Stockton Creditors Face Long Odds to End City Bankruptcy

By Steven Church - Mar 22, 2013 12:00 AM ET

Throwing Stockton, California, out of bankruptcy will require creditors including Assured Guaranty Corp. and mutual-fund manager Franklin Resources Inc. (BEN) to convince a judge that the city isn’t insolvent and never really tried to cut a deal.

The odds are against them, said attorneys who aren’t involved in the case. Assured, a bond insurer, and Franklin’s high yield, tax-free income fund are set to be in court March 25 for the start of a four-day trial before U.S. Bankruptcy Judge Christopher M. Klein in Sacramento.

“I think it is always an uphill battle,” said James E. Spiotto, a partner at Chapman & Cutler LLP who represents creditors of insolvent public agencies and has written about the history of the U.S. Chapter 9 Bankruptcy Code.

If creditors win, they will be free to sue the city in state court, where it is much easier to force the sale of assets, or a reduction in services or a boost in revenue to pay off debts, Spiotto said in a phone interview. While in bankruptcy, the city is shielded from such tactics and also has more power to decide which bills it will — or won’t — pay.

A trial victory by Stockton would allow the city to pursue its original debt-reduction plan. Before filing bankruptcy in June, the city asked bondholders and other lenders owed more than $300 million to take less than full repayment.

In court papers, the city listed assets of more than $1 billion and debt of more than $500 million.

Even with the long odds, creditors have little choice other than to pursue their claims, said bankruptcy attorney Dale Ginter, who represented Vallejo’s retired workers when the NorthernCalifornia city filed bankruptcy in 2008.

‘Tremendous Leverage’

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

“It gives the city tremendous leverage,” Ginter said in a phone interview.

To win, the creditors must show the city failed to meet at least one of three tests specified in Chapter 9. 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.

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

Calpers

On the good faith test, creditors led by Assured and the other bond insurer in the case, 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. The city never negotiated with theCalifornia Public Employees’ Retirement System, or Calpers, which provides retirement plansfor city employees.

Those arguments will be very hard to make, especially about good faith negotiations, said Ginter of Downey Brand LLP.

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 during a court hearing that the city wasn’t insolvent and hadn’t filed its case in good faith. Later, Vallejo cut costs and reached a deal with lenders to repay principal in full while extending maturities and adjusting interest rates.

Calpers, the biggest U.S. public pension fund, refused to negotiate with Stockton. It claimed that under state law it isn’t authorized to reduce the city’s contributions to the fund.

‘Tough Negotiations’

Proving someone didn’t negotiate in good faith is very difficult, said Chris L. Dickerson, a bankruptcy attorney with DLA Piper LLP.

“One person’s bad faith is another person’s tough negotiation,” Dickerson, who has representedhedge funds in talks with bankrupt companies as well as debtors, said in a phone interview. “It’s a difficult thing to prove.”

The creditors probably understand how hard it will be to win, Dickerson said. Spending the money to fight anyway may simply be a tactic to push the city and Calpers to make concessions.

The creditors may also be motivated by the frustration of facing a loss on their debt, while Calpers is repaid in full.

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

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 atschurch3@bloomberg.net

To contact the editor responsible for this story: John Pickering at jpickering@bloomberg.net