The federal bankruptcy judge presiding over the Chapter 9 restructuring of Detroit’s finances rejected a $165 million settlement with some of the city’s biggest creditors, suggesting the city could do better, perhaps through a lawsuit.

US Bankruptcy Judge Steven Rhodes ruled late Thursday that the proposed settlement, which would have allowed the city to exit a troubled and complicated pension debt deal, was inconsistent with the goal to get the city on more sound financial footing.

“The court ... will not participate or perpetuate hasty and imprudent financial decision-making. It’s just too much money,” Judge Rhodes said in his verbal ruling, adding that the sum was “higher than the highest reasonable number.”

The ruling is significant as it suggests Rhodes will not necessarily rubber stamp whichever deal the state’s emergency financial team presents before him as the result of ongoing settlement talks with the city’s many financial creditors, pension groups, bond insurers, and labor organizations.

“It will be incumbent on parties to prove to him that the settlement is fair and equitable for everyone, including the non-settling parties,” says Michael Sweet, a bankruptcy attorney with Fox Rothschild in San Francisco. “It also shows that he is going to scrutinize settlements, even those brought to him and recommended by his own mediators.”

Rhodes directed both parties back to the negotiating table. As part of his ruling, he allowed the city to borrow $120 million from London-based Barclays to improve city services, specifically emergency services, lighting, utilities, and blight remediation. The process to use the new funds is strict, but could potentially slow services: To access the money, the city must file a court notice, which will allow creditors 14 days to file an objection.

The state emergency financial team, led by emergency financial manager Kevyn Orr, entered mediation on Christmas Eve with UBS AG and Bank of America’s Merrill Lynch Capital Services to find a solution to ending a disastrous “swap” deal the city entered in 2005 that is widely credited for helping speed the city to insolvency.

Under that early agreement, the city borrowed $1.44 billion in 2005-06 to help pay down its pension liability. The deal was structured using variable rates, which helped protect the city in case rates increased but not if they fell. So, when interest rates fell in 2008-09, the city took a hit: annual interest payments that grew to approximately $50 million.

Orr’s plan was to have the city exit the agreement with a $165 million payment; both banks were collectively owed $247 million by the end of this year.

Following Rhodes’ decision, Mr. Orr released a statement saying that he was “reviewing” the ruling and pledged to “continue to work toward a resolution of the pension ‘swaps’.”

The decision was applauded by a coalition of creditors at Detroit’s doorstep who fear they will receive smaller payouts from the ongoing restructuring settlements. They include bond insurers Syncora and Financial Guaranty Insurance Co., two pension funds, and several other banks.

Jordan Marks, executive director of the National Public Pension Coalition in Washington, issued a statement Thursday calling the Rhodes ruling “a win for Detroit retirees, who are at risk of being thrown into poverty thanks to unscrupulous practices on Wall Street.”

“At a time when retirees stand to lose 84 cents of every dollar they earned, a payout to Wall Street is unconscionable,” Mr. Marks said.

Rhodes suggested that Detroit would “reasonably likely” win a lawsuit against the banks to recover the $300 million it has already paid. He suggested that the “swaps” deal would likely be ruled invalid in court due to investigations in recent years suggesting they may have been illegal. He added, however, that a lengthy court trial will also be costly, so suggested that more mediation is necessary before reaching that point.

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Mr. Sweet agrees that Orr will first return to the negotiating table before considering a lawsuit: “I would think the next step would still be for them to go another round of mediation or settlement discussions. I don’t think this will result in an immediate firing up of the litigation machine.”

The city faces a March 1 deadline to file a comprehensive debt-cutting plan to Rhodes, which will include the settlement.