CHICAGO — As Detroit heads into trial on its bankruptcy adjustment plan next week, a long-simmering parallel battle over $1.4 billion certificates of participation is just heating up.
The city sued in January to invalidate the certificates, arguing that it should not have to pay the debt because it was issued illegally.
The insurer that wraps the bulk of the certificates filed a series of counterclaims last week, asking the court to dismiss the lawsuit, and saying if the city prevails, the insurer is owed damages for fraud, misrepresentation and unjust enrichment.
Without a settlement, the dispute over the COPs could end up being a major loose end as the city prepares to exits its historic Chapter 9 case.
Whether or not the bankrupt city has to pay back the debt could also affect its long term recovery plan, experts said. Detroit is nearing a settlement with $5.3 billion of water and sewer bondholders, leaving the COPs dispute one of the last major unsettled pieces of the case.
The COPs lawsuit "isn't going to be determined until some later date, and that will be an issue: whether you can confirm a plan without deciding that issue," said James Spiotto, managing director of Chapman Strategic Advisors. "The reason why you've had virtually everyone settle in Jefferson County, in Vallejo, and most creditors in Stockton, is because of the dynamic uncertainty of not having it settled on these big issues can be problematic."
Detroit's debt adjustment plan — which will be the focus of the trial set to begin Aug. 29 — offers certificate holders a roughly 10% recovery but also treats the debt as disputed and sets up a COPs claim litigation reserve fund. If the city wins the lawsuit, it would distribute the money in the litigation trust among retirees for health care costs and limited-tax general obligation bondholders.
Bankruptcy Judge Steven Rhodes, who is overseeing the city's bankruptcy, will also hear the COPs lawsuit.
As part of the litigation, Rhodes ruled on Aug. 6 the insurer could file counterclaims in the lawsuit, and the city has filed an objection to FGIC's intervention.
"Given the timing of the city's filing of the action against the service corporations, and its objection to FGIC's intervention request, getting this resolved through litigation in tandem with the confirmation hearing was infeasible," Melissa Jacoby, who teaches bankruptcy and commercial law at the University of North Carolina, said in an email.
"Many Chapter 11 plans for corporate debtors have contingencies in the plans regarding unresolved litigation, and sending matters to litigation trusts, so what we see in Detroit's plan is of a piece with that model," she said.
Spiotto notes that COPs litigation is also important to the city's overall recovery plan, which relies partly on assumptions it won't have to pay the COPs.
"It also goes to feasibility," Spiotto said. "The judge has already said, 'How are you going to get the money to reinvest in Detroit?' Some of that money is coming from not paying on the $1.4 billion of the COPs, so if the city loses that, they won't have those savings."
If the COPs holders win in the dispute, and are owed more than 10 cents on the dollar, "that's going to be a loose end," Spiotto said.
In the COPs lawsuit, the city argues that the city issued the debt under a corrupt mayor and through an illegal debt structure that relied on service corporations set up solely to evade its debt limit and triggering a requirement to win state approval.
If the city wins the lawsuit, FGIC argues that it will be owed damages from the city and the two pension funds that got the deal's proceeds, saying the city fraudulently induced it to wrap the debt.
"For almost nine years, the city and the retirement systems, and the retirees they serve, have benefitted from the pension funding transactions," FGIC says in its counterclaims. "Opportunistically, the city has engaged in 'revisionist history' and now wants to characterize its obligations under the service contracts as full faith and credit debt obligations that run afoul of the city's debt limit and should be declared illegal and unenforceable. In doing so, the city and the retirement systems seek to foist the burden of funding the city's constitutional and statutory pension obligations on the same entities that have already funded the pension funding transactions."
Detroit began courting FGIC as early as 2004 to insure the debt, FGIC says. Detroit finance officials and the city's advisors made numerous presentations to win the insurer's business in which the city argued that the transaction was legal, the debt would not apply to the city's debt limit, and that Detroit was obligated to make the contract payments to the service corporations. The city also presented the insurer with several memos from law firms to support its position.
Detroit law firm Lewis & Munday PC, certificate counsel on the deal, also presented the Detroit City Council with a "detailed 19-page letter" explaining why the city had the power to enter into the transaction and why the city's payments would be valid and binding and would not constitute indebtedness under state limits.
"Part of the city's pitch was to reassure FGIC that the securities FGIC was being asked to insure were backed by a reliable payment stream," the insurer said in its brief. "In this regard, the city warranted that it would live up to and abide by its promises and had taken all necessary steps to confirm that the pension funding transactions and the city's obligations under the service contracts were valid and lawful, including steps to confirm that the city's obligations would not constitute indebtedness for the purpose of any statutory or constitutional debt limit."
But Detroit did not inform FGIC that one major Detroit-area law firm questioned the legality of the transaction and refused to participate, according to the insurer.
The law firm is likely Miller Canfield Paddock and Stone PLC, which is now local counsel for the city in its Chapter 9, according to the complaint.
"The city did not share this legal advice with FGIC or inform FGIC that the law firm had refused to participate in the 2005 pension funding transaction," the brief says. "Instead, the city provided FGIC with the 2004 memos and related correspondence, through which the city represented that it took all necessary steps to assess the legality of the alternative funding mechanism and pension funding transactions and had conclusively determined that the city's contractual obligations could not constitute indebtedness under Michigan law or be subject to be subject to any limitations on the city's net indebtedness capacity."
FGIC also argues that its then-triple-A rating saved the city up to $390 million in interest on a deal that otherwise would have been rated in the triple-B category.
Detroit's unfunded obligation for both retirement systems as of 2004 totaled $1.7 billion and would have accrued interest at 7.8% to 7.9%, according to FGIC. Issuing the insured certificates with triple-A ratings meant interest rates of around 5.8 %, saving the city $460 million, or $390 million present value in 2005.
Most of the pension certificates are now owned by hedge funds, which purchased them two months ago from several European banks that had owed them for years.
The hedge funds paid roughly 46 cents on the dollar for the troubled debt. FGIC, which filed for bankruptcy, is now operating under a court-rehabilitation plan that has the insurer paying an initial cash payment of 17% of the claim, with the remainder of the payments deferred payable only to the extent cash becomes available.
Syncora Guarantee Inc., which insured roughly $400 million of the certificates, now owns its certificates. With FGIC, Syncora remains one of the city's staunchest opponents, challenging the so-called grand bargain at the heart of the bankruptcy plan as a politically motivated plan that unfairly favors pensioners over other unsecured creditors.
