Another CA City Goes Bankrupt; More to Come?
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July 2, 2012

Stockton, California, the largest city in the United States to ever file for bankruptcy, could create a new template for struggling cities and potentially lift the stigma that scars municipalities if they seek court protection from creditors.

If Stockton, which filed for Chapter 9 municipal bankruptcy on June 28, can reach consensus with its creditors and craft a plan to exit bankruptcy quickly others may follow suit, legal experts said.

"Successful cases breed more filings," said Andrew Glenn, a bankruptcy partner in New York at Kasowitz Benson Torres & Friedman. "Municipalities watch these cases closely around the country, and once the template is set up, if other towns have these problems, they’re going to follow the template."

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Other cities and counties have gone bankrupt because of a bad investment or ill-conceived public works project, like the sewer system that sank Jefferson County, Alabama, into $3.14 billion of debt. But Stockton may be a new breed of failing city, swamped by routine costs, pension payments, a payroll for city employees, a years-long economic slide and depressed housing tax receipts – the same issues that currently face many other cities still struggling to recover from the cavernous U.S. recession.

"Stockton is a precursor of something very different" from Jefferson County, Glenn said. "That’s [why it's] a game-changing type of case."

It will be the first case to test California’s mandated mediation process. State lawmakers changed the rules after the city of Vallejo went bankrupt in 2008 and then slogged through a three-year bankruptcy battle that racked up at least $10 million in attorneys’ fees.

Now, unless they declare a fiscal emergency, California municipalities must participate in mediation before they are allowed to file for bankruptcy. Each state has different requirements for cities and towns that want to file for Chapter 9 bankruptcy. Some use budget commissions, receivers and other measures to try to help resuscitate cities before allowing them to go bankrupt as a last resort. Nearly half of U.S. states don’t allow municipal bankruptcies at all.

James Spiotto, a partner at Chapman and Cutler in Chicago, said California is the only state that requires mediation prior to a Chapter 9 filing. A similar proposal failed to pass the Illinois legislature this session, he said. He also noted in a recent national survey of Chapter 9 state provisions that California labor unions supported the mediation law as "a reaction to the difficulties they experienced in the city of Vallejo Chapter 9 bankruptcy proceeding."

Though the mediation process didn’t stave off the bankruptcy for Stockton, lawyers said it forced the city and creditors to talk to each other ahead of time and put the city in a better position going into court – and could result in a quicker exit from the case. "Stockton is incredibly well-prepared for a bankruptcy filing and very forthcoming in terms of disclosing to creditors and the public," said Karol Denniston, a bankruptcy partner at Schiff Hardin in San Francisco.

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A third of Stockton’s creditors reached agreements with the city during mediation, giving the city "a huge leg up, because at least they’re not filing bankruptcy like Vallejo did, fighting with everybody," she said. That result will also allow the city to show a bankruptcy judge it has tried in good faith to negotiate with creditors and is truly insolvent – requirements a California city must normally meet for a bankruptcy filing to be ruled valid.