Another CA City Goes Bankrupt; More to Come?
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Another CA City Goes Bankrupt; More to Come?

David McNew/Reuters

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.

One big step Stockton is not expected to take is to attempt to dodge its pension obligations to city employees. If it did, the city would have to confront the powerful California Public Employees’ Retirement System (Calpers), which handles pension plans for many California cities and counties.

Calpers and unions around the country have made it clear they see a pension as an iron-clad right, one that’s legally protected even in a bankruptcy. Whether pensions are contract rights, which can be changed, or property rights, which are protected under the U.S. Constitution, has never been tested in court. That’s largely because of the time, money and emotional effort it would take for a municipality to fight deep-pocketed and politically connected pension systems to full resolution at an appellate level, experts said.

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"Calpers is going to push back hammer and tong," said Kenneth Klee, a professor at the University of California at Los Angeles Law School. Public employees pensions weren’t challenged by Vallejo, which used the same attorneys Stockton has hired.

Even so, bankruptcy is no easy road for municipalities. Business leaders in Jefferson County, which last year filed the biggest-ever U.S. municipal bankruptcy, at $4.23 billion, have said the bankruptcy has deterred industrial investment.

Stockton, as a case everyone’s watching, could also be a deterrent to some other cities. "The threat of bankruptcy is quite a lever, particularly if people believe it’s a realistic threat," said Mark Kalla, a partner at Barnes & Thornburg in Minneapolis. "It may make other cities’ negotiations more successful, more fruitful."

The possibility that Providence, Rhode Island could run out of money and eventually have to file for bankruptcy prompted labor unions, retirees and city officials to come to the table and reach a tentative deal in May on pension and healthcare benefit reforms.

Firefighters, police officers and city workers could have faced more layoffs, and retirees could have seen steep cuts in benefits, if the city went under. Retirees have approved the agreement, and if union members sign off the deal is expected to save the city up to $18.5 million a year and help avert insolvency.

Cities may also be drawn to negotiate because they need good credit ratings to borrow money at affordable rates – ratings that are harmed by defaults on loans and bankruptcy filings. Both Standard & Poor’s Rating Services and Moody’s Investors Service cut Stockton’s credit ratings in the days leading up to its bankruptcy filing.

"This is a case the whole country is watching," Denniston said. "It is a case where we’re all looking to see if we can create a better way to do this."

(Additional reporting by Jim Christie in San Francisco)