other Chapter 9 cases.71 Moreover, cases like Lincoln County v. Luning and Monell v. Department of Social Services of the City of New York establish and limit the extent to which municipalities can be sued and held accountable for monetary awards.72
To clarify, the statutory protections afforded to public assets are not absolute. In the past, there has been a distinction made by various courts between public assets used for the public good, and assets of a proprietary nature, i.e. assets held for the profit of the municipality.73 The latter of the two has not enjoyed the same immunization from seizure.74 But because the idea of proprietary assets in the municipal context is so inexact, and the idea of public purpose so broad, the distinction has rarely been acted upon inside or outside of bankruptcy, and has since fallen into disfavor.75 However, the distinction between classes of assets has been made and is relevant to the discussion of public assets and creditors’ remedies in default.
In other instances, state law has provided little protection for municipal debtors when the state is a major creditor. For example, in the Chapter 9 case filed by the city of Stockton, California in 2012, the California Public Employees’ Retirement System (CalPERS) turned out to be one of the city’s adversaries.76 CalPERS is the pension system for the state of California, but it also contracts with numerous municipalities to administer their pension systems. Prior to bankruptcy, Stockton partnered with CalPERS to administer its pension system. In bankruptcy, Stockton moved to end its relationship with CalPERS. Due to the contract terms, CalPERS asserted that the city owed a hefty termination fee of $1.6 billion. CalPERS claimed to have a statutory lien on all the assets of Stockton in accordance with California law.77 CalPERS’s lien was rejected in the course of the bankruptcy, but outside of bankruptcy the city would have been at the mercy of CalPERS. California law indeed says that “[t]he board (CalPERS) shall have a lien on the assets of a terminated contracting agency (in this case, Stockton), subject only to a prior lien for wages, in an amount equal to the actuarially determined deficit in funding for earned benefits of the employee members of the agency, interest, and collection costs.”78
Still, the court system has provided protection for public assets either in conjunction with or in the absence of state law. In numerous states, courts have ruled that public assets are not subject to seizure.79 Most public assets are connected with services rendered, and the seizure of those assets would interrupt the delivery of those services to citizens, an unacceptable result to jurists.80 Moreover, with respect to debt issuance, secured debt in particular, it is unusual for a municipality to secure its debt with its own physical plant as collateral. A municipality could not easily surrender its police or fire stations in the case of default. Such debts are typically secured by the revenue which comes either from the fees collected or taxes levied by the municipality. Liens, i.e. security interests, can be acquired for tax revenue and fee collection, but typically not physical assets. For example, in Detroit’s case, a majority of the city’s secured debt was related to the city’s Water and Sewerage Department.81 Prior to bankruptcy the city issued revenue bonds on behalf of the city’s water and sewer department to finance the sewer system82 Revenue bonds are often issued to pay for the construction, implementation, and or administration of a public project, in which fees or levies for service will be collected, and the revenue is used to pay back the debt.83 In bankruptcy, contracts are broken, and bond contracts are no different. The determination of how a contract is treated in bankruptcy is in part made by the kind of debt. The important distinction is between secured debt and unsecured debt.
Secured claims are debts in which collateral was posted at the time money was borrowed or a liability was incurred. Unsecured claims are just the opposite, there is no collateral posted, and there is no further reassurance that the debt would be repaid. In part, the demands made by Financial Guaranty and Syncora Guarantee were weakened by the fact that they were creditors with unsecured claims. There was not an explicit promise in the bond contract, nor an implicit promise in the city’s oath to use its full faith and credit to repay debts, that the city would auction off art in order to repay creditors. Had the city used the DIA’s art collection to securitize a debt on which it failed to perform, then the city would have had to use the collateral, the art collection, to compensate creditors in one form or another. The city would have had to either surrender the art collection to creditors, auctioned off the art and used the proceeds for payment, or paid out to creditors the fair market value of the collateral.84
Public assets, such as the DIA’s art collection, enjoy broad immunity from liquidation, but these protections are strongest under Chapter 9. In bankruptcy, creditors are no more empowered to seize public assets and municipalities are no more compelled to sell public assets in order to satisfy creditors with unsecured claims. This is reflected in numerous Chapter 9 cases, and in Detroit’s case.85 For one, Bankruptcy Code § 904, does not make any distinction between public assets and proprietary assets.86 Moreover, § 904 of Chapter 9 appears to be worded in such a way as to purposefully include proprietary assets when it precludes interference by the Bankruptcy Court in the municipal debtor’s “use or enjoyment of any income-producing property.”87
Further protections for public assets under Chapter 9 stem from the lack of a bankruptcy trustee, this is because the municipal debtor does not have an estate to oversee and the municipal debtor holds the exclusive ability to submit a plan to resolve its insolvency under § 941.88 The municipal debtor’s plan of adjustment is key to the issue of public assets in Chapter 9 bankruptcy. To reiterate an earlier point, the plan of adjustment is a settlement between a debtor and its creditors to restructure debt. The plan of adjustment identifies who will be paid, how much they will be paid, and who will not be paid at all. A municipality may file a plan of adjustment concurrent with its request to enter into Bankruptcy Court, or in the interim of the trial. Exit from Bankruptcy Court is dependent upon the approval of the municipal debtor’s plan of adjustment or dismissal of the case.89
Creditors cannot offer an alternate plan of adjustment for consideration, and therefore, cannot offer an alternate plan for the division of the municipal debtor’s public assets.90 In sum, there is not an available mechanism for creditors to force a municipal debtor to sell public assets. Only indirectly can creditors apply such pressure, insofar as the acceptance of creditors is needed to approve a municipal debtor’s plan of adjustment.91 For instance, a creditor may only approve of a plan of adjustment if they receive a better recovery rate and the city may only be able to improve the recovery rate of a creditor with the money derived from the sale of public assets. Indeed, this happened in Detroit’s case.92
On September 15, 2014, the city reached a deal with Syncora Guarantee, providing an extended lease to Syncora on the Detroit-Windsor Tunnel. This lease existed prior to bankruptcy and was on a portion of the tunnel owned by the city, but operated by a private company. The bond insurer also obtained another lease on a city parking garage, separate from the first. Its monetary award was also increased. Without the deal, Syncora Guarantee may have collected less than 10% on its claim of $200 million, reduced from an earlier claim of $400 million. With the deal, Syncora Guarantee collected 13% on its claim. Additionally, the deal included property on the city’s riverfront.93
In a deal obtained on October 16, 2014, Financial Guaranty was sold 8.6 acres of land which currently houses Joe Louis Arena.94 The city ensured Financial Guaranty’s ability to build a hotel, retail stores, and a condominium complex on the site of the arena, which is set to be demolished in 2017. In addition to the land obtained in the deal, Financial Guaranty obtained a lease of a city parking garage.95 Like Syncora Guarantee, Financial Guaranty’s recovery rate was substantially improved. Before the deal was made, the plan of adjustment treated the company’s $1.1 billion claim with a 10% recovery rate, which increased to 13%.96 To improve its recovery rate, Financial Guaranty will receive new bonds valued at $146 million, and credits toward new land purchases valued at $20 million from the city. However, note that the only public assets which were either leased or sold to Financial Guaranty and Syncora Guarantee were those on the list of assets made available for liquidation by the city.97 The public assets leased or sold were not essential to city functions, and were not of major value. Creditors only had access to the assets explicitly offered by the city in its plan of adjustment further confirming of the level of control municipal debtor’s exercise over public assets in bankruptcy.
The role of the Governor and State Legislature are worth note at the end of this discussion. “The chief unencumbered asset we had was the art museum, and from my view I didn’t want to sell art … But my personal feeling about a Matisse or the quarter of other things had nothing to do with my job … And if I had to we were going to have a yard sale,” said the Emergency Manager in his interview with the Detroit Economic Club.98 The state played the role of savior, but it could have easily ordered a selloff. Detroit was not in control at the time of bankruptcy, in a technical sense. The city was in receivership; under the auspices of a state administrator who was appointed by the Governor. Had the Governor decided on austerity, he could have demanded that Detroit deal with its liabilities with the assets at its disposal rather than orchestrate outside intervention with the philanthropic community. Such interference by the state in a Chapter 9 case is not without precedent.99
IV. Conclusion
Once the city of Detroit declared bankruptcy, citizens feared that to repay creditors the Detroit Institute of Art would be plundered. By this account, these fears were unfounded. Evidenced by the Bankruptcy Code’s provisions that lend themselves to the preservation of the municipal debtor, not merely as a political entity, but a space with all of its assets free from creditors reach. Chapter 9 does not provide for the debtor’s disincorporation, nor does the law alter the debtor’s spatial boundaries, or attempt to restructure its administration. The intent of the law, while left unsaid, is clear upon examination of provisions that deal with insolvency, security interests, and political control. The intent is to allow debt adjustment, and continued delivery of services to citizens. To allow a municipality to be stripped bare, dispossessed of the very assets which are linked to the services delivered would be to counter every other effort by which the law attempts to keep the municipal debtor intact.