“The best interests of creditors”: A Public Sector Inc. Q&A with David Skeel on what’s next for Detroit
David Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School. A leading authority of bankruptcy law and corporate law, Prof Skeel has published widely in a variety of scholarly law journals, more popular publications such as the Wall Street Journal and Weekly Standard, and he has also written three books. In public finance circles, he is probably best known for his arguments about the underappreciated benefits of bankruptcy for cities, and maybe even state governments as well.
Public Sector Inc. editor Steve Eide recently interviewed Prof. Skeel. Below is an edited transcript.
EIDE: On Tuesday, Judge Steven Rhodes declared Detroit eligible for municipal bankruptcy. Leading up to the decision, did you think there was any way that Detroit might have been ruled ineligible?
SKEEL: The short answer to that is “no.” I can’t say that I wasn’t surprised by everything that Judge Rhodes said, but it was no surprise to me or anybody else that he concluded Detroit is eligible for bankruptcy.
EIDE: Attention will now shift to the city’s so-called plan of adjustment, said to come out in early January. What will you be looking for?
SKEEL: The main thing that I will be looking for is whether pensions can be restructured in a municipal bankruptcy. The unions in Detroit argued that there’s a state constitutional provision that says that pensions can’t be impaired, that it’s illegal to adjust pensions in any way. Judge Rhodes said no, they can be adjusted in bankruptcy and, if that ruling stands up (it’s likely to be appealed), I think it’s a hugely important ruling. To be quite honest, I didn’t think he would decide it with his initial ruling.
EIDE: Yes, many believed he would say that pensions are not an eligibility issue, but something to be addressed later on, with the plan of adjustment. Any thoughts as to why Judge Rhodes decided to go there in his eligibility ruling?
SKEEL: My best guess is that he might have thought the unions, and the retirees in particular, who are the ones most affected by this, just would not give any ground and would not be willing to negotiate at all so long as they thought there was a pretty good case that pensions can’t be restructured. So it may be that he just wanted to signal that they are on the bargaining table and the retirees should at least consider the possibility.
EIDE: With regard to the appeal process, any way that this goes to the Supreme Court, or is that just boasting on the unions’ part?
SKEEL: In my view, there’s no question that the pension issue is going to go to the Supreme Court. It’s just a question of whether it’s going to be in Detroit or whether it’s going to be in one of the California bankruptcies, Stockton or San Bernardino, and if it’s in Detroit, whether it is at this stage of the case. There’s a little bit of a question whether a decision to allow a municipality to file for municipal bankruptcy can even be appealed and what the nature of that appeal is. So it’s possible that the pension issue doesn’t get decided now but it will get decided, either now, or when there’s a restructuring plan that proposes to adjust pensions. I just can’t imagine that the Supreme Court would do anything other than take the case, because it’s never been decided before, and it’s a hugely important issue, not just for Detroit, but for a whole lot of other cities and potentially even states as well. If pensions can be restructured, we might see more big municipal bankruptcies. If they can’t, then we probably won’t, because pensions are at the heart of most troubled municipalities’ troubles.
EIDE: In the press, there’s been much discussion about the status of the holdings of the Detroit Institute of Art, but, it’s my understanding that, under Ch. 9, a creditor can’t demand sale of any assets. Could the art somehow come into play here?
SKEEL: There’s nothing in Ch. 9 that a creditor can use as a lever to directly force the sale of art. The only party or person in the case who has much influence over what happens with the art is the judge, and the judge can’t directly force a sale of the art. In theory, the judge could be reluctant to approve a plan that didn’t provide for the sale of any art, but I doubt that would be the case. The bottom line is, if Detroit feels like it doesn’t need to or doesn’t want to sell the art, it doesn’t have to.
Now, one thing that’s complicated things with Detroit is the emergency manager has signaled that he thinks that the art is on the table. So, although the emergency manager, on behalf of Detroit, can’t be forced to sell the art, it’s possible that that issue will come into play.
The plan is required to do the best that Detroit can do to pay back some of what it owes to its creditors. So the question of whether Detroit is trying hard enough to pay back creditors may include the issue of whether it’s willing to sell some art to make the plan work. Creditors could also refuse to vote for a plan that doesn’t provide for the sale of the art. The plan has to be approved by the bankruptcy judge, as well, and one of the questions he’s going to need to take into account is, is Detroit doing the best it can to pay back its creditors? The particular requirement is that the proposed restructuring plan has to be in the “best interests of creditors.” It’s not entirely clear what means, but a plan that involves lots of sacrifice on the part of creditors, and not a lot of sacrifice on the part of Detroit probably doesn’t satisfy that “best interests of creditors” standard.
EIDE: Why would any creditor, ever, vote in favor of a plan of adjustment in which his claim is impaired? He just thinks he won’t get a better deal otherwise?
SKEEL: Exactly. You make a calculated decision whether you’re better off with this plan than you would be without this plan. You consider what happens if this plan gets voted down. One possibility is, we get another plan proposed, which may or may not treat you better. Another possibility, at least in theory, is that nothing is approved, we just don’t get any plan at all, and the alternative you would consider there is, am I better off just voting against everything in hope that I can prevent a plan from being approved, because I think I’m better off taking my chances with Detroit outside of bankruptcy. Now, an obstacle to that, if you’re a creditor, is a plan can be crammed down even over a class of creditors that votes “no,” under certain circumstances. So you can’t be sure that you would stymie a plan, but you can make it more complicated.
Creditors, when they’re voting, take a calculated risk after assessing what their options are. And the likely options are, I vote no on this plan, we’ll get another plan, but it’ll take three more months and things will get even worse in Detroit, so I might be offered even less. Or a creditor might think, I might as well take my lumps and vote yes on this.
EIDE: What do you think is going to happen with Orr’s attempt to treat general obligation (GO) bonds as unsecured?
SKEEL: I think he’s absolutely right about it. This is a place in Ch. 9 where I think there is an honest and serious difference of perspectives between the muni bond world and the bankruptcy world. In the muni bond world, people think GO bonds are like secured credit. They’re absolutely protected. For bankruptcy purposes, they pretty clearly are not. Ch. 9 provides special protection for revenue bonds. It does not provide special protection for GO bonds. And that’s just the opposite of what people in the muni world think about these bonds.
My view is that GO bonds definitely can be restructured, but that the different expectations of the different unsecured obligations can be taken into account under another of the requirements of Ch. 9. Ch. 9 says that a plan cannot “unfairly discriminate.” So what that’s interpreted to mean is that any differences among general creditors have to be fair: there has to be a principled basis for them. And based on that, the GO bondholders could take the position that GO bonds, even if subject to restructuring, are a higher-status bond than, say, the certificates of participation. I think they have a pretty strong claim that they ought to be closer to 100% payout rather than 0% payout.
EIDE: The city wants to wrap up proceedings by September, before the November elections and Kevyn Orr’s term as emergency manager ends. Does that seem realistic to you?
SKEEL: It seems very optimistic. There’s talk that he is going to roll out his plan in early January, which would, in theory, leave plenty of time to jump through all the hoops, have the vote and have it confirmed by next September. It’s possible, but it does seem optimistic. This is a case where people are not happy with each other, the negotiations have been fraught at every turn. The unions and retirees have not given up on the pension issue. If we have a lengthy appeal process, that’s going to complicate things.
EIDE: There has also been much discussion over whether more cities will follow Detroit, the “who’s next?” question. But it’s not clear to me, at least, that many more cities could actually qualify for Ch. 9. For example, how many cities do you think are out there that could actually pass the cash flow insolvency test?
SKEEL: That’s a great question. The insolvency issue, historically, has been a big hurdle to filing for municipal bankruptcy and I think there aren’t a lot of cities that can show that they are insolvent, for the purposes of municipal bankruptcy. Detroit was pretty extraordinary in that respect. Some have argued even with Detroit there was a question of whether it was truly insolvent, given all of their assets that they could theoretically have been selling to pay off their creditors.
Bridgeport, CT got thrown out of bankruptcy. Even though it was in terrible shape, the court said it’s not bleak enough. People talk about Chicago, which has a really horrendous pension problem. I don’t think Chicago could come close to satisfying the insolvency requirement. Because of the difficulty of showing insolvency, I don’t think you see lots of big cities suddenly jumping into bankruptcy.
EIDE: Do you think Ch. 9 should be reformed?
SKEEL: The short answer to that is yes. I think that the insolvency requirement may be a little bit too strict. Detroit credibly could meet it because Detroit is in such terrible shape. But, a lot of cities who might be good candidates for Ch. 9 are going to have trouble meeting that insolvency standard. We do not use that standard for other bankruptcies. When an individual or corporation files for bankruptcy they don’t have to actually show that they’re insolvent. So I would be in favor of relaxing that requirement. I would also want to define what the “best interests of creditors” means a little more precisely.
It’s certainly not a perfect statute. But, though I think there are some things that ought to be done with Ch. 9, I also think it’s likely to work relatively well. I’m not saying it needs to be just gutted and thrown out and we need to start over.