By: Addison Pierce

In 2005, when the world was yet to enter into the Great Recession, Detroit was already deep in financial distress.[1] On top of the population exodus and a plethora of other financial and political issues, the City of Detroit was facing massive arrears on retirement obligations.[2] The short-term solution for then Mayor Kwame Kilpatrick was to sell $1.4 billion of specialized debt instruments called pension obligation certificates.[3] While the deal wiped out the arrearages, it only shifted the problem. Saddled with this debt, the City then entered into a credit swap deal to lock in a favorable interest rate.[4]

As the market turned, however, interest rates plummeted and Detroit has been left with a sour deal; a deal that consumes about 5% of Detroit’s annual revenue.[5] While these swaps contributed to Detroit’s need to enter the safe haven of Chapter IX bankruptcy, Chapter IX does not offer any simple solution. Twice before the City has attempted to settle the debt, but on each occasion U.S. Bankruptcy Judge Steven Rhodes found the deals to be too rich for the creditors.[6] With a third deal reached in the first week of March 2014,[7] it is again up to Judge Rhodes to weigh in on the issue. How he will decide is anyone’s guess, but based on his previous harsh warnings for the City, this deal should be favorable enough to be approved.

On January 17, 2014, Judge Rhodes rejected the City’s second attempt at settling the billion-dollar debt obligation.[8] Rehashing the first deal reached with the creditors to settle the debt for $230 million, the parties approached the court with a deal calling for a payment of $165 million.[9] Judge Rhodes, who views the original debt as legally dubious, said “[t]he court … will not participate in or permit the City to perpetuate the very kind of hasty and imprudent financial decision-making that led to the” original deal.[10] Judge Rhodes went on to remind that it is his judicial responsibility to ensure the City emerges from Chapter IX bankruptcy as a financially sustainable municipality.[11] Specific to the dollar amount, Judge Rhodes adds that “[i]t is higher than the highest reasonable number . . . If it were close, the court would approve it. But it’s not close. The court looked for every way it could to approve this settlement. It could not find a way. It’s just too much money.”[12]

In addition to the dollar amount, a major point of contention for Judge Rhodes has been the legality of the swap deal. When the original deal soured in 2009, the City pledged the revenue of the City’s casinos as collateral to avoid immediate balloon payment, potentially violating the Gaming Act.[13] “In the absence of this settlement, the City might pursue an underlying claim challenging the swaps themselves,” Judge Rhodes said.[14] Emergency Manager Orr and Jones Day admitted that they too thought there were “litigable’ issues behind the swaps but added that a lawsuit could prove too costly and take too long while tying up crucial casino revenues.[15]

What is critical to the current plan on the table being approved then, is sticking a proper balance between the settlement costs and the litigation costs to challenge the swaps, and more fundamentally, the settlement painting a picture that reflects a careful and prudent decision-making process that will contribute to Detroit emerging from bankruptcy on solid footing. So how does the new deal stack up against these lofty goals?

On its face, the deal reflects a marked improvement for the City of Detroit. Looking back to the deal reached last October for $230 million, and more recently, the deal reached for $165 million, the $85 million price tag alone reflects a tremendous improvement.[16] In its settlement filing, the City valued the swaps at $288 million; the $85 million would be a 70% discount for the City.[17] Additionally, the lower dollar amount lessens the cost-benefit concern of those who would prefer to see the City challenge the swaps in court. Factoring in the risk of loss, the massive amount of time and money (neither of which Detroit has to spare) required to wage such a suit, $85 million should be viewed as good enough in light of the costly and uncertain alternative. More important, however, is what this deal means for the rest of the bankruptcy process for Detroit.

If one of Judge Rhodes’ chief concerns is Detroit’s ability to emerge from bankruptcy as financially viable, having such a large creditor willing accept such a large discount only improves Detroit’s prospects. In its brief filed with the court, Detroit’s attorneys argued that “[t]he existence of a significant impaired accepting class will, provided the City can satisfy the cramdown and other applicable confirmation standards, allow the City to confirm a plan of adjustment over a dissenting class vote. This ability will assist the City’s efforts to adjust its debts and reach resolution with other creditors, which the City views as a material benefit.”[18] The $85 million deal “obviates the risk of hundreds of millions of dollars of swap termination claims that are secured (or that are unsecured but nonetheless cannot be impaired) hanging over the City’s restructuring efforts for an extended period of time.”[19]

In rejecting the last deal, Judge Rhodes said that “[t]he court … will not participate in or permit the City to perpetuate the very kind of hasty and imprudent financial decision-making that led to the” original deal and that it’s his judicial responsibility to ensure the City emerges from Chapter IX bankruptcy as a financially sustainable municipality.[20] With a new $85 million deal on the table that adequately reflects a cost benefit of settling the matter as opposed to fighting in court, it would be hard to imagine how Judge Rhodes could reject this most recent deal struck by the City. While there are many, many grounds on which the deal could be challenged or rejected, the issues that have held up approval in the past seem to have been addressed. If Rhode really feels that it is his judicial responsibility to ensure the City emerges from Chapter IX bankruptcy as a financially sustainable municipality, it would seem to be his responsibility to approve this third agreement reached by the City.

 

[1] See generally Global Recession Timeline, BBC, https://news.bbc.co.uk/2/hi/8242825.stm (last visited Mar. 9, 2014) (providing a timeline for the global recession).

[2] See Editorial: Will judge sign off on key settlement in Detroit Bankruptcy, Detroit Free Press, Mar. 5, 2014.

[3] Id.

[4] Id.

[5] Id.

[6] See Caitlin Devitt, Detroit’s New Swaps Settlement Aids Cramdown Plan, Bond Buyer, Mar. 3, 2014, https://www.bondbuyer.com/issues/123_42/detroits-new-swaps-settlement-aids-cramdown-plan-1060381-1.html.

[7] See In re City Of Detroit, Michigan, Debtor., 2014 WL 834783 (Bkrtcy.E.D.Mich.).

[8] See In re City of Detroit, at 14-15 (citing motion to approve second deal filed on December 27, 2013 being denied by court order on January 17, 2014.).

[9] See id.

[10] Nathan Bomey & Alisa Priddle, Detroit Bankruptcy Judge Denies Proposal to Pay of Disastrous Debt Deal, Detroit Free Press, Jan. 16, 2014, https://www.amestrib.com/news/detroit-bankruptcy-judge-denies-proposal-pay-debt-deal.

[11] Id.

[12] Caitlin Devitt, Judge Rejects Detroit Swaps Settlement, Bond Buyer, Jan. 16, 2014, https://www.bondbuyer.com/issues/123_12/judge-rejects-detroit-swaps-settlement-1059073-1.html.

[13] Nathan Bomey & Alisa Priddle, Detroit Bankruptcy Judge Denies Proposal to Pay of Disastrous Debt Deal, Detroit Free Press, Jan. 16, 2014, https://www.amestrib.com/news/detroit-bankruptcy-judge-denies-proposal-pay-debt-deal.

[14] Id.

[15] Id.

[16] See In re City of Detroit, at 2.

[17] Id.

[18] See In re City of Detroit, at 4.

[19] See In re City of Detroit, at 32.

[20] Nathan Bomey & Alisa Priddle, Detroit Bankruptcy Judge Denies Proposal to Pay of Disastrous Debt Deal, Detroit Free Press, Jan. 16, 2014, https://www.amestrib.com/news/detroit-bankruptcy-judge-denies-proposal-pay-debt-deal.