May/June 2015

Feasibility in Municipal Restructurings Recent Rulings from the City of Detroit

Phoenix Management Services was recently called upon to be an independent expert in evaluating the feasibility of the City of Detroit’s restructuring plan. Senior managing directors Brian Gleason and Martha E. M. Kopacz discuss feasibility in Chapter 9 cases, departures from Chapter 11 and obstacles in interpretation prior to the City of Detroit bankruptcy.



Brian Gleason, Sr Managing Director/ Shareholder, Phoenix Management Services

Brian Gleason,
Senior Managing Director/Shareholder,
Phoenix Management Services


Martha E. M. Kopacz, Sr Managing Director, Phoenix Management Services

Martha E. M. Kopacz,
Senior Managing Director,
Phoenix Management Services

The following has been said about feasibility in municipal restructurings: “What is merely unclear in Chapter 11 is an impenetrable fog in Chapter 9.”1 Until Judge Steven W. Rhodes of the U.S. Bankruptcy Court for the Eastern District of Michigan provided an oral summary of his opinion in the City of Detroit Bankruptcy2 and issued his Supplemental Opinion on December 31, 2014,3 few authoritative writing existed on Chapter 9 cases where feasibility played a central role.

One of the myriad issues addressed during the Detroit bankruptcy is how the feasibility test would be applied absent authoritative case law. Much like U.S. Supreme Court Associate Justice Potter Stewart’s approach to pornography — “I know it when I see it…” — most experienced restructuring professionals have at least an intuitive sense of how to interpret feasibility in a commercial setting, but have given scant thought to how to apply the feasibility requirement to a city attempting to emerge from bankruptcy.

Feasibility for Detroit and Beyond

Municipalities are mission-based enterprises; they do not exist to generate a profit but rather to fulfill a mission. In the case of a city, its purpose is to provide public services to its citizens and visitors. Judge Rhodes had previously ruled that the city was “service delivery insolvent”4 and unable to provide a basic level of municipal services.

The difference in the timeline of existence for a municipality and potential alternatives to reorganization in Chapter 9 also comes into play. Cities are designed to exist in perpetuity so commercial alternatives — including liquidation or selling the company — are not available. Because a city really has few options but to survive, it must be put on a path to sustainability. Complicating the time frame for a feasibility assessment is that municipalities are creatures of the democratic system and greatly impacted by election cycles. While it may be evident who will lead the restructuring of a city near term, this time frame is likely limited to the next election, typically less than four years.

These and many other issues impacted how we, as Judge Rhodes’ independent expert, evaluated the feasibility of Detroit’s restructuring plan.

Feasibility Standard

It was clear to us that a feasibility standard would need to be developed in the abstract before we understood what the fact gathering and analysis indicated. After intensive conversation, brainstorming and research we developed the following standard:

Is it likely that the City, after confirmation of its Plan, will be able to sustainably provide municipal services to its citizens, and, make payments contemplated without the significant probability of default?5

To meet the standard, we determined that qualitative and quantitative measurements were required.

Assessment Questions


We developed assessment questions to address both prongs of the standard. They are general enough to provide a framework for future Chapter 9 cases and ensure that feasibility is assessed in a holistic manner. An appropriate balance between the hard numbers and subjective factors is the goal. The assessment questions are as follows:

Are the projections materially correct and the assumptions used to develop them individually and collectively reasonable?Restructuring professionals know there are different ways to model projections and make assumptions. However, the modeling techniques need to be credible and replicable. The math needs to be materially accurate, and the assumptions need to be reasonable, individually and when taken as a whole.

Does the city have the human resources, or can it likely recruit the human resources required to execute the plan? Plans may be designed by outside professionals but they are executed by leaders and individuals left behind when the professionals depart. CEO-level and C-suite level talent is the most important for a city exiting Chapter 9. We determined that every resource did not need to be in place, but rather, there must be a concrete plan in place to obtain and pay the necessary human capital to execute the plan. Having strong leaders in financial functions, public safety and other areas of particular emphasis may be so critical that without them, feasibility is threatened.

Does the city have appropriate systems and procedures to monitor its financial performance and make appropriate adjustments if it falls short of the projection? Like human resources, a municipality needs to have, or be able to obtain and pay for, the information systems and financial reporting infrastructure to ensure proper compliance with, execution of and early warning signals for financial and operational activities. Although current systems may be unsatisfactory, a plan for new systems and interim “workaround” processes, could provide reasonable assurances that a city can achieve a full recovery.

Are there appropriate structures to ensure the city’s compliance with the plan and with reasonable government standards of operation? To overcome concerns regarding future democratic processes, we determined that appropriate oversight structures would be required. In Detroit’s case, the State of Michigan established a Financial Review Commission.6 In general, we believe a strong oversight mechanism with the ability to intervene and protect against a future failure of municipal leadership is desirable.

Will the city be able to reasonably deliver a minimum level of municipal services? Is the city’s trajectory sustainable? In Chapter 11, a debtor is not able to exit bankruptcy if it is insolvent. With Detroit, we determined there was an achievable plan over a reasonable period of time and that the city would likely be able to deliver a minimum, but adequate, level of service. Based on evidence of successful implementation of the operational plan during our six-month visit, we also believed the trajectory appeared to be sustainable.

In Detroit, there was great pressure to use a finite, and short, time frame for the evaluation of feasibility. After many discussions, we based our standard on an indeterminate time period. We determined that the question of time frame was more closely tied to risks germane to the city’s operations. We were mindful that risks should be viewed in terms of total potential impact and the time horizon over which the impact may occur.

Risks and Guarantees

How much risk can be accepted so that a plan remains feasible? Mount Carbon, a census-designated place in Fayette County, WV, established that unrealistically favorable assumptions will cause the debtor to fail the feasibility test.7 On the other hand, we would argue that a plan with low levels of risk is “so feasible” as to likely fail the best interests test in Chapter 9. If a proposed plan of adjustment is essentially guaranteed, creditors will likely claim that more money could have been provided for distribution unless all creditors are paid in full.

Elected Leadership

As noted above, we found that the issue of leadership and the electoral process presented challenges to the question of feasibility. We could only evaluate the skill and will of the current elected officials. While the court or other stakeholders can insist on certain levels of oversight or control, ultimately, we have to trust the democratic process and the electorate to demonstrate wisdom when selecting future leaders.

‘Reasonable’ Continuum

The last feasibility test feature we pondered was: Is feasibility a binary test? In the end, we determined there is no single data point that defines feasibility, and the reasonableness of the quantitative and qualitative components of the standard should be viewed as a range of values. We fundamentally believe that “reasonable” can exist along a continuum. Assumptions skewed towards conservative or aggressive still remain along the reasonable continuum. By changing the name of the entity in question, we believe the standard can be applied to a wide range of municipal insolvency and restructuring issues in the future.

The court found it is likely that the City of Detroit, after the confirmation of the plan of adjustment, would be able to sustainably provide basic municipal services to the citizens of Detroit and meet the obligations contemplated in the plan without the significant probability of a default. Accordingly, the court found that the city’s plan of adjustment was feasible.8

Brian Gleason is senior managing director and shareholder, and Martha E. M. Kopacz is senior managing director, both at Phoenix Management Services.

Footnotes


1. Pryor CS. Who Bears the Cost? The Necessity of Taxpayer Participation in Chapter 9. Available at: http://widenerlawjournal.org/files/2015/03/Pryor-5.pdf (Last accessed April 20, 2015).
2. Oral Opinion On The Record – In re City of Detroit Bankruptcy Judge Steven Rhodes, November 7, 2014. Available at: www.mieb.uscourts.gov/news/oral-opinion-record-re-city-detroit-bankruptcy-judge-steven-rhodes-november-7-2014 (Last accessed April 20, 2015).
3. www.kccllc.net/detroit docket #8993
4. www.kccllc.net/detroit docket #1945
5. M. Kopacz Expert Report of July 18, 2014 at www.detroitmi.gov./emergencymanager/bankruptcychapter9
6. Under the “Grand Bargain Legislation” that was integral to Detroit’s PLAN, Michigan enacted PA 181 of 2014 establishing a Financial Review Commission, to oversee the city’s fiscal activities including authority to approve the City’s 4-year financial plans, contracts over $750,000, collective bargaining agreements and possibly pension funding obligations.
7. In re Mount Carbon, 242 B.R. at 36
8. www.kccllc.net/Detroit docket #8206