The status of a bankruptcy filing of compelling interest to the municipal finance and legal industries will be in the hands of a federal judge in Harrisburg, Pa., this week.

On Wednesday, Mary France of the U.S. Bankruptcy Court for the Middle District of Pennsylvania will hear arguments on the validity of the Chapter 9 filing by the City Council of Pennsylvania’s capital city — a move that a majority of City Council members favor, but the mayor, governor and major creditors oppose.

Harrisburg is saddled with at least $310 million in debt due to cost overruns on an incinerator retrofit project.

This politically gridlocked city of 49,000 has three times rejected a state-supported workout plan, prompting the state legislature to enact a takeover law in September aimed at Harrisburg. Gov. Tom Corbett Friday named David Unkovic, chief counsel for the Department of Community and Economic Development, as his choice of receiver for the city, an appointment that requires approval from the Commonwealth Court. The City Council’s lawyer maintains that the bankruptcy filing, if upheld, would effectively negate the state takeover.

The muni world will scrutinize what happens in France’s court. Bond insurer Assured Guaranty Municipal Corp. has been making payments the city and surrounding Dauphin County had guaranteed, and the city has missed about $60 million in payments on the bonds, according to bankruptcy documents. Harrisburg’s attempt to use Chapter 9, the Bankruptcy Code provision for municipalities, will draw a legal glare, as will France’s handling of it.

But this case also has riveting storylines well beyond bond and legal spheres. The conflicts include mayor versus council, city versus county, city versus state, Democrat versus Republican, and Wall Street versus Main Street.

Harrisburg’s plight has also raised questions about the use of debt to underwrite questionable enterprise projects and issues about municipal sovereignty. Racial overtones also surfaced. One council member last summer said Republican suburban lawmakers put a bull’s-eye on Harrisburg because its mayor and five of its seven councilors — all Democrats — are African-American.

“Convoluted best describes the Harrisburg situation,” said St. John’s University business professor Anthony Sabino.

In 2003, Harrisburg and the county backstopped a $125 million loan to modernize the incinerator on nondescript South 19th Street four miles southeast of downtown after the federal government closed it, citing clean-air violations.

City officials expected revenue from neighboring cities and towns paying to use the incinerator would essentially pay for the project. But that didn’t materialize and costs escalated.

“In the case of Harrisburg, the city decided to guarantee the project financing, presumably with the view that the guarantee would never be called,” Natalie Cohen, a Wells Fargo Securities senior analyst, wrote in a municipal commentary.

The city’s debt could soar to nearly $500 million. The Harrisburg Authority, the public works agency that runs the incinerator, acknowledged last week that it may need a further $70 million, unrelated to the incinerator, to comply with federal wastewater treatment mandates.

“The good thing is that most of the previous borrowings are paid off,” said interim executive director Shannon Williams.

Separately, city Controller Dan Miller said last month that in about five years the city is likely to be responsible for repaying another $95 million for two series of city-guaranteed capital-appreciation bonds that its redevelopment authority issued in 1998. The bonds begin to mature in 2017, according to official statements.

The key conflict Wednesday will be city versus state: will the bankruptcy court side with the city’s claims that it can file Chapter 9, or defer to the state government’s procedures for handling local financial problems?

Three times Harrisburg’s council has rejected, by 4-to-3 votes, a workout plan under Pennsylvania’s Act 47 program for distressed communities. Mayor Linda Thompson’s political opponents voted in the majority. The four — as well as Miller, who plans to challenge Thompson for the mayor’s office in 2013 — favor the bankruptcy filing and see the state takeover as helping bondholders at the expense of city needs.

Thompson, who as councilwoman voted for the original loan, was elected mayor in 2009, ousting 28-year incumbent Stephen Reed, whom voters blamed for the incinerator fiasco and other debt-laden projects. They included a Wild West museum that never materialized and the city’s mid-1990s purchase of the Harrisburg Senators minor league baseball team, which it no longer owns.

On Wednesday, all roads will lead to France’s court on Walnut Street in Harrisburg.

Chapter 9 has relatively little legal precedent, which intrigues legal observers. It is “the stealth chapter of the Bankruptcy Code,” according to Sabino. “Chapter 9 is such a bland provision, but there are so many politically charged questions. Harrisburg is a wonderful example, for better or worse — some would say worse.”

Whether a state-appointed receiver or the federal bankruptcy court determines Harrisburg’s financial future, the city will be better off in other hands, according to David Fiorenza, the former chief financial officer of Radnor Township, Pa.

“I think the federal judge will rule that the state has lots of experience with lots of municipalities. I think the state will be able to obtain a debt restructuring and see if it can get the city a refinancing for the bonds, with historically low rates in place,” said Fiorenza, a professor at the Villanova School of Business.

“The state can also put some operational mechanisms in play and make some forecasting that will benefit Harrisburg in the long run,” he said.

What kind of receivership Unkovic has in store for Harrisburg is anyone’s guess, Fiorenza added. “What I see with Corbett, and I don’t say this as a negative, is that he plays his prosecutor’s role a bit,” he said of the Republican governor, a former state attorney general. “The governor plays everything close to the vest. He doesn’t let out much.”

Bill Brandt, the president and chief executive of consulting firm Development Specialists Inc. and chairman of the Illinois Finance Authority, sees Harrisburg as Exhibit A in the perils of enterprise risk, or what he calls “event-driven” financial decision making.

“It’s usually a bad idea gone really bad. As Harry Reasoner once said, if you’ve got a get-rich-quick deal and you’ve already heard about it, then you’re too late,” Brandt said, referring to the late television journalist.

“A good bond deal should be sufficient to stand alone. Don’t try to sweeten the frosting by adding layers of credit enhancement,” Brandt said, citing the city’s original guarantee. “When I look at Harrisburg, I see risk failure.”

Mark Schwartz, the Bryn Mawr, Pa., lawyer representing the City Council, called a new state law restricting the bankruptcy filing illegal. He said Harrisburg enrolled in Act 47 last December with bankruptcy as an option, only for the state to “change the rules in the middle of the game.”

Schwartz favors a 1% city sales tax as part of any workout and wants to make bondholders whole. He said major creditors, which include Assured Guaranty, Covanta Energy Corp. and Ambac Financial Corp., should not have agreed to the deal in the first place.

He also asked the Internal Revenue Service and the Securities and Exchange Commission to investigate the bond deal, and recommended initiating a “clawback” of money paid during the incinerator retrofit.

“What did they know and what did they not know? These guys made big bucks,” Schwartz said.

“Wall Street can sell any piece of garbage, which brought us to where we are today. The prevailing attitude has been, 'Give us enough juice for a broker, and we’ll sell it,’ ” he said.

Assured Guaranty earlier this month rejected a request by the city to forgive $100 million worth of debt. And last week, Covanta, which issued a loan to the city to finish the incinerator project, blamed “the financial mismanagement of the city and the Harrisburg Authority” in a memo to employees from Paul Gilman, the company’s chief sustainability officer.

The original engineering firm on the incinerator refit, Barlow Projects Inc. of Fort Collins, Colo., filed for bankruptcy in 2007.

“The current situation in Harrisburg remains very uncertain and any potential outcome is unclear at this time. We will be supportive of any outcome or plan that is good for the city and good for our company,” said Gilman, who released the memo to the media.

Ambac is the insurer for Harrisburg’s general obligation bonds, on which the city is current with payments. Harrisburg avoided a GO default in September by raising money through a 10-year lease extension with the parking authority, which sold taxable debt at a 10.75% coupon to make the up-front lease payment to the city.

Brandt said Pennsylvania fears the domino effect of Chapter 9 filings, should France uphold Harrisburg’s request.

“If I’m Pennsylvania, I don’t want to let it happen because a line will form outside the door. The state would lose control. If they let it fly and it happens 'just this once,’ it won’t be just this once,” he said.

France will operate in her home court, where she is chief judge. Theodore McKee, chief judge for the U.S. Court of Appeals for the Third Circuit, appointed her.

“She is a real smart lady. She has the right skills fit to do this, and the temperament as well,” Brandt said.

“The chief judge could have assigned the case to any judge, from Pennsylvania, New Jersey, Delaware. … That he chose Judge France shows a lot of faith in her ability because this is a big Chapter 9 case,” said Juliet Moringiello, a professor at Widener University’s law school in Harrisburg.

France has appeared at Moringiello’s classes, often performing roleplaying legal exercises with students.

“I have read a lot of her written opinions and they strike me as well thought out,” she said. “This is a big case over whether Harrisburg has the authority to file for bankruptcy under state law and who can act on behalf of the city. There are a few issues to be settled and she will consider everything carefully.”

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