Bankruptcy Judge Steven Rhodes rejected two previous settlement deals between Detroit and swap counterparties.

CHICAGO — Detroit has reached a new settlement with its interest-rate swap counterparties, a deal that could significantly boost the city's efforts to pursue a cramdown plan of adjustment.

The settlement, filed on the federal bankruptcy court late Monday, calls for Detroit to pay the counterparties $85 million. It's the city's third proposed deal with the banks, UBS AG and Merrill Lynch Capital Services Inc. U.S. Bankruptcy Judge Steven Rhodes in January rejected the previous deal, for $165 million, as too rich. The city last October proposed paying the banks $230 million.

Rhodes still has to sign off on the new proposal. Detroit asked the judge for an expedited hearing on the motion, while noting that resolution of the matter before March 14, when the first quarterly payment toward the settlement would be due, is "likely not feasible."

As part of the agreement, UBS and Merrill Lynch have agreed to sign off on the city's debt adjustment plan.

That would give Detroit its first accepting impaired creditor class and allow the city to pursue a cramdown of remaining creditors.

"We look forward to Judge Steven Rhodes' decision on our proposed settlement, and we hope the swaps resolution serves as a model for compromise on other matters related to Detroit's finances," emergency manager Kevyn Orr said in a statement late Monday after the settlement motion was filed.

It would be Detroit's first major settlement since entering Chapter 9 last July. Bond insurers and other creditors have fought the previous swaps settlements in court.

Orr and his advisors have negotiated with the counterparties for months to reach a deal to end the swaps, talks that began even before the city filed for bankruptcy. Detroit considers the swaps secured even as it treats much of the rest of its debt as unsecured. The city has continued to make its payments to the swap counterparties — $4.2 million a month — throughout the bankruptcy.

Orr has said repeatedly he was eager to reach a deal with the counterparties because a court battle with them could mean losing access to the casino revenues that act as collateral on the swaps. Casino revenues are the city's third-largest, and most stable, revenue stream.

The new deal calls for a 70% haircut for the counterparties, according to the city's court filing.

The swaps hedge roughly $800 million of $1.4 billion of pension certificates that the city is trying to repudiate as illegal with a lawsuit.

The city values the swaps at $288 million, according to the settlement filing. The $85 million would be divided equally among the two banks, and would be less $8.4 million already deposited in the so-called lockbox account.

Under the terms of the deal, the swaps would not be terminated and the rights of the banks would remain in place until the full $85 million payment is made. The banks themselves would continue to have the ability to terminate the swaps at any time.

"In addition to providing a 70% discount off of the amount that would allegedly be payable by the city, the settlement will provide greater certainty with respect to the city's cash flows and liquidity — the city will have continued access to its casino revenues and will not have an obligation to put aside monies in a disputed claims reserve for the benefit of the swap counterparties," attorneys argue in the brief.

The deal will "simplify" the city's effort to obtain a debtor-in-possession financing to finance city services and improvements, the brief says. Detroit is in the midst of trying to obtain a roughly $200 million loan with Barclays or another financial institution that is expected to feature pledges on the casino revenues and income taxes.

The banks' willingness to sign off on the debt adjustment plan will help the city in its efforts to obtain final court confirmation of the plan, Detroit's attorneys said.

"The existence of a significant impaired accepting class will, provided the city can satisfy the cramdown and other applicable confirmation standards, allow the city to confirm a plan of adjustment over a dissenting class vote. This ability will assist the city's efforts to adjust its debts and reach resolution with other creditors, which the city views as a material benefit."

Rhodes, in rejecting the previous swap settlements, suggested the city would have a reasonable case if it sued the banks and tried to overturn the swaps as illegal under state law, in part because it may have been a violation of Michigan's gaming act to pledge casino revenues as collateral.

The city is reluctant to pursue litigation because it could be end up being costly and time-consuming and tie up the casino revenues in the process.

"These risks are not acceptable to the city," the attorneys argue in the brief.

The $85 million deal "obviates the risk of hundreds of millions of dollars of swap termination claims that are secured (or that are unsecured but nonetheless cannot be impaired) hanging over the city's restructuring efforts for an extended period of time."

But at the same time, the city was only able to reach the settlement because of the "relative strength" of its litigation claims against the counterparties, according to the filing.

"As a result of [the city's] demonstrated willingness and ability to pursue every option available against the swap counterparties, the city was able to secure a materially better deal from the swap counterparties than it had been at any time before or after its bankruptcy filing."

The settlement calls for Detroit to make quarterly payments to the banks to cover the settlement, with the $4.2 million monthly payments set aside in two accounts. The payments will continue until Oct. 15, 2014, at which point the city expects to be out of bankruptcy court.

If the $85 million is not fully paid off by Oct. 15, Detroit will be required to use the proceeds from an expected post-petition financing to pay off the banks. The remaining payment would include an interest rate set by the post-petition borrowing.

If the city is unable to secure enough money with the financing, it will have an additional 180 days. During that time, the claims will remain secured by the casino revenues and the remaining payment will accrue interest at a rate of 1.5% plus the rate in the post-petition deal and a so-called deferral fee equal to 1% of remaining principal.

The city agreed it would support the swap counterparties in the event of any litigation brought against the banks or the casino revenues. The deal does not prohibit the city from pursuing its lawsuit that repudiates the $1.4 billion of pension certificates that the swaps hedge.

The terms also prohibit the city and its advisors from making any "disparaging or negative" comments about the banks or the settlement to the press.

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