"This is a significant issue for the bond community, not just in Detroit but in all cases, because the implication is that if the court finds these aren't secured,this will go far beyond Detroit," said Michael Sweet, a bankruptcy attorney with Fox Rothschild in San Francisco.
The outcome could revolve around the meaning of the word "pledge" under Michigan law. In the proceeding on Wednesday, Rhodes will hear Detroit's argument that the city's pledge to repay some $410 million of general obligation bonds outstanding as of the end of the city's fiscal 2012 is far less than binding.
In their lawsuits, bond insurers on the hook for making up missed payments on the bonds have asked Rhodes to rule without hearing any testimony, in what is known as a summary judgment. Rhodes could rule for either side, or he could send the matter to a trial and allow both sides to begin taking depositions and finding expert witnesses to support their arguments. In a December hearing, Rhodes said he might want testimony about how the dispute impacts other creditors.
(Read more: Detroit faces new speed bump in bankruptcy process)
Promise vs. obligation
Detroit must treat the bonds as secured only if a legal lien exists, and under Michigan law, there is no lien, Detroit argues. When Detroit issued the bonds,its pledge to repay the borrowed funds, was, under state law, only a synonym for "'promise,' as in 'I pledge allegiance to the flag,'" the city argued in a court filing.
The three bond insurance firms do not see it that way. National Public Finance Guarantee Corp, the public finance subsidiary of MBIA Inc, and Assured Guaranty Municipal Corp jointly filed one lawsuit, and Ambac Assurance Corp filed another, soon after Detroit defaulted on a $9.4 million interest payment last October 1. That was its first GO bond default under Kevyn Orr, the city's state-appointed emergency manager.
They claim bondholders and the insurers have a statutory lien on property-tax revenue specifically earmarked for the bonds. Instead of repaying the bonds, the city is using that tax money for general purposes and has no right to do so, the insurers argue.