‘Safe Harbor’ in Bankruptcy Is Upended in Detroit Case
As Detroit struggles to come up with money to improve services for its residents, two large banks are poised to receive hundreds of millions of dollars to cancel a deal that helped push the city into bankruptcy in the first place.
The two banks, UBS and Bank of America, were the only creditors that managed to reach a settlement with Detroit before the city declared bankruptcy last July. They agreed to let Detroit out of financial contracts called interest-rate swaps for 75 percent of what the city owed, or about $230 million. They also agreed to give up some casino tax proceeds that Detroit had pledged to them as collateral for the swaps.
The 75 cents on the dollar is a far better deal than the city's other creditors will probably get. And because of an unusual provision in the federal bankruptcy code, these two banks actually have a legal right to 100 cents on the dollar. The provision gives traders in swaps, options and other derivatives a so-called safe harbor, exempting them from the usual stay that blocks creditors' efforts to collect debts.
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The provision has turned on its head the meaning of safe harbor in bankruptcy. Bankruptcy proceedings are supposed to give debtors like Detroit a safe place to negotiate a way out their problems under the protective eye of a federal judge.
Bankruptcy law rests on the bedrock principle that the best outcome can be achieved if everybody shares equitably in the pain and losses. But in the brave new world of municipal bankruptcy, the law gives derivatives traders an even safer harbor than Detroit's.
"These safe harbors make no logical sense in this context," said Steven L. Schwarcz, a professor at Duke University School of Law who has written on the special treatment of derivatives in corporate bankruptcies. Detroit was in bankruptcy court last week seeking approval for its deal with Bank of America and UBS.
But on Friday, the bankruptcy judge, Steven W. Rhodes, sent the city and the banks back to confidential mediation to improve the terms for the city. The mediation was expected to continue through Christmas Eve.
But in the tangle that is Detroit's finances, the swaps deal is only one part of the equation. The city is seeking to borrow $350 million from another bank, Barclays Capital, to finance its operations in bankruptcy, and it needs to resolve the swaps deal before it can get the loan. Without the loan, lawyers for the city say, it soon might not be able to meet its payroll.
But any time a debtor tries to borrow in bankruptcy, it stirs opposition, since the new loan will worsen the insolvency. The Barclays deal also gives it priority over all the existing creditors. And the bulk of the $350 million loan will go to pay UBS and Bank of America to terminate the swap contracts. Since those two banks would no longer need Detroit's casino revenue as a backstop, the city could then use that money as collateral for the new Barclays loan.
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The rest of the proceeds from the loan, $120 million, would go to the streetlights, the police, the razing of dilapidated properties and other city services that the residents of Detroit sorely need.
Last week's hearing over these arrangements broke down when Judge Rhodes asked the city's emergency manager, Kevyn Orr, to explain why 75 cents on the dollar was a good deal. Mr. Orr declined to answer the question and asked instead for the hearing to be suspended.
If the current mediation talks fail, the two banks would once again have the safe harbor advantage under law, leaving Detroit to fight back in court by arguing that the swaps were flawed in some way and unenforceable. James E. Spiotto, a bankruptcy lawyer with the law firm Chapman and Cutler in Chicago, who is not involved in Detroit's case, said that prospect might explain why Mr. Orr was unwilling to sing the praises of Detroit's swap settlement in court. If he had, it would be hard for Detroit to come back with a lawsuit contending the swaps were no good.
(Read more: Detroit bankruptcy boils down to good faith)
Bank of America and UBS declined to comment.
Congress created the safe harbor for derivatives because they could pose systemic risk—if one bankrupt institution failed to make payment, it could swiftly bankrupt its trading partners, and they, in turn, might bankrupt their other trading partners, setting off a toxic cascade.
But some bankruptcy experts question the fairness or even the effectiveness of this exception.
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