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Judge: State lawsuits cannot block Detroit bankruptcy filing  

Federal courts will decide if Detroit is eligible for what would be the largest municipal bankruptcy ever, a federal judge ruled Wednesday, suspending challenges to the Chapter 9 filing in state court.

Detroit's Emergency Manager Kevyn Orr—a bankruptcy expert appointed by Gov. Rick Snyder earlier this year to oversee Detroit's finances—has said the federal bankruptcy filing is necessary to get the city out from under some $18 billion in liabilities.

But the city's employee unions argued the bankruptcy is an end-run around the state constitution, which protects their pension benefits. The unions backed a series of lawsuits filed in Michigan courts to block the bankruptcy. Last week, Ingham County Circuit Judge Rosemarie Aquilina ruled the bankruptcy filing unconstitutional, but a state appeals court put her ruling on hold, and Orr argued the federal court should make that stay indefinite.

The emergency manager said bankruptcy is a federal matter. A bankruptcy filing normally puts all other litigation on hold, but Orr's office asked the judge to extend that automatic stay to cover him and state officials, including the governor. Orr's attorneys acknowledged the request was unusual, but said "recent events"—the lawsuits in state court—made it necessary.

"That kind of activity has got to stop," city attorney Heather Lennox said. Lennox is a partner at Jones Day—Orr's former law firm—which is collecting millions of dollars in legal fees from the city.

But attorney Sharon Levine, representing the local council of the American Federation of State County and Municipal Employees, said the federal bankruptcy code "is not there to enforce rights that do not exist."

The unions said framers of the Michigan constitution decided to guard public employee pensions because public pensions have no insurance protection, unlike private pensions, which are insured by the federal Pension Benefit Guarantee Corp.

"Here, there is no safety net," Levine said. She said nonuniformed employee pensions in Detroit are below $19,000 per year.

Attorney Robert Gordon, representing the police and fire pension funds, argued that because of the constitutional provision, the governor had no right to authorize the bankruptcy filing in the first place. As a result, Gordon said, the filing is "void," and it was premature to even be discussing it in federal court.

"The motions assume facts not in evidence," Gordon said.

(Read more: What's next for Detroit? Long court battle)

But the judge appeared unconvinced.

"How do you deal with the law that gives the bankruptcy court exclusive jurisdiction," Rhodes asked.

Gordon responded that there was no need to deal with the provision, because there was no valid bankruptcy filing to begin with.

Because of the intense interest in the largest municipal bankruptcy filing in U.S. history, the hearing was moved from Rhodes' normal courtroom to a much larger one across the street at the Theodore Levin Federal Courthouset. Many members of the public and the media were relegated to an overflow courtroom down the hall to view a video feed.

Outside the courthouse, a handful of protesters carried signs in support of the unions. One demonstrator played a recording of Martin Luther King's "I have a dream" speech through a megaphone.

City firefighter Mark Jackson.said he came to the courthouse because so much is at stake.

"I am scared. Scared that I will lose my retirement. I'm scared for all of us," Jackson told CNBC.

(Read more: Detroit bankruptcy could hit millions of retirees)

But Orr and Snyder have repeatedly insisted that city pensions will not be cut entirely under a bankruptcy. In an interview before the hearing, Orr said the majority of the pensions are funded, but there remains a $3.5 billion shortfall—and the city has no way to make it up.

"The money's not there," Orr said.

Reuters contributed to this article.