Karol Denniston

LOS ANGELES — The road out of bankruptcy has been long and full of obstacles, but if Stockton, Calif. can get through one more roadblock, it'll be in the home stretch.

That roadblock is the Central Valley city's last major creditor, Franklin Advisers Inc., with which it is still fighting over about $35 million of the city's lease revenue bonds.

If a deal is not reached with Franklin, the creditor is likely to raise objections to the plan of adjustment, which the city will have to address during its confirmation hearing.

The hearing, set for March 5, is the last step in the Chapter 9 bankruptcy process, during which U.S. Bankruptcy Judge Christopher Klein will either approve or deny the city's plan of adjustment.

"The major hurdle here is Franklin's intended objection and their ability to execute on that objection," said Karol Denniston, a bankruptcy partner at Schiff Hardin LLP. "I think that's going to force Stockton — unless something shifts dramatically — into a contested confirmation hearing, and we can expect to see as they move through that process that there will need to be some time spent on discovery."

Franklin, together with Franklin High Yield Tax-Free Income and Franklin California High Yield Municipal Fund, owns bonds that would recover less than 20 cents on the dollar under Stockton's plan of adjustment.

Denniston said Franklin could object to the feasibility of the city's plan, arguing that, without impairing pension benefits, Stockton does not have sufficient cash flow to perform under the plan during a reasonable time period.

Franklin could also assert that the plan is not "fair and equitable," meaning that, as a general unsecured creditor, they are not getting the same treatment as another creditor — the California Public Employees' Retirement System.

The city's obligations to CalPERS are unimpaired under its adjustment plan, which Stockton proposed in September. The plan does, however, impair the retiree health benefits. Claimants will be paid a portion of their claims equal to the unsecured claim payout percentage of 0.94796%.

"I think these objections are real and viable, but it's hard to predict what the court's going to decide because the evidence isn't in," Denniston said. "We have to see the objections, how they're developed and what evidence gets flushed out during the process."

James Spiotto, a bankruptcy partner at Chapman and Cutler LLP, also said it will depend on the objections and their merits.

"In bankruptcy court and especially in Chapter 9 bankruptcy, many times even with or without objections, things get resolved," he said. "So hopefully they will find a way to a solution and get everybody on board."

Klein set the trial date during a hearing on Monday when he approved the city's disclosure statement — a document that elaborates on the terms laid out in the city's plan of adjustment.

"Approval of the disclosure statement was an important step, because if it had not been approved, the city's exit from chapter 9 would be delayed," said Marc Levinson, Stockton's bankruptcy attorney and a partner at Orrick, Herrington & Sutcliffe LLP. "The approval means that the city can seek the vote of creditors on the proposed plan of adjustment."

The next step is for Stockton to send its plan of adjustment to those creditors who are entitled to vote on it. The plan of adjustment, disclosure statement, ballots and related documents must be transmitted to creditors no later than Dec. 13. The completed ballots must be returned on or before Feb. 10 in order to be counted.

"Creditor approval is important because the more creditors that accept the plan, the fewer confirmation battles the city will have to fight," Levinson said.

If a class of creditors does not vote to approve the plan in February, Stockton will move for a "cram-down," which means it will have to show that its plan meets a fair and equitable standard and treats all similar classes of claims alike, with no class receiving property or remuneration before another creditor senior to it does.

Even if there is no cram-down, a creditor still has the right to raise an objection in court.

But if the plan is approved during the creditor vote, and then also approved by the judge, Stockton will have the green light to exit bankruptcy, which would occur on an "effective date." Levinson expects that this could happen sometime during the second quarter of next year.

"If all goes well at the confirmation hearing, the bankruptcy court will confirm the plan sometime in March," he said. "If we have to fight, and as of now we are fighting with Franklin, confirmation may take longer."

Levinson remains optimistic about the outcome of the confirmation hearing, particularly because Stockton has made deals with all but one of its major creditors.

The city negotiated with 18 sets of creditors and bondholders before releasing its plan of adjustment. Those included its employee unions as well as other debt stakeholders Dexia Credit Local, Union Bank, and the U.S. Department of Housing and Urban Development.

Stockton also reached a deal with Assured Guaranty to restructure over $155 million of insured bonds, including a plan to pay off more than $120 million of unsecured pension obligation bonds over a longer period of time.

Under an agreement with National Public Finance Guarantee, the city agreed to resume lease payments on $45.1 million of insured obligations for the city's sports arena, and $43.7 million of debt secured by parking garages. Stockton also made a deal with Ambac Assurance earlier in February.

Stockton's bankruptcy exit plan also includes additional revenue from a sales tax increase that was approved in a referendum on Nov. 5. A sales tax increase of three quarters of a cent will go into effect on Jan. 1, which will help the city to restore its finances.

Moody's Investors Service recently said the vote is a credit positive for Stockton because the additional revenue — estimated to be $296 million over ten years — increases the likelihood that its reorganization plan will be approved by the bankruptcy court.

If the plan is denied in March — whether it's because the judge says the plan is not feasible or because a creditor successfully contests the plan — Stockton will have to modify its plan of adjustment and go through the whole process again, including getting a disclosure statement approved, having a creditor vote, and having another confirmation hearing.

If the plan is approved, then Stockton will implement its plan, adhering to its agreements, paying claims, and meeting all of the conditions under its plan, and officially emerge from bankruptcy.

But it doesn't end there.

"The debt adjustment plan is just a step toward sustainability and affordability," Spiotto said. "There needs to be a recovery plan so that the city will be sustainable and affordable, and that it has the infrastructure and essential services at an acceptable level that will attract business, or grow business."

Sustainability is important, he said, because a city shouldn't have to find itself going through the bankruptcy process again, especially in the near-term.

A lot will depend on the economy and, in particular, housing prices. One of the main reasons for Stockton's financial woes was the housing downturn when prices dropped and kept property tax revenues low.

After struggling to recover from the downturn, and after years of fiscal emergencies, Stockton declared bankruptcy in June 2012. The city received eligibility approval in April 1 and proposed its exit plan on September 27.

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