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Detroit's expected bond default seen raising constitutional issue

The word 'Bankruptcy' is seen painted on the side of a vacant building by street artists as a statement on the financial affairs of the city
The word 'Bankruptcy' is seen painted on the side of a vacant building by street artists as a statement on the financial affairs of the city

(Reuters) - Detroit is poised to default on about $641 million of its general obligation bonds on Tuesday, an event that is likely to spur a legal challenge over Detroit's decision to take tax money earmarked for bond payments and apply it instead to city needs.

About $411 million of the bonds targeted for default were subject to voter approval and raise money through property taxes, called millages.

A default on bonds that had been considered secured obligations could give rise to a claim that it is a violation of Michigan's constitution, which prohibits diverting revenue from tax millages to alternative purposes.

If the city does default, bondholders can still expect to receive payments, but the funds will come from bond insurance policies purchased by Detroit as its financial picture weakened in recent years.

Kevyn Orr, the state-appointed emergency manager who has been running the city since March, first warned bondholders on June 14 that he was labeling nearly $641 million of unlimited tax and limited tax general obligation debt outstanding as unsecured.

His plan to pay pennies on the dollar to unsecured creditors, including general obligation bondholders, through the future sale of notes is the template for Detroit's reorganization plan should the city be deemed eligible to remain in federal bankruptcy court, according to Orr's spokesman, Bill Nowling.

With Detroit sinking under more than $18 billion of debt and other obligations, Orr on July 18 filed what would be the biggest municipal bankruptcy in U.S. history.

"It seen pretty clear, you need to stop collecting the millage," said Eric Lupher, director of local affairs at the Citizens Research Council of Michigan, a non-partisan public affairs research group.

The constitution prevents revenue from tax millages from being diverted to cover a city's operational expenses. The millage "is only used to pay principal and interest. You just can't ignore that now because you need the money," Lupher said.

Anthony Minghine, associate executive director of the Michigan Municipal League, said that if any Michigan city were to tap debt service millage for operating purposes outside of bankruptcy proceeding the move would definitely be called into question.

"A (property tax) millage was levied for a specific purpose and if you don't use it for that purpose -- I want my money back," he said, referring to property taxpayers who may not agree with diverting the money. He added that it was unclear how voter-approved general obligation bonds will fare in Detroit's bankruptcy case.

Orr has said all unsecured debt is subject to immediate moratoria on payments, and the bonds that come due Tuesday are the second to fall under the moratorium after the city defaulted on $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 its citizens," Orr said in his June 14 statement. His office pegged principal and interest payments on the city's general obligation bonds at $129 million in fiscal 2014, which began July 1.

Nowling and Michigan officials have declined to comment on the plan for the tax revenue earmarked for paying off Detroit's voter-approved general obligation bonds.

Of $1 billion of outstanding debt carrying Detroit's general obligation pledge, Orr has said he believes only $349 million of limited and unlimited tax general obligation bonds and nearly $90 million of notes and loans should be considered secured liabilities of the city.

Orr's office may shed some light on the situation later this week. Nowling said "the city will discuss its rationale for making any payment decision after it has made it."

Detroit bondholders can receive full payment on general obligation debt thanks to insurance policies purchased by the city.

Assured Guaranty, a major insurer of Detroit's bonds, said in a statement that it will meet its obligations under the policy sold to the city. "As always, investors that hold bonds insured by Assured Guaranty can be certain that they will continue to receive uninterrupted full and timely payment of scheduled principal and interest when due," it said in a statement.

Assured insures about $187 million of Detroit's unlimited tax general obligation bonds and $17.7 million of the city's limited tax bonds as of the end of fiscal 2012, according to a debt summary from Orr's office.

Other bond insurers -- National Public Finance Guarantee Corp, the public finance subsidiary of MBIA Inc.; Ambac Assurance Corp; and Syncora Guarantee -- also said they would make payments on Detroit debt they insure.

Ahead of the default, Fitch Ratings on Monday dropped Detroit's current credit rating to the lowest level of D, from C, affecting $613.8 million of limited and unlimited tax general obligation bonds.

In a report earlier this month, Fitch noted there is little precedent for classifying unlimited tax general obligation bonds as unsecured debt. Should a bankruptcy court approve Detroit's treatment of these bonds as unsecured debt, Fitch will reassess its ratings of tax-supported debt ratings within Michigan and perhaps the rest of the country, the firm said in a statement.

Frank Shafroth, director of the State and Local Government Leadership Center at George Mason University, said Detroit's treatment of unlimited tax general obligation bonds has a "fair chance" of getting appealed all the way to the U.S. Supreme Court if the bankruptcy court goes along with the move.

Detroit's historic bankruptcy filing and the uncertainty it is causing in the $3.7 trillion municipal bond market has grabbed the attention of regulators and others.

John Cross, head of the Securities and Exchange Commission's Office of Municipal Securities, said the office is closely following developments in Detroit's case with an eye toward implications it could have for general obligation bonds and public pensions beyond Detroit.

Allen Robertson, the newly elected president of the National Association of Bond Lawyers, said his group will be looking at general obligation bonds in the context of disclosure and bankruptcy cases like Detroit's. If the bankruptcy court agrees with Orr's handling of general obligation bonds, he said, investors and others would probably reconsider their assumptions about full faith and credit pledges on debt.

(Reporting by Karen Pierog; additional reporting by Bernie Woodall and Joseph Lichterman; Editing by Leslie Adler)

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