SAN FRANCISCO — Ambac Assurance Corp. has filed a lawsuit against Hercules, Calif., after the city’s redevelopment agency defaulted Wednesday on a debt service payment. The city said the suit could tip it into bankruptcy.

The agency failed to make a $2.4 million debt service payment on Wednesday using its tax revenues, and instead used the insurer’s surety reserve to do so.

The move prompted Standard & Poor’s to downgrade the underlying rating on the tax allocation bonds further into junk — to CC from CCC — in a report released Thursday.

Ambac alleges in the lawsuit, filed Monday in Contra Costa County Superior Court, that the redevelopment agency illegally transferred tax money to the city instead of using it to pay bondholders.

The city said it had loaned the money to the RDA for earlier debt service payments and the most recent tax revenues were used to pay the city back.

Hercules said in a disclosure filing for bondholders that if it loses the lawsuit, it may be forced to file for Chapter 9 bankruptcy.

“Since the cessation of city operations, including public safety operations, would be unacceptable and dangerous to the public health safety and welfare, the city and agency might be left with no choice but to seek to file a petition under Chapter 9 of the bankruptcy code,” said the filing by the city’s interim finance director and RDA treasurer, David Baum, on the Municipal Securities Rulemaking Board’s EMMA website.

Standard & Poor’s said in its downgrade report that it expects Hercules will continue to lack the necessary tax revenue to cover its redevelopment debt service, and the insurer’s reserve funds could run out in less than two years.

Hercules, which has a population of 26,000, sits on the northeast shore of San Francisco Bay, a few miles south of Vallejo, which itself exited bankruptcy earlier this month.

On Tuesday, Ambac filed a preliminary injunction to freeze $4.1 million of city funds, which it claims is the amount of tax revenue owed to the trustee, or in lieu a claim on city property for the amount. The court denied the insurer’s requests and set a hearing for Feb. 12 on the injunction.

Ambac has issued surety bonds and insured $56.2 million of tax allocation bonds issued by the city’s RDA in 2005 and $60.5 million of tax allocation bonds issued in 2007.

The issue is complicated by recent legislation that forced California redevelopment agencies to cease operations Wednesday. It also could be a harbinger of what could happen with other cities and counties in the state because of loans and transfers with their redevelopment agencies.

Obligations between cities and their RDAs, such as loans or transfers, made since the beginning of last year could be voided because of the legislation.

Contracts between redevelopment agencies and third parties, such as bondholders, are expected to be protected during the process of transferring the responsibility for obligations.

The lawsuit is just the latest in a long string of legal troubles related to the city’s finances.

In August, state Controller John Chiang ordered an investigation into the city, saying his office found major problems with the city’s finances. The investigation is still ongoing.

Earlier in 2011, the Contra Costa County grand jury said in a report that the city has used bond funding to make up a $6.6 million deficit. In 2010, the same grand jury described the appearance of impropriety and-or lack of transparency in the city housing and business loan program.

In April, Hercules hired the Municipal Resource Group to review its finances. The consultant found that the city’s RDA was basically insolvent and unable to make debt service payments without help from the city’s general fund.

The redevelopment agency and the Hercules Public Financing Authority have more than $162 million of outstanding debt. That does not include debt associated with assessment districts, the report said.

The consultant report said the RDA’s assessed valuations and tax-increment revenues have fallen by 25% over the past three years.

The financial troubles have also coincided with political problems.

In June, Hercules residents voted to remove the police major and a City Council member from office following a recall drive by residents in a controversy over the budget and their dealings with the former city manager.

While that city manager, Nelson Oliva, was out on sick leave,  interim city manager Charlie Long uncovered Hercules’ dire financial situation, made structural changes and hired a new finance director.

Then the City Council fired Long and put Oliva back in his position until he retired.

The city’s police chief temporarily took over the position until an interim city manger was hired and then replaced in October by Steve Duran.

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