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After opening gambit, Detroit manager's next move vexes creditors

By Nick Carey and Tom Hals

(Reuters) - Now that Detroit's emergency manager has laid out a tough road that could include a bankruptcy filing for the city, the bondholders, pension managers and others with a stake in the outcome are left to assess his next steps while seeking to minimize any possible losses.

Kevyn Orr faces a difficult task, for he must either coerce the financially troubled city's creditors into cutting a deal that would leave many with just pennies on the dollar, or file for Chapter 9 bankruptcy, where his powers would be greater but the likelihood of long, costly litigation far higher.

Rather than a corporate setting, the city's emergency manager is acting in a political realm where the interests of Detroit's citizens and even credit ratings throughout the state of Michigan may hang in the balance.

There was a forceful start to negotiations with debtholders at a Detroit hotel on Friday, with the city represented by Orr saying it would stop making payments on some of its $18.5 billion in debt, which would put it in default.

Orr also presented a proposal on Friday to creditors, bondholders, pension funds and union representatives, laying out his case for concessions from them in a plan that ran to 134 pages.

Orr told reporters on Friday there was a 50/50 chance of bankruptcy for Detroit, which would be a first for a major U.S. city. At the same time, he insisted this was "not a jaded effort just to go through the process to get to a bankruptcy filing."

The emergency manager's proposal went to great lengths to detail the city's financial ruin, declaring in a stark subheader: "THE CITY IS INSOLVENT" and cataloguing Detroit's disastrous record of keeping its citizens safe and its streetlights on.

Detroit, the center of the U.S. auto industry, is the poorest large city in the country, with more than a third of its residents living below the official government poverty line.

At a minimum, Orr's opening move could be seen as part of a checklist he needs to tick off in order to meet legal requirements needed to declare a bankruptcy of America's most troubled metropolis. But some restructuring experts see in Orr's approach an attempt to put together a pre-packaged bankruptcy, a strategy that has been adopted for Chapter 11 bankruptcies in the corporate world but never before used for a municipality seeking Chapter 9 bankruptcy protection.

"Kevyn Orr is a bankruptcy lawyer and he's going down a checklist of the things he needs to do," said Michael Sweet, an attorney at Fox Rothschild who helped the city of Richmond, California, restructure its finances to avoid bankruptcy. "He's keeping all the options on the table."

A pre-packaged bankruptcy occurs when an entity has negotiated a deal with creditors and other interested parties in advance, put it into written form and received enough votes from creditors to get a judge's approval - forcing it on objecting creditors. Pre-packaged plans greatly reduce uncertainty and legal fees.

Without a pre-packaged plan, Chapter 9 proceedings for the city of 700,000 could be lengthy, litigious and expensive, and cash-strapped Detroit would have to foot the bill. Proving insolvency and demonstrating a municipality's inability to pay its bills would be critical to filing for Chapter 9.

"He (Orr) will get a pre-packaged plan," said James McTevia of Michigan-based consulting firm McTevia & Associates. "But it will be contentious and it will cost a lot."

"Ultimately, given the size of Detroit, the scale of its problems and the number of issues involved, this could go all the way to the Supreme Court."

PRESSURE POINTS

Unlike many lawyers in the consensus-building world of bankruptcy, Orr earned his keep as a litigator and he led automaker Chrysler's fight in 2009 to get approval to close a quarter of its dealerships early in its bankruptcy. The Chrysler experience was a factor when Michigan Republican Governor Rick Snyder tapped Orr in March to fix Detroit's finances.

Those who have worked with Orr said he knew how to zero in on an adversary's pressure points and narrow their options. They cited his decision to make one presentation to all creditors on Friday.

"If you want to do it right, you get all creditors in the same room and you tell the story one time so there's no misunderstanding," said Pat O'Keefe, president of O'Keefe and Associates, a turnaround firm based in the Detroit suburbs.

O'Keefe added he expected Orr "will try to get some pre-negotiation done with creditors, then use Chapter 9 to implement his plan." He noted that Orr's warning on Friday to reporters that Detroit should know "within the next 30 days or so" if it can avoid bankruptcy could serve as one more proof of "good faith" if he does file for Chapter 9.

Pre-packaged bankruptcy using Chapter 11 was pioneered by Jay Goffman of law firm Skadden, Arps, Slate, Meagher & Flom in New York. He said it could work for municipalities.

"Whether it is a city or state or county, there's no reason that you can't get smart people together, figure out the right solutions from a business standpoint and essentially prepack the solution," Goffman said.

But getting everyone on board for a pre-packaged plan is easier said than done, said Douglas Bernstein, a bankruptcy attorney at Plunkett Cooney in the Detroit area.

"When it comes to a pre-packaged plan, the big question is whether he (Orr) would have enough acceptance going into court," he said. "He would need sufficient votes from all the creditor classes and that will not be easy."

One problem is that Detroit's creditors or stakeholders have different priorities. The main areas of uncertainty surround its unions and pension funds, which may not have much bargaining room and may feel their best chance lies in bankruptcy proceedings rather than a negotiated pre-packaged deal.

"It's quite possible that we will see infighting between Detroit's creditors," said John Pottow, a University of Michigan law professor who specializes in bankruptcy.

'POWERFUL' TOOL

Orr has options available to him that can give him leverage over the competing groups. If he goes to bankruptcy court as the sole representative of Detroit, experts say he would have more options and power, which he alluded to publicly last week.

"I have a very powerful statute," Orr said Monday. "I have an even more powerful Chapter 9. I don't want to use it, but I am going to accomplish this job. That will happen."

Orr would be able to drag recalcitrant creditors into court. While no one can force Detroit to sell assets involuntarily in bankruptcy, he can sell them voluntarily.

Much has also been made of a clause in Michigan's constitution that specifically protects pensions and retirement benefits, and it is unclear how that provision would be treated in a federal bankruptcy.

Fox Rothschild's Sweet said a judge would have to "determine whether the 10th Amendment (of the U.S. Constitution) trumps the notion that federal law is supreme." The amendment states that powers not delegated to the federal government by the Constitution or prohibited to the states are reserved for the states or the people.

"The last thing (union pension funds) may want is for a judge to rule on that," he said. "Because if the judge ruled against them, it would open the floodgates" for similar cases.

Time is also of the essence, as Detroit's default could hurt Michigan along with other municipalities in the state and make them "suffer higher interest costs and more difficulty borrowing," Richard Larkin, senior vice president at investment firm HJ Sims, wrote in a note on Friday.

The longer a deal takes, the more likely Chapter 9 becomes, the University of Michigan's Pottow said, as that will be an indication of how much resistance Orr faces from stakeholders.

"My heart says that Kevyn Orr will be able to get everyone around a table and hammer out a deal," Pottow said. "But my brain says that he is going to have no choice but to file" for Chapter 9.

(Additional reporting by Karen Pierog, Bernie Woodall, Steve Neavling and Deepa Seetharaman; Editing by David Greising, Mary Milliken and Peter Cooney)

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