What are the odds?
By Curt Guyette
Special to the Michigan Citizen
Twice now, U.S. Bankruptcy Court Judge Stephen Rhodes has rejected proposed settlements that would enable the city of Detroit to extricate itself from terribly costly obligations known as “interest rate swaps.”
These swaps were essentially a huge gamble, with the city betting that interest rates would rise over time when it borrowed more than $1.4 billion back in 2005-06 to shore up its two pension funds. Instead, when the economy crashed in 2008, interest rates plummeted, forcing the city to pay out an extra $4 million or so a month ever since. Making matters worse, in 2009, the city, for reasons too complicated to explain here, agreed to secure that debt with tax revenues generated by Detroit’s three casinos.
Last summer, Detroit Emergency Manager Kevyn Orr announced he and his restructuring team had reached an important settlement with the swap counterparties: Bank of America/Merrill Lynch and UBS AG, an investment bank based in Switzerland.
The proposed agreement had the city paying $230 million to get out of the swap deals. But Judge Rhodes eventually nixed the deal, saying it was too generous to the banks. So the city and the banks returned to the bargaining table, this time with U.S. Judge Gerald Rosen serving as mediator. A new settlement was arrived at, with the city agreeing to pay the two banks $165 million.
But in January, Judge Rhodes rejected that second deal as well. Along with ruling the banks were still getting much more than they deserved, the judge also decided that, if Detroit were to sue the banks, the city would have a good chance of succeeding. First of all, a very strong case can be made that the law prohibits using casino taxes to pay off a debt. There is also, among other things, a case to be made that the swap deal involved fraud.
If the city were to litigate instead of negotiate, the potential upside is huge. It’s possible, if the swap deal is judged to have been void from the beginning, instead of having to pay out $165 million, the city in fact might be able to recoup the $300 million it has paid out so far. By some estimates, if borrowing fees and interest are included, that’s a swing of almost $500 million in the city’s favor. If it were to lose, though, the city would be on the hook for the full amount.
That’s too much to risk on what Orr has previously said is a coin flip.
What has come out in the bankruptcy proceedings, though, is that the chances of successfully challenging the swap payments are considerably better than the 50/50 scenario that Orr described in court. The strongest evidence of that, ironically, comes from Orr himself in a sworn deposition taken on Dec. 31, 2013.
Caroline Turner English, who represents Ambac, one of the creditors standing in line for a payout in the bankruptcy case, pressed Orr to go into detail about the various ways the swap deals might be challenged. Based on input from his legal team — headed by lawyers from Jones Day, the law firm where Orr was a partner until his appointment as emergency manager last year — Orr laid out eight separate causes of action that could be the basis for negating the swap deal.
Under persistent questioning, Orr — himself an attorney — at one point in the deposition reluctantly admitted, in his estimation, each one of the potential claims had an equal chance of success. “I think on all of these claims, whatever their legal theory, all of them were basically 50/50 chance of success because for each claim there was always a corresponding risk that the claim would not be successful.”
Which brings us momentarily from the court of law to the law of probabilities.
Every time you flip a coin, there’s an equal chance it will come up either heads or tails, no matter how many times it gets tossed. However, once you start stringing those flips together, the overall odds begin to change. What are the chances that a coin flipped eight times wouldn’t come up heads at least once?
About 99 to 1.
Lawsuits, however, are much more complicated than a simple coin flip. Which is why some people think Orr’s desire to negotiate a settlement is the prudent approach. Wayne State University law professor Laura Bartell, for one, gives him high marks for the way he has handled the situation.
“From all I can tell, (Orr) has bargained very hard,” says Bartell.
Some others, however, have openly questioned his actions. Part of the reason for their concern is the fact Jones Day — Orr’s former firm — represents Bank of America in matters not related to this case. (The Detroit City Council essentially waived any conflict of interest concerns when it voted to approve hiring Jones Day to oversee the city’s restructuring last year.)
“Detroiters have the basic right to competent and loyal legal representation, as well as democratically accountable local government, as we proceed through the largest municipal bankruptcy case in U.S. history,” asserts Detroit attorney Tom Stephens in a piece he wrote for the lefty publication CounterPunch. “Jones Day and Orr are mercenaries plagued by conflicts of interest, who have repeatedly demonstrated their lack of candor, integrity and faithfulness to our interests. They should be fired and replaced by competent professionals who are in a position to truly represent Detroit.”
Another Detroit attorney, Jerome Goldberg — who represents retiree David Sole in the bankruptcy proceedings — says, based on testimony Orr has provided so far, “it’s clear he never seriously considered” suing the banks to get out of the swaps deal.
Court records show Orr and his team did at least prepare a lawsuit against Bank of America/Merrill Lynch and UBS. But instead of directly suing them, the city recently filed a lawsuit in federal court challenging the validity of the underlying $1.4 billion loan those swaps are connected to. Known as certificates of participation, or COPs, these loans were part of an elaborate scheme set up in 2005-06 by the Kilpatrick administration to shore up the city’s two pension funds while evading state-mandated borrowing limits. What’s interesting about the lawsuit just filed is its sole target are two nonprofit “shell” corporations controlled by city officials, and the funds they created. Neither the lenders involved in the deal, nor any of the parties that helped put it together, are named in the action.
The question is, “What the heck is going on?”
Orr spokesman Bill Nowling didn’t respond to emails seeking an answer.
Wallace Turbeville — a lawyer and former Goldman Sachs investment banker who is now a senior fellow at Demos, a progressive nonprofit think tank — has some theories, but is really only certain about the question all this raises:
“The judge’s ruling (rejecting the swaps deal) deepens a lingering mystery surrounding the deal with the swaps banks: Why did the emergency manager rush through a settlement that even the bankruptcy court found to be fundamentally out of balance, while simultaneously pounding away at the public employee pensions?”
Whatever the answer, Judge Rhodes has clearly signaled the deals Orr has brought before him so far have not been in the city’s best interests.
Curt Guyette is an investigative reporter for the ACLU of Michigan. You can contact him at firstname.lastname@example.org or 313.578.5834.