UPDATE 2-Judge rules Detroit bankrupt, sets stage for new finance plan

Reuters

(In paragraph 31, corrects number of museum pieces to 500 from50)

By Joseph Lichterman and Bernie Woodall

DETROIT, Dec 3 (Reuters) - A federal judge on Tuesdayformally declared Detroit bankrupt, a landmark ruling thatclears the way for potentially sweeping cuts to city workerpensions and retirement benefits and for steep and possiblyprecedent-setting losses to the cash-strapped city's bondholders.

The ruling by U.S. Judge Steven Rhodes, who cited the city'sdismal finances and $18 billion owed to a multitude of creditorsin support of his decision, marks a watershed in the history ofDetroit. Once known as the cradle of the U.S. auto industry, thearsenal of democracy and the birthplace of Motown music, Detroitnow adds an ignominious new title: largest bankrupt city in U.S.history.

Detroit's emergency manager, Kevyn Orr, in a news conferenceafter the court hearing, said the city will seek to file a planof readjustment - the city's roadmap toward financial solvency -by early January. He said negotiations are continuing withunions "even now," and called on all parties to bridge gaps inorder to conclude Detroit's bankruptcy and move back towardfiscal stability.

In a financial plan he had laid out prior to the bankruptcyfiling, Orr had proposed offering unsecured creditors shares ina $2 billion note in exchange for $11 billion in unsecured debt.Orr declined to state on Tuesday whether that remains his plan,and also refused to say how much of a reduction he will seekfrom secured creditors.

Judge Rhodes, in his ruling that Detroit is eligible,accepted the city's contention that it is broke and thatnegotiations with its thousands of creditors were infeasible.That was enough to declare Detroit bankrupt under Chapter 9 ofthe federal bankruptcy code, Rhodes ruled. In a symbolic setbackfor the city, however, Rhodes found that Orr did not negotiatein good faith with creditors prior to the city's July 18bankruptcy filing.

"It is indeed a momentous day," Rhodes said as he read aloudfor more than an hour from a written statement in a packedcourtroom. "We have here a judicial finding that this once-proudand prosperous city cannot pay its debts. It's insolvent. It'seligible for bankruptcy. At the same time it has an opportunityfor a fresh start."

Rhodes also said the city could cut pensions as part of therestructuring, ruling against an argument that Michigan'sconstitution protects them from being slashed. However, Rhodeswarned he will not rubber-stamp any pension cuts.

"Nobody should interpret this holding, that pension rightsare contract rights, to mean that this court will necessarilyconfirm any plan of adjustment to impair pensions. It will notcasually or lightly exercise the power under federal bankruptcylaw to impair pensions," Rhodes said.

His ruling encompassed fine points of law as well as broadobservations about Detroit's fiscal health. He stated that his findings were informed by a breakdown in Detroit's publicinfrastructure and rising crime rate.

STRUGGLING CITY

Detroit is burdened by $18.5 billion in debt as it strugglesto provide even the most basic services to 700,000 residents.About 40 percent of the city's streetlights do not work andabout 78,000 abandoned buildings litter the city, whosepopulation peaked at 1.8 million in 1950.

"The city no longer has the resources to provide itsresidents with basic police, fire and EMS services," Rhodessaid. He noted the average police response time is 58 minutes,more than five times the national average of 11 minutes.

"The city needs help," Rhodes said.

The judge declined to stay the bankruptcy proceedings aspotential appeals proceed through the courts. He also turneddown an effort to allow any appeals of his ruling to go directlyto the 6th Circuit U.S. Court of Appeals. Rhodes declared thatmotions to appeal the case must first be filed in bankruptcycourt. He previously stayed all state court action in the case.

The American Federation of State, County and MunicipalEmployees Council 25 filed a notice of appeal of Rhodes' rulingin the bankruptcy court. The appeal, expected to be joined bythe city's largest pension funds, claims the judge erred inruling that federal bankruptcy law trumps public employeepension protections embedded in the Michigan Constitution.

Rhodes ruled that bankruptcy proceedings will continuedespite the appeals.

NEW CHAPTER

Tuesday's ruling begins a new chapter in the case that firstarrived in federal court with Detroit's July 18 bankruptcypetition. As emergency manager Orr works towardsubmitting a plan to readjust Detroit's more than $18 billion indebt - to be accomplished chiefly by forcing creditors to take adiscount on what the city owes them - an appeals process willbegin in the federal courts.

In order to meet federal eligibility requirements, Detroithad to prove that it is insolvent, it was authorized to file forbankruptcy and that it negotiated with creditors in good faithor that negotiations were impractical.

Orr, a former bankruptcy lawyer, was appointed in March byMichigan Governor Rick Snyder, a Republican.

In his lead-up to the ruling, Rhodes offered a detailedanalysis of key arguments made by the city's labor unions,retirees and pension funds opposed to the bankruptcy. He foundthat Chapter 9 of the federal bankruptcy code is constitutionaland while Michigan's constitution protects public pensionbenefits as contracts, those contracts can be impaired in amunicipal bankruptcy.

"Municipal pension rights are contract rights," he said. Thejudge noted that he changed his mind about ruling on the pensionissue as part of the eligibility ruling because he said"resolving this issue now will likely expedite the resolution ofthis bankruptcy case."

The judge also found that the 2012 Michigan law that allowedthe city to file for bankruptcy with the governor'sauthorization was constitutional. Before Orr filed forbankruptcy, he obtained approval from Governor Snyder.

Despite ruling that the city met the test for bankruptcy,Rhodes found fault with how Orr proceeded toward the bankruptcyfiling.

The city should have more "openly and forthrightly"discussed bankruptcy as a possibility to rectify Detroit'sproblems in the months and years leading up to the filing. Aseries of meetings and presentations the city held withcreditors leading up to the filing did not meet the good-faithrequirement, he said.

The city's financial troubles were so bad that Detroit'sfiling was inevitable, Rhodes said.

"The court must conclude that the bankruptcy filing by thecity of Detroit was a foregone conclusion during 2013, butwaiting too long does not constitute bad faith," Rhodes said.

The city acted in good faith when it ultimately filed itsbankruptcy petition, largely because it was impracticable forthe city to negotiate with its thousands of creditors.

"Pre-bankruptcy negotiations were impracticable, impossiblereally," Rhodes stated.

UNION CONCERNS

With Rhodes' ruling in hand, attention will now turn toDetroit's negotiations with creditors, retirees, unions andpension funds.

Detroit says about half its liabilities stem from retireebenefits, with $5.7 billion in liabilities relating to retireehealthcare and another $3.5 billion from pensions.

Likely cuts to retiree pensions and changes in healthcarebenefits are at the heart of union concerns about Detroit'sbankruptcy. And a separate issue, the future of the collectionof the Detroit Institute of Arts, a prized city asset, has drawnattention inside Detroit and around the world. The museumincludes paintings by Vincent van Gogh and Henri Matisse, anoriginal cast of Auguste Rodin's "The Thinker," and a frescomural by Mexican artist Diego Rivera.

Orr, in remarks after Rhodes' ruling on Tuesday, said onlyabout 500 pieces of the museum's collection might be affected byDetroit's bankruptcy. He declined to offer any details but saidan announcement will be made soon.

He also emphasized the need for the city to move on. "Whilewe are very pleased, we remain very concerned to adjust thecity's debt and improve the level of service for its citizensand to also prepare for the city to exit this receivership in afashion that restores democracy to the city."

Some critics of Orr have claimed his position isundemocratic because it leaves elected officials like Mayor DaveBing and the city council without power to set policy or makebinding decisions.

Rhodes in announcing his ruling said asset sales or otherone-time infusions of cash will not solve Detroit's long-termfinancial troubles.

"A one-time infusion of cash, whether from an asset sale orborrowing, delays the inevitable," he said.

(Additional reporting by Karen Pierog in Chicago and BenKlayman in Detroit; editing by David Greising, Dan Burns andMatthew Lewis)

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