UPDATE 2-Detroit files lawsuit seeking to void pension debt

Fri Jan 31, 2014 9:43pm EST

By Karen Pierog

Jan 31 (Reuters) - Detroit on Friday filed a lawsuit in U.S. bankruptcy court seeking to invalidate $1.44 billion of debt sold to fund public worker pensions - a move that also could void the ill-fated interest-rate swaps contracts that were a factor leading Detroit into bankruptcy.

The lawsuit contends the city and its retirement systems violated Michigan law when they set up "sham" service corporations and funding trusts to facilitate the debt sales in 2005 and 2006. All other contracts or obligations connected to the debt are also void, the lawsuit claims.

Detroit in its lawsuit said the pension debt was "nothing more" than a borrowing by the city, and it violated borrowing limits imposed on Detroit by the state of Michigan.

In the suit, Detroit asked bankruptcy judge Steven Rhodes to issue a judgment declaring the city is not obligated to continue making payments on the so-called pension certificates of participation (COPs). The COPs were issued during the term of former Mayor Kwame Kilpatrick, 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," Kevyn Orr, Detroit's state-appointed 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."

A ruling in the city's favor could invalidate the interest-rate swap contracts Detroit reached with investment banks UBS AG and Merrill Lynch Capital Services, a unit of Bank of America Corp. The swaps were meant to hedge interest-rate risk arising on variable-rate COPs, and Detroit in the lawsuit claims 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."

Bill Nowling, Orr's spokesman, said Detroit still is negotiating with Merrill Lynch and UBS to end the city's swap agreements. The swap deals, valued at $400 million in 2011, soured as interest rates dropped along with Detroit's credit ratings. The money owed to the banks was a key element that drove Detroit to file for municipal bankruptcy in July.

Earlier this month, Rhodes rejected a deal the city reached with the firms to end the swaps at a 43 percent discount of $165 million plus up to $4.2 million in costs.

Rhodes in his ruling said Detroit could succeed with legal challenges to the validity of the swaps, noting that the city probably did not have a right under Michigan law to pledge casino tax revenue as collateral to secure the swaps.

Orr has been trying to free the up to $180 million in annual casino revenue so that it could be used to help revitalize the city.

UBS and Bank of America declined to comment.

Steve Spencer, financial adviser to Financial Guaranty Insurance Co, one of the bond insurers, said the COPs issue was a strategic and lower-cost way for the city to pay down its unfunded pension liability in 2005.

"It's inaccurate and irresponsible to group the COPs with some of the 'bad' deals the city previously entered into under the past administration," he added.

Bruce Babiarz, spokesman for Detroit's Police and Fire Retirement System, said the pension funds support the city's legal assault on the COPs deals. "Let's be clear, this lawsuit is not against the retirement systems or pension funds, but service companies and trusts that were created by the city to complete the COPs transactions," he said in a statement.

The city names "service corporations" associated with its general retirement system as well as its police and fire retirement systems among defendants in the suit.

Detroit defaulted on a $39.7 million June payment on the pension COPs after Orr labeled that debt as unsecured, along with some of the city's general obligation bonds. Bond insurance provided payments on some of the pension debt.

A proposed debt adjustment plan Orr sent to creditors this week cited the interest rate swaps as a disputed claim that is not part of the settlement.