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Detroit's Bankruptcy: End(s) and Means

posted by Melissa Jacoby

TobecontinuedOn Friday November 7, 2014, Judge Rhodes confirmed the City of Detroit's plan of adjustment. As previously noted, this judicial act permits the release of debt and clears the way for the City to forge ahead, but the future of Detroit is in the hands of many others. Although a fuller written decision is expected, the court's oral ruling already hints strongly at new bankruptcy doctrine. Two examples: unfair discrimination and professional fees.

Unfair Discrimination: The Bankruptcy Code says that to confirm a plan over the objection of a dissenting class of claims, a court must find that the plan does not unfairly discriminate against the dissenting class (discussed here and here). The creditors most vigorously arguing unfair discrimination had settled and switched sides before the confirmation trial's end, reducing the number of classes entitled to this protection to two (one of which is projected to receive the lowest return of any class). Those classes are largely comprised of myriad personal injury, civil rights, and rejected contract and lease claims. During the City's closing arguments on October 27, Judge Rhodes indicated his dislike of two commonly-cited tests of unfair discrimination. On Friday, rumors of a "Rhodes Test" came to fruition.

In the absence of further guidance from Congress in the statute, Judge Rhodes said, the test of whether discrimination is unfair turns on "matters of conscience," informed by factors such as the purpose of municipal bankruptcy and the judge's "experience, education and sense of morality." With respect to pension claimants, the judge concluded that the City "demonstrated a substantial mission-related justification," namely preserving relationships with employees and enhancing their motivation. Judge Rhodes observed no similar dynamic with respect to the dissenting classes. Judge Rhodes also sought to recognize the judgment of the people of Michigan to give constitutional protection to pensions even though that would not prevent impairment in bankruptcy. The court considered the reasonable expectation of parties; other unsecured creditors, Judge Rhodes said, should have been on notice that they lacked the same level of protection as public pensions.

Finally, Judge Rhodes concluded that if each of the settlements within the plan is reasonable, as he in fact found, then the resulting discrimination in the plan must be fair. This argument ends up being highly consequential in Detroit's case because other classes receiving greater returns are comprised of creditors to whom state constitution and workforce arguments do not apply. In less careful hands, the test's reliance on settlement could write unfair discrimination out of the statute altogether. Perhaps the teeth of this analysis will be apparent in the written decision.

The Rhodes Test, as applied in the oral ruling, focuses far more on the attributes of accepting classes than of dissenting classes. If one considers the latter, the test becomes awkward to apply.  Some of the claims in the dissenting classes were involuntary. The plaintiffs did not ask to be run over by a city bus, or to have their constitutional rights violated by a police officer. What does it mean, then, to have reasonable expectations of recovery before extending credit? To the extent they had post-incident expectations, civil rights plaintiffs maintained that the U.S. Constitution protected their claims from discharge in bankruptcy entirely (on Friday, Judge Rhodes overruled that argument). 

Also, a mission-related justification for discrimination is inherently difficult to apply to classes comprised of miscellaneous claims. Surely a city's mission includes the avoidance of bodily or constitutional harm to its residents and guests. To the extent that mixing tort and contract claims dilutes objectors' unfair discrimination arguments, then perhaps separate classification should be required. And, unlike the accepting classes, the dissenting classes in Detroit had no mechanism to coordinate a settlement with the City (had there been an unsecured creditors' committee, the story might be different). If settling on behalf of a whole class is what entitles parties to more, then the process should provide an outlet to achieve that. In any event, we'll see what further elaboration the written plan confirmation opinion offers.

Professional Fees: In most municipal bankruptcies, courts have little to do with professional fees throughout the case because Congress told them to stay out of that business. Municipalities can take it upon themselves to be transparent about the fees they pay and face the consequences. From the beginning of Detroit's bankruptcy, Judge Rhodes has taken a different approach by proposing and appointing a fee examiner (noted here and here). Congress did give courts what I previously would have characterized as a modest gatekeeping role at the end of the case: chapter 9 plan confirmation depends in part on a court finding that the fees to be paid have been fully disclosed and are reasonable (11 U.S.C. 943(b)(3)). On Friday, Judge Rhodes interpreted this Bankruptcy Code provision to give the judge an independent duty to review all professional fees in the case, including those already paid and those already found to be reasonable by his own fee examiner. The reasonableness-of-fees question apparently is being sent to that little slice of heaven known as mediation.  

Speaking of "Mediation..."  Doctrinal developments pale in comparison to the methods used to corral this case into submission by Chief Judge Gerald Rosen, who was appointed lead mediator for everything/anything/anyone early in the case. Watch Chief Judge Rosen's most recent press conference (yes, press conference, and yes, there has been more than one) replayable here (from 11:00 to 27:00). Or read about a speech Chief Judge Rosen made yesterday. And behold the new third rail of federal court politics.

To be continued photo courtesy of Shutterstock.

 

 

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