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Detroit bankruptcy judge keeps city lawsuit on pension debt alive

(Reuters) - A federal judge has blocked an initial attempt to stop Detroit from trying to invalidate $1.4 billion of debt sold to boost funding for the city's two retirement systems.

U.S. Bankruptcy Judge Steven Rhodes on Monday denied a motion by two service corporations created for the 2005 and 2006 debt sales that asked the court to dismiss the city's lawsuit.

In his ruling, Rhodes noted the pension debt was "a significant factor in later forcing the city into bankruptcy" and that the corporations were the proper defendants in the case.

The Detroit General Retirement System Service Corporation and the Detroit Police and Fire Retirement System Service Corporation had argued that because the city has labeled them as sham entities created to get around a Michigan debt limit law the city could not sue them.

"While the city does allege that the service corporations were created to the unlawful purpose of enabling the city to avoid debt limitations imposed by state law, nowhere in the pleadings does the city allege that the service corporations are not distinct and separate legal entities," Rhodes' ruling said.

Detroit filed the lawsuit on Jan. 31, claiming that because the pension certificates of participation (COPs) were illegally sold the court should void the city's obligation to pay them off.

In fact, Detroit defaulted on the debt in June 2013, just weeks before it filed the biggest municipal bankruptcy in U.S. history. Earlier this year, the city won court approval to settle costly interest-rate swaps related to the COPs.

Rhodes also ruled Financial Guaranty Insurance Co, which guaranteed payments on some of the COPs and European banks that purchased some of the debt, can intervene in the lawsuit seeking to void the debt.

His ruling came on the same day the city and a group of hold-out creditors, including Syncora Guarantee Inc, were to attend a court-ordered mediation session over the COPs.

(Reporting by Karen Pierog; Editing by Bernard Orr)