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Stockton ruling seen key to U.S. cities' bankruptcy options

Shuttered and padlocked businesses line Main Street in Stockton, California June 27, 2012. REUTERS/Kevin Bartram
Shuttered and padlocked businesses line Main Street in Stockton, California June 27, 2012. REUTERS/Kevin Bartram

By Jim Christie

SAN FRANCISCO (Reuters) - A federal judge on Monday is expected to rule on whether the city of Stockton, California is eligible for bankruptcy protection, a key milestone in a case likely to set critical precedents for cash-strapped U.S. cities, their employees and their bondholders.

The decision follows a three-day trial last week in which the city argued it had no choice but to file for bankruptcy after the financial meltdown devastated local tax revenues and harsh budget cuts still left the city with a $26 million shortfall.

Municipal bankruptcies have historically been rare, but troubled American cities increasingly see it as an option as they struggle with big debt loads, shrinking tax bases and massive pension and healthcare obligations. The California city of San Bernardino has also filed for bankruptcy, and some expect the city of Detroit, Michigan eventually to surpass Stockton as the biggest U.S. city to file for bankruptcy.

In the Stockton case, attorneys for bond insurers, who could potentially be forced to absorb major losses in a bankruptcy, argued the city could have done more to cut costs and raise revenues. The bondholders, who are not being paid in full under the city's interim operating plan, have also argued that pension payments made to the California Public Employees Retirement System (Calpers) should be slashed.

Bankruptcy experts expect U.S. Bankruptcy Judge Christopher Klein to find the city eligible for bankruptcy.

Michael Sweet, a lawyer at Fox Rothschild who helps local governments on bankruptcy issues but is not directly involved in the Stockton case, said the city had proven even before last week's trial that it was truly broke when it filed for bankruptcy protection last June. A municipality must be insolvent to be eligible.

"It will be hard for the judge to conclude that they weren't insolvent," Sweet said.

Stockton, a city of 300,000 residents in California's Central Valley, aims to use the Chapter 9 bankruptcy process to right the city's finances with a number of drastic measures. The city has already defaulted on some debt and allowed creditors to seize the assets - including a parking garage and a city building - and has cut payments to other municipal bondholders.

The city slashed the police department by 25% and cut other departments even more before it filed for bankruptcy. It has moved to eliminate a generous retiree healthcare plan - a major hit for many former city employees - but has not challenged pension payments to Calpers.

The retirement fund argues that under state law, pension payments cannot be reduced even in bankruptcy - an issue that is also front-and-center in the San Bernardino bankruptcy and one that could eventually find its way to the U.S. Supreme Court.

KEEPING TRADITION INTACT

Bondholders in major U.S. municipal bankruptcies have been repaid all of their principal since at least the 1930s - and Stockton's creditors don't want to see that change.

Bond insurers Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp were joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund in contesting Stockton's bid for bankruptcy eligibility.

Assured's net exposure to Stockton's general fund-backed debt is $158 million. A spokesman for National said the MBIA Inc unit's Stockton-related exposure is $224 million, $89 million of it tied to the city's general fund. Franklin Advisers Inc, holds $35 million of uninsured Stockton lease revenue bonds.

Lawyers for the creditors argued to U.S. Bankruptcy Judge Christopher Klein that Stockton did not meet requirements to be eligible for bankruptcy court protection.

They claimed Stockton officials did not do enough to mend the city's finances and acted in bad faith by exempting the city's largest creditor - Calpers - from concessions in a mandatory pre-bankruptcy mediation.

They also said Stockton is not really broke, and that city officials are conflicted because they have accounts with the pension fund.

James Spiotto, a municipal law specialist at the Chapman and Cutler law firm, said that attack fell flat, noting that a finding of bad faith is a high bar.

CITY FINANCES A MESS

Stockton's legal team, which includes lawyers who worked for Vallejo, California in its 2008 bankruptcy, said the city needs to maintain pensions to retain and recruit employees, especially police officers who patrol a city with one of the highest crime rates in the country.

Stockton's officials note they have slashed $90 million in spending over three years, and say that deeper cuts would threaten public safety.

Ahead of the filing, Stockton won concessions from its unions and implemented the retiree healthcare cuts but has remained at odds with all but one of its capital markets creditors.

Judge Klein said at the close of the trial on Wednesday that a verbal ruling on eligibility would likely come on Monday. A written opinion would follow, and if the judge affirms its eligibility for bankruptcy, the city could then begin drafting a so-called plan of adjustment for its debts. At the same time, the capital markets creditors would be able to appeal to U.S. District Court or a bankruptcy appellate panel.

If the city is ineligible it could operate under its current budget while seeking concessions from creditors, who could press claims against the city in state or federal court.

Stockton's spokeswoman said a plan of adjustment would largely be guided by the city's so-called pendency plan, essentially the city's $155 million budget. Because it leaves pension payments intact, Stockton's capital markets creditors could strike at them again as a plan of adjustment takes shape.

"They'll still have the point unless the judge rules on it, which I doubt he will. That will be an issue for later on," Spiotto said, adding the eligibility trial was "a battle, not the war. The real game is coming up with a plan that works."

(Reporting by Jim Christie; Editing by Jonathan Weber, Martin Howell and Chris Reese)

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