By Joseph Lichterman
DETROIT (Reuters) - A U.S. bankruptcy judge on Thursday rejected a deal allowing Detroit to end interest-rate swap agreements with two investment banks, a move that puts pressure on banks for more concessions while throwing a wrench into the city's plans to exit bankruptcy by September.
Ending costly swaps agreements with UBS AG and Bank of America Corp's Merrill Lynch Capital Services has been a key component of Detroit emergency manager Kevyn Orr's plan to adjust the city's finances through the bankruptcy process.
But Detroit's proposal to pay $165 million - a 43 percent discount from its original obligation - was still "too high a price to pay," federal bankruptcy judge Steve Rhodes ruled.
Rhodes, who is overseeing the city's historic bankruptcy, said Detroit likely could succeed with legal challenges to the validity of the original swaps agreements.
Since Detroit would make such a challenge in Rhodes' court, the ruling is a strong signal that banks could leave with nothing if they do not give up more in negotiations. UBS and Bank of America declined to comment as did bond insurer Syncora Guarantee, which had opposed the deal Rhodes rejected.
Rhodes said that settling the swaps was better for Detroit than lengthy, costly litigation over the claims. Rhodes said he "strongly encourages the parties to continue to negotiate" even if the city decides that filing suit is its best option.
Orr, who previously had said he was uncertain of victory in a legal dispute over the swaps, in a statement said the city would "continue to work toward a resolution" of the swaps deal.
Detroit's bankruptcy plan depended on raising cash by ending the swaps, which were used to hedge interest-rate risk for some of the $1.4 billion of pension debt the city sold in 2005 and 2006. Therefore the ruling puts on hold the process, which Detroit hoped to end by September, when Orr's term ends.
Detroit had planned to finance the swaps termination with part of a $285 million loan from Barclays Plc, but the judge denied the city's request to borrow that sum. Detroit could, however, still borrow $120 million to improve services, Rhodes ruled.
The $285 million loan from Barclays had been contingent on Detroit's pledging funds from the city's casino tax as collateral, but those funds may not be available to secure a loan because they are pledged as security on the original swaps, which remain in effect because of Rhodes' ruling.
It was not immediately clear if Barclays would be willing to provide the $120 million loan to help Detroit cover the cost of city services.
STRONG LEGAL ARGUMENTS
In rejecting the swaps deal, Rhodes said the city could argue that the use of the casino tax revenue as a lien in the original swaps transaction violated Michigan gaming law. The city could convincingly argue that the swaps themselves were illegal, he added.
An attorney following Thursday's proceeding said if he were Detroit he'd be considering litigation with an eye on a favorable settlement.
"They have to seriously consider having a complaint on his desk by Tuesday or Wednesday following his comments," the attorney said.
That could mean delay.
"I'm willing to place a wager. If the over/under is September, I'll take the over," said Kenneth Klee of legal firm Klee, Tuchin, Bogdanoff & Stern in Los Angeles. He represented Jefferson County Alabama, which recently came out of its Chapter 9 bankruptcy.
"The judge is on Detroit's side but it will take a long time," he said.
'FAR TOO RICH'
Robert Gordon, lawyer for the city's pension funds, which opposed the deal, said Detroit's planned payment to UBS and Merrill essentially treated them as secured creditors. "Paying them close to whole dollars was just far too rich," Gordon said.
Detroit's pension funds, bond insurers, banks and others opposed the termination deal. The objectors argued that the city should not have settled with the banks because it had convincing legal arguments to completely terminate the swaps.
But Orr, who has been running Detroit since March, testified in court that the city had only a 50-50 shot of winning the litigation, and he did not want to risk expensive legal proceedings or losing access to casino tax revenue, which was used as a lien in the swaps. The casino tax accounts for about 20 percent of the city budget, Orr has said.
The deal Rhodes rejected was the city's second such agreement with its swaps counterparties. Detroit originally had proposed a deal with Merrill and UBS in which the city would have ended the swaps at 75 cents on the dollar with a $230 million payment, but in a December hearing Rhodes called on the city to negotiate more favorable terms.
Detroit reached the new agreement with the banks after two days of mediation in late December.
Orr testified in court earlier this month that Detroit initially proposed a termination fee of $145 million to $150 million but that the investment banks would not agree to anything less than $165 million.
Meanwhile, mediation efforts have begun to bear fruit, with philanthropic foundations connected to Detroit pledging $330 million to help the city. In addition, Governor Rick Snyder is preparing to propose $350 million of support, over 20 years, to help protect worker pensions and prevent the Detroit Institute of Arts collection from being sold, according to reports on Thursday in the Detroit Free Press and elsewhere.
(Reporting by Joseph Lichterman in Detroit, Tom Hals in Wilmington, Delaware, and Karen Pierog in Chicago; Editing by David Greising, Chris Reese, Peter Henderson, Steve Orlofsky and Eric Walsh)