CHICAGO — The bank counterparties to Detroit's interest-rate swaps have mounted their first public defense of a controversial proposed settlement with the city, arguing that the derivatives are legally secured and warning that litigation would be costly and painful for Detroiters.

UBS AG and Merrill Lynch Capital Services, Inc. filed the 1,701-page document on the bankruptcy court web site late Friday. Also Friday, the city filed an omnibus response to its creditors' objections to the deal.

U.S. Bankruptcy Judge Steven Rhodes has scheduled an April 3 hearing on the settlement, which has become one of the most divisive aspects of the high-profile bankruptcy case.
The proposal calls for Detroit to pay UBS and Merrill Lynch $85 million in exchange for access to casino revenues that serve as the swaps' collateral and the banks' approval of the debt adjustment plan. The city and the banks say the $85 million is a 70% discount off the current cost of terminating the swaps, currently estimated at $288 million.

The counterparties' approval of the plan would give Detroit an impaired accepting class, allowing it to pursue a cramdown for the rest of its creditors if necessary.

It's the third proposed swaps settlement floated by the city. Rhodes has rejected the two previous deals as too costly for Detroiters.

Like the counterparties, the city argues in its omnibus response that the settlement should be approved because it is "well above the lowest point in the range of reasonableness."

In rejecting a $165 million settlement in January, Rhodes suggested that the swaps might be illegal under state law, due largely to the use of casino revenues as collateral. The judge suggested that the city could win if it took the banks to court to overturn the contracts.

Rhodes' ruling helped drive the latest compromise.

"To be clear: all parties to the negotiations were well aware of the court's view of the city's likelihood of success on the merits regarding the validity of the swaps and the liens," Detroit's attorneys argue in the filing. "That determination sends a clear signal to the litigants as to their respective chances of success before the trial court. Here, that signal has helped drive the settlement number. It does not mean, though, that there should be no compromise."

Opponents of the settlement include the city's retirees and pension funds. Syncora Guarantee Inc., which insures the swaps, is one of the most vigorous opponents and has been fighting the city's proposed payments since before the bankruptcy was filed last July.

In their filing, the two banks warn that if the deal is not approved, the resulting litigation would be "costly and hotly contested," and take years to resolve.

"The objections ignore both the risks and the costs of complex and lengthy litigation. A settlement that discounts the city's obligation by approximately 70%, eliminates all risk of cash trapping [the casino revenue], and pays the swap counterparties over an extended period, is reasonable," the banks argue. "Moreover, the city's residents have a compelling interest in seeing a resolution of this bankruptcy and certainty as to the city's cash flows, which is unlikely to happen in the near term absent a settlement of the claims — and of the many counterclaims that could be asserted by the swap counterparties."

The banks argue that the swaps are legally secured by the city's casino revenue because Michigan law allows the revenue to be used to improve the city's quality of life.

"The gaming act permits casino revenues to be used to avoid tax increases that would have negatively impacted the quality of life in the city and that would have placed the city's residents under a severe financial burden," the banks argue, quoting an ordinance passed by the Detroit City Council in 2009. The swap termination payment at the time was estimated to be as high as $400 million.

In addition, the city itself suggested using the casino revenue as a lien, presenting it as a legal use of the money under state law. The city's outside counsel, its special counsel, the corporation counsel, and the Detroit City Council all signed off on the collateral, the banks said.

The outside counsel approving the deal was Lewis & Munday. Orrick, Herrington & Sutcliffe LLP was special counsel.

As part of the battle over the swaps settlement, the city in January sued to repudiate the debt the swaps hedge, $1.5 billion of pension certificates of participation issued in 2005.

The city filed the lawsuit against the service corporations it set up in 2005 to issue the certificates, arguing that they are sham entities that were created only to allow the city to avoid its debt limit.

UBS and Merrill Lynch say in their filing that they have strong arguments that would could prevail if that lawsuit went to court. The debt limit argument does not apply because it only governs the city's borrowings, not the service corporations, a relatively common municipal financing mechanism, the banks say. And the city's payments under the contracts are not technically debt, because they refinanced existing pension debt.

Detroit in fact benefited from the COPs issuance and the swaps, which provided flexibility, and eight years later cannot seek to overturn the deal, the counterparties argue.

"The COPs provided the city with over $1.4 billion to fund its constitutionally mandated pension obligations, and the swaps enabled the COPs to be marketed on terms attractive to investors, while protecting against interest-rate risk," the filing says. "Because the city received a substantial benefit from the pension funding transactions, it cannot now be heard to complain that those transactions were invalid from the inception."

The argument echoes the one made by bond insurer Financial Guaranty Insurance Corp., which last week objected to the city's COPs lawsuit.

Syncora argued in its settlement objection that the city itself does not have the power to give the counterparties a lien on the casino revenues; that only the service corporations have that power.

The banks countered that the service corporations, in the 2009 collateral agreement, "expressly granted the swap counterparties a security interest in their rights to payment from the city and in their lien in the gaming revenues."

In a pair of footnotes, the banks note that FGIC, which insures $1.1 billion of the COPs, has agreed to not object to the settlement and that in return the banks will not use the that failure to object against the insurer in future litigation.

Syncora, however, has refused to sign off on the settlement unless it's released from its policies.

Davis Polk & Wardwell LLP and Paul, Weiss, Rifkind, Wharton & Garrison LLP, and Warner Norcross & Judd LLP represent UBS and Merrill Lynch.

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