A bond insurer on Monday struck a blow against Detroit’s proposal to exit bankruptcy, arguing in a new lawsuit that Detroit’s approach would illegally discriminate against the city’s third-biggest group of creditors â€" the investors who provided $1.4 billion for its workers’ pensions nearly a decade ago.
Those investors bought “certificates of participation,†which were the first securities Detroit defaulted on as it prepared to file for bankruptcy last summer. The city now contends that the 2005 borrowing was a “sham transaction†and is proposing to give the investors who bought into it one of the lowest recovery rates in its bankruptcy.
The insurer, the Financial Guaranty Insurance Company, said in its lawsuit that Detroit “seeks to turn a crooked eye to history.†It said the city had benefited greatly from the transaction but was now pretending to be “the innocent victim of fraud perpetrated on a grand scale.â€
The new lawsuit could have far-reaching consequences. It might lead to a bigger recovery for the investors who hold the certificates and smaller losses for Financial Guaranty and another insurer, Syncora, which insured them. But it might also lead to a fight to claw back the $1.4 billion from the city pension system, which would throw a wrench into Detroit’s efforts to cushion its workers and retirees from some of the pain as it attempts to resolve its outsized debts.
The retirees, current and future, make up Detroit’s biggest and second-biggest unsecured creditors, first as participants in the city’s retiree health plan, which is entirely unfunded, and second as participants of its pension plan, which is partly funded. (They are secured creditors to the extent the benefits are funded.) Although they are in the same general creditor class as the insurers, they stand to receive significantly better recoveries under Detroit’s proposal to exit bankruptcy, called the plan of adjustment.
“The city’s opportunism and revisionist history have broad repercussions, not the least of which being the impact on the funded status of the city’s retirement systems,†Financial Guaranty said in its suit. It said the municipal pension system would “be subject to claims of unjust enrichment†if Detroit pursued its plan of debt adjustment unchanged.
“This, in turn, raises significant questions about the city’s future, including the feasibility of its existing, proposed Chapter 9 plan,†the insurer said.
The suit, filed in United States Bankruptcy Court for the Eastern District of Michigan, responds primarily to a lawsuit that Detroit itself filed in late January, when it first argued that its 2005 pension transaction was a sham. Detroit said that it already had as much debt as it was legally allowed to carry in 2005 and therefore structured the borrowing in a needlessly complicated way to circumvent the ceiling. Detroit added that it embarked on the transaction “at the prompting of investment banks that would profit handsomely from the transaction.â€
In its suit, Detroit argued that the borrowing should be considered “void ab initio,†meaning it should be treated as if it never happened, and that none of the obligations it created are enforceable.
When it issued its plan of adjustment, Detroit built upon the idea that the 2005 transaction was null and void: It said that the investors who bought the certificates of participation had no valid claim in the bankruptcy. But to bring about a settlement more quickly, Detroit said it was willing to accept 40 percent of the certificate holders’ claims if they would vote in favor of the overall plan of adjustment. If Detroit is able to persuade one impaired creditor to vote in favor of its plan of adjustment, it can try to have the judge overseeing the case, Steven W. Rhodes of United States Bankruptcy Court for the Eastern District of Michigan, impose the plan on everybody else.
Financial Guaranty’s lawsuit challenges the notion that the 2005 borrowing was illegal. The insurer says that it was concerned about Detroit’s total indebtedness when it was first approached to insure the certificates, so it sought legal opinions from the city, the city’s financial advisers and even the state government. All of them told the insurer that the transaction was legal, binding and enforceable and that it would not put Detroit in violation of its legal debt limit.
Financial Guaranty is asking Judge Rhodes to dismiss Detroit’s case against the 2005 transaction and to bar Detroit from contending that the 2005 debt was invalid and does not have to be repaid. It also says its bankruptcy claim should be honored in full.
Moreover, Financial Guaranty argues that if Judge Rhodes disagrees and ultimately finds that the 2005 borrowing was illegal, then he should also issue a ruling that Detroit fraudulently induced the insurer to issue a policy and that Detroit and its pension system were unjustly enriched.
“The retirement systems should disgorge all amounts or benefits that they received as a result of the pension funding transactions,†the lawsuit said. It says the money should be used to make restitution to all of the certificate holders and insurers.
In addition to the certificates of participation, the borrowing gave rise to some derivatives contracts, called interest-rate swaps, but Detroit has continued to pay those, even though it has defaulted on the related debt certificates. Its counterparties on the swaps are UBS and Bank of America.
The swap contracts are written in a way that makes them almost impossible to terminate without paying large fees to the counterparties. Detroit has already made several proposals to pay its way out of the swaps, but its initial proposals â€" first to pay the banks about $230 million, and then $165 million â€" were rejected by Judge Rhodes. He said that was too much money for a bankrupt city to pay.
In rejecting Detroit’s proposal to pay the two banks $165 million, Judge Rhodes said that Detroit had a habit of coming to hasty financial decisions that cost its residents too much, and ordered the city and the banks to go back and negotiate a lower termination fee. He also said he had doubts about the legality of the 2005 transaction, and thought that if Detroit were to sue, its lawsuit might succeed.
Although Judge Rhodes did not give the city specific instructions for such a lawsuit, the city soon filed one, apparently for use as leverage in its negotiations with the two banks.
Detroit and the two banks have agreed on a new total swap termination fee of about $85 million. The banks have also said they would vote in favor of Detroit’s overall plan of adjustment if those terms are approved. They are now waiting to see whether Judge Rhodes accepts this approach.
