CHICAGO -- Attorneys for Detroit's pension funds said they will challenge a new settlement between the city and its interest-rate swap counterparties.

The city and counterparties announced they had reached a new agreement on Tuesday, after two days of court-ordered mediation. The deal is expected to shave $65 million off the costs of terminating the swaps.

As part of the agreement, the city will borrow $285 million from Barclays PLC to pay off the banks. That's down from the original $350 million debtor-in-possession financing.

But an attorney for the city's two pension systems said the terms continue to unreasonably favor the counterparties, UBS AG and Bank of America Merrill Lynch Capital Services Inc.

"We will challenge the new deal on the same basis as the old deal," Clark Hill attorney Robert Gordon, who represents the city's two pension funds, said in an email to the Bond Buyer. "In our opinion, the new deal simply remains too rich relative to our legal arguments that the swap counterparties did not have valid prepetition liens in the casino tax revenues, and, even if they did, those liens do not extend to the postpetition casino tax revenues."

Detroit emergency manager Kevyn Orr is expected to file an outline of the new settlement by Friday. The pension funds will file a response before the next bankruptcy court hearing, set for Jan. 3, Gordon said.

Orr is expected to be deposed about the new deal on Dec. 31.

It remains unclear whether bond insurers challenging the original settlement will fight the new one. Syncora Guarantee Inc., the main challenger of the original agreement, did not respond to requests for comment by press time. Syncora insures the swaps as well as a chunk of the $800 million of pension certificates hedged by the swaps.

Assured Guaranty Municipal Corp. and National Public Finance Guarantee Corp. last week withdrew their objections to the city's proposed debtor-in-possession financing and the swap settlement. The city added language to the proposed order authorizing the DIP and the settlement that assuaged some of the insurers' concerns.

In court filings ahead of last week's hearings on the swaps and the DIP, the city acknowledged there are issues it could litigate involving the status of the swaps — as the challengers have argued — but said that any litigation would be prolonged and tie up access to much-needed casino revenues that serve as collateral on the swaps.

Federal Judge Steven Rhodes, the judge overseeing Detroit's historic bankruptcy case, suspended last week's hearings after reaching an impasse with Detroit's attorneys, who refused to disclose details behind the city's strategy for treating the swaps as a secured debt and entering settlement negotiations.

The city and its counterparty banks then began federal mediation Monday aimed at striking terms more favorable to the city. The talks also included the settlement objectors including insurers Syncora Guarantee Inc. and Berkshire Hathaway Reinsurance Group, as well as other insurers and a committee representing holders of the pension certificates tied to the swaps.

Mediation began amid a threat from the city that it would consider suing the banks if a more agreeable deal to the court, objectors to the deals, and city couldn't be reached.

Orr has called the termination settlement and DIP central to his plan of adjustment to deal with the city's more than $18 billion of debts.

The original settlement called for a roughly 75-cent-on-the-dollar payout — totaling about $230 million — to counterparties UBS and Merrill Lynch to terminate the swaps that have contributed heavily to the city's fiscal woes.

The new agreement was struck shortly before noon Tuesday between Orr and the bank counterparties. Orr's office said a statement the settlement would close the "chapter on a financial deal that helped drive the city to insolvency" and free up access to $15 million in much-needed monthly casino revenues.

"After two days of intense negotiations led by Chief Mediator U.S. Chief District Court Judge Gerald Rosen, the city of Detroit and the swap counterparts have reached an agreement," an advisory from the U.S. District Court for the Eastern District of Michigan said. "The agreement is subject to approval by Bankruptcy Judge Steven Rhodes."

The city said the deal marks "a significant reduction" in the costs for terminating the swaps. The payout of $230 million as proposed in the original settlement represented a 25% reduction in the swap debt that was valued at $293 million. The new agreement's payout of $165 million raises the city's discount to 43%, according to the statement.

As a result of the new deal, the city said it would lower the DIP loan to $285 million with $165 million going to cover the termination payment and $120 million to fund improvements in city services.

Under the deals, a pledge of the city's casino revenues that currently backs the swaps will be shifted to the DIP deal. City income taxes would also be pledged. The DIP agreement with Barclays expires on Jan. 7, 2014.

Ernst & Young Capital Advisors LLC consultant Gaurav Malhotra testified during hearings last week that the city could exhaust its cash by the end of 2013 and face a $284 million shortfall by June 2015 if the swaps are not terminated. The original settlement would generate between $1.5 million to $3 million in monthly savings on interest rate payments, he said. The original swaps settlement was reached days before Orr filed for Chapter 9 in July.

Under the original plans, the DIP loan would consist of two loans: "Swap Termination Bonds," totaling $230 million, and the "Quality of Life Bonds," totaling $120 million. City attorneys had said a more favorable swaps settlement would raise the amount available for city quality of life projects and services.

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