The Summer California Went Bankrupt

Contributed by Will Hueske
The summer of 2012 may be remembered, at least to avid bankruptcy law enthusiasts like yourselves, as the “Summer California Went Bankrupt.” With two municipalities already in chapter 9 proceedings, a third having recently voted to file, and a fourth likely unable to avoid a filing by summer’s end, California has become a hotbed of municipal bankruptcy activity.  Each case presents its own unique combination of economic hardships that have necessitated bankruptcy protection, and each may provide lessons for some of the 19,000 municipalities nationwide that currently share the same kinds of economic hardships as these California debtors.
California is no stranger to municipal bankruptcies, with 39 chapter 9 filings since the 1978 Bankruptcy Act was adopted.  In 2008, the City of Vallejo was forced to file for bankruptcy protection when a $17 million budget gap resulted from unfunded obligations to municipal employees and a substantial drop in the city’s revenues following the housing collapse.  At the time, Vallejo, with a population of 117,000, was the largest municipal filing in California’s history.  After the Vallejo bankruptcy, the state passed Assembly Bill 506, now codified at Cal. Gov’t Code § 53760, hoping to limit access to chapter 9 and reduce the length and expense of cases by first requiring a municipality to take efforts to avoid bankruptcy, in addition to those required under section 109(c)(5) of the Bankruptcy Code.  The law, enacted in October 2011, requires any California municipality contemplating a chapter 9 filing to engage in a formalized mediation or “neutral evaluation process” with creditors and an independent arbiter for 60-90 days before a petition may be filed. [See Weil Bankruptcy Blog entry, The Politics of Municipal Bankruptcy, by Debora Hoehne, Dec. 2, 2011].  If the health and safety of a municipality’s residents would be compromised by waiting 60-90 days, an “emergency off-ramp” mechanism is available, whereby a municipality may avoid the neutral evaluation process by voting to declare a fiscal emergency.
City of Stockton, California: Pop. 292,000
In February 2012, the City of Stockton, located 50 miles south of Sacramento, was seeking a solution to its chronic budgetary difficulties.  Although the city experienced a boom in the real estate sector and dramatic population (and revenue) growth in the early 2000’s, the city suffered immensely from the housing collapse and ensuing foreclosure crises of 2007-2008, resulting in a drop in revenues of 30% between the peak of 2006 and the nadir of 2010.  Additionally, like many cities across the nation, pension benefits, which already weighed heavily on the city’s budget, as well as cuts in municipal funding at the state level over the past few years, increased during the recession.
Given Stockton’s 20% unemployment rate, raising additional revenues through tax increases—which, under California law, require voter approval—was inconceivable, as was additional borrowing from public or private creditors. Thus, the City of Stockton was forced to balance the fiscal 2009-10 and 2010-11 budgets by cuts to employee compensation and benefits as well as city services, including police and fire departments, infrastructure maintenance, and community programs. These efforts reduced the city’s 2011-12 deficit by $90 million, but an additional $26 million shortfall remained.
Beginning in March 2012, the city began the neutral evaluation process with its largest creditors, hoping to forge some kind of resolution to avoid a bankruptcy filing.  With the 2011-12 fiscal year expiring on June 30, 2012, the city already had defaulted on payments to capital market creditors and delayed payments to retirees.  On June 26, the day after the mediation process finally ended without the city and its creditors reaching a workable solution, the city council voted to authorize a chapter 9 filing, and on June 28, the City of Stockton filed its voluntary petition in the United States Bankruptcy Court for the Eastern District of CaliforniaThe filing was the first municipal bankruptcy since the enactment of the neutral evaluation process law, and the effect, if any, of the months of prepetition negotiations on the outcome of the case will certainly be scrutinized by California lawmakers and bankruptcy professionals in the months and years to come. Subsequent to the filing, on July 10, a putative class of city retirees filed an adversary proceeding in the bankruptcy case over the city’s postpetition action of cutting premium payments for retiree health insurance.  Mediation over the suit is currently scheduled to begin on August 30.
Town of Mammoth Lakes, California: Pop. 8,200
The summer’s second California chapter 9, filed by the Town of Mammoth Lakes, a resort town to the east of the Sierra Nevada, resulted from a more unique set of circumstances than Stockton.  The city had been working with a real estate developer, Mammoth Lakes Land Acquisition (MLLA), on a hotel and condominium project at the Mammoth Yosemite Airport.  In 2006, the city informed MLLA that it would no longer proceed with the development, and MLLA filed an action for anticipatory breach of contract against the city.  In 2008, a jury awarded MLLA breach damages in the amount of $30 million, and a writ was entered in March 2012 mandating payment by June 30, 2012.
For the fiscal year 2011-12, the town originally faced a potentially manageable $2.8 million budget shortfall, but the court judgment, which by the spring of 2012 had ballooned to nearly $43 million, proved entirely too burdensome.  Multiple negotiations with MLLA over a workable structure for payment of the award had failed, and the town began to pursue a chapter 9 filing.  In April 2012, the town entered into the neutral evaluation process under A.B. 506, and was able to reach restructuring agreements with many of its creditors, freeing enough revenue to cover its operational deficits.  MLLA, however, who was, by far, the town’s largest creditor, did not participate in the process.
The Town of Mammoth Lakes voted in favor of a chapter 9 filing on July 2 and filed its voluntary petition on July 3 in the United States Bankruptcy Court for the Eastern District of California. Concurrently, it filed a plan for the adjustment of debts, based on the successful negotiations with most of its creditors during the A.B. 506 process.  A hearing regarding the disclosure statement and plan is scheduled for August 29.
City of San Bernadino, California: Pop. 210,000
In southern California’s Inland Empire, the City of San Bernadino’s fiscal woes have been festering for 16 years—though many in the city government were unaware of the fact.  The San Bernadino County Sheriff’s Department recently initiated an investigation into potential criminal falsification of city budget documents presented to the mayor and city council for 13 of the past 16 years.  The allegedly false documents presented an image of a city in sound fiscal health, while, in reality, large deficits continued to mount.  When the city’s actual debt was revealed earlier this year, the city was struck with the sudden prospect of a $45 million budget shortfall for the 2011-12 fiscal year. This financial left-hook came on top of 15% unemployment, a drop in revenue of 13% since 2008, and one of California’s worst foreclosure rates.
Although the city had worked to cut expenses over the past four years, including reduction of its workforce by 20%, the sudden revelation of the true size of the city’s debt, along with ongoing criminal investigations into members of the city government and no promise of economic recovery on the horizon, caused the city to vote to seek bankruptcy protection under chapter 9.  Rather than begin the A.B. 506 neutral evaluation process, the city took advantage of the “emergency off-ramp” exception in the law, voting on July 18 to declare a fiscal emergency and immunizing itself from the mediation requirement. The city plans to file its voluntary petition by August 10.
Interest in the bankruptcy case will certainly be piqued by the city’s innovative—if not controversial—plan to use eminent domain to seize over 20,000 underwater mortgages and replace them with modified mortgages set to the current value of the residents’ property.  The city’s plan, which is being fiercely challenged by Wall Street lobbying groups, would test the limits of the type of property eligible for seizure under eminent domain, but if successful, could provide a bold way for troubled municipalities to boost their citizens’ pocketbooks and generate some much-needed tax revenues.
City of Compton, California: Pop. 95,000
Finally, the City of Compton in Los Angeles County seems to be inexorably drifting towards a chapter 9 filing within the next month.  Accusations of “waste, fraud, and abuse” resulted in the appointment of an auditor to evaluate the city’s finances.  The auditor, however, abruptly ceased its investigation in June, due to an alleged lack of cooperation that precluded it from obtaining an accurate accounting of the city’s finances. On August 1, the city will face a $42 million budget gap and will have to decide whether bankruptcy is the solution.  It is unknown whether the city will soon begin the A.B. 506 process, declare a fiscal emergency to allow for an immediate chapter 9 filing, or determine that it can dodge the bankruptcy bullet altogether.
A recently released report by the non-partisan State Budget Crisis Task Force, led by former New York Lt. Gov. Richard Ravitch and former Federal Reserve Chairman Paul Volker, has determined that rapidly growing Medicaid programs, underfunded pension plans, cuts in federal support, and depressed tax revenue are contributing to massive budget gaps for municipalities in California, Illinois, New Jersey, New York, Texas, and Virginia.  Underscoring the severity of the problem for the national economy, the report further notes that “state and local governments spend $2.5 trillion annually and employ over 19 million workers—15 percent of the national total.”  While the above four California municipalities may represent unique circumstances of cities disproportionately affected by the foreclosure crisis, a crippling jury award, criminal malfeasance, or excessive “waste, fraud, and abuse,” they may also be a barometer of the financial pain that many municipalities across the nation continue to face.  Whether as a harbinger of things to come or a simple coincidence of badly mismanaged local finances, the Summer California Went Bankrupt will certainly stick out in the annals of chapter 9. Stay tuned as we report more tomorrow on what is turning out to be one of the “hottest” sections of the Bankruptcy Code this summer, section 109(c).