NOTES. Investing in Detroit: Automobiles, Bankruptcy, and the Future of Municipal Bonds

Transcription

1 NOTES Investing in Detroit: Automobiles, Bankruptcy, and the Future of Municipal Bonds ANNA M. RICE* TABLE OF CONTENTS INTRODUCTION I. THE HISTORY OF DETROIT A. AUTOMOBILES B. MUNICIPAL BONDS C. BANKRUPTCY II. MUNICIPAL BOND REGULATION A. DEVELOPMENT OF MUNICIPAL BOND REGULATIONS B. THE DODD FRANK ACT AND MUNICIPAL BONDS III. THE FUTURE OF MUNICIPAL BONDS A. WHY REGULATE MUNICIPAL BONDS? B. BANKRUPTCY LAWS C. PROPOSED SEC DISCLOSURE REQUIREMENTS Calls to Action Modifying Initial Disclosure Guidance Modifying the Rule for Continued Disclosure Price Transparency CONCLUSION * Georgetown Law, J.D. 2015; Harvard University, A.B , Anna M. Rice. I would like to thank Professor Heidi Li Feldman for getting me started, Professor Eloise Pasachoff for encouraging me to keep working, and Professor Guy Neal and his colleague Peter Canzano for their invaluable advice. Thank you also to my family for their constant support. Finally, thank you to The Georgetown Law Journal editors and staff for their help and hard work. All errors are my own. 1335

2 1336 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 INTRODUCTION The Michigan constitution does not single out the obligations of municipal bonds for protection in the same way it protects pension rights. Bond obligations can no longer be the only first-budget municipal obligations. Bankruptcy Judge Steven Rhodes 1 On July 18, 2013, Detroit, Michigan became the largest municipality in United States history to file for bankruptcy. 2 Since the days of Henry Ford, Americans have been investing in Detroit by buying its most famous product automobiles. 3 They have also been investing directly in Detroit itself, buying a financial product called municipal bonds. Detroit, along with many other cities, sells municipal bonds to raise money for city projects. 4 Holders of those municipal bonds were major creditors in the city s bankruptcy case. Many municipal bonds are held by retail investors because bonds have long been considered a relatively safe investment on the theory that cities are not likely to default or go bankrupt. 5 The bankruptcy of a city as large as Detroit, coming on the heels of other Chapter 9 municipal bankruptcies, has made investors question the bonds stability. Although Detroit s bankruptcy has not undermined bonds overall safety, the treatment of municipal bond debt in Detroit could affect the future of the $3.7 trillion municipal bond market 6 and the savings of many people outside the Motor City. The ability of cities to finance their projects could also be affected the riskier municipal bonds are seen to be, the more difficult it will be for cities to sell them at high prices, leaving them stuck in a cycle of municipal poverty. 7 One mission of the Securities and Exchange Commission (SEC) is to protect investors; 8 municipal securities have historically escaped stringent regulations because they are stable investments. As worries about bond defaults and munici- 1. Oral Opinion on the Record at 42, In re City of Detroit, Mich., 504 B.R. 191 (Bankr. E.D. Mich. Nov. 7, 2014) (No ), available at Opinion_on_Detroit_Plan_Confirmation_Judge_Rhodes_FINAL_for_Release.pdf. 2. See, e.g., Nathan Bomey et al., Judge Rules Detroit Eligible for Historic Chapter 9 Bankruptcy, Says Pensions Can be Cut,DETROIT FREE PRESS (Dec. 3, 2013, 2:22 PM), /NEWS01/ /Detroit-bankruptcy-eligibility-Steven-Rhodes-Chapter-9-Kevyn-Orr. 3. See Our History, FORD, (last visited Mar. 16, 2015). 4. See, e.g., U.S. SEC. & EXCH. COMM N, REPORT ON THE MUNICIPAL SECURITIES MARKET i ii (2012), available at [hereinafter SEC REPORT]. 5. Id. at See, e.g., Louis Basenese, Why Detroit s Bankruptcy Could Detonate a $3.7-Trillion Muni Bond Bomb, WALL ST. DAILY (July 24, 2013), 7. Objection of Ambac Assurance Corp. at 5, In re City of Detroit, Mich., 504 B.R. 191 (Bankr. E.D. Mich. May 12, 2014) (No ), 2014 WL The Investor s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation, SEC. & EXCH. COMM N, (last visited Mar. 16, 2015).

3 2015] INVESTING IN DETROIT 1337 pal bankruptcies surfaced during the Great Recession, the federal government started to reassess the regulation of municipal securities. Although a complete overhaul of municipal securities regulation may take decades, this Note suggests two proposals to implement in the short term. The proposals address growing concern about the rights of municipal bondholders in Chapter 9 bankruptcy: first, the SEC should issue interpretive guidance detailing the bankruptcy law and risk information to be disclosed in the initial bond-offering documents; second, the SEC should modify Securities Exchange Act Rule 15c2-12 to ensure ongoing review of municipal bankruptcy laws and risks throughout the term of the bond. 9 SEC Commissioners from both sides of the aisle have expressed concern about how the opacity of pricing in the bond market makes it difficult for individual investors to access accurate price information. 10 This Note s proposal to clarify complex municipal bankruptcy law in online filings accessible to all investors would help individual investors participate in the market without prohibitive research costs. In addition, the proposed federal guidance and disclosure rules do not interfere with the rights of states to regulate their own economies and pass their own municipal bankruptcy authorization laws. Transparently incorporating the risk of bankruptcy into bond prices will be a crucial first step in making the bond market safe for all investors while leaving the federal state balance intact. Municipal bondholders, who are primarily retail investors, should be protected by the SEC and provided with easily accessible information on municipal bankruptcy law and precedent. This Note proposes specific bankruptcy-related disclosure requirements to enable these investors to properly price in the risk of bankruptcy. Part I of this Note traces the history of Detroit, with a focus on its municipal bond issuances and descent into bankruptcy. Part II describes the history and current state of municipal bond regulation. Finally, Part III proposes two important initial regulatory steps that will improve disclosure of bankruptcy risks and potential outcomes for bondholders in bankruptcy. I. THE HISTORY OF DETROIT The history of Detroit is a history of its major industry automobiles. The economy of the city rises and falls with the industry. Throughout its history, Detroit has been issuing municipal bonds to finance auto plants, transportation, and more. In July 2013, with Detroit s major industry struggling and the massive debt owed to city workers pension funds and municipal bondholders stifling economic growth, Detroit was forced to file Chapter 9 bankruptcy. A 9. See infra sections III.C SEC REPORT, supra note 4, at (report overseen by former Democratic Commissioner Elisse B. Walter); Bob Pisani, SEC s Gallagher: Market Regulation Overhaul Needed, CNBC (Oct. 1, 2014, 4:51 PM), (interview with Republican Commissioner Daniel M. Gallagher).

4 1338 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 federal judge approved Detroit s plan to exit bankruptcy in November The disparate treatment of unsecured creditors in Detroit s plan, which elevated pensioners rights above bondholders rights, should concern bondholders in future municipal bankruptcies. A. AUTOMOBILES During World War II, George W. Romney headed the Automotive Council for War Production, encouraging the industry to produce military equipment. 11 Romney, who later became Michigan s governor, had a vested interest in the auto industry as the chief executive of American Motors. 12 In a state that already idolized Henry Ford and the big auto companies, the increased wartime production only cemented the industry as Michigan s primary source of revenue. In the first two years of the war, half a million people moved to Detroit, the Arsenal of Democracy, to work. 13 The auto factories shaped Detroit s culture and population. 14 Ford Motor Company was the first company to start advertising assembly-line jobs in By 1925, there were thirty-seven car factories in Detroit. 15 The African- American population of Detroit increased more than twenty-fold between 1910 and 1930 as new autoworkers flooded into the city to fill the jobs. 16 Racial tensions after this migration added to Detroit s financial problems. White city-dwellers started moving en masse to the suburbs in the 1950s and 11. See RAPHA HOLDING,GOVERNORS OF THE UNITED STATES:POWERS AND LIMITATIONS 86 (2010). 12. See David E. Rosenbaum, George Romney Dies at 88; A Leading G.O.P. Figure, N.Y. TIMES (July 27, 1995), Nathan Bomey & John Gallagher, How Detroit Went Broke: The Answers May Surprise You And Don t Blame Coleman Young, DETROIT FREE PRESS (Sept. 15, 2013, 2:10 AM), com/interactive/article/ /news01/ /detroit-bankruptcy-history-1950-debt-pensionrevenue; see also FRED KAPLAN, 1959: THE YEAR EVERYTHING CHANGED (2009). The Arsenal of Democracy phrase is used by multiple sources. See, e.g., Nick Carey, Detroit Files for Bankruptcy, Stage Set for Court Fight, REUTERS (July 18, 2013, 7:55 PM), 18/us-usa-detroit-bankruptcy-idUSBRE96H16O Even in tiny Portland, over a hundred miles from Detroit, the automobile industry was the lifeblood of the community. There were no college prep classes at the local high school, and only about a tenth of students in the mid-1970s went on to higher education. However, the high school included a state-of-the art automotive shop half as large as the classroom building. As Portland native Julie Rice remembered: Higher education wasn t necessary for a lifetime of working in the automobile factories. from Julie Rice (née Bauer) to author (Mar. 12, 2014, 10:39 AM) (on file with author). 15. KAPLAN, supra note 13, at 214; see also ELIZABETH ANNE MARTIN, DETROIT AND THE GREAT MIGRATION, , at 4 (1993). 16. KAPLAN, supra note 13, at 214. Influenced by black musical traditions, the Motown Records assembly line produced so many hit records starting in 1959 that Motown short for Motor Town became a genre. See Top 5 Motown Singles: 1963,CURVATURE (July 20, 2012), com/2012/07/20/top-5-motown-singles-1963/. Motown was just one example of a cultural outgrowth of the car industry, specifically of the black migration spurred by the industry s swift rise and seemingly endless demand for labor. KAPLAN, supra note 13, at 213.

5 2015] INVESTING IN DETROIT 1339 especially after race riots in the 1960s, 17 abandoning entire sections of Detroit, eroding the tax base, and leaving behind a segregated city rife with slums and crime. 18 Citizens of all races have been fleeing the city ever since Detroit has lost 60% of its population since As the Detroit Free Press succinctly summarized: People leave, taxes go up, more people leave. 20 In 2012, Detroit had the highest income tax rate and the highest property tax rate in the state, yet income tax revenue had fallen 40% since Michigan continued to rely heavily on automobile production, its economy suffering with each industry setback. Extensive federal auto safety regulations were passed in the 1960s, putting a costly burden on the entire industry. 22 In the 1970s, gas prices rose and compact foreign cars flooded the market; Detroit s automakers struggled to keep up. 23 The politically powerful United Auto Workers (UAW) union kept labor costs high. 24 Although this helped Michigan workers, it further slowed the big American automakers competing with the smaller, cheaper cars built by foreign companies with low-cost labor. 25 American companies started releasing compact cars in response, including the Ford Pinto in 1971; a rash of lawsuits followed when Pintos started exploding in otherwise minor accidents. 26 Coleman Young was elected mayor in To rebuild the city, Young raised taxes and cut spending, encouraged auto companies to build factories in Detroit, and developed downtown. 28 Young started reducing the city s own 17. How Detroit Lost Its Way: White Flight, TIME, article/0,28804, _ _ ,00.html (last visited Mar. 16, 2015). 18. See Bomey & Gallagher, supra note 13. Julie Rice remembers that riding through the slums...looked like black and white television: all the scenery was in shades of gray. Walking into the [Detroit Tigers] ballpark was a remarkable contrast; like entering the Land of Oz, in full color with green grass and blue skies. from Julie Rice (née Bauer) to author (Mar. 12, 2014, 10:39 AM) (on file with author). 19. See Bomey & Gallagher, supra note 13; see also KEVYN D. ORR, CITY OF DETROIT OFFICE OF EMERGENCY MANAGER, FINANCIAL AND OPERATING PLAN 22 (2013) [hereinafter FINANCIAL AND OPERATING PLAN], available at 20Final%20Financial%20&%20Operational%20Plan%20_45%20Day%20Pl.pdf. 20. Bomey & Gallagher, supra note Id.;FINANCIAL AND OPERATING PLAN, supra note 19, at See generally LISA SCHULTZ BRESSMAN ET AL., THE REGULATORY STATE (2d ed. 2013). 23. James Sherk, The Union Difference: A Primer on What Unions Do to the Economy, CAPITAL RES. CTR. (Jan. 3, 2012), 12.pdf; see also David Kiley, Small Cars Rising: This Time Detroit Is Prepared, AUTOBLOG (Mar. 22, 2011, 3:00 PM), Sherk, supra note 23, at Id. 26. The 50 Worst Cars of All Time: 1971 Ford Pinto, TIME (Sept. 7, 2007), time/specials/2007/article/0,28804, _ _ ,00.html. 27. Bomey & Gallagher, supra note 13. Young was the first African-American mayor of Detroit. See Coleman A. Young, 79, Mayor of Detroit and Political Symbol for Blacks, Is Dead, N.Y. TIMES (Dec. 1, 1997), Bomey & Gallagher, supra note 13.

6 1340 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 workforce, aware of the ballooning pension obligations Detroit was incurring. 29 Young improved the city s finances so much, however, that Detroit was able to issue highly rated bonds with abandon, increasing the city s debt by 72% between 1987 and After he left office in 1994, pension obligations skyrocket[ed]. 31 The city was hit hard by the financial crisis in Many Americans no longer had the money to buy new cars, and auto manufacturers stock plummeted. Government bailouts and bankruptcy filings by Chrysler and General Motors two of the Big Three followed. 32 Since 2000, unemployment has tripled in Detroit. 33 And now, the city is bankrupt. 34 B. MUNICIPAL BONDS American municipal bond issuances have been taking place for over two centuries, beginning with a canal-financing bond offering in 1812 in New York City. 35 The SEC explains municipal bonds succinctly: Investors who buy municipal bonds are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or principal. 36 In short, bond buyers give the municipality money to help finance certain operations or projects, in effect buying pieces of the municipality s debt. In exchange for this loan, the municipality pays out set returns to the bondholders, often financed by taxes or other city revenues. Because taxes are seen as a steady revenue stream, investors expect consistent payments. 37 General obligation bonds are paid off with taxes or other general revenues, backed by the full faith and credit of the municipality. In addition, general obligation bonds usually include a promise from the municipality to levy ad 29. Id. 30. Id. 31. Id. 32. Timothy J. Sturgeon & Johannes Van Biesebroeck, Effects of the Crisis on the Automotive Industry in Developing Countries: A Global Value Chain Perspective 7 (World Bank Pol y Research, Working Paper No. 5330, 2010). Chrysler and General Motors (GM) filed for bankruptcy and were bailed out by the federal government. Id.; see also Tim Higgins et al., GM Bailout Ends as U.S. Sells Last of Government Motors, BLOOMBERG (Dec. 10, 2013, 12:01 AM), /gm-bailout-ends-as-u-s-sells-last-of-government-motors-.html. 33. FINANCIAL AND OPERATING PLAN, supra note 19, at See infra section I.C. 35. Basenese, supra note 6. Detroit has also been issuing bonds since the 1800s, including streetcar bonds issued in See Charles Moore, Municipal Ownership of Street Railways in Detroit, 13 Q.J. ECON. 453, 454 (1899). 36. Municipal Bonds, SEC. & EXC. COMM N, (last visited Mar. 16, 2015). 37. Darrell Preston et al., Detroit Case Scrutinized by $900 Billion G.O. Market, BLOOMBERG (July 19, 2013, 11:45 AM),

7 2015] INVESTING IN DETROIT 1341 valorem property taxes in an amount sufficient to repay the bonds. 38 There are both limited tax general obligation (LTGO) bonds, which carry the promise only to raise taxes to a certain point (limited by the state constitution), and unlimited tax general obligation (UTGO) bonds, which do not have that ceiling. 39 Bonds can also be issued to finance specific projects, or on behalf of private entities such as colleges or hospitals ( conduit borrowers ). 40 Many of the bonds at issue in Detroit s bankruptcy are general obligation bonds, including both LTGO and UTGO bonds. 41 The SEC found that [i]ndividuals, or retail investors, directly or indirectly hold more than 75% of the outstanding principal amount of municipal securities. 42 Households are the single largest owner of municipal securities and have been for the past six years. 43 Mutual funds are also heavily invested in these bonds. 44 The bond market was, and despite recent developments still is, viewed as a safe place to invest. 45 Municipalities have defaulted on bonds in the past, and Detroit is not the first to declare bankruptcy. 46 But defaults on investment-grade municipal bonds between 1970 and 2007 comprised only 0.1% of issuances; in comparison, 2.1% of investment-grade corporate bonds defaulted during that time. 47 Municipal bonds are popular investments for risk-averse investors due to consistent income payments, tax breaks, 48 steady tax revenue backing the bonds, 49 and the possibility of state statutory protections General Obligation Bond or Go Bond, MUN. SECS. RULEMAKING BD., definition/general-obligation-bond-or-go-bond.aspx (last visited Mar. 16, 2015). 39. Limited Tax General Obligation Bond, MUN. SECS. RULEMAKING BD., definition/limited-tax-general-obligation-bond.aspx (last visited Mar. 16, 2015); Unlimited Tax Bond, MUN.SECS.RULEMAKING BD., (last visited Mar. 16, 2015). 40. Municipal Bonds, supra note 36 (internal quotation marks omitted). 41. Preston et al., supra note 37; FINANCIAL AND OPERATING PLAN, supra note 19, at SEC REPORT, supra note 4, at v. 43. See id. at (graphing the primary holders of municipal securities). 44. See id. at Conrad de Aenlle, After Setbacks, Municipal Bond Sector Is Looking Up, N.Y. TIMES (Feb. 10, 2014), SEC REPORT, supra note 4, at 23 (noting that 917 bonds defaulted in the 1990s); id. at 23 n.117 (claiming that the actual monetary losses from defaults have been tiny in comparison to the size of the defaults). 47. Jason Saylor, Note, Credit Rating Agencies and Municipal Bonds: How a Misunderstood Industry Has Cost Taxpayers,4GEO.MASON J. INT L COM. L. 259, 264 (2012). 48. See 26 U.S.C. 103(a) (2012). 49. Preston et al., supra note Objection of Ambac Assurance Corp., supra note 7, at 5. ( [M]unicipal finance is constrained by state constitutions and legislation.... Specifically, the statutory restrictions operate to create a structure establishing the seniority of specified obligations that will produce a low risk profile and thereby ensure credit is available at a low cost. ).

8 1342 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 Mayor Coleman Young s fiscal program gave Wall Street some reassurance. In 1986, twelve years into Young s twenty-year tenure as mayor, the rating for Detroit s bonds was increased to investment-grade, allowing the city to borrow even more from investors at a lower interest rate. 51 Detroit was still putting all its eggs into the auto-industry basket and using bonds to help keep the industry healthy; in 1990, $130 million in general obligation bonds was issued to finance Chrysler s Jefferson North Assembly Plant. 52 Jefferson North was not the first time auto companies had supported the city s accumulation of debt on their behalf. As early as 1929, Ford supported a ballot measure for a bond issuance meant to finance rail transportation so workers could commute more easily to the automaker s River Rouge Plant. 53 The Detroit Free Press concluded that in 2001 the city still could have avoided disaster. Bankruptcy was not inevitable. But under the [Mayor Kwame] Kilpatrick and [Mayor Dave] Bing administrations, the city started borrowing aggressively to cover its operating expenses, enabled by Wall Street s irresponsible lending of the 2000s. 54 In 2005, Kilpatrick received the Bond Buyer s Midwest Regional Deal of the Year award for his $1.44 billion deal involving borrowing to fund pensions. However, the massive borrowing ended up hurting the city in September 2013, that deal accounted for nearly 20% of the city s debt. 55 By issuing bonds to pay for fiscal stabilization and pension obligations, Detroit slid deeper into debt. The Free Press calls the 2000s a decade-long borrowing binge that doubled the city s debt between 2000 and Kilpatrick issued fiscal stabilization bonds in 2002; Bing issued more in 2009, both just to keep the city budget afloat. 57 Corruption further depressed the city s finances. Kilpatrick is now serving a twenty-eight-year sentence in federal prison for racketeering, extortion, and other offenses Bomey & Gallagher, supra note Id. 53. Charles K. Hyde, Planning a Transportation System for Metropolitan Detroit in the Age of the Automobile: The Triumph of the Expressway, 32 MICH. HIST. REV. 59, (2006) (noting that this ballot measure failed in favor of expressways). 54. Bomey & Gallagher, supra note Id. 56. Id. 57. Id. 58. Heather Catallo, Kwame Kilpatrick Leaves Michigan as a Federal Prisoner with a 2037 Release Date, WXYZ DETROIT (Jan. 16, 2014, 7:28 AM), kwame-kilpatrick-leaves-michigan-as-a-federal-prisoner-with-a-2037-release-date. His corruption is estimated to have harmed the city to the tune of $20 million. Tresa Baldas, How Corruption Deepened Detroit s Crisis, USA TODAY (Oct. 6, 2013, 8:03 AM), 10/06/how-corruption-deepened-detroits-crisis/ /.

9 2015] INVESTING IN DETROIT 1343 C. BANKRUPTCY In April 2012, Michigan Governor Rick Snyder subjected Detroit to greater oversight by the state government. 59 A state-appointed review team determined in February 2013 that Detroit was in a state of financial emergency and had no satisfactory plan to remedy it. 60 The findings allowed Snyder to announce the state was taking full control of Detroit s government. Snyder appointed Kevyn Orr as the city s Emergency Manager in March 2013, 61 giving him broad powers such as the ability to rewrite contracts and liquidate city assets, and a mandate to turn the city s finances around. 62 At the time, five smaller cities in Michigan were under the control of Emergency Managers, including Pontiac and Flint both long-time homes of General Motors plants. 63 On July 18, 2013, Detroit became the largest U.S. municipality to file for Chapter 9 bankruptcy, which provide[s] a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. 64 Sitting at the wheel of the city when the filing was made in the Eastern District of Michigan was Emergency Manager Orr. Orr attended the University of Michigan, just forty-five miles from Detroit, graduating with a B.A. in 1979 and a J.D. in Orr s work at Jones Day in Washington, D.C., brought him back to Michigan decades later, right in the middle of the auto industry s decline Orr represented Chrysler during its 2009 bankruptcy proceedings. 66 His broadly acclaimed 67 restructuring of the giant auto manufacturer, which allowed many Michigan workers to retain their jobs, 59. Michigan Gov. Rick Snyder Takes Over Detroit s Finances Amid Financial Emergency, CTV NEWS (Feb. 20, 2013, 6:41 AM), Id. (internal quotation marks omitted). 61. Monica Davey, Bankruptcy Lawyer Is Named to Manage an Ailing Detroit, N.Y. TIMES (Mar. 14, 2013), html. 62. See Emergency Manager, MICH.GOV, Sheet2_347889_7.pdf (last visited Mar. 16, 2015). 63. See id.; see also Michigan Gov. Rick Snyder, supra note 59; Joseph Szczesny, Workers: Pontiac GM Plant Left to Die, OAKLAND PRESS (Feb. 15, 2012, 12:00 AM), general-news/ /workers-pontiac-gm-plant-left-to-die (noting that both Flint currently and Pontiac formerly have been the homes of GM plants). 64. Municipality Bankruptcy, U.S. CTS., BankruptcyBasics/Chapter9.aspx (last visited Mar. 16, 2015). 65. Facts on Kevyn D. Orr, DETROIT FREE PRESS (Mar. 24, 2013), /NEWS01/ /KEVYN-D-ORR. In a twist of fate, the Michigan Innocence Clinic at the University of Michigan Law School earned freedom for Dwayne Provience, wrongfully convicted of murder in He earned a settlement of $5 million from the city, which he now will not receive due to the bankruptcy. Imran J. Syed, Doubly Wronged in Detroit, SLATE (Dec. 12, 2013, 10:01 AM), 5_million_in_compensation_for_a_wrongful_conviction.html. 66. Brian Dickerson et al., New Detroit Emergency Financial Manager Kevyn Orr Takes on Challenge of a Lifetime, DETROIT FREE PRESS (Mar. 24, 2013, 10:21 AM), article/ /news01/ /new-detroit-emergency-financial-manager-kevyn-orr-takes-onchallenge-of-a-lifetime.

10 1344 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 put him on the short list for the Emergency Manager job in Detroit. 68 Six weeks after his appointment, Orr described just how dire things were in Detroit in a Financial and Operating Plan filed with the State Treasurer on May 12, He wrote, [w]hat is clear...is that continuing along the current path is an ill-advised and unacceptable course of action if the City is to be put on the path to a sustainable future. 70 The first item on his list was the long-term debt issuances bonds used for years to cover shortfalls in the budget. 71 He recognized that issuing municipal bonds had created significant debt, and that borrowing would not save the city this time. Detroit bonds were rated junk status by ratings agencies, and debt limits meant the City [had] effectively exhausted its ability to borrow. 72 In addition to bond obligations, pension obligations to former city employees (including medical benefits) made up most of what was then estimated to be $15 billion in debt. 73 Shortly after his report was issued, Orr stopped making payments on some of Detroit s debts, including pension payments and certain bond payments. He created a comprehensive restructuring proposal to avoid bankruptcy and presented it to bondholders and other creditors, but they did not accept his settlement suggestions, instead offering what Orr called untenable counterproposals. 74 The dispersed nature of the bondholders and the low payments Orr was offering made it difficult to negotiate; Orr noted that in many instances the City is unable to negotiate with a single contact with the authority and willingness to bind its bondholders. 75 On July 17, 2013, city pension funds filed suit in state court to prevent Orr from cutting retiree benefits. 76 Orr would say later that these legal tactics forced him to declare bankruptcy early; he did not want the state courts to preemptively block the bankruptcy before he had a chance to bring his case in federal 67. See, e.g., Micheline Maynard, Chrysler: From Bankrupt to a $6 Billion Company, FORBES (Mar. 28, 2013, 8:41 PM), See Dickerson et al., supra note See FINANCIAL AND OPERATING PLAN, supra note Id. at Id. 72. Id. at Id. The debt was later estimated to be over $18.5 billion. See, e.g., Carey, supra note Letter from Kevyn D. Orr, Detroit Emergency Manager, to Richard D. Snyder, Mich. Governor, Exec. Off. of Governor, and Andrew Dillon, State Treasurer, Mich. Dep t of Treasury, Re: Recommendation Pursuant to Section 18(l) of PA 436, at 9 (July 16, 2013), available at snyder/detroit_em_kevyn_orr_chapter_9_recommendation_427831_7.pdf. 75. Letter from Kevyn D. Orr, supra note 74 ( Certain parties rejected the City s proposals altogether. In other cases, creditors made untenable counterproposals suggesting that they should not be materially impaired or should not be impaired at all. ). 76. Joe Guillen, Detroit s Pension Boards File Suit Against Orr, Snyder to Block Cuts in Workers Benefits, DETROIT FREE PRESS (July 18, 2013, 7:57 AM), NEWS01/ /detroit-pension-board-detroit-lawsuit-kevyn-orr.

11 2015] INVESTING IN DETROIT 1345 court. 77 The next day, Detroit filed for Chapter 9 bankruptcy in the U.S. Bankruptcy Court in the Eastern District of Michigan. 78 Filing bankruptcy created an automatic stay on pending court actions, allowing Orr and the city some breathing room to work out a plan of reorganization. 79 Governor Snyder wrote in his authorization letter that bankruptcy is a necessary step as a last resort to return this great City to financial and civic health. 80 Protests followed despite public officials reassurances that city services would continue. 81 Ratings agencies downgraded Detroit s bonds even further after the filing, making it more difficult for Detroit to borrow. 82 Richard Larkin, Herbert J. Sims & Co. s director of credit analysis, stated that Detroit s name in the muni[cipal bond] market is probably mud. 83 On July 19, the day after Detroit s bankruptcy filing, Judge Rosemarie Aquilina of the Ingham County Circuit Court ruled that by impairing pension payments, the bankruptcy filing violated the Michigan Constitution. 84 While Judge Aquilina s decision was being appealed, on July 23, the Michigan Court of Appeals ruled to stay the other pending state court actions, keeping the pension fund and union cases on hold until the bankruptcy question was 77. See, e.g., Emergency Manager Kevyn Orr, State Treasurer Andy Dillon Address Detroit Bankruptcy, WXYZ-TV DETROIT (July 19, 2013), 5quOcu5W4kY; Hundreds Protest Detroit Bankruptcy, WXYZ-TV DETROIT (Oct. 23, 2013), watch?v TF8uMdNPOvg; What Bankruptcy Means for Detroit, N.Y. TIMES (Dec. 4, 2013), youtube.com/watch?v Ew-4PPjKVEk; see also Jack M. Beermann, Resolving the Public Pension Crisis, 41 FORDHAM URB. L.J. 999, 1006 (2014). 78. See Carey, supra note See 11 U.S.C. 362(a) (2012). 80. Letter from Richard D. Snyder, Mich. Governor, to Kevyn D. Orr, Detroit Emergency Manager, and Andrew Dillon, State Treasurer, Mich. Dep t of Treasury, Re: Authorization to Commence Chapter 9 Bankruptcy Proceeding, at 1 (July 18, 2013), available at Governor_Snyder_Chapter_9_Authorization_427830_7.pdf. 81. See, e.g., Detroit Has Filed for Chapter 9 Bankruptcy, WXYZ-TV DETROIT (July 18, 2013), K0vbQ8WWTBY; Union Workers Protest Detroit Bankruptcy Ruling,ASSOCIATED PRESS (Dec. 3, 2013), iyhqve_dtd See Carey, supra note 13; Moody s: Detroit Bankruptcy Filing Credit Negative, REUTERS (July 18, 2013, 9:01 PM), D Preston et al., supra note 37 (internal quotation mark omitted). 84. See Paul Egan, Michigan AG Challenges Judge s Ruling that Detroit Bankruptcy Is Unconstitutional,DETROIT FREE PRESS (July 19, 2013, 2:56 PM), /detroit-bankruptcy-ingham-county-rosemarie-aquilina-pension. For Detroit s arguments, see Pre-Trial Brief for City of Detroit at 14, In re City of Detroit, Mich., 504 B.R. 191 (Bankr. E.D. Mich. 2013) (No ). The city argues that a [s]tate s authorization of municipal bankruptcy does not impair pensions or any other contractual obligations, and thus does not violate the Pensions Clause or the Contracts Clause of the U.S. Constitution. Id. Detroit also argues it does not violate the Michigan Constitution because the purpose behind the filing is simply restructuring. Id. at 69. The UAW brief argues that the bankruptcy violates the Michigan Constitution s Article 9 Section 24, which says that the legislature may not reduce pension benefits that have accrued. See Objection of International Union, UAW at 19, In re City of Detroit, 504 B.R. 191 (No ).

12 1346 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 resolved. 85 Of Detroit s approximately $18 billion in debt, $369 million was owed to holders of unlimited tax general obligation bonds (UTGOs) and $163 million to holders of limited tax general obligation bonds (LTGOs). 86 Although those bonds represented less than 3% of the city s liabilities, 87 the payouts on the bonds could influence how much bondholders recover the next time a city files for bankruptcy. In bankruptcy, creditors are paid off according to their priority, and frequently receive only a percentage of the money owed to them; where bondholders are deemed to fall in that priority scheme could determine how much of their investment can be recovered. 88 Orr decided to treat UTGO and LTGO bonds as unsecured, giving those bondholders a low priority among creditors. 89 Bondholders had assumed general obligation bonds received significant protections and rights that are superior to all unsecured creditors, 90 including a lien on ad valorem tax revenues. One LTGO insurance company creditor explained that [t]he State of Michigan has dictated a structure for municipal debt, pursuant to which LTGOs... have seniority for repayment. 91 According to the creditor, the bonds should be senior to unsecured obligations such as pensions, and deserve more than the 10% recovery Orr originally proposed for bondholders: A plan that takes a senior debt instrument and throws it to the very bottom of the barrel, while elevating other debt [such as pensions] to recoveries some five or six times greater, cannot be confirmed. 92 In December 2013, U.S. Bankruptcy Judge Steven W. Rhodes ruled Detroit eligible for bankruptcy protection, against the protests of 110 opposing parties. 93 His ruling that pension payments could potentially be reduced under 85. Karen Pierog et al., Michigan Court Stays Challenges to Detroit Bankruptcy Filing, REUTERS (July 23, 2013, 6:03 PM), 6M0XX Preston et al., supra note Id. 88. See MARK S. SCARBERRY ET AL., BUSINESS REORGANIZATION IN BANKRUPTCY: CASES AND MATERIALS (4th ed. 2012); see also Overview of Creditor and Bankruptcy Types, THOMPSON L. GROUP, aspx (last visited Mar. 16, 2015). 89. See supra note 88. In his June 14, 2013 proposal for creditors, Emergency Manager Orr rattled bondholders (and markets) by categorizing these obligations as unsecured, such that all UTGO bonds... would be treated... with all general fund obligations, then proposing a plan of reorganization that would have meant a substantial haircut for bondholders. Christine Sgarlata Chung, Zombieland/ The Detroit Bankruptcy: Why Debts Associated with Pensions, Benefits, and Municipal Securities Never Die...and How They Are Killing Cities Like Detroit,41FORDHAM URB. L.J. 771, 837 (2014). 90. Objection of Ambac Assurance Corp., supra note 7, at Id. (citing the Revised Municipal Finance Act, MICH. COMP. LAWS ANN (l) (West 2012), which requires municipal bonds to be secured by a revenue stream). 92. Id. 93. In re City of Detroit, Mich., 504 B.R. 191, 204 (Bankr. E.D. Mich. 2013); see also Daniel Fisher, Detroit Bankruptcy Ruling Good News for Muni Bonds, Insurers, FORBES (Dec. 4, 2013, 3:20 PM),

13 2015] INVESTING IN DETROIT 1347 federal bankruptcy law as contracts that can be impaired in bankruptcy proceedings was a serious blow to pension-fund participants that had believed they would be first in line to receive Detroit s meager tax revenue. 94 However, bondholders also found themselves undermined by the same contractual argument. Since bonds are contractually based, like pensions, they can be impaired by bankruptcy. 95 Although the court agreed with the pensioners and unions that [t]he City did not negotiate in good faith, the opinion went on to say Detroit was not required to because such negotiation was impractical with so many creditors, including the dispersed bondholders. 96 Orr proposed a plan to exit bankruptcy in February that suggested cutting various groups of pension obligations by between 4% and 34%, while cutting 80% of obligations to the now-unsecured bondholders. 97 The Financial Guaranty Insurance Company (FGIC) is one of Detroit s largest bond creditors. Steve Spencer, advisor to FGIC, said [w]hile we understand that favoring pensioners and discriminating against bondholders and other creditors might be politically popular, we believe this is contrary to bankruptcy law and will result in costly litigation that will hamper the City s emergence from bankruptcy. 98 By July 2013, Orr settled with some of the large UTGO bond-insurance companies for a much more favorable 74% of their claims. 99 Bankruptcy Judge Steven Rhodes approved Detroit s plan of reorganization on November 7, He approved the separate treatment of pension creditors and municipal bond creditors, even though Orr had named them both unsecured creditors. Rhodes wrote that the Michigan Constitution s special protection of pension 94. Fisher, supra note 93; see also Ed White, Bankruptcy Judge Puts Kevyn Orr on the Spot over Detroit Pension Remark, HUFFINGTON POST (Nov. 4, 2013, 2:50 PM), /11/04/detroit-bankruptcy-remark_n_ html?utm_hp_ref detroit-bankruptcy. Judge Rhodes stated that [i]mpairing contracts is what the bankruptcy process does. Adam Santeusanio, Note, In re Detroit: Consequences of Detroit s Bankruptcy for Pensioners, 33 REV. BANKING & FIN. L. 430, 433 (2014) (quoting In re City of Detroit, 504 B.R. at 244) (internal quotation marks omitted). 95. Richard M. Hynes & Steven D. Walt, Pensions and Property Rights in Municipal Bankruptcy, 33 REV.BANKING &FIN. L. 609, (2014). 96. In re City of Detroit, 504 B.R. at Nathan Bomey et al., Detroit s Bankruptcy Exit Plan Includes Pension Cuts, Millions for Blight Removal, Technology, DETROIT FREE PRESS (Feb. 21, 2014, 8:41 PM), /NEWS01/ /Detroit-Chapter-9-bankruptcy-plan-of-adjustment-Steven-Rhodes-Kevyn- Orr. 98. Id. (internal quotation marks omitted); see also Mary Williams Walsh, Detroit in Deal with Its Biggest Holdout Creditor in Bankruptcy Case, N.Y. TIMES (Oct. 16, 2014), /10/17/business/detroit-reaches-settlement-with-remaining-big-creditor.html?_r See Matthew Dolan & Emily Glazer, Detroit Reaches Settlement with Some Bond Insurers, WALL ST. J. (Apr. 9, 2014, 3:43 PM), ; see also Ambac Announces LTGO Settlement with the City of Detroit, AMBAC.COM (July 25, 2014), ; Ronald P. Bernardi, Detroit Settles with UTGO Creditors, BERNARDI SECS. INC. (Apr. 15, 2014), content/detroit-settles-utgo-creditors-bond-right-side-still-%e2%80%9cwaiting-godot%e2%80%9d See Peter Suciu et al., U.S. Judge: Detroit Needs to Put Bankruptcy Plan in Motion, REUTERS (Nov. 12, 2014, 2:42 PM), USKCN0IW1OU

14 1348 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 plans is entitled to substantial deference in determining plan fairness, while the lesser treatment of bondholders could be upheld as the product of negotiated settlements and the claimants arguments to relative priority and security under State law. 101 Overall, Judge Rhodes found the plan could be accepted under 11 U.S.C. 1129(b) in part because [t]he City s proposal of the differential treatment between Classes of unsecured Claims under the Plan was made in good faith and was not motivated by personal animosity or antipathy. 102 In the grand bargain struck to bring the city out of bankruptcy, pensioners had their benefits cut by up to 4.5%, with additional cuts in cost-ofliving increases. 103 UTGO bondholders who thought they would have the right to levy nearly unlimited taxes to be fully paid recovered 74% of their claims, and LTGO bondholders recovered just 44%. 104 A review commission was put in place to oversee Detroit s finances for the next thirteen years and hopefully avoid another bankruptcy. 105 Although the exact percentage recovered by pensioners is hard to calculate over the long term, some commentators were concerned that the interests of general obligation bondholders appear firmly entrenched behind pension and retirement plans and government services when it comes to who will receive the most favorable outcome. 106 Even though it will not have official precedential value, the plan approved in Detroit will certainly be analyzed by bondholders in future municipal bankruptcies. 107 II. MUNICIPAL BOND REGULATION Former SEC Commissioner Elisse B. Walter wrote, Despite its size and importance, the municipal securities market has not been subject to the same 101. Order Confirming Eighth Amended Plan for the Adjustment of Debts of the City of Detroit at 23 24, In re City of Detroit, Mich., 504 B.R. 191 (Bankr. E.D. Mich. Nov. 12, 2014) (No ), available at [hereinafter Order Confirming Plan] Id. at See, e.g., Paul Burton, Ravitch, Spiotto: Use Carrots, Sticks to Avoid More Detroits, BOND BUYER (Nov. 12, 2014, 9:33 AM), Order Confirming Plan, supra note 1, at Matt Helms, Board Begins Financial Oversight of Detroit, DETROIT FREE PRESS (Nov. 12, 2014, 1:35 PM), Benjamin Horney, What Detroit Means for Bonds in Ch. 9 Cases, LAW360 (Nov. 10, 2014, 7:03 PM), (citing the Moody s report, which estimates the eventual pensioner recovery at 82% and states that the emerging picture is one in which pensions have better recovery probabilities than debt in a Chapter 9 case ) See Andrew Scurria, Detroit Settlement Model Looms over Future Chapter 9s, LAW360 (Nov. 10, 2014, 7:57 PM), ( Rhodes...confirmed a plan that ultimately forced financial creditors to cover most of the cost of restructuring. The settlements with city stakeholders underscore the political considerations at the heart of Chapter 9, where flexible legal standards and sparse appellate precedent leave creditors at the mercy of the presiding judge... ).

15 2015] INVESTING IN DETROIT 1349 level of regulation as other sectors of the U.S. capital markets. 108 Municipal securities are exempt from registration under the Securities Act of 1933 (Securities Act) under section 3(a)(2) and thus from the disclosure requirements of the Securities Exchange Act of 1934 (Exchange Act; collectively, the Securities Acts). 109 The antifraud provisions of the Securities Acts, section 17(a) of the Securities Act and section 10(b) of the Exchange Act, still apply to municipal securities, however. 110 At the time of their enactment, the broad exemptions from regulation made sense because they allowed states room to regulate their own municipalities and they accurately reflected the safety of municipal securities as compared to corporate securities markets. 111 Despite statutory limitations, the SEC has found a way to regulate municipal bond issuances to some extent through its antifraud enforcement capabilities and by regulating the actions of underwriters in the municipal bond market. The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank) required research into additional municipal bond market regulation, but the SEC s resulting report did not propose specific bankruptcy-related rules. A. DEVELOPMENT OF MUNICIPAL BOND REGULATIONS The Securities Act Amendments of 1975 created the Municipal Securities Rulemaking Board (MSRB) and gave the SEC some oversight powers over municipal securities dealers. 112 But municipal securities issuers still remained mainly outside of federal control: in 1975, the Tower Amendment provisions expressly limited the Commission s and the MSRB s authority to require municipal securities issuers, either directly or indirectly, to file any application, report, or document with the Commission or the MSRB prior to any sale of municipal securities by the municipal issuer. 113 However, the SEC has since issued interpretive guidance listing what filings should be made with the MSRB, 114 and has sidestepped the bar on regulating issuer disclosure statements by promulgating rules to regulate underwriters in the market. 115 Exchange Act Rule 15c2-12, adopted in 1989, requires certain conditions to be satisfied before underwriters can participate in municipal securities offerings. 116 Rule 15c2-12 requires underwriters to obtain and review specified 108. SEC REPORT, supra note 4, at ii JAMES D. COX ET AL., SECURITIES REGULATION:CASES AND MATERIALS 434 (7th ed. 2013) See SEC REPORT, supra note 4, at ii See Municipal Bond Disclosure, WM FIN. STRATEGIES, Disclosure.htm (last visited Mar. 16, 2015) See SEC REPORT, supra note 4, at ii iii Id. at iii See Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others, Securities Act Release No , Exchange Act Release No , 59 Fed. Reg. 12,748 (Mar. 17, 1994) [hereinafter Release No ] Underwriters help price and sell the bonds to investors; without underwriters, issuers would not be able to sell their bonds, so the SEC is effectively regulating issuers as well C.F.R c2-12 (2014); see also SEC REPORT, supra note 4, at 30.

16 1350 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 information and make that information available to potential buyers before they can underwrite a series of municipal bonds. 117 The rule also gives underwriters an ongoing duty to obtain an undertaking from issuers to disclose their annual financial statements and reports, and provide notice when the material events listed in the rule occur. 118 A 2008 amendment required that all such information be deposited in a central database; the Electronic Municipal Market Access (EMMA) database of MSRB filings is now available online for all investors. 119 Still, the rule s only mention of bankruptcy is that a municipal bankruptcy must be disclosed within ten days of its occurrence. 120 B. THE DODD FRANK ACT AND MUNICIPAL BONDS The Dodd Frank Act 121 required the SEC to make reforms to protect municipal bond investors. The reforms include ratings agency regulations, increased regulation of municipal advisors, the expansion of the MSRB s authority, and a study of the municipal securities market. 122 The shortcomings of the ratings agencies are well-known. They dramatically overrated junk mortgage-backed securities before the housing bubble popped in the 2008 financial crisis. 123 Congressional testimony as early as 1969 decried their substantial influence on municipal bond prices. 124 Yet, to a great extent, their ratings are still relied upon today. 125 Ratings agencies decided Detroit bonds were investment-grade even as the city borrowed excessively in the early 2000s, supported by the credit enhancement from the bond insurance such a risky investment required. 126 Ratings agency reforms meant to encourage more accurate ratings are included in Dodd Frank, including the adoption of rules requiring annual reports of internal controls, disclosure of the agency s performance, and disclosure of the assumptions and data underlying ratings. 127 Dodd Frank also amended the Exchange Act to allow the Commission to bar bad actors (insider traders, for example) from participating in certain industries. Included in these new industry bars are municipal advisors, thus demonstrating C.F.R c Id See SEC REPORT, supra note 4, at 30; see also Programs and Long-Range Plan, MUN. SECS. RULEMAKING BD., (last visited Mar. 16, 2015) C.F.R c2-12(b)(5)(i)(C)(12) (2014) Dodd Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010) SEC REPORT, supra note 4, at iii See COX ET AL., supra note 9, at See Roy M. Goodman, Municipal Bond Rating Testimony,24FIN.ANALYSTS J. 59, 59 (1968) See COX ET AL., supra note 9, at ; Saylor, supra note 47, at See Bomey & Gallagher, supra note 13 ( But even after eventual downgrades, investors continued to scoop up each new city bond issue. That s because the lower the credit rating, the higher the interest paid to investors. The demand was also fueled by Wall Street s mistaken impression that the State of Michigan would never allow the city to file for bankruptcy. ) Credit Rating Agencies, SECS. & EXCH. COMM N, creditratingagencies.shtml (last visited Mar. 16, 2015).

17 2015] INVESTING IN DETROIT 1351 an intent to protect the municipal bond market from bad actors. 128 In addition, section 15B of the Exchange Act now requires municipal advisors to register with the SEC. 129 Dodd Frank required the SEC to undertake a study of the municipal securities market, created an Office of Municipal Securities at the SEC, and added registration requirements for municipal advisors, but it did not give the SEC much additional regulatory power over the market. 130 Dodd Frank marginally expanded MSRB s authority to adopt rules regulating transactions in and advice regarding municipal securities, explicitly requiring it to protect municipal entities and obligated persons, and changed the makeup of its board to include more public representatives. 131 III. THE FUTURE OF MUNICIPAL BONDS Supreme Court Justice Louis Brandeis famously said, Sunlight is said to be the best of disinfectants. 132 The 2012 SEC report required by Dodd Frank recognizes that clear and consistent disclosure about municipalities finances, including their pension obligations, 133 is necessary to protect investors and allow them to find a fair price. This Note proposes that the risks and remedies of municipal bankruptcy must also be fully disclosed in order to shine sunlight on the types of problems Detroit bondholders faced in recovering their investments. The SEC needs to provide greater transparency to bondholders who are mainly individual investors than the current case-by-case approach that left bondholders unsure of their standing in Detroit. State bankruptcy laws authorizing Chapter 9 bankruptcy do not exist in all states and vary widely even among the states that do have them. States could not be forced by the federal government to enact authorizing statutes without implicating federalism concerns and complicating the treatment of municipal debt in state constitutions, so the clearest path to protection of investors is through the SEC s adoption of bankruptcy-related disclosure rules. Section III.C.2 proposes new nonbinding guidance that the SEC could issue to improve initial disclosure by issuers, and section III.C.3 proposes an amendment to Rule 15c2-12 to ensure ongoing disclosure of changes in bankruptcy law See Pub. L. No , 124 Stat (2010); see also John W. Lawton, Securities Act Release No. 3513, 2012 WL , at *5 8 (Dec. 13, 2012) SEC REPORT, supra note 4, at iii Id.; see also U.S. Financial Reform: Municipal Securities, DUANE MORRIS (Aug. 24, 2010), SEC REPORT, supra note 4, at iii, See Louis D. Brandeis, What Publicity Can Do, HARPER S WKLY., Dec. 20, 1913, at 1, available at papers/1910/1913_12_20_what_publicity_ca.pdf SEC REPORT, supra note 4, at 84.

18 1352 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 A. WHY REGULATE MUNICIPAL BONDS? City pensioners at risk of losing their promised retirement funds constitute the most vocal, human faces of Detroit s bankruptcy. Their underfunded plans were undermined by decades of poor political choices and money management, including Mayor Kilpatrick s $1.44 billion deal in Today, Detroit s pensioners outnumber city employees two to one, and more is spent on retired police and fire department employees than on active workers. 135 However, the futures of many more retirees are also at stake. Seventy-five percent of municipal bonds are held by retail investors, such as mutual funds and individuals. 136 The investment accounts of millions of Americans contain these securities, including those of many people already in retirement, who chose the regular, guaranteed income of bonds over the higher-risk, higherreturn option of stocks. Protecting the rights of bondholders does not have to be a political nonstarter. The debate is currently framed as pensioners vs. large banks, Main Street vs. Wall Street. 137 In light of the overwhelming individual ownership of municipal bonds, the debate could be reframed as Detroit retirees vs. individual American investors, in the hopes that both constituencies would be given as much relief as possible. 138 The municipal bond market is not about to fail, but stress from the Detroit bankruptcy has exposed potential problems with blindly presuming the bonds are safe investments. Florida s bond finance director, Ben Watkins, explained that general obligation bonds like those at issue in Detroit have been the gold standard of the municipal-bond market, but that [i]nvestors and analysts are going to rethink...what it really means when an issuer is under financial stress. 139 Detroit s Emergency Manager treated general obligation bonds as unsecured debt, which leads to lower priority and lower payouts, even though investors had considered them secured (backed by collateral, in this case tax revenues). 140 The Wells Fargo fixed-income team warned this plan could 134. See Bomey & Gallagher, supra note Id SEC REPORT, supra note 4, at v See Richard Brodsky, Detroit s Bankruptcy, Wall Street, and Real People: Good News or Bad News?, HUFFINGTON POST (Feb. 21, 2014, 2:08 PM), detroits-bankruptcy-wall_b_ html?utm_hp_ref detroit-bankruptcy. See generally David Waring, The Safety of State Bonds: A Historical Perspective, LEARNBONDS (May 14, 2012), learnbonds.com/state-bond-defaults/ (concluding that investors should be careful to separate their political views from actionable investment information when considering the risk of state general obligation bond default) See Steve Schaefer, Detroit in Bankruptcy: What It Means for the Muni Bond Market, FORBES (July 19, 2013, 1:21 PM), ( Then it becomes Wall Street vs. Main Street... which is a different argument than saying mom and pop put their faith in the government through what they thought were tax-efficient, guaranteed securities. ) Preston et al., supra note 37 (internal quotation marks omitted) Caitlin Devitt, No Challenge to Detroit s Eligibility from Bond Issuers, Investors, BOND BUYER (Aug. 20, 2013, 3:42 PM),

19 2015] INVESTING IN DETROIT 1353 effectively make [general obligation] bonds purely a moral obligation, 141 and in a worst-case scenario could lead to lower ratings for bonds elsewhere. 142 Undermining the safety of the $3.7 trillion municipal bond market could alter individual savings across the country. B. BANKRUPTCY LAWS Chapter 9 bankruptcy allows municipalities to create a plan to pay off creditors, and section 903 of the Bankruptcy Code requires deference to a state s right to decide whether to authorize its political subdivisions to avail themselves of federal bankruptcy law. 143 Bankruptcy courts are federal courts, 144 but for the federal government to control a municipality s bankruptcy beyond administering the bankruptcy and approving or disapproving the reorganization plan violates the states constitutional right to administer their internal affairs. 145 In addition, the Bankruptcy Code has priority provisions carefully balancing debtor and creditor interests, and adopting a uniform federal solution for holders of municipal bonds with widely varying rights risks undermining the Code s general priority scheme. 146 State Chapter 9 authorization laws are far from consensus. Eleven states authorize Chapter 9 filings by municipalities; twelve, including Michigan, authorize filings only upon certain conditions. Michigan s authorization statute was not passed until 2012, 147 showing that states are willing to change or pass 141. Jeff Cox, Detroit s Bankruptcy Gain May Be Others Pain, CNBC (Mar. 11, 2014, 2:48 PM), Carey, supra note See 11 U.S.C. 903 (2012). In addition, [t]he requirement that states explicitly authorize access to Chapter 9 before municipalities are eligible to file gave states greater control over their municipalities and added an extra layer of protection for state control... Jackson T. Garvey, Note, Municipal Bankruptcy and Public Pensions: Detroit s Eligibility for Chapter 9 Relief and Legal Restraints on the City s Actions as a Debtor,89NOTRE DAME L. REV. 2299, 2308 (2014) Bankruptcy, U.S. CTS., (last visited Mar. 16, 2015) Seena Foster, Annotation, Eligibility for Chapter 9 Bankruptcy Relief, Applicable to Municipalities, Pursuant to 11 U.S.C.A. 109(c), 57 A.L.R. FED. 2D 121 (2011); see also Municipality Bankruptcy, U.S. CTS., (last visited Mar. 16, 2015) SCARBERRY ET AL., supra note 88, at 228 ( Section 507 of the Bankruptcy Code fixes the priority order of claims... Creditors within a given class are to be treated equally, and bankruptcy courts may not create their own rules of superpriority within a single class. (excerpting Shapiro v. Saybrook Mfg. Co., 963 F.2d 1490, (11th Cir. 1992))). Academics have discussed the optimal priority scheme in municipal bankruptcy at length and considered how different constituencies particularly citizens and creditors should be treated under the bankruptcy laws. See, e.g., Michelle Wilde Anderson, The New Minimal Cities, 123 YALE L.J. 1118, (2014); Beermann, supra note 77, at ; Clayton P. Gillette, Bondholders and Financially Stressed Municipalities, 39 FORDHAM URB. L.J. 639, 641 (2012) (describing the effort to resolve competing claims by bondholders and residents to a limited municipal treasury ); Hynes & Walt, supra note 95, at 660 (suggesting providing pensions with statutory priority status); Richard C. Schragger, Citizens Versus Bondholders, 39 FORDHAM URB. L.J. 787, 789 (2012) ( In practical terms, courts should be more willing to impose losses on bondholders than to demand that a defaulting city raise taxes or decrease services. ) Garvey, supra note 143, at 2316.

20 1354 THE GEORGETOWN LAW JOURNAL [Vol. 103:1335 Chapter 9 authorization statutes in response to a municipality in crisis. Three states allow only specific entities (such as irrigation districts in Oregon) to declare bankruptcy; the rest have no clear Chapter 9 authorization. 148 Rhode Island established a high priority for bondholders, but their priority remains unclear in other states. 149 The way to effect change in this arena would be with suggestions rather than requirements: facilitating academic and policy discussion, drafting model legislation, and encouraging state adoption of clear, consistent bankruptcy laws protecting bondholders rights as creditors. C. PROPOSED SEC DISCLOSURE REQUIREMENTS It is more realistic to begin by reforming the SEC s disclosure obligations for municipal bond issuances. The SEC should (1) pass nonbinding guidance for bond issuers encouraging disclosure of risks for bondholders in bankruptcy, and (2) modify Rule 15c2-12 so underwriters must require bond issuers to disclose changes in municipal bankruptcy law to investors. An SEC disclosure solution is respectful of federalism concerns by simply requiring disclosure of state standards on a federal level, states remain free to set their own Chapter 9 bankruptcy authorization requirements. 1. Calls to Action In July 2012, Democratic Commissioner Elisse B. Walter led the SEC s research and writing of the Report on the Municipal Securities Market required by Dodd Frank. 150 The report includes recommendations for broadly revising disclosure obligations and market structure. The report proposes new legislation, including laws focused on disclosure, and suggests an expanded regulatory approach and improvements to industry best practices. 151 The report enumerates serious issues complicating municipal bond market regulation. There are approximately one million different municipal bonds outstanding compared to fewer than 50,000 different corporate bonds. 152 Municipal bonds are traded over the counter; because there is no central exchange like the New York Stock Exchange providing clear pricing data for the vast number of bonds available, it is hard for individuals to trade on their own behalf Bankrupt Cities, Municipalities List and Map, GOVERNING, municipal-cities-counties-bankruptcies-and-defaults.html (last visited Mar. 16, 2015) R.I. GEN. LAWS ANN (West 2014); see also Beermann, supra note 77, at ( Full payment to bondholders was apparently justified by fear of the negative impact on the ability of Rhode Island municipalities to sell bonds in the future, referred to as the contagion effect. ); Schragger, supra note 146, at (discussing another academic s view that [b]ondholders are more appropriate risk bearers... because they have been paid ex ante to assume the risk (citing Kevin A. Kordana, Tax Increases in Municipal Bankruptcy,83VA.L.REV. 1035, (1997))) SEC REPORT, supra note 4, at i See id. at i, vii Id. at 5 (footnote omitted) See id. at 19,