Bankruptcy Judge Steven Rhodes

CHICAGO — Bankruptcy Judge Steven Rhodes has set a trial for later this month to examine several legal issues in the Detroit bankruptcy case, including whether the city's proposed treatment of its bondholders is legal.

In an order released Tuesday, Rhodes outlined 14 legal issues related to the city's plan of confirmation to exit bankruptcy. It's part of the legal groundwork for the high-profile trial on the confirmation plan itself, currently set to begin July 24.

At least three of the 14 legal issues identified by Rhodes involve bondholders. One asks whether the city's settlement with its unlimited-tax general obligation bondholders violates Michigan's Unlimited Tax Election Act, the 1979 state law that authorized local governments to attach unlimited tax pledges to their bonds. The city's settlement with the three insurers who wrap the ULTGOs call for a 74% recovery with the rest of the 26% portion of the property tax levy going toward pensioners.

On the limited-tax GO bond side, Rhodes asked attorneys to prepare arguments on whether the "failure of the plan to treat LTGO claims as senior unsecured claims violates the bankruptcy code, Michigan law, or a contract right that is enforcable in bankruptcy."

The city has not yet settled with the LTGO holders, and has proposed repaying them roughly 10 cents on the dollar, among the lowest of all the city's unsecured creditors. Ambac Assurance Corp., which insures some of the debt, is challenging the treatment.

Rhodes also wants attorneys to weigh in on the city's water and sewer bonds. The plan calls for the full repayment of principal, but Detroit Emergency Manager Kevyn Orr wants to restructure the debt by lowering the interest rate, eliminating call protections, and possibly pushing debt service below other payments.

Rhodes posed the question of whether the part of the plan "relating to the interest-rate modification and call protection modifications of certain debt secured by special revenues violates the provisions of the bankruptcy code relating to such debts."

As revenue bonds, the city's water and sewer bonds, which total roughly $5.7 billion, have long been considered among the most protected in the bankruptcy.

Rhodes asked attorneys to debate whether the counties of Macomb, Oakland, and Wayne have standing to object to the plan, as they have, and whether the plan's assumed pension investment return rate of 6.75% and discount rate restrictions violate state law.

He also wants to hear opinions on whether the bankruptcy code requires the city to sell "non-core" assets to meet creditor obligations. That's widely seen as a reference to the Detroit Institute of Arts, one of the key players in the Chapter 9 case.

The deadline for filing briefs is June 17. A hearing will be held on June 24. Each side will be allowed 15 minutes to argue their case.

In related news, advisory firm Municipal Market Advisors put out a note Monday highlighting a complicated part of the Motown bankruptcy case: voting rights.

The plan currently calls for votes from both the bond insurers and the bondholders. But bond insurers have asked Rhodes to allow them to have exclusive voting rights. If the judge allows it, that would "bring the voting process in line with market expectations: that insurers have the rights and remedies afforded bondholders to the extent that they are in compliance with their payment obligations under the insurance policy," MMA writes.

If both the insurer and the individual holder are allowed to vote, that "could undermine the insurers' ability to protect against losses with possible negative consequences accruing, such as higher premiums and greater uncertainty as to recovery prospects in the face of bankruptcy."

Nearly all insurers have covered full principal and interests on Detroit's debt since the city stopped making payments last June.

One exception is Financial Guaranty Insurance Corp., which insures the city's pension certificates of participation and a piece of the water and sewer bonds. FGIC has paid only 17 cents on the dollar on the COPs, according to MMA. The insurer, as part of rehabilitation, worked out a plan with all its clients that has it covering only a portion of its claims up front, with the balance paid off after the claim matures.

Insurer Berkshire Hathaway, which wraps some of the FGIC-insured water and sewer debt, has asked for the exclusive right to vote on that debt, according to MMA. "It would seem reasonable for the court to a different view with respect to FGIC, perhaps finding in Berkshire's favor or maybe even splitting the vote so that each insurer has a say related to its share of likely coverage."

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