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Detroit bankruptcy challenged on constitutional grounds

The word 'Bankruptcy' is seen painted on the side of a vacant building by street artists as a statement on the financial affairs of the city
The word 'Bankruptcy' is seen painted on the side of a vacant building by street artists as a statement on the financial affairs of the city

By Joseph Lichterman and Bernie Woodall

DETROIT (Reuters) - Public labor unions took aim at Detroit's historic bankruptcy filing on Monday, asking a U.S. court to toss the city's bid for protection from its creditors because it is constitutionally flawed on both the state and federal levels.

A union that represents public-sector workers even took the unusual step of arguing that Chapter 9 of the federal bankruptcy code, under which municipalities seek protection from their creditors, violates the U.S. Constitution.

But as a midnight deadline for filing objections to the bankruptcy passed, Detroit's bondholders were conspicuously absent from the long list of unions, pension funds and individual creditors lining up to argue against bankruptcy.

Unions representing the city's firefighters and police alleged that state-appointed emergency manager Kevyn Orr had failed to negotiate in good faith, stating "there were no negotiations."

Under U.S. bankruptcy code, Detroit must prove it is insolvent and has negotiated with creditors in good faith, or there were too many creditors to make negotiations feasible, in order to be certified by a federal judge for a bankruptcy proceeding.

For his part, Michigan Attorney General Bill Schuette said in a filing that even if the bankruptcy case continues, the city cannot be allowed to ignore state constitutional protections for retirement benefits earned by its employees.

Schuette's filing does not ask the judge to prevent Detroit's bankruptcy from proceeding.

Unions and the city's two public pension funds made similar arguments in their filings, claiming a bankruptcy filing will lead to an unconstitutional reduction in retirement benefits.

The American Federation of State, County and Municipal Employees Council 25, in its filing with the U.S. Bankruptcy Court in Detroit, argued that Chapter 9 encroaches on states' rights.

The union made more conventional legal arguments as well.

It argued that Detroit, which last month filed for what would rank as the largest-ever U.S. municipal bankruptcy, has not proven it is insolvent and has not negotiated in good faith with its creditors.

AFSCME also said Michigan's emergency manager law, which enabled Detroit to file for bankruptcy on July 18, violates the state constitution because the law does not explicitly protect retirement benefits for public workers.

The United Auto Workers, whose members work for the city, also filed an objection early Monday evening, claiming that Gov. Rick Snyder violated Michigan's constitution when he permitted Detroit's emergency manager Kevyn Orr to file for bankruptcy.

A June 14 "Proposal to Creditors" made roughly a month before the bankruptcy filing "serves as the vehicle of Governor Snyder and EM Orr to use federal bankruptcy law to impair pensions protected from impairment" by the Michigan constitution, the UAW said in its objection.

AFSCME's arguments were adopted by two other city unions -SEIU Local 517 and International Union of Operating Engineers Local 324 - in separate filings.

Municipal bankruptcy experts said the U.S. Supreme Court settled Chapter 9's constitutionality in 1938.

Jim Spiotto, an attorney at Chapman and Cutler, said as long as a state allows a local government to file for bankruptcy, as in Detroit's case, states' rights are not at issue.

"I'm sure somebody at the bankruptcy court level brought it up before, but I don't think (the argument) lasted very long," he said.

An AFSCME spokesman did not return messages seeking comment on the federal constitutional argument.

Schuette, the Michigan attorney general, said in his filing that Detroit is bankrupt, and the governor was authorized to allow the city's bankruptcy petition.

"However, throughout this bankruptcy process, protections enshrined in the Michigan Constitution by the citizens of our state must be honored, respected and followed," Schuette said, pointing to a constitutional prohibition against diminishing or impairing accrued retirement benefits for public workers.

He added unaccrued benefits can still be part of proceedings.

CLOCK TICKING

Prior to the 11:59 p.m. Eastern Daylight Time deadline set for Monday night by U.S. Judge Steven Rhodes, who is overseeing Detroit's case, objections had been expected by bondholders and bond insurers.

Members of both groups have challenged an agreement the city reached with counter parties to interest-rate swaps that would enable the city to unwind its swaps contracts at a discounted rate.

No explanation was immediately available for why no objection was filed by bondholders and bond insurers. Bond insurers, which step in and make debt payments on the city's behalf when it cannot meet its obligations, are particularly at risk after Orr in June announced plans to default on Detroit debt he considers unsecured.

In a court filing earlier this month, Detroit released a list of creditors, including current, former and retired workers, that filled 3,504 pages. An initial filing in the case by Orr said that "further negotiations with all of the city's various stakeholders is impracticable."

Orr's filing included a litany of Detroit's financial woes, including more than $18 billion in debt and other obligations, with nearly $12 billion of that amount considered unsecured.

Detroit, a former manufacturing powerhouse and cradle of the U.S. automotive industry and Motown music, has struggled for decades as companies moved or closed, crime surged and its population fell from a peak of 1.8 million in the 1950s to around 700,000 currently. The city's revenue fell short of spending, while its budgets and borrowing ballooned.

Orr will respond "specifically and completely" to the objections in court, said his spokesman, Bill Nowling.

"Mr. Orr believes he has surpassed the legal standard of negotiating in good faith with creditors and stakeholders," Nowling said. "He submitted a proposed restructuring plan to creditors on June 14."

About 50 individuals filed objections at the federal court in Detroit on Monday morning. The group was organized by the Detroit chapter of the National Action Network, a national civil rights organization founded by Rev. Al Sharpton.

The group's objection cites potential constitutional problems with a Michigan law that allowed for the bankruptcy filing and claims that the judge did not allow enough time for objection filings.

Rev. Charles Williams II, the chapter's president, said many residents, himself included, received notice only last week that they were parties of interest who could object to the filing.

"The process hasn't been as clear and transparent as it should have," Williams said. "Many Detroit residents received letters giving them the opportunity to file for an objection and they didn't even know they received it. They weren't properly notified."

Rhodes has scheduled October 23 for the start of a hearing to determine if Detroit is eligible to file for bankruptcy under Chapter 9. If Detroit is deemed eligible for municipal bankruptcy, it would be the biggest such case in U.S. history.

Detroit's largest unsecured creditors are its two pension funds, which have claims totaling $3.74 billion in estimated unfunded liabilities, according to a court filing by the city.

The remainder of the city's top 20 creditors include bondholders of $1.47 billion of certificates of participation that Detroit sold for its pension funds and hundreds of million dollars of general obligation bonds.

The Detroit Institute of Arts said on Monday it will not file an objection to the bankruptcy. The DIA has become embroiled in the city's case because its assets, which include works by Van Gogh and Matisse, could be sold to pay Detroit's debt. However, Orr has said he hopes he does not have to sell DIA assets.

Rhodes on Monday appointed Chicago attorney Robert Fishman as the fee examiner in the case.

(Additional reporting by Karen Pierog, Nicholas Brown and Deepa Seetharaman; Editing by Dan Grebler and Elizabeth Piper)

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