In 2005, the city of Detroit faced a monumental dilemma: It desperately needed to borrow more than $1.4 billion to help shore up its two pension systems, but doing so would far exceed the legal limit on the amount of debt it could amass.

The solution arrived at by the administration of then-Mayor Kwame Kilpatrick was to sidestep the law by turning to something called certificates of participation, or COPs, which are similar to municipal bonds.

But instead of borrowing the money directly, Kilpatrick and his crew – following the advice of investment bankers who would reap massive profits from the deal – set up two nonprofit “service corporations,” which in turn created trusts that would sell the COPs to investors. Technically, it was these two nonprofits that were obligated to ensure repayment of the debt. The city then entered into a contract with the nonprofits – both of which were controlled entirely by city officials -- agreeing to pay them for services rendered.

In other words, they were mere shells.

“At the time, it was seen as a clever legal circumvention of the debt limit,” says Laura Bartell, a Wayne State University Law School professor who specializes in bankruptcy.

Last Friday, lawyers representing the city filed a federal lawsuit claiming that the deal was illegal from the start, and because of that Detroit should not be required to continue paying off the debt. The case is now in the hands of U.S. Bankruptcy Judge Stephen Rhodes.

The lawsuit came as a complete surprise to most people, even those who have been following the bankruptcy proceedings closely. Until this point, attention in this aspect of the bankruptcy proceedings has been focused instead on interest rate swaps, a controversial side deal to the COPs transactions.

A type of hedge, these swaps were essentially a very high-stakes gamble. In effect, the city bet that interest rates were going to rise over time. If they did, the banks would be on the hook for the increased costs. Instead, the economy crashed in 2008, and interest rates fell to almost nothing. As a result, the cost to the city has been about $300 million in payments to what are known as the swap counter-parties – Bank of America/Merrill Lynch and UBS, an investment bank based in Switzerland.

For the better part of a year, the city has been trying to end the swaps. The banks claim that the cost of doing so should be about $300 million, and that the city is in a bad negotiating position because, even in bankruptcy, the swap payments are secured by casino tax revenues (as a result of another deal, struck in 2009).

This is where the weeds thicken.

Flippin’ Coins

Back in July, Detroit Emergency Manager Kevyn Orr announced that the two banks had agreed to a settlement that required the city to shell out $230 million, or about 75 cents on the dollar -- compared to the roughly 20 or 25 cents on the dollar so-called unsecured creditors, such as the city’s pensioners, are reportedly in line for. But Judge Rhodes rejected the proposal, ruling that it was too generous to the banks. So the city and the banks returned to the bargaining table in December, this time with U.S. Judge Gerald Rosen serving as mediator. A new settlement was quickly arrived at, with the city agreeing to pay the two banks $165 million – money that it would have to borrow, driving the bankrupt municipality even deeper into debt. Orr maintained that the deal was crucial, because Detroit desperately needs that casino tax revenue.

But in January, Rhodes rejected that second deal as well. Part of the reason for doing so was his determination that the city, if it were to sue the banks, would actually have a good chance of succeeding – on a number of fronts. First of all, a very strong case can be made that the law prohibits using casino taxes to pay off such a debt. There is also a case to be made that, among other things, the swap deal involved fraud and therefore should be voided.

While on the witness stand in early January, Orr testified that the city's chances of winning a court battle over the swaps were "more or less 50-50."

A coin flip.
The potential upside to litigating instead of negotiating is huge. If the swap deals are judged to have been invalid from the beginning, instead of having to pay $165 million more, the city could possibly recoup the $300 million it’s shelled out so far. That’s a swing of $450 million in Detroit’s favor. And even if the city only succeeded in having the swap debt classified as “unsecured” rather than “secured,” as the banks claim it is, then the banks, instead of being entitled to full repayment, would have to settle for dimes on the dollar, just like all the other unsecured creditors.

If it were to lose, though, the city would be on the hook for the full amount.

This has been the stated reason Orr and his team have been pushing hard for a negotiated settlement, saying that the city couldn’t afford to lose in court. Detroit desperately needs those casino tax revenues to pay for basic services such as street lighting and police officers.

"Twenty percent of the city's budget could go away," Orr testified. "If that happened to the city, you could not cut enough services."

That’s just too much to risk on a flip of the coin.