SAN FRANCISCO — The California State Controller's Office has filed a motion in the Vallejo, Calif., bankruptcy case, saying state intercept funds should be used to protect debt owners.

The motion filed by the Attorney General's Office on behalf of Controller John Chiang asks for the U.S. Bankruptcy Court for the Eastern District of California to allow it to intervene in the case to help protect a state program that uses fees to support credit.

National Public Finance Guarantee has filed a lawsuit related to the bankruptcy case, claiming Vallejo is not entitled to divert intercept fees from a state credit-enhancement program. The bond insurer asks that funds from a state aid intercept program be diverted from the city to owners of NPFG-insured certificates of participation.

"The Intercept Act is designed to provide municipal debt holders with an independent payment source and to provide greater assurance that the debt will be timely and fully paid regardless of the financial circumstances of the municipality," said the controller's motion, filed at the end of November.

"The state controller has a compelling interest in implementing the Intercept Act as intended," it said.

The hearing on the motion, originally scheduled for Jan. 10, has been pushed to Jan. 18 in order to give Vallejo and NPFG more time to reach a settlement, said the city's bankruptcy lawyer, Marc Levinson, a partner at Orrick, Herrington & Sutcliffe LLP.

Vallejo has taken the position that the intercept mechanism is unenforceable given its Chapter 9 bankruptcy filing, and the revenues should continue flowing to the city even though it has defaulted on its debt-service payments.

The intercept program cited in the motion — the vehicle licensing fee enhancement program — secures some bonds issued by municipalities. Revenues secured by the intercept pledge can be diverted from a bond issuer like Vallejo and sent directly to a bond trustee for debt-service payments.

The controller's office distributes millions of dollars of motor vehicle license fees collected by the state, the motion said.

The National Federation of Municipal Analysts has filed a brief in the Vallejo case in support of NPFG.

The NFMA said denial of the insurer's motion would have a potentially devastating effect on access to capital for cities, towns, counties, school districts, and other municipalities in California, as well as across the country.

The federation claims that 34 similar intercept programs in 24 states, supporting billions of dollars of debt issued by municipalities, are potentially at risk of significant downgrades if the motion from NPFG is rejected.

The city's bankruptcy lawyers have described the NFMA claim as "utterly speculative" and said there was no evidence a denial would devastate California's municipal credit markets.

Vallejo, which has a population of 120,000, filed for bankruptcy in 2008 in response to what it said were unsustainable labor contracts and dwindling tax collections. That move represents the largest municipal bankruptcy in the state since Orange County filed in 1994.

The bankruptcy filing affected $53 million of debt backed by the city's general fund, including COPs sold in 1999. The deal carried insurance and a debt-service reserve surety bond from MBIA Insurance Corp., now carried by its subsidiary, NPFG.

Union Bank of California, which provided the letter of credit on Vallejo's defaulted debt, is owed more than $20 million from general fund obligations and around $50 million by the city, while insurer NPFG is owed about $5 million.

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