A California city on the brink of seeking federal bankruptcy protection has become a national bellwether for financially shaky local governments considering the pitfalls of filing Chapter 9 municipal bankruptcy.
Lawyers advising local governments around the country are watching Vallejo to see how long the city stays in bankruptcy, how it emerges, whether the judge allows the city to renegotiate contracts with unions and bondholders, whether it sells city assets and who buys them, said Sajan George, a municipal restructuring specialist in consultancy Alvarez & Marsal’s Atlanta office.
Though Chapter 9 remains rare – there have been little more than 200 nationwide in the past 25 years – more financially squeezed municipalities may seek it as property tax and sales tax revenues drop and employee pension and health costs soar, according to bankruptcy experts.
Chapter 9 was created in 1933 to provide some protection for cities, counties, townships and a variety of special districts from creditors and bondholders.
“We’re getting a lot of concern and interest,” said Shayne Kavanagh, senior researcher with the Government Finance Officers Association in Washington. Long-term financial stability tops the list of Web site inquiries, and GFOA’s bookings to speak to local state groups have sharply increased, Kavanagh said.
Vallejo may be on the razor’s edge, but it is not alone. San Diego, the nation’s eighth largest city, has been on the brink of a financial abyss for several years. In April, the U.S. Securities and Exchange Commission charged five former San Diego officials with securities fraud for allegedly concealing from the bond market that the city had not set enough aside to cover pension and retiree health care obligations. SEC v. Uberuaga, C08-621DMS. The SEC alleges officials knew, but didn’t disclose, that the city’s unfunded liability would expand from $284 million in 2002 to $2 billion by 2009.
Jefferson County, Ala., faces dire financial straits after it amassed $3.2 billion in sewer debt in a failed effort to save on interest payments by engaging in risky derivatives investments. The debt dwarfs one of the most notorious municipal bankruptcies, the 1994 default by Orange County, which lost $1.6 billion in its investment pool after failed derivatives investments.
“Chapter 9 is very little used – there have only been a handful since Orange County – but it is being watched more significantly by numbers of municipalities in California and around the country facing severe financial pressure by the recession and housing crisis,” said George. He worked on the Orange County case.
The confluence of external pressures have created a “perfect storm” today for many local governments, according to Van Durrer II, who coordinates the West Coast restructuring practice in the Los Angeles office of New York’s Skadden, Arps, Slate, Meagher & Flom.
He too is hearing from more troubled municipalities, though total numbers remain small. “Before it was a ZIP code or a small town, now it is a set of ZIP codes and towns whose names people would recognize,” he said.
The squeeze comes from several factors, including pensions suffering due to the market downturn and tight capital markets that make raising money tough, Durrer noted. San Diego in particular has two problems magnifying its difficulties, both the employee pension expense and the dire need to overhaul an aging water and sewer system, he said.
Vallejo, a once prosperous city of 117,000 on the northern rim of San Francisco Bay, has found that its police, fire and staffing costs outstrip its ability to pay. The city projects its $80 million annual budget will be $16 million short next year, even with staff and service cuts it has already imposed.
On May 6, the city council, faced with coffers running dry on June 30, unanimously approved filing for Chapter 9 protection. The filing is expected any day, according to city spokeswoman JoAnn West.
Alabama’s Jefferson County, which is home to Birmingham, began considering Chapter 9 after its dubious debt policy ran into the collapse of bond insurers.
Pamela A. MacLean is a reporter for The National Law Journal, a Recorder affiliate based in New York.
