Stockton Creditors Say It Didn’t Try to Avoid Bankruptcy

Stockton, California, shouldn’t be allowed to reorganize under court protection because it can’t prove it negotiated in good faith to avoid bankruptcy, creditors told a judge who said he will rule by April 1.

When the city did engage in talks, it told parties, “in essence, to take it or to leave it,” said Matthew Walsh, a lawyer for creditors, at the end of a three-day trial. “That’s not the mark of a good faith negotiation strategy.”

If U.S. Bankruptcy Judge Christopher M. Klein in Sacramento, California, decides that Stockton can remain in bankruptcy, it will be protected from creditor lawsuits and other actions designed to force it to immediately repay its debts.

Norman Hile, an attorney for the city, said in closing arguments yesterday that there was no evidence Stockton didn’t negotiate in good faith, and that it met the criteria for bankruptcy because it was insolvent in three ways: it couldn’t provide the services needed to protect the health and safety of its citizens, it couldn’t present a balanced budget, and it had no cash to pay its employees,

“The focus is on cash insolvency, not whether city could have made better budget decisions in the past,” Hile said. Creditors had said Stockton should have handled its taxes differently and cut another $24 million from its budget. The city only had $2 million in cash as of its June 28 petition for court protection, Hile said.

Good Faith

Creditors, including Assured Guaranty Corp. and Franklin Resources Inc. had argued that Stockton didn’t qualify for bankruptcy because the city isn’t truly insolvent, and that its leaders didn’t negotiate a potential settlement in good faith.

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. The other two are San Bernardino, California, and Jefferson County, Alabama. No city or county since at least the 1930s has used the power of a U.S. bankruptcy court to force a reduction in its debt principal.

Without bankruptcy court protection, Stockton’s creditors would 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. 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.

Take Less

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. The city listed assets of more than $1 billion and debt of more than $500 million in its bankruptcy petition.

Creditors claimed that 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.

“Does your honor want to tell future municipalities that it’s OK to negotiate with some creditors, but only go through the motions with others?” Walsh argued to the judge yesterday.

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.

Bond Payments

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.

Guy Neal, an attorney for Assured, argued yesterday that, as the bonds Assured had don’t mature until 2048, it has a long-term interest in the city’s wellbeing.

“Assured cares about Stockton’s financial condition,” he said. “It cares immensely.”

“The city simply wants to wipe out its debt for good,” Neal told the judge, “but hold on to the proceeds that the debt provided and continues to provide to its citizens.”

On the good faith test, 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.

The city never held talks 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.

“By failing to seek impairment of its single largest unpaid liability, the city is forcing creditors to fight over a reduced pool,” Walsh said yesterday.

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

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