Mish's Global Economic Trend Analysis

Bank of America and City Official Fraud Enters the Detroit Bankruptcy Equation; Fair Settlement Reviewed Again

Posted: 08 Feb 2014 12:34 PM PST

Corruption, fraud, and bankruptcy are often found together. Such is the case with Detroit. I have seen allegations and suggestions of fraud, but a recent article shows that fraud by Bank of America, city officials, or both is now a given, and likely provable in a court of law.

Does that change my view on what constitutes a "fair" settlement?

Before answering, let's take a look at the charges as presented in Democracy Watch: Swaps, COPs & Lingering Questions.

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.

Was there fraud here? And if so by whom? At this point I am not sure. Let's continue.

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 counterparties – Bank of America/Merrill Lynch and UBS, an investment bank based in Switzerland.

Again, I am still in the same place. This deal may very well be illegal, but I am not sure why. If it was illegal, did both parties knowingly enter a fraudulent deal, one party, or neither party. I strive to be fair to all sides.

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).

That last paragraph is where fraud comes into play, but the article did not yet mention why. The story gets more interesting at this point.

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.

For judge Rhodes to push this back at Orr twice, something I did not realize had happened, is strong evidence something foul is at play. Is Orr watching out for Bank of America/Merrill Lynch interests not Detroit city interests?

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.

Under Oath

What has come out in the bankruptcy proceedings, though, is that the chances of successfully challenging the swap payments are actually considerably better than the 50/50 scenario that Orr declared in court. That's certainly the position held by Judge Rhodes, who pointedly told attorneys for the city that it was possible to both litigate and negotiate. Some of strongest evidence that the city could indeed prevail if it filed a lawsuit against the banks comes, ironically, from Orr himself.

Caroline Turner English is an attorney who represents Ambac, one of the creditors standing in line for a payout in the bankruptcy case. During the deposition taken on the last day of 2013, English 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 in March of last year – Orr laid out eight separate causes of action that could be the basis for negating the swaps.

Under persistent questioning from English, Orr – himself an attorney – at one point in the deposition reluctantly admits that, 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 [sic] of success because for each claim there was always a corresponding risk that the claim would not be successful."

English didn't let up, asking Orr after he explained the basis for each potential claim, "So, you ascribe a 50/50 chance of success on this claim then, too?"

"Generally speaking, yes."

Which brings us momentarily from the court of law to the law of probabilities.

Each time you flip a coin, there's an equal chance it will come up either heads or tails. But there are formulas that let you calculate the likely overall outcome once you start stringing those flips together. So, what are the odds that, out of eight consecutive flips, a coin would come up tails every time?

About 99 to 1.

Not Quite. Given the claims are all likely related, if the first one fails, the rest might quickly fail as well. So I highly doubt 99-1 is the correct math. That said, the odds of winning something should be substantially greater than 50-50.

For the sake of argument, and to be conservative let's say 75-85%. Nonetheless, Orr has his supporters.

Lawsuits, however, are much more complicated than a simple coin flip. Which is why some experts say that Orr's desire to negotiate a settlement is the prudent approach.

Wayne State University Law Professor Bartell, for one, gives him high marks for the way he has handled the situation so far.

"From all I can tell, he [Orr] has bargained very hard," says Bartell.

I suggest it's clear Orr did not bargain hard. That the bankruptcy judge rejected Orr's proposal twice is proof enough for me.

Some others, however, have been questioning why Orr has been so willing to push for settlement deals that Judge Rhodes has twice rejected as far too generous to the banks. Part of the reason for their concern is the fact that Jones Day – Orr's former firm – represents Bank of America in matters with no direct relation to this case. (A majority of the Detroit City Council essentially waived any conflict of interest concerns when it approved hiring Jones Day to lead the restructuring of the city last year.)

In addition to representing Bank of America/Merrill Lynch, Jones Day reported in material submitted to the city last year that it also has a "client relationship" with UBS. In subsequent court documents, it revised that disclosure, saying that "it does not represent UBS AG, although it does represent other entities related to UBS AG."

"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."

There is certainly reasonable cause to assume Orr may not be doing what is best for the city. That may be on purpose, or happenstance. Either way, there are clear grounds for suspicion.

Who Knew What When?

I suspect both Bank of America and the city officials knew that pledging casino receipts was questionable if not fraudulent. If it could be proven the parties knew it was fraud, then everyone involved should be facing criminal charges.

Unless the law is quite clear, proof may be difficult to come by. Either way, I can see why both sides would not want a trial, because fraud charges are bound to come out. Perhaps Orr is aware, and is protecting not Bank of America/Merrill Lynch, but rather former city officials.

Regardless, if pledging casino receipts is illegal, even if there are no fraud charges, the loan becomes unsecured, not secured.

I strongly suspect that is the worst that could happen to Detroit were this to go to court.

Question of Fairness

Does any of this change what I said in Controversy in Detroit: What's a Fair Settlement of Bondholder and Pension Obligation Claims?

In terms of "how" a fair settlement is reached, the answer is not really. Yet, fraud may greatly influence settlement amounts and percentages. Here is the key snip.

Both the pension obligations and bondholder debt are unsecured debt.

Why not treat both pensioners and bondholders equally? The proposal currently on the table is for pensions to get 50 cents on the dollar (a 50% haircut) and bondholders 20 cents on the dollar (an 80% haircut).

I have a simple proposal. Give everyone 35 cents on the dollar (a 65% haircut). Neither side would be happy, but the ruling would be fair.

Essential Math

The $230 million Orr wanted to give Bank of America was 75 cents on the dollar. Thus, the actual amount owed is in the neighborhood of $307 million.

I see no way a court would return money already repaid back to Detroit unless the fraud was entirely one-sided, which I doubt. However, It seems highly likely a court would rule whatever the amount the city still owes is unsecured debt.

Final Thoughts

If there is fraud, I want to see criminal charges, whether on city officials, Bank of America officials, or both.
If all then unsecured creditors are treated equally, throwing that $307 million in the pot, might mean something like 40-45 cents on the dollar to everyone involved, not the 35 cents I originally proposed.
Whatever the math is, all unsecured debt should be treated similarly.

All eyes are on Judge Stephen Rhodes who appears to be doing a brilliant job. Orr's performance is questionable (once in favor of Bank of America, once in favor of Detroit pensioners). The best one can say about Orr, is that his actions are not completely one-sided.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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