SAN FRANCISCO - Experts say Vallejo, Calif.'s decision to file for bankruptcy protection will result in long, hard negotiations between the city and its creditors - including bondholders.
And the market should pay close attention because the U.S. will probably see more municipal bankruptcies in the years ahead, as local governments deal with the mountain of pension and retiree health care benefits they've promised but never funded.
City officials said Tuesday night that they planned to file for Chapter 9 bankruptcy protection sometime next week.
No one knows right now how the bankruptcy court would treat owners of Vallejo's roughly $200 million of debt. But it is in the city's long-term interest to try and avoid defaulting on its bonds, according to one expert.
"If you want to successfully come out of bankruptcy, you have to pay your bondholders," said James Spiotto, a lawyer at Chapman & Cutler LLP in Chicago. He's worked on municipal bankruptcies and the Washington Public Power Supply System's landmark 1983 bond default. "You need municipal debt to function as a governmental body."
Spiotto and other bankruptcy lawyers say they can't predict the precise outcome of the Vallejo case because municipal bankruptcy is so uncommon that there is limited precedent to guide the judge and lawyers in the case. Municipal bankruptcies are further complicated by the Constitution's protections of states' rights, which takes away many of the powers a bankruptcy court has in a corporate or personal bankruptcy.
"The municipality has more cards in its hands than the creditors, as compared to a regular Chapter 11 [corporate] proceeding," said Paul Glassman, a lawyer with Greenberg Traurig LLP in Los Angeles. "A city can't be forced to liquidate. You can't sell off City Hall."
The biggest municipal bankruptcy case ever was filed in 1994 in Southern California's Orange County. Glassman, who represented Orange County cities for five and a half years during the case, said municipal bankruptcies differ from the more common Chapter 11 corporate bankruptcies in several other key respects.
The court can't appoint an independent trustee to take over Vallejo's business affairs. The City Council will remain in charge at City Hall. Though creditors have a right to negotiate, they can't propose a plan of reorganization to the court.
What bankruptcy offers is a court-supervised forum for renegotiating the city's obligations. Since 1937 there have been 557 municipal bankruptcies - not including Vallejo - most in small special districts, Spiotto said.
"It costs. It is a dangerous and risky solution," said John Moorlach, president of the Orange County Board of Supervisors, who was appointed treasurer of the county after its filing. "The world hasn't forgotten about it."
Vallejo is the biggest California city to declare bankruptcy. But its financial problems differ from Orange County's, which resulted from ill-fated investments. Vallejo is trying to get out of labor contracts that it agreed to but now says it cannot afford. Lawyers for the working-class city 30 miles northeast of San Francisco said it would seek to do as little harm as possible to bondholders during the process. But they may not have control over how the court decides to handle the outstanding debt.
Officials in Vallejo are fully aware that bankruptcy will mean continued negotiations with the labor unions. At times, they sound as though they are simply trying to raise the pressure on the policemen and firefighters to whom they promised 21% pay raises over three years of relatively flat revenue growth.
"We can pull the plug on bankruptcy at any time," said Councilwoman Joanne Schivley at the council's Tuesday night meeting. "This isn't a life sentence."
The problem for bondholders is that bankruptcy experts disagree over whether a bankrupt city can pick and choose whom it wants to pay. Governments usually want to pay bondholders so that they can maintain access to the municipal market in the future, but public employee unions are not going to want to go to the back of the line for payments.
"There's some question as to whether payments can be made voluntarily or not" to unsecured creditors like bondholders, according to Glassman. "It's an issue of some controversy."
The city's bankruptcy lawyers and bankruptcy lawyers who aren't involved in the Vallejo case agreed that bondholders with liens on specific revenue streams should be safe.
Vallejo has just over $200 million of bonds and certificates of participation outstanding. The city's general fund-supported debt is unrated.
Standard & Poor's this week downgraded two city bond issues with dedicated revenue streams over uncertainty about the sanctity of the dedicated revenue streams. The agency downgraded the Vallejo Public Financing Authority's Vallejo-Glen Cove Community Assessment District revenue bonds to B from A-minus and cut COPs issued in 1999 and secured by Vallejo's share of California motor vehicle license fees to B from A.
Investors in secondary market trading yesterday appeared to be reacting to the planned bankruptcy. Vallejo water revenue refunding bonds maturing in May 2012 and insured by MBIA Insurance Corp. with a 5% coupon traded as low as 96.21, yielding 6.09%, according to the Securities Industry and Financial Markets Association's Web site InvestinginBonds.com. That's down from a price of 106.79 with a 3.2% yield a week ago.
Standard & Poor's analyst Gabe Petek said he doesn't think Vallejo's bankruptcy is a sign of things to come, saying most of the local governments the agency rates are nowhere near the condition of Vallejo.
Moody's Investors Service, which does not rate Vallejo debt, issued a special comment this week saying Vallejo appears to be a "unique case" among California cities.
"While fiscal challenges are on the horizon for all California municipalities, they are not of the same magnitude, or even necessarily of the same cause, as those experienced by the state and the city of Vallejo," according to Moody's.
Others disagreed, saying Vallejo's filing could signal something new and different because it's a direct effort to get out of the city's obligations to labor. Most other municipal bankruptcies have been the result of one-time events like lawsuits or Orange County's bad bets in the derivatives market.
If Vallejo teaches other governments that they can escape labor obligations, such as unfunded pension and retiree health care benefits liabilities, it could be a sign of things to come, Spiotto said.
"This is the tip of the iceberg," said Orange County's Moorlach, using the same phrase Spiotto used to describe the situation.
"If you can actually undo employee bargaining unit agreements that enhance pension benefits, that might be a great strategy, but if it doesn't work, you've spent a boatload of money to drive your car into a cul-de-sac," Moorlach said. "Everybody's going to line up to file for Chapter 9 in California."
Moorlach said Orange County won't be heading that way again. He said the county negotiated a deal to cut its unfunded employee health care benefits to $400 million from $1.4 billion.