July 6 (Bloomberg) -- Lawyers for Stockton, California’s bondholders, who face a fight with the bankrupt city over proposed cuts, arrived in court today armed with fewer weapons than investors owed money by reorganizing companies.
Stockton is trying to become the first American city to use bankruptcy to successfully impose losses on bondholders. Bondholders will be limited to two main options if they are to block Stockton in court, said Lee Bogdanoff, a bankruptcy attorney: get the case thrown out or defeat the city’s reorganization proposal.
“The most important power they have is a seat at the negotiating table,” Bogdanoff, a founding partner of Klee, Tuchin, Bogdanoff & Stern LLP in Los Angeles, said in a telephone interview. “They can try to influence the decision makers.”
An initial hearing was held today in U.S. Bankruptcy Court in Sacramento, where the city proposed a tentative schedule for the case, which gives bondholders and other creditors until Aug. 24 to decide whether they will try to oppose the city’s eligibility to remain in bankruptcy. Should any creditor file an objection to the bankruptcy filing, the city proposed that U.S. Bankruptcy Judge Christopher Klein, the chief bankruptcy judge in Sacramento, schedule a hearing for the end of October.
City council members have set aside more than $3 million for the first year of a bankruptcy court fight with bondholders and labor unions over how to divide a smaller budget.
Today’s hearing is different from a typical corporate case, Bogdanoff said. Unlike a company, the city doesn’t need to ask Klein for permission to pay any bills it ran up before filing for court protection, such as wages, utility bills or rents. As a result, creditors won’t be able to use the hearing to pressure the city on its spending habits, Bogdanoff said.
Chapter 9 of the U.S. Bankruptcy Code also bars creditors from offering their own reorganization plan. Nor are they entitled to form an official committee with legal fees paid by the city. Unsecured creditors typically have those rights under the code’s Chapter 11, which is used by companies to try to stay in business and reorganize.
Public officials’ fear of alienating the bond market may be bondholders’ most powerful tool, said Jim Spiotto, a bankruptcy attorney with Chapman & Cutler LLP in Chicago who helped write a book about municipalities in financial distress.
“You have to take into consideration what happens if you increase the risk perspective in the financial markets,” Spiotto said. Cutting bond debt today may “increase the cost of borrowing in the future.”
Spiotto and Bogdanoff are on opposite sides of the biggest municipal bankruptcy ever filed in the U.S. Bogdanoff represents Jefferson County, Alabama, which is trying to use Chapter 9 to get bondholders to take less than the $3.2 billion they are owed. Spiotto represents a group of the county’s creditors. Neither is involved in the Stockton case.
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.
The Chapter 9 petition allows Stockton to suspend payments to creditors while it seeks court approval for a plan that balances revenue with debt. Only a negotiated settlement can fix the city’s finances, Spiotto said. Any city in bankruptcy will need creditor support to win approval of a so-called plan of adjustment, he said.
“It has to be something where you get creditor buy-in,” Spiotto said.
William Kannel, a lawyer for bondholder trustee Wells Fargo & Co., declined to comment on Stockton’s bankruptcy. Richard Lapping, an attorney who represents creditor National Public Finance Guarantee Corp., didn’t return a call for comment.
Creditors are particularly powerful when they vote as a bloc on a plan. Under the bankruptcy code, persuading a judge to override opposition to a plan from a class of creditors is harder than defeating objections from individual creditors.
It may be easier for bondholders to make their case outside of the courtroom by trying to influence elected officials, Bogdanoff said. Creditors can make campaign contributions to opposing politicians, or use other forms of political pressure to persuade officials to compromise, he said.
No U.S. municipality has used bankruptcy to force bondholders to take less than the full principal due since the Great Depression in the 1930s, according to Spiotto and Richard Ciccarone, chief research officer at McDonnell Investment Management LLC in Oak Brook, Illinois.
The two biggest creditors named in the bankruptcy filing reflect the groups most likely to face cuts imposed as part of the case: bondholders and city employees.
Stockton said its biggest unsecured creditor is the California Public Employees’ Retirement System, or Calpers, the largest U.S. pension fund, owed $147.5 million.
It’s followed by Wells Fargo, as trustee for both $124.3 million in pension obligation bonds and for three other sets of bondholders owed $107 million, according to court papers.
Wells Fargo “expects to take an active role in the bankruptcy proceedings,” Elise Wilkinson, a spokeswoman for the San Francisco-based bank, the nation’s biggest home lender, said in an e-mail the day Stockton filed bankruptcy. The bank didn’t lend the city any money, she said.
Calpers, Wells Fargo and bond insurer Assured Guaranty Ltd. were among at least 18 creditors involved in failed talks with Stockton that began March 27 and were extended to June 25. The only non-routine question the city has asked Klein to decide today is whether details about the months-long mediation process can be made public, according to the court docket.
Assured Guaranty insured $161.4 million of Stockton’s bonds, the company said in a statement.
“Assured Guaranty intends to vigorously enforce its rights as a creditor in any Chapter 9 proceeding, including the right to contest eligibility and confirmation of any plan of adjustment proposed by the city,” the company said in a statement e-mailed by Ashweeta Durani, a spokeswoman.
The case is In re Stockton, 12-32118, U.S. Bankruptcy Court, Eastern District of California (Sacramento).
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