SAN FRANCISCO — San Bernardino, Calif.’s decision this week to authorize a bankruptcy filing, which would make it the third California city to do so in less than a month, has shaken the municipal market and set up a likely showdown with bondholders.
The City Council Tuesday night during a special meeting voted 4 to 2 with one abstention in favor of filing for Chapter 9 protection in U.S. Bankruptcy Court because it said it would otherwise be unable to pay its workers.
The move came as a surprise to the municipal market as city officials have only in the last few days been quoted as using the word “bankruptcy.”
“I think what caught people off guard was that the decision happened so quickly,” said Howard Cure, head of muni research at Evercore Wealth Management. “People are starting to get concerned about California cities.”
Elsewhere in California, both Stockton and Mammoth Lakes have filed for Chapter 9 bankruptcy since late June, though both municipalites had telegraphed the likelihood of a filing months in advance.
San Bernardino city attorney James Penman said during Tuesday’s meeting that the city’s finances had been misstated going back 16 years. “Restricted funds were borrowed without council knowledge to supplement the general fund to keep the city going,” he said.
It’s unclear when the city actually intends to file. That likely sets up a serious blowback from bondholders.
“Creditors are going to have to challenge eligibility because they are not going to know what the financials are,” said Karol Denniston, an attorney with Schiff Hardin. “If you are a bondholder in San Bernardino or anywhere else and you don’t know what is going on and someone tells you they have 16 years of bad numbers, you are not in a position to negotiate.”
She said the lack of financial disclosure will also raise questions about whether the city may have misled investors when they issued debt and will likely lead bond trustees to evaluate whether defaults have occurred.
According to San Bernardino’s 2010 audited financial report, its most recent, the city said it had $223 million of outstanding debt at the end of June 2010, of which $131 million were tax allocation bonds.
The statement said the city also had $48 million of pension obligation bonds, $12.5 million of revenue bonds and $31 million of certificates of participation.
San Bernardino officials did not return calls for comment by the time this story was filed for publication.
Standard & Poor's on Wednesday downgraded its rating on San Bernardino's 1997 lease revenue refunding bonds, issued through the San Bernardino Joint Powers Financing Authority, 12 notches to CC from BBB-plus because of the council's action.
Some of the debt is insured. National Public Finance Guarantee Corp. said it is exposed to a San Bernardino bankruptcy through $33 million of insured debt.
NPFG said $18.4 million of it is insured debt tied to the general fund through lease revenues issued through the city’s joint powers financing authority, which are backed by lease payments made by the city for use of its central police station and jail.
Assured Guaranty, Ambac Assurance and Radian also have insured San Bernardino debt, according to Thomson Reuters data.
U.S. Bank and Wells Fargo are listed as trustees for some of the debt issued by the city and its agencies. Neither could comment by the time of publication on their relationship as trustee with the city.
San Bernardino, a city of more than 211,000 located 65 miles from Los Angeles, faces a $45 million deficit for fiscal 2013 after declaring fiscal emergencies for several years amid a steep decline in tax revenues due to the recession, according to a staff report prepared for the City Council Tuesday.
Interim city manager Andrea Miller and recently hired finance director Jason Simpson said in the report that San Bernardino is facing insolvency because of accounting errors, deficit spending, lack of revenue growth, and increases in pension and debt costs.
Penman said during the meeting the city would violate state law if it could not pay its employees by Aug. 15 and would face a “mass exodus.”
It is also unclear whether San Bernardino is able to file for bankruptcy without going through the state mandated mediation process created under the recently enacted Assembly Bill 506. Both Stockton and Mammoth Lakes participated in AB 506 mediation before filing for Chapter 9 protection.
The city has declared fiscal emergencies, and AB 506 does include language allowing cities to go directly to bankruptcy if a fiscal emergency is declared.
In a staff report on the city’s budget problems, city staff said the AB 506 mediation process was a possibility.
The city has reportedly hired Paul Glassman of Stradling Yocca Carlson & Rauth as its bankruptcy attorney.
Stradling Yocca along with financial advisor Urban Futures advised the city on its finances before it decided to declare bankruptcy.
The next question is if or when the next domino will fall, as observers note that San Bernardino’s problems are not uncommon in many parts of the state.
“I think if the stigma is gone about so quickly going into bankruptcy and the real estate market doesn’t rebound, there is not much a city can do,” Cure said.