Home ListingFebruary 3, 2014

Detroit Seeks Legal Relief over Interest Rate Swaps

<em>The City of Detroit has asked a bankruptcy judge to cancel $1.4 billion of debt sold to fund public worker pensions.</em>

Reported by Featured Author

(February 3, 2014) — Detroit’s state-appointed emergency manager Kevyn Orr has applied to a bankruptcy judge to negate the city’s payment obligations on $1.44 billion of debt.

The lawsuit, filed on Friday, contends that the city and its retirement systems violated Michigan law when they set up what Orr refers to as “sham” service corporations and funding trusts to facilitate the debt sales in 2005 and 2006, according to documents seen by aiCIO.

All other contracts or obligations connected to the debt are also void, the lawsuit claimed.

The suit has called on bankruptcy judge Steven Rhodes to issue a judgment declaring that the city is not obligated to continue making payments on the pension certificates of participation (COPs) that were issued during the term of former mayor Kwame Kilpatrick, who is now in prison on federal corruption charges.

“This deal was bad for the city from its onset, despite reassurances it would adequately resolve the city’s pension issues,” Orr said in a statement.

If Orr is successful, the ruling could invalidate the interest-rate swap contracts that Detroit reached with investment banks UBS and Merrill Lynch Capital Services, a part of Bank of America.

The swaps were meant to hedge interest-rate risk arising on variable-rate COPs. In the suit, Detroit claimed that any contract arising from the COPs would be invalid from the start since “all other obligations incurred by the city in connection with the COPs transactions are unenforceable and void”.

Like all other municipalities in Michigan, Detroit was subject to a strict limitation on the amount of indebtedness it could incur. In particular, Section 4a of the Home Rule City Act (HRCA) set maximum limits on a city’s net indebtedness. This would be the greatest of either 10% of the assessed value of all the real and personal property in the city or 15% of this assessed value if money that exceeded the original 10% was or had been used solely for the construction or renovation of hospital facilities.

At the time the $1.44 billion of COPs were issued in 2005, the city had only approximately $660 million remaining under its HRCA debt limit, and therefore could not issue traditional debt to cover the $1.70 billion pension shortfall, the lawsuit explained.

The swap deals, valued at $400 million in 2011, began to cause two public sector pension funds problems as interest rates fell at the same time as Detroit’s credit ratings. The money owed to the banks was a key element that drove Detroit to file for municipal bankruptcy in July.

Orr was appointed in March 2013 to oversee bankruptcy operations of Detroit. A veteran bankruptcy lawyer, Orr was a partner at the Jones Day firm, and worked on some of the US’s most notable bankruptcy cases, including that of Chrysler in 2009.

Last year, Detroit attempted to be awarded bank redress over other debt investments of its pension funds.

In September 2013, an arbitration panel from the Financial Industry Regulatory Authority, an independent regulator of US securities firms, dismissed claims brought by Detroit’s Police and Fire Retirement System.

The system had brought claims against Citigroup, Morgan Stanley, and several other smaller institutions in 2010, claiming the banks had defrauded and breached both contracts and their fiduciary duty when recommending the system invest in various collateralised debt obligation funds.