Stockton Creditors Face Long Odds to End City Bankruptcy

Removing Stockton, California, from federal bankruptcy protection will require that creditors such as Assured Guaranty Corp. and Franklin Resources Inc. prove the city isn’t truly insolvent, and that its leaders didn’t negotiate a potential settlement in good faith.

That is the task ahead for creditors in the biggest city bankruptcy in U.S. history, and the odds of success aren’t in their favor, said attorneys following the case. Assured, a bond insurer, and Franklin, a mutual-fund manager, will appear in court for a four-day trial starting next week before U.S. Bankruptcy Judge Christopher M. Klein in Sacramento.

“It is always an uphill battle,” said James E. Spiotto, a partner at Chapman & Cutler LLP who represents creditors of insolvent public agencies.

Stockton is among three municipalities that have said they will try to force creditors, including bondholders, to take less than the principal they are owed. No city or county since at least the 1930s has used the power of a U.S. bankruptcy court to force a reduction in the principal on its debt. The other two are California’s San Bernardino and Jefferson County, Alabama.

San Bernardino shouldn’t be allowed to cancel contracts with its three biggest unions until a judge decides whether its bankruptcy is legal, the city’s main police and fire unions said in a court filing yesterday.

The unions asked U.S. Bankruptcy Court Judge Meredith Jury in Riverside, California, to delay an April 4 court hearing on whether San Bernardino officials can throw out the three contracts.

Pension Cuts

The unions are fighting the city’s effort to cancel their contracts and force workers to accept pension changes imposed by elected officials in January. Those changes will save the city about $26 million by requiring workers to pay for 50 percent of their monthly pension premium.

The city prematurely ended mediation with its labor unions and then imposed the changes at an emergency council meeting, Ron M. Oliner, an attorney for the police union, said in court papers.

If Stockton’s creditors win at trial, they will be free to sue the city of 300,000 in state court, where it’s easier to force asset sales, cuts in city services or a boost in revenue to pay debt, Spiotto said. While in bankruptcy, Stockton, located 80 miles (129 kilometers) east of San Francisco, is shielded from such tactics and has more power to choose which bills to pay.

Trial Victory

A trial victory by Stockton would allow the city to pursue its original debt-reduction plan. Before filing for bankruptcy in June under Chapter 9 of the U.S. Bankruptcy Code, the city asked bondholders and other lenders owed more than $300 million to take less than full repayment.

Creditors of the city, which listed assets of more than $1 billion and debt of more than $500 million when it sought court protection, have little choice other than to pursue their claims in the trial, said bankruptcy attorney Dale Ginter, who represented retired workers of Vallejo, California, when that northern California city filed bankruptcy in 2008.

Should Stockton survive the eligibility challenge, it will gain more freedom from creditors than corporate debtors have under Chapter 11.

“It gives the city tremendous leverage,” Ginter said in a telephone interview.

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To win, the creditors must show the city failed to meet at least one of three primary tests specified in Chapter 9 or California law. Before turning to bankruptcy, a city must be insolvent, have permission from its state government, and have tried in “good faith” to negotiate a deal with creditors.

The creditors are focusing on two of the tests, insolvency and good faith negotiations.

Assured, based in Hamilton, Bermuda, argued in court papers that the city, in an effort to become insolvent, manipulated its budget process by refusing to raise taxes and limiting service cuts.

The insurer would be on the hook for tens of millions of dollars in bond payments if the city wins permission to eliminate the debt.

On the good faith test, creditors led by Assured and the other bond insurer in the case, MBIA Inc. unit National Public Finance Guarantee Corp., claim the city wasn’t serious about striking a deal during months of pre-bankruptcy talks required by California law.

Franklin’s subsidiary, Franklin High Yield Municipal Fund, and Wells Fargo Bank NA filed court papers saying they support the objections of Assured and National Public Finance.

Good Faith

The city never negotiated with the California Public Employees’ Retirement System, or Calpers, which provides retirement plans for city employees. The biggest U.S. public pension fund refused to negotiate with Stockton, claiming that under state law it isn’t authorized to reduce the city’s contributions to the fund.

Lawrence Larose, a lawyer for Armonk, New York-based National Public Finance Guarantee, Guy Neal, a lawyer for Assured Guaranty, and James Johnston, a lawyer for San Mateo, California-based Franklin, didn’t immediately respond to e-mails seeking comment on the trial.

The Stockton creditor arguments will be very hard to make, especially about good faith negotiations, said Ginter, of Downey Brand LLP, and Chris Dickerson, a bankruptcy attorney with DLA Piper LLP.

‘Tough Negotiation’

“One person’s bad faith is another person’s tough negotiation,” Dickerson, who has represented hedge funds in talks with bankrupt companies as well as debtors, said in a phone interview. “It’s a difficult thing to prove.”

Marc Levinson, the lead attorney for Stockton, said the city didn’t go into bankruptcy “happily.”

“The city has always believed, and continues to believe, that it is eligible for bankruptcy,” said Levinson, of the law firm of Orrick, Herrington & Sutcliffe, LLP.

Vallejo, a onetime U.S. Navy town of about 120,000 on San Francisco Bay, successfully fought off a challenge to its bankruptcy by three labor unions, which tried to show during a court hearing that the city wasn’t insolvent and hadn’t filed its case in good faith. Levinson also represented Vallejo.

Later, Vallejo cut costs and reached a deal with lenders to repay principal in full while extending maturities and adjusting interest rates.

The Stockton creditors probably understand how hard it will be to win, Dickerson said. Spending the money to fight anyway may simply be a tactic to push the city and Calpers to make concessions.

The creditors may also be motivated by the frustration of facing a loss on their debt, while Calpers is repaid in full.

“They don’t want to be the schmuck who’s the only one taking a haircut,” he said.

The case is In re Stockton, 12-32118, U.S. Bankruptcy Court, Eastern District of California (Sacramento). The San Bernardino case is In re San Bernardino, 12-28006, U.S. Bankruptcy Court, Central District of California (Riverside).