Stockton Creditors Dispute City's Insolvency at Trial

Stockton, California city employee leaves a damaged City Hall amid a battle over whether the municipality can file bankruptcy and shed some debt owed to its creditors. The situation in Stockton represents a test case for the future of the debt crisis., a photo by Pan-African News Wire File Photos on Flickr.

Stockton Creditors Dispute City’s Insolvency at Trial

By Steven Church & Jared Goyette
Mar 25, 2013 2:51 PM ET

Stockton, California, creditors asked a judge to end its bankruptcy case, saying at the start of a four-day trial that the city should cut excessive employee pay and pension benefits before seeking court protection.

Creditors such as Assured Guaranty Corp. and Franklin Resources Inc. (BEN) must prove at the trial that began today in Sacramento that the city isn’t truly insolvent and didn’t engage in good faith negotiations.

Guy Neal, a lawyer for bond insurer Assured Guaranty, said the city should be thrown out of bankruptcy and allowed back only after it trims “excess fat.”

“The city is not insolvent,” Neal told U.S. Bankruptcy Judge Christopher M. Klein.

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. Bondholders have complained for months about the city’s plan to cut their debt while maintaining tens of millions of dollars in future pension payment to the California Public Employees’ Retirement System, or Calpers.

That issue isn’t directly in front of Klein today, though lawyers say it will eventually be the key battle in court when the city tries to adopt a plan to adjust its debt downward.
Forced Reduction

“The city has always believed, and continues to believe, that it is eligible for bankruptcy,” Stockton’s lawyer, Marc Levinson, of the law firm of Orrick Herrington & Sutcliffe LLP, said before the trial began. He said the city didn’t go into bankruptcy “happily.”

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

If Stockton’s creditors win at trial, they will 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.

A trial victory by Stockton would allow the city to pursue its original debt-reduction plan.

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.

Little Choice

Creditors of the city, which listed assets of more than $1 billion when it sought court protection, have little choice other than to pursue their claims in the trial, said bankruptcy attorney Dale Ginter, who represented retired workers of Vallejo, California, when that Northern California city filed for bankruptcy in 2008.

Should Stockton survive the eligibility challenge, it will gain more freedom from creditors than corporate debtors have under Chapter 11.

To win, the creditors must show 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.

At least 18 creditors were involved in failed talks with creditors which started in March 2012 and continued until the end of June, just before the city filed bankruptcy.

Two Tests

The creditors are focusing on two of the tests, insolvency and good faith negotiations.

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.

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.

On the good faith test, creditors led by Assured and the other bond insurer in the case, MBIA Inc. (MBI) 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’s agenda was clear before the process began: They would restructure by targeting the capital-market creditors,” Matthew M. Walsh, an attorney for National Public Finance, said in court today.

Good Faith

The city never held talks with 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.

Creditors are mostly upset because Stockton is treating their debt as a lower priority than payments to CalPers. That is unusual in a bankruptcy case, where the philosophy is that similar debt should bear similar losses, Chris Dickerson, a bankruptcy attorney with DLA Piper LLP said in interview.

“They don’t want to be the schmuck who’s the only one taking a haircut,” he said.

Lawrence Larose, a lawyer for Armonk, New York-based National Public Finance Guarantee; Guy Neal, a lawyer for Assured Guaranty; and James Johnston, a lawyer for San Mateo, California-based Franklin, didn’t respond to e-mails seeking comment on the trial.

Vallejo Challenge

Vallejo, a onetime U.S. Navy town of about 120,000 on San Francisco Bay, successfully fought off a challenge to its bankruptcy by three labor unions, which tried to show in court that the city wasn’t insolvent and hadn’t filed its case in good faith. Stockton lawyer Levinson also represented Vallejo.

Later, Vallejo cut costs and reached a deal with lenders to repay principal in full while extending maturities and adjusting interest rates.

The collapse of the housing market left Stockton to contend with mounting retiree health-care costs and an eroding tax base in the wake of the recession, while accounting errors overstated municipal revenues.

California’s cities have struggled to keep up pension payments that have been climbing, partly because many of the plans have become more generous over time and partly because of investment losses suffered by CalPers.

Sweetened Pensions

City councils across the state, spurred by then-Governor Gray Davis’s move to enhance pensions for California Highway Patrol officers in 1999, sweetened retirement benefits for police, firefighters and other workers in the decade that followed. Public-safety employees could retire after working for 30 years, collect 90 percent of their top salaries and take jobs elsewhere while still in their 50s.

Pension liabilities in the cities of Fairfield, Inglewood, Pomona, San Bernardino, Stockton and Vallejo rose 6 percent to $4.3 billion for the year ending June 30, 2010, from $4.1 billion in 2009, according to the most recent data available from Calpers.

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

To contact the reporter on this story: Steven Church in Wilmington, Delaware, at schurch3@bloomberg.net; Jared Goyette in U.S. Bankruptcy Court in Sacramento
To contact the editor responsible for this story: John Pickering at jpickering@bloomberg.net