California’s Stockton May Ask Bondholders to ‘Suffer,’ City Says

Stockton, California, may take the first steps toward becoming the most populous U.S. city to file for bankruptcy next week because of burdensome employee costs, excessive debt and bookkeeping errors that misrepresented accounts, city officials said yesterday.

The Stockton City Council will meet Feb. 28 to consider a type of mediation that allows creditors to participate, the first move toward a Chapter 9 bankruptcy filing under a new state law. The council will also weigh suspending some payments on long-term debt of about $702 million, according to a 2010 financial statement.

“Somebody has to suffer and in this case the city manager has decided it should be the bondholders who suffer,” Marc Levinson of the Sacramento-based law firm Orrick, Herrington & Sutcliffe LLP, which represents the city, said at a news briefing at City Hall yesterday.

Stockton, a farming center about 80 miles (130 kilometers) east of San Francisco, has fought to avert bankruptcy by shrinking its payroll, including a quarter of the roughly 425-member police force. At 292,000, the city has more than twice as many residents as Vallejo, California, which became a national symbol for distressed municipal finance in 2008 when it sought protection from creditors.

Shrinking Current Budget

Stockton’s council will be asked to reduce the current budget by $15 million because of newly uncovered accounting errors and mismanagement that have left the city almost broke, City Manager Bob Deis told reporters yesterday. To keep the city solvent through June 30, the end of the fiscal year, the council will be asked to default on $2 million of debt payments.

“Our employees and the citizens of Stockton who receive city services have borne the entire brunt of our restructuring efforts so far and now it’s time for others to do the same,” Deis said in a report to the council. “We can’t ‘grow our way’ out of the problem and no amount of forward-looking financial planning will properly fix it.”

Deis said he wants to use the mediation process to work out a compromise with creditors such as bondholders and with labor unions representing city workers before Stockton needs to seek bankruptcy protection.

“This is all being done with the goal of getting to June 30,” Deis said. “It’s always best to negotiate and work out a settlement.”

Budget Deficit

Deis said the city is facing a $20 million deficit in the next fiscal year. Expanded retiree health insurance commitments in the 1990s have left the city with a looming $450 million unfunded liability.

“Next year, we expect to pay more for retiree health insurance than for our current employees,” Deis said, likening the promises to a “Ponzi scheme.”

State officials are monitoring the situation. “We haven’t talked to them about it, but where we could help, we would,” Governor Jerry Brown, a Democrat, said yesterday in an interview in Washington.

State Treasurer Bill Lockyer said the city’s financial troubles may be felt statewide.

“The reputational stain can bleed onto other local issuers and the state, and that can hurt taxpayers in the bond market,” he said in a statement. “So we hope a Chapter 9 filing is not the final outcome.”

‘Bad Message’

Telling bondholders they will suffer is “a bad message to send out to bond-land,” said Marilyn Cohen, president of Los Angeles-based Envision Capital Management Inc., which manages about $200 million in municipal debt.

“The whole idea has always been to preserve the bonds because one day we’re going to have to re-enter in the bond market,” Cohen said yesterday in a telephone interview.

The council will be asked to pay $175,000 to Management Partners Inc. of Cincinnati, a consulting firm hired to evaluate the city’s finances, for project management and technical assistance during the state-required mediation.

“The sustained recession has reduced revenues significantly,” Management Partners said in a report dated Feb. 23. “In the years prior to the recession, the city took on a large amount of debt in anticipation of ongoing growth that now exceeds the city’s ability to pay.”

“Compensation packages exceeded sustainable levels and the city assumed a significant liability for improved retiree health coverage without sufficient recurring revenues to cover growing costs,” the report said. “Prior fiscal management practices obscured problems.”

Moody’s Downgrade

Moody’s Investors Service yesterday downgraded Stockton’s rating to Ba2, two levels below investment grade, from Baa1. The city’s proposal to suspend general-obligation debt service and enter mediation with creditors “demonstrates significantly reduced willingness, if not ability” to pay bondholders, Moody’s said in a report. The decision affected about $341 million in debt.

Standard & Poor’s cut its rating to BB, two levels below investment grade, from A- and lowered the city’s credit outlook to negative.

News about Stockton didn’t affect the municipal bond market yesterday, which was quiet with “underlying firmness,” said Alan Schankel, director of fixed-income research at Janney Montgomery Scott LLC in Philadelphia.

‘Just Playing Chicken’

Schankel said he thinks Stockton might avoid filing for bankruptcy. “They’re just playing chicken again,” he said.

Stockton had the eighth-highest violent crime rate in the country in 2010; the second-highest foreclosure rate in the U.S., behind Las Vegas; and the eighth-highest unemployment, at 15.9 percent in December, almost double the national average.

Such factors helped earn Stockton the title of “most miserable city” in the U.S. twice in the past four years by, out of the 200 largest metropolitan statistical areas.

The city can expect to pay $20 million in legal fees if it pursues bankruptcy, Dale Fritchen, a member of Stockton’s City Council, said in a Feb. 23 telephone interview.

Legal Costs

“Municipal bankruptcy won’t just erase all your debt, so we are still going to have to make cuts to balance the budget and on top of those cuts come up with the $20 million extra for legal fees,” Fritchen said.

A state law backed by unions and passed last year in response to Vallejo’s bankruptcy requires cities to work with a “neutral evaluator” for at least 60 days before seeking bankruptcy court protection. The process gives creditors a right to participate. It can be bypassed if the city declares a fiscal emergency, according to the law.

Entering the 60-day evaluation period may cause a “run on the general fund” by vendors, said Lee R. Bogdanoff, a bankruptcy specialist at the Los Angeles law firm Klee, Tuchin, Bogdanoff & Stern LLP, which filed the biggest municipal U.S. bankruptcy on behalf of Jefferson County, Alabama.

Suppliers may demand cash on delivery, or require past bills to be paid immediately before continuing to do business with the city, Bogdanoff, who isn’t involved in Stockton’s situation, said yesterday in a telephone interview.

Since 1937, 635 municipalities have filed for Chapter 9 bankruptcy protection, according to James Spiotto, head of the bankruptcy practice at Chicago-based law firm Chapman & Cutler. Stockton would be the biggest city to do so, he said.