Stockton May Show Way for California Cities to Avoid Bankruptcy

Stockton, California, might inspire other cities to avoid Chapter 9 filings by bringing in a mediator to untangle municipal finances without going to court, according to a lawyer who helped write the new law it’s invoking.

Stockton, an agricultural and shipping hub of 292,000 people about 80 miles (130 kilometers) east of San Francisco, yesterday became the first city to use a state law approved last year to avert municipal bankruptcies by appointing an outsider to resolve disputes among creditors and unions.

Other cities in California, dealing with new fiscal stresses after the state eliminated redevelopment agencies, are watching closely, said Karol K. Denniston, a Los Angeles-based lawyer and arbitrator who helped write the statute.

“It’s a harbinger for a lot of other municipalities,” Denniston, a managing partner at Brownstein Hyatt Farber Schreck LLP, said in a telephone interview. “The focus on the muni market in California is due to the pressure on a lot of the municipalities, due to the winding-up of the redevelopment agencies.”

Most states have refused to authorize their municipalities to file for bankruptcy, which means lawmakers would need to change state law before a city or county could seek court protection from creditors, according to a report by the American Bankruptcy Institute.

Official Permission

Of the 24 that passed laws allowing Chapter 9 filings, at least four require permission from state officials, while others impose various restrictions, according to the 2010 report. In Iowa, for example, a city or county can only file bankruptcy if it accumulated “involuntary debt.”

“States are increasingly moving in the direction of regulating Chapter 9,” Sam Gerdano, director of the institute, said in an interview Feb. 27.

After Stockton, the most logical candidate in California for a municipal bankruptcy is Hercules, a city of 24,000 in the San Francisco Bay Area, which inherited debt from a now-defunct redevelopment agency, Denniston said.

Other such cities may be pushed toward bankruptcy if, like Hercules, the redevelopment projects aren’t generating sufficient revenue to repay bondholders, she said.

The law dissolving redevelopment agencies contains provisions to stave off bankruptcies by allowing cities to sell properties in redevelopment zones and for host counties to bail out cities with additional property-tax revenue, said Chris McKenzie, executive director of the League of California Cities.

Holes in the Statute

“That said, nothing would surprise me given how many holes there are in the statute,” McKenzie said by telephone.

On Feb. 2, the day after California dissolved more than 400 redevelopment agencies, Standard & Poor’s cut the rating on the Hercules Redevelopment Agency’s housing tax allocation bonds, noting the dispute between the city and Ambac Assurance Corp. over whether the insurer was liable for $2.4 million in payments to bondholders.

If Hercules loses its lawsuit with Ambac, the city would “not have sufficient funds to continue normal operations” for the remainder of the fiscal year and might seek bankruptcy protection, Municipal Market Advisors noted in a Feb. 6 report.

The Hercules city manager, Steve Duran, said in a telephone interview Feb. 24 that he’s “optimistic” the city can resolve its dispute with Ambac and not need court protection.

“Bankruptcy is the absolute worst option until it becomes the only option,” Duran said. “That’s not my quote. That’s from the Orrick people in Vallejo.”

2008 Bankruptcy

Vallejo, a city of 120,000 in the San Francisco Bay Area, was represented by Orrick, Herrington & Sutcliffe LLP as it filed for bankruptcy in 2008. It was the biggest California city and at the time, the second-biggest local government after Orange County to file for protection from creditors. Vallejo, which emerged from court supervision in 2011, spent $10.6 million on legal fees from the bankruptcy while cutting more than 40 percent of its police and fire budgets.

The Vallejo example spurred Assemblyman Bob Wieckowski, a Fremont Democrat and bankruptcy attorney, to work on a bill that would discourage Chapter 9 filings by bringing in arbitrators, he recalled in a telephone interview.

The bill, signed into law by Governor Jerry Brown last year, requires cities to either consult an outside mediator or declare a fiscal emergency before seeking bankruptcy.

‘Litigation Fever’

“Stockton would really benefit from having their bondholders and employee groups and creditors in a meeting where they can discuss their issues candidly,” Wieckowski said Feb. 27. “Everybody gets litigation fever. We should leave the litigators at the door.”

Like California, Pennsylvania’s law requires cities to try to work out their differences with creditors before filing bankruptcy, said Neal Colton, with the law firm of Cozen O’Connor. In November, Colton was among a team of lawyers who succeeded in getting Harrisburg, home to Pennsylvania’s capital, thrown out of bankruptcy by arguing the city council violated state law when it filed the case.

Harrisburg and similar-sized municipalities in Pennsylvania, known as Class Three cities under the state law, cannot put themselves into bankruptcy. Only a state-appointed receiver has that power, said attorney Kenneth W. Lee, who was also on the team that won dismissal of Harrisburg’s Chapter 9 filing.

Larger and smaller cities must negotiate with creditors first, Colton said.

Elected officials are unwilling to file bankruptcy because of the negative political implications of voting for such a move, bankruptcy attorney Ben Logan, with the law firm of O’Melveny & Myers LLP, said in an interview yesterday.

“It is a very difficult political decision,” Logan said.

Should Stockton succeed in avoiding bankruptcy, other cities may follow its example, Logan said.

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