Sept 30 (Reuters) - Detroit is poised to default on about$641 million of its general obligation bonds on Tuesday, anevent that is likely to spur a legal challenge over Detroit'sdecision to take tax money earmarked for bond payments and applyit instead to city needs.
About $411 million of the bonds targeted for default weresubject to voter approval and raise money through propertytaxes, called millages.
A default on bonds that had been considered securedobligations could give rise to a claim that it is a violation ofMichigan's constitution, which prohibits diverting revenue fromtax millages to alternative purposes.
If the city does default, bondholders can still expect toreceive payments, but the funds will come from bond insurancepolicies purchased by Detroit as its financial picture weakenedin recent years.
Kevyn Orr, the state-appointed emergency manager who hasbeen running the city since March, first warned bondholders on June 14 that he was labeling nearly $641 million of unlimitedtax and limited tax general obligation debt outstanding asunsecured.
His plan to pay pennies on the dollar to unsecuredcreditors, including general obligation bondholders, through thefuture sale of notes is the template for Detroit'sreorganization plan should the city be deemed eligible to remainin federal bankruptcy court, according to Orr's spokesman, BillNowling.
With Detroit sinking under more than $18 billion of debt andother obligations, Orr on July 18 filed what would be thebiggest municipal bankruptcy in U.S. history.
"It seen pretty clear, you need to stop collecting themillage," said Eric Lupher, director of local affairs at theCitizens Research Council of Michigan, a non-partisan publicaffairs research group.
The constitution prevents revenue from tax millages frombeing diverted to cover a city's operational expenses. Themillage "is only used to pay principal and interest. You justcan't ignore that now because you need the money," Lupher said.
Anthony Minghine, associate executive director of theMichigan Municipal League, said that if any Michigan city wereto tap debt service millage for operating purposes outside ofbankruptcy proceeding the move would definitely be called intoquestion.
"A (property tax) millage was levied for a specific purposeand if you don't use it for that purpose -- I want my moneyback," he said, referring to property taxpayers who may notagree with diverting the money. He added that it was unclear howvoter-approved general obligation bonds will fare in Detroit'sbankruptcy case.
Orr has said all unsecured debt is subject to immediatemoratoria on payments, and the bonds that come due Tuesday arethe second to fall under the moratorium after the city defaultedon $1.45 billion of pension debt in June.
The purpose of the moratorium was "to conserve cash so that(Detroit) can continue to provide essential services to itscitizens," Orr said in his June 14 statement. His office peggedprincipal and interest payments on the city's general obligationbonds at $129 million in fiscal 2014, which began July 1.
Nowling and Michigan officials have declined to comment onthe plan for the tax revenue earmarked for paying off Detroit'svoter-approved general obligation bonds.
Of $1 billion of outstanding debt carrying Detroit's generalobligation pledge, Orr has said he believes only $349 million oflimited and unlimited tax general obligation bonds and nearly$90 million of notes and loans should be considered securedliabilities of the city.
Orr's office may shed some light on the situation later thisweek. Nowling said "the city will discuss its rationale formaking any payment decision after it has made it."
Detroit bondholders can receive full payment on generalobligation debt thanks to insurance policies purchased by thecity.
Assured Guaranty, a major insurer of Detroit's bonds, saidin a statement that it will meet its obligations under thepolicy sold to the city. "As always, investors that hold bondsinsured by Assured Guaranty can be certain that they willcontinue to receive uninterrupted full and timely payment ofscheduled principal and interest when due," it said in astatement.
Assured insures about $187 million of Detroit's unlimitedtax general obligation bonds and $17.7 million of the city'slimited tax bonds as of the end of fiscal 2012, according to adebt summary from Orr's office.
Other bond insurers -- National Public Finance GuaranteeCorp, the public finance subsidiary of MBIA Inc.; AmbacAssurance Corp; and Syncora Guarantee -- also said they wouldmake payments on Detroit debt they insure.
Ahead of the default, Fitch Ratings on Monday droppedDetroit's current credit rating to the lowest level of D, fromC, affecting $613.8 million of limited and unlimited taxgeneral obligation bonds.
In a report earlier this month, Fitch noted there is littleprecedent for classifying unlimited tax general obligation bondsas unsecured debt. Should a bankruptcy court approve Detroit'streatment of these bonds as unsecured debt, Fitch will reassessits ratings of tax-supported debt ratings within Michigan andperhaps the rest of the country, the firm said in a statement.
Frank Shafroth, director of the State and Local GovernmentLeadership Center at George Mason University, said Detroit'streatment of unlimited tax general obligation bonds has a "fairchance" of getting appealed all the way to the U.S. SupremeCourt if the bankruptcy court goes along with the move.
Detroit's historic bankruptcy filing and the uncertainty itis causing in the $3.7 trillion municipal bond market hasgrabbed the attention of regulators and others.
John Cross, head of the Securities and Exchange Commission'sOffice of Municipal Securities, said the office is closelyfollowing developments in Detroit's case with an eye towardimplications it could have for general obligation bonds andpublic pensions beyond Detroit.
Allen Robertson, the newly elected president of the NationalAssociation of Bond Lawyers, said his group will be looking atgeneral obligation bonds in the context of disclosure andbankruptcy cases like Detroit's. If the bankruptcy court agreeswith Orr's handling of general obligation bonds, he said,investors and others would probably reconsider their assumptionsabout full faith and credit pledges on debt.
- general obligation bonds