CHICAGO — The judge overseeing Detroit's bankruptcy will rule next week on a critical interest-rate swaps settlement after an all-day hearing Thursday that centered on the legality of the lien backing the derivatives.
U.S. Bankruptcy Judge Steven Rhodes announced he would issue a verbal ruling on April 11 after listening to the city and several of its major creditors spar over the settlement, one of the most controversial and drawn-out aspects of the historic Chapter 9 case.
Under the proposal, Detroit would pay $85 million to the counterparties, UBS AG and Merrill Lynch Capital Services Inc. The city would pay off the banks in a series of quarterly payments, and expects to make the full payment after Oct. 15 — its expected bankruptcy exit date — with proceeds of a $300 million post-petition financing.
The swaps would not be terminated and the rights of the banks would remain place until the full payment is made.
An earlier deal required the banks to sign off on the city's plan of debt adjustment. The approval from one impaired accepting creditor would theoretically give the city the power to impose a cramdown on the rest of its creditors. The new deal drops the approval language from the order, but includes it in supporting documents. The city and banks have made it clear that the banks still expect to support the plan.
Rhodes has rejected two previous swaps settlements as too costly for the city.
The derivatives hedge roughly $800 million of $1.4 billion of pension certificates of participation that the city is separately trying to repudiate as illegal.
The city values the swaps at $288 million. The $85 million would be divided equally among the two banks.
At the heart of the dispute is the legality of the casino revenues that serve as the swaps' lien. Creditors, including Syncora Guarantee Inc., argue that the Michigan Gaming Act prohibits the use of the gambling revenue as collateral.
Rhodes has rejected two previous settlements as too costly in light of the questionable legality of the casino pledge. Carole Neville, an attorney for a committee that represents the city's retirees, said state law prohibited Rhodes from granting the lien. "It's a settlement that asks you to approve something that's in direct violation of state law," Neville said.
She also noted that the settlement gives the city the ability to cramdown the rest of its unsecured creditors.
Syncora's attorney Stephen Hackney argued Thursday that not only is the casino pledge illegal, but the settlement also violates the insurer's rights as a party to the original financing. Syncora insures the swaps as well as $329 million of the pension certificates that the swaps hedge.
Hackney argued that Syncora would, under the deal, still have to pay the banks, which would therefore receive roughly $200 million from Syncora as well as $85 million from the city. Hackney called the payout a "windfall" for the banks.
"The implications for Syncora in this transaction are very significant," Hackney said. "Even though the liens are a sensitive issue and they're this radioactive topic, they're unbelievably important to my client's rights."
Hackney suggested Syncora would "surrender" if the banks agreed to release the insurer from its policy.
In defense of the settlement, Detroit's attorneys argued that it was within the court's power to approve the lien, despite the legal uncertainty. "Questionable liens are settled every single day in every single bankruptcy court across the nation," Pepper Hamilton attorney Robert Hertzberg said.
"Is the city asking the court to find or conclude that this use of the gaming revenues is consistent with the Michigan Gaming Act?" Rhodes later asked Detroit's Jones Day attorney Corinne Ball. "No," she said.
If he approves the settlement, "legally it raises the lien from the status of arguably invalid to valid," Rhodes said. "Because the settlement involves the court in blessing this lien, the court has to find that that's legal under state law."
Bank of America attorney Marshall Huebner told Rhodes that without a settlement, the banks faces the loss of $200 million that it considers "both secured and insured."
BofA, along with UBS, filed a long defense of the swaps settlement in court last week. Among other arguments, the banks argue that Michigan law allows the casino revenue to be used to improve the city's quality of life. Without the lien, the city would have been forced to pay a termination payment estimated at the time to be $400 million, which would have had draconian consequences, the banks argue.
Detroit emergency manager Kevyn Orr also testified Thursday morning, repeating earlier assertions that a settlement is a greater benefit to the city because litigation would be too expensive and would endanger the flow of the casino revenue, Detroit's third-largest revenue stream.
Orr said that after Rhodes rejected the previous settlement in January, he ordered the city's attorneys to prepare a lawsuit if the banks were unwilling to come to terms. Detroit attorneys prepared a 17-count lawsuit against the banks that included fraud and misrepresentation, Orr said. The banks offered a $120 million settlement, and Orr said "that wasn't good enough," offering a counteroffer of $75 million to $80 million.
"I continue to believe that resolving the swap agreement was in the best interest of the city," Orr said. He later added that fighting the banks in court would cost the city "millions of dollars a month."
In related news, Rhodes pushed back by three days a hearing on objections to the disclosure statement. The new hearing is set for April 17, instead of April 14, after creditors requested more time to review the documents.
Also on April 17 a hearing will be held on the Chapter 9 plan confirmation process. Objections to the bankruptcy plan from anyone other than individual bondholders and individual retirees are due May 1. The city's response to the objections is due May 12.
A trial on the plan confirmation is scheduled for July 16.
