CHICAGO -- U.S. Bankruptcy Judge Steven Rhodes Thursday rejected Detroit's proposed $165 million interest-rate swaps settlement, delivering a major blow to the swap counterparties and a victory to bond insurers, bondholders and retirees in one of the most closely watched rulings in the historic Chapter 9 case so far.
Rhodes also ruled that the city can pursue a debtor-in-possession financing with Barclays. The DIP loan was originally for $285 million, but without the need for the $165 million swap termination payment, the new loan will be $120 million.
"It's just too much money," Rhodes said in rejecting the swaps settlement.
"It 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," he said, according to local reports of the hearing.
Rhodes also scolded Detroit for entering into the deal too quickly, and said it "must stop" making hasty decisions. "The court will not participate in or permit the city to perpetuate" the very kind of hasty and imprudent decisions that led to the original settlement, he said.
The counterparties are UBS AG and Merrill Lynch Capital Services Inc.
The rejection means the city will have to fight or negotiate anew with counterparties for access to roughly $15 million a month in casino revenues, which emergency manager Kevyn Orr says are crucial to the city's regrowth. The casino revenue is currently used as collateral on the swaps.
Bond insurers, led by Syncora Guarantee, Inc., which wraps some of the interest-rate swaps and the pension certificates they hedge, bondholders, as well as retirees and the city's two pension funds, have fought the settlement for months, arguing that the deal was too favorable to the counterparties and that using the casino revenues as swap collateral was illegal.
Rhodes agreed with the challengers, saying it was "reasonably likely" that the city would succeed if it challenged the casino revenue pledge and original swaps deal in court.
"In the absence of this settlement, the city might pursue an underlying claim challenging the swaps themselves," Rhodes said.
During a trial on the swaps settlement, Orr and Jones Day admitted that they too thought there were "litigable" issues behind the swaps. But a lawsuit could prove too costly and take too long while tying up crucial casino revenues, the city argued at the time.
After his ruling, Rhodes said he hoped the city and the counterparties would renew negotiations. But if the city sues the banks instead, then "so be it," he said.
The settlement called for Detroit to pay the banks $165 million to terminate the swaps, whose value is now estimated at around $230 million. The $165 million deal came after Rhodes in late December ordered the city and counterparties back into mediation to bring down a settlement originally sized at around $220 million. The court's mediator, Chief District Judge Gerald Rosen, had recommended Rhodes approve the new $165 million settlement.
"I have to say I'm surprised," said Melanie Cyganowski, an attorney with Otterbourg PC and former chief bankruptcy judge in the Eastern District of New York, who also works as a mediator. "Typically when the settlement comes with the recommendation of the mediator, there's a pretty good feel that it's going to get approved."
Cyganowski added that it's rare for a mediator to recommend a settlement. "Usually they only say if the parties resolved it or didn't, and don't comment on whether it's fair," she said. "To me that means the parties thought it would be important to have Judge Rosen's recommendation and they asked him if he would and he gave it."
Rhodes' ruling showed he is "actively involved in administering the case," said Cyganowski. "It sounded like he was looking at it very sternly, very strictly, and obviously chastising the city for not entering into a more robust agreement that would be beneficial to the citizens of Detroit."
Like Cyganowski, bankruptcy attorney James Spiotto of Chapman and Cutler warned that litigation often means a long-drawn out process. That could hurt the city's efforts to speed through the Chapter 9 process by September.
"Traditionally settlements are to be encouraged and are a necessary ingredient in having a plan of adjustment work," said Spiotto. "But the question here is, are the numbers right? There was certainly a dialogue in the hearings on different perspectives," he said. "That's why you have hearings, so everyone will hear the explanation of what's in the best interest of everyone."
One municipal bond analyst said Rhodes' decision is a sign at last of some "common sense" in the case. The city's contention that the swaps agreement has been disastrous is wrong, according to Dick Larkin, senior vice president, director of credit analysis at HJ Sims & Co., Inc. Larkin argues that the swaps actually saved the city more than $100 million of interest costs from 2006 through 2013.
"The decision to take these swaps was a good financial move for the city compared to what they would have paid if they had just done a fixed-rate bond issue in 2006," Larkin said. "The swap arrangement was a smart decision. Now to go and say the city should pay $165 million to terminate is ridiculous because the swaps saved them money."
Detroit is likely to pursue its DIP loan with Barclays before the end of the month, when the agreement expires. The loan carries pledges of the city's income tax and casino revenue, and it's unclear whether the city will be able to use the casino revenue -- or a portion of it -- as a pledge in light of the swaps litigation.
