Nebraska, Not California, is King of Municipal Collapse

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San Bernardino City Hall reflected on one of the vacant buildings across the street on July 12, 2012 in San Bernardino, California. Close

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San Bernardino City Hall reflected on one of the vacant buildings across the street on July 12, 2012 in San Bernardino, California.

Busted land deals and empty subdivisions bankrupted more governmental entities in Brian C. Doyle’s home state than anywhere in America. With the recent financial collapse of three of its cities, it might be easy to assume he’s from California.

Doyle, however, lives in Nebraska.

Quirks in local, state and federal law have made Nebraska home to almost one-fifth of the more than 220 Chapter 9 bankruptcies filed in the U.S. since 1981, according to a nationwide review of federal court records. California, with more than 20 times Nebraska’s population, is second, followed by Texas and Alabama. California may soon add to its total, as San Bernardino decides whether to seek court protection this week.

The main difference between Nebraska and its larger brethren is the kind of governmental bodies that file for bankruptcy. No town, city or county has sought court protection in the state. All 45 of Nebraska’s Chapter 9 cases were by special tax districts, most of them owned by residential subdivision developers who used property-tax revenue to pay for streets, sewers and other infrastructure.

“Chapter 9 is an effective tool that can be used to protect taxpayers and treat creditors fairly,” said Doyle, a land-use attorney in Omaha who represents bankrupt subdivisions. Those special tax districts become vulnerable to bankruptcy when housing sales slow, he said.

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San Bernardino's City Council voted to become the third California municipality this year to seek bankruptcy protection after officials learned they might not have enough cash to pay workers. Close

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San Bernardino's City Council voted to become the third California municipality this year to seek bankruptcy protection after officials learned they might not have enough cash to pay workers.

Chapter 9 Filings

Only about 20 percent, or 43, of the Chapter 9 cases filed in the U.S. since 1981 were by towns, cities or counties. Of those, California, Alabama and Texas led the way, accounting for more than two-fifths of such filings, according to a Bloomberg News review of court filings.

The three states share the regulatory confluence of strong restrictions on revenue-raising and low bars on bankruptcy filing.

In California, five of its 39 Chapter 9 petitions were made by cities or counties: Orange County in 1994, and the cities of Desert Hot Springs in 2001, Vallejo in 2008, and Stockton and Mammoth Lakes in the past month. Alabama had seven such filings by cities and counties, including one repeat, and Texas had six filings by five cities.

Elected officials in San Bernardino, a town at the foot of a mountain range that shares its name and about 60 miles (97 kilometers) east of Los Angeles, voted July 10 to seek U.S. court protection. Since then, they have been trying to decide whether to file a Chapter 9 case immediately or use state- mandated mediation with creditors first.

San Bernardino’s City Council will hear advice from lawyers today about whether it should declare a fiscal emergency and put the municipality into bankruptcy without going through the 60- day mediation process.

Five States

Just five states account for more than half of all types of Chapter 9 filings in U.S. bankruptcy courts: Nebraska, California, Texas, Alabama and Oklahoma.

Their numbers are dwarfed by those of corporate reorganizations. Since 1981, more than 20,000 companies have sought protection under Chapter 11 of the U.S. bankruptcy code.

Chapter 9, used by local governments and entities they create, differs significantly from Chapter 11, the section written for private companies and nonprofit groups. State lawmakers must pass a law authorizing local governmental bodies to file for bankruptcy before they can do so.

About half of the states allow full, or conditional, access to bankruptcy court, according to a legal analysis by Jim Spiotto, a bankruptcy attorney with Chapman & Cutler LLP in Chicago who helped write a book about municipalities in financial distress. Nebraska grants special tax districts unobstructed access to bankruptcy courts, Doyle said.

Difficult Politically

For cities and counties, filing a Chapter 9 case is also more difficult because it requires a vote of elected officials.

“Political will is clearly an important factor,” said Lary Stromfeld, a New York-based attorney who specializes in capital markets and distressed municipal debt at Cadwalader, Wickersham & Taft LLP, of Chapter 9 filings. “It’s a difficult thing to do politically.”

Once in bankruptcy, Chapter 9 gives cities and counties an advantage over companies using Chapter 11 to reorganize. Unlike a company, municipalities don’t need to ask the bankruptcy court for permission to pay any bills they ran up before filing for court protection, including wages, utility bills and rents.

That means creditors can’t put as much pressure on a city over its spending habits, as sometimes happens in Chapter 11 cases, said Lee Bogdanoff, an attorney with Klee Tuchin Bogdanoff & Stern LLP. The Los Angeles law firm represents Mammoth Lakes and Alabama’s Jefferson County, which filed the biggest municipal bankruptcy in the U.S. last year, listing more than $4 billion in debt.

Reorganization Plans

Chapter 9 creditors also can’t offer their own reorganization plan and aren’t entitled to form an official committee with legal fees paid by the municipality. Unsecured creditors typically have those rights under Chapter 11, which is used by companies to try to stay in business and reorganize.

Small tax districts are more easily reorganized than cities or counties, mainly because the districts typically don’t have to contend with labor unions, Doyle said.

In Nebraska, Chapter 9 bankruptcies are more like prepackaged Chapter 11 cases because the district owners and creditors most often work out an agreement beforehand, he said.

Cases in Nebraska usually take only a few months to go through the federal court system and most are approved by a U.S. bankruptcy judge based on whatever deal is worked out with creditors. Those deals almost always guarantee full repayment of bondholders’ principal, stretched over a longer period of time and at a lower interest rate, Doyle said.

Housing Slump

Most of the subdivisions that own the special tax districts are located in or around Omaha, Doyle said. In the next two years, as many as 10 more of the special districts may go bankrupt as debt comes due for subdivisions built during the housing slump that followed the credit crisis, he said.

Since the Great Depression of the 1930s, no U.S. municipality has used bankruptcy to force bondholders to take less than the full principal due, according to Spiotto and Richard Ciccarone, chief research officer at McDonnell Investment Management LLC in Oak Brook, Illinois.

That may change, if Stockton’s lawyers have their way. The bankrupt municipality has begun a historic effort to be the first American city to use bankruptcy to successfully impose losses on bondholders.

Similar Traits

California, Alabama and Texas share several traits that help explain why they have such a large share of municipal bankruptcies, Spiotto said.

All three allow cities and special tax districts to file bankruptcy with few, if any, conditions. While California requires cities to first go through mediation with creditors, a loophole lets officials declare an emergency to shorten, or even eliminate, the talks.

In Alabama, a state supreme court ruling this year in the Jefferson County case made it easier for municipalities in that state to meet Chapter 9 eligibility standards.

“One of the things that many states are asking is, ‘Should we have more active supervision?'" Spiotto said.

The three states also restrict the power of local officials to increase existing taxes or impose new ones.

Sewer System

In Alabama, only state lawmakers can authorize new local taxes. Jefferson County lost about $70 million in revenue when the state high court struck down a wage tax.

The decision, combined with a sewer system that doesn’t generate enough money to cover payments on about $3.2 billion in debt, forced the county into bankruptcy, according to court documents.

In California, cities struggle with the effects of the 1970s tax reform known as Proposition 13, which limits how quickly property taxes can increase, said Michael A. Pagano, dean of the College of Urban Planning and Public Affairs at the University of Illinois at Chicago.

And in Texas, the state constitution limits how much cities with more than 5,000 people can collect annually in property taxes, Spiotto said.

Public officials have traditionally been wary of Chapter 9 for fear of alienating the bond market and driving up the future cost of borrowing, said Spiotto, who represents a group of Jefferson County’s creditors.

Political Stigma

Those fears and the political stigma may be fading as cities, especially in California, face increased budget pressures, said Matt Fabian, a managing director for Municipal Market Advisors, based in Concord, Massachusetts.

“Stockton has a potential to reverse the precedent,” Fabian said. “Cities tend to follow the example within their states. Things that happen tend to keep happening.”

Stockton on June 28 became the biggest U.S. city to seek court protection, listing assets of more than $1 billion and debt of more than $500 million. The collapse of the housing market left Stockton, a city of about 292,000, to contend with mounting retiree health-care costs and an eroding tax base in the wake of the recession, while accounting errors overstated municipal revenues.

Mammoth Lakes, a High Sierra resort town of 8,200, followed Stockton into bankruptcy on July 3 to shield itself from a $43 million judgment won by a land developer in a lawsuit.

San Bernardino

In San Bernardino, a city of 209,000, officials are looking to Chapter 9 after being confronted with a $45 million fiscal- year deficit fueled by declining tax revenue and growing employee costs.

Despite any perceived stigma, the option for municipalities to seek court protection may be gaining favor due to political expediency, bankruptcy attorney Stromfeld said.

“Municipalities are recognizing that it can be a very valuable tool to address these difficult financial situations,” he said.

The California cases are in Re Stockton, 12-32118, and In re Mammoth Lakes, 12-32463; U.S. Bankruptcy Court for the Eastern District of California (Sacramento).

To contact the reporter on this story: Steven Church in Wilmington, Delaware at schurch3@bloomberg.net.

To contact the editor responsible for this story: John Pickering at jpickering@bloomberg.net

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