CHICAGO - Detroit's attorneys told the judge in the city's bankruptcy case a $1.5 billion 2005 certificates of participation financing was an "insider deal" that benefited banks and helped doom the struggling city.

The city has sued to repudiate the debt, arguing that it was illegally issued. Bond insurer Financial Guaranty Insurance Co. and the certificate trustee have countersued, saying they were duped into wrapping the deal.

The dispute is separate from the city's bankruptcy case, but its outcome could influence a key settlement between Detroit and FGIC.

The insurer is the last major holdout creditor in the Chapter 9 case, and is reportedly close to a settlement with the city. A deal would effectively secure full creditor support for the city's plan of confirmation.

U.S. Bankruptcy Judge Steven Rhodes held a hearing on the COPs dispute during a break in a trial on the confirmation plan. After the hour-long hearing, Rhodes said he would issue a ruling later. Such a ruling could influence the negotiations between the city and FGIC.

The city issued the debt in 2005 and 2006, using the proceeds to fund the city's two pension funds.

In January, six months into the city's bankruptcy, Detroit filed a lawsuit claiming that the COPs issuance was illegal because it was structured as certificates of participations to deliberately avoid state-imposed debt limits.

FGIC, which wraps $1.1 billion of the $1.5 billion claim, and Wilmington Bank, the trustee, filed a series of counterclaims in August, asking Rhodes to dismiss the lawsuit, and saying if the city prevails, the insurer is owed damages for fraud, misrepresentation and unjust enrichment.

Detroit has since asked Rhodes to dismiss the counterclaims.

"This wasn't a favor to the city," Detroit's attorney Geoffrey Stewart from Jones Day told Rhodes, according to local reports from the courtroom. "This was an insider deal that benefited the banks." He said the city might not have gone into bankruptcy if not for the deal.

"Everyone knew it was aggressive," he said. "Everyone knew it was iffy."

Michigan law does not entitle investors who lent money outside legal debt limits to any repayment, Stewart argued.

FGIC attorney Ed Soto argued the insurer relied on good faith negotiations when the city presented legal opinions, including outside bond counsel and corporation counsel, in favor of the deal. The city even passed an ordinance approving the debt, attorneys said.

Detroit also did not inform FGIC that one major Detroit law firm - likely Miller Canfield Paddock and Stone PLC - questioned the legality of the transaction and refused to participate, according to FGIC's court briefs.

The deal in fact did benefit the city by funding its pension systems and was not responsible for pushing the city closer to bankruptcy, argued Paul Saint-Antoine, with Drinker Biddle & Reath LLP, on behalf of certificate trustee Wilmington Trust.

Rhodes asked Saint Antoine how the financing helped the city.

"With no path to solvency, what good does it do to substitute one debt for another?" the judge asked.

Saint Antoine said the deal helped the city meet its pension obligations.

An open and so far unaddressed question is whether, if the lawsuit proceeds and the city wins, the pension funds could be forced to disgorge the money.

UBS Financial Services Inc. was the book-running senior manager on the 2005 transaction. Robert W. Baird & Co. and Scott Balice Strategies worked as co-financial advisors. Lewis & Munday PC was certificate counsel. Mayer Brown Rowe and Maw worked as special tax counsel.

Siebert Brandford Shank & Co., LLC was a co-manager on the original sale.

Law firms Foster Swift Collins & Smith PC and Honigman Miller Schwartz and Cohn LLP also worked on the deal.

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