Analysis: Stockton, California new paradigm for struggling cities

By Hilary Russ | Reuters
NEW YORK (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."

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 what makes it sort of a game-changing type of a 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."

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