Detroit filed suit on Friday to invalidate some complex transactions it used to finance its pensions, contending they were illegal from the very beginning.
In a complaint filed in United States bankruptcy court, the city argues that deals with special entities set up in 2005 and 2006, which raised $1.4 billion, were aimed only at circumventing a ceiling on the amount of debt it could take on. It is seeking a ruling that it has no obligation to make payments on the so-called certificates of participation issued to raise the money.
In a stunning turnaround, Detroit is also seeking to cancel some costly long-term contracts that were part of the deal, leaving two large banks, Bank of America and UBS, empty-handed just weeks after offering to pay them $165 million to get out of them. If a judge agrees, Detroit could be freed from having to honor the contracts, known as interest-rate swaps, which require it to pay tens of millions of dollars a year to the two banks.
Detroit’s lawsuit came two weeks after its bankruptcy judge, Steven Rhodes, rejected the $165 million proposal as “too much money†and sent the city back to negotiate less costly terms. He also suggested that the city could bring suit contesting the legality of the transactions.
Rather than proposing to pay a smaller amount to terminate the swaps, Detroit is seeking a court ruling that they were illegal from the outset. It says that in 2005 it was in no position to borrow, having exhausted its capacity to issue debt under state law. It argues that the two banks led a team that created sham corporations and made it look as if those corporations, and not Detroit, had issued the debt.
“This deal was bad for the city from its onset despite reassurances it would adequately resolve the city’s pension issues,†Kevyn Orr, the city’s emergency manager, said in a statement. “We have tried without success to negotiate a resolution to this dispute and to allow the city and its taxpayers to move forward and unwind these illegal transactions.â€
Some creditors, angry at seeing the swaps being paid while they were being told to expect losses, have argued that the city should try to claw back some of the money it has been paying the two banks.
Detroit explained some of the mechanics of the coming litigation in a proposed plan of adjustment that it recently gave to its creditors. The city said it would set aside $4.2 million a month in a special reserve in case its lawsuit failed. If the judge finds that the swaps were not only valid but also a secured credit, then Detroit said it would use the money to pay some portion of the claim on the swaps.
In case of a partial victory, with the court deciding that swaps were valid but unsecured, Detroit said it would to take back all the money in the reserve and use it to provide services. Instead of cash, Bank of America and UBS would be given portions of some notes that the city proposes to issue to unsecured creditors.
Some of those notes would also be used to pay the investors who bought the 2005 debt and the insurers that have promised to step in and make Detroit’s payments if it defaults.
The swaps have been a big sticking point in the bankruptcy case because Detroit had previously pledged some casino tax revenue to the two banks to secure the stream of payments the contracts called for it to make. In bankruptcy, Detroit wanted to get the casino money back to use as collateral for a special new loan it needed to finance its activities in bankruptcy.
