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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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California's Stockton Opts to File for Bankruptcy

In opting to become the nation's largest city to seek federal bankruptcy protection, Stockton, Calif., took a rare financial step of last resort after struggling with the economic downturn, soaring pension costs and contractual obligations.

Only 13 cities, counties and other government entities filed for bankruptcy protection last year — the highest annual level in nearly two decades. Stockton, a river port of 290,000, was the seventh U.S. municipality to file this year and the first California city since Vallejo, which sought protection in 2008, according to James Spiotto, a Chicago bankruptcy attorney who tracks municipal bankruptcies.

"Filing bankruptcy is time-consuming, expensive and complicated," said Spiotto, noting that Vallejo spent millions of dollars alone on attorneys and other bankruptcy professionals. "And you never get the results you desire."

That's why experts are divided on whether other financially struggling cities, towns and other government entities will follow Stockton to bankruptcy court. Spiotto said it will be hard and expensive for Stockton to obtain financing.

Others say bankruptcy comes with non-monetary costs, too.

"Being in bankruptcy is decimating to your staff and morale," said Deborah Lauchner, Vallejo's finance director. "There's so much uncertainty. ... We've been taken apart and ripped by the seams and everybody examined us."

Since Congress added Chapter 9 to the bankruptcy code in 1937 to allow municipalities to seek protection, some 640 government entities have filed. Last year's 13 filings almost doubled the six filed in 2010. That was the most since an equal number were filed in 1994.

By comparison, roughly 1.5 million Americans file for personal bankruptcy a year while some 50,000 companies file for business bankruptcy.

"Bankruptcy is a huge drain on municipalities, because they have limited ways to create more revenue," said Los Angeles bankruptcy lawyer Karol Denniston.

Stockton City Manager Bob Deis said officials were left with little choice but to recommend bankruptcy after failing to hammer out finance agreements with creditors to address the city's $26 million budget shortfall.

"Unfortunately we have no comprehensive set of agreements with our creditors that would eliminate the deficit and avoid insolvency," Deis said at the City Council meeting Tuesday night. He said, however, that the city was still negotiating with some creditors and could reach deals with as many as one-third of them.

"We think Chapter 9 protection is the only choice left," Deis said. "If we get any agreements, those will be honored in Chapter 9."

The City Council on Tuesday voted 6-1 to adopt a special bankruptcy budget to address Stockton's $26 million shortfall if the city files for bankruptcy, as expected, by Friday.

The city has been hit hard by high crime and the collapse of the housing market in the past three years. It's also dealt with $90 million in deficits through a series of drastic cuts.

The new budget did not call for additional service cuts beyond those that earlier slashed the police force by one-fourth, the fire department by one-third and 40 percent of other city employees, along with wages and medical benefits.

The budget approved Tuesday night would suspend payments for debts and legal claims; reduce payments for retiree medical benefits; further cut some pay and benefits; and increase revenue through code enforcement and parking citations.

In standing room only chambers, former city employees told council members about their life-threatening medical conditions and said benefit cuts meant they would effectively lose their health insurance.

"For me, bankruptcy might as well be a life sentence," said Gary Jones, a retiree who used to be a police officer in Stockton and said he was diagnosed with a brain tumor.

Other residents complained about plummeting property values, and recurring break-ins and robberies.

"The average citizen will not put up with this. Their home prices have plummeted, they have no jobs, a lot of people are getting fed up so that they have to resort to crime." said Gregory Pitsch, a 22-year-old unemployed resident who made an unsuccessful run for mayor. "I'm asking you to make the right decision, not destroy the property values in this city, which bankruptcy will do."

But city officials said this Central Valley city in California's agricultural heartland has run out of options. In recent years, thousands of new homes mushroomed in Stockton, part of a suburban housing boom that attracted buyers from the San Francisco Bay Area and beyond. When the economy crashed and the construction bubble burst, Stockton was battered by foreclosures and lost income from property taxes and other fees.

Under bankruptcy protection, officials would retain power over day-to-day city operations and staffing, but a judge would take over all decisions concerning the city's debts, said Robert Benedetti, professor of political science at the University of the Pacific in Stockton.

The judge would decide which creditors should be paid, how much and in what order. He would make allowances for expenditures needed by the city to function, and it would be up to city officials to decide how to spend that money.

"One of reasons a city might want to go the bankruptcy route is that they don't want a situation where they have to pay out debts and have to close the police or fire department," Benedetti said. "Filing for Chapter 9 means you're asking the court to protect you against lawsuits from people who hold your debt.

"Bankruptcy won't take away Stockton's underlying financial problems, one of which is the economy, the high unemployment rate and the high foreclosure rate," he said. "It will take years for them to come out of this.""

If Stockton files for bankruptcy, it would be the largest city by population to do so, according to Spiotto, the Chicago bankruptcy lawyer who tracks filings. He said Bridgeport, Conn., is currently the largest city to file for bankruptcy, which it did in 1991.

Jefferson County in Alabama is the largest local government bankruptcy filing to date in terms of the size of its debt. It occurred in November 2011 and was followed by Orange County, Calif., in 1994.

Stockton was the first city to test a new state mediation law, Assembly Bill 506, which is less than six months old.

Under the law, municipalities considering bankruptcy must first negotiate behind closed doors with creditors for up to three months, with the goal of settling debts without filing for Chapter 9 protection.

Bankruptcy lawyer Denniston, who helped draft the bill, said legislators in other states are interested in how the mediation process could be used elsewhere.

"Nationwide, we're faced with a ton of municipal distress," Denniston said, noting dire economic conditions, massive foreclosures and future pension obligations. "It's the perfect storm."