Detroit’s record $18 billion bankruptcy should end an erroneous presumption of municipal bond investors that they have more protection from losses than other creditors, a lawyer for the city told a judge.
Bruce Bennett, a lead attorney for Detroit, urged U.S. Bankruptcy Judge Steven Rhodes yesterday to rule that the city’s general obligation bondholders don’t have a higher repayment priority than other creditors in the case.
“It’s not a good thing that we have to change so many things that are pre-existing assumptions,” Bennett said, referring to the municipal bond market. Detroit’s bankruptcy “is going to change many, many things very substantially.”
The dispute may require the judge to weigh in on a long-running debate over whether holders of certain municipal bonds get priority over more traditional unsecured creditors, such as public employees or suppliers. A decision favorable to the city may raise borrowing costs for other municipalities.
Detroit filed for creditor protection in July under Chapter 9 of the Bankruptcy Code, which covers municipalities, after years of decline, saying it couldn’t provide basic services while meeting its financial obligations.
Bond insurers who back at least $233 million in debt sued Detroit last year, claiming a proposal by the city’s emergency manager to cut payments to general obligation bondholders is illegal.
The insurers say pledges the city made when the bonds were issued give bondholders certain collateral rights under Michigan law, including the right to a lien on taxes. They asked Rhodes to make the city segregate tax revenue tied to the bonds.
Rhodes ended yesterday’s hearing urging the two sides to negotiate a settlement because when he rules in two or three weeks, he will hand victory entirely to one side or the other.
“For you to maintain control of this, you have two or three weeks to settle,” Rhodes said.
The hearing took place as creditors and the public waited for the city to file a revised proposal for cutting debt and exiting bankruptcy. Detroit has said it will file the plan this week, ahead of a March 1 deadline set by Rhodes.
Creditors received a draft of the proposal last month. Under that version, two underfunded pension plans would get 45 percent to 50 percent of what they are owed, and some general obligation bondholders would get as little as 20 percent.
Bond insurers including National Public Finance Guarantee Corp. and Assured Guaranty Municipal Corp. argue that general obligation bonds enjoy more protection than other debt. Insurers may be forced to cover bondholder losses if the city doesn’t fully repay the debt.
“These are not simple promises that the city made to its bondholders,” Guy Neal, an attorney for National Public Finance, told the judge. “These are requirements under state law.”
Mark Berman, a bankruptcy attorney at Nixon Peabody LLP, said municipal bondholders have long thought general obligation bonds were better protected than other forms of debt. Rhodes’s decision could affect how investors view such bonds in the future, he said.
“Treating unlimited and limited tax bonds as unsecured debt in a Chapter 9 case will result in municipalities, especially those suffering from financial distress, possibly finding themselves unable to access the public debt market at all and certainly incurring significantly higher costs to obtain future financing,” Berman said in an interview.
Bennett argued the city’s pledges to bondholders are no different from those made to all unsecured creditors. Such general promises mean the municipal bonds in dispute are unsecured, he said. Detroit didn’t set aside any property that could be used as collateral for the bonds, nor create a special lien on the taxes, according to Bennett.
“There is not a lien, there is no property interest and these creditors are just like all others,” he told Rhodes.
The city may also try again to resolve a dispute over interest-rate swaps that cost taxpayers about $4 million a month. Detroit may present a new proposal for canceling the swaps in the next three or four days, Robert S. Hertzberg, a lawyer for the city, said in court yesterday.
Depending on how bond insurers receive the proposal, Detroit may be able to avoid a court fight over the cancellation. Rhodes last month rejected the city’s deal with Bank of America Corp. and UBS AG to terminate the swaps for a $165 million payment, calling it too costly.
Bill Nowling, the spokesman for Detroit emergency financial manager Kevyn Orr, said yesterday that the city had reached a new settlement with the banks.
“It is substantially smaller,” he said in an e-mail.
The bankruptcy case is City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).