Cities weigh Chapter 9 as liability pressures strain municipal budgets

It's a 5-minute stroll from Los Angeles City Hall and Los Angeles County's Kenneth Hahn Hall of Administration to the Central District Bankruptcy Court in the Edward R. Roybal Federal Building. 

Municipal finance lawyers don't want to take that walk. But the question is in the air: Could L.A. go broke?

Los Angeles County and the City of Santa Monica both owe large legal settlements to childhood sex abuse plaintiffs. And over the last two years, the City of Los Angeles has been on the hook for a half-billion dollars in liability payouts, largely from LAPD claims--way above the budgeted amount.

There are also huge firestorm costs to contend with, unfunded pension obligations and other budget stresses. 

That raises the prospect that L.A. city or county or Santa Monica could be forced to seek shelter under Chapter 9 of the Bankruptcy Code, the provision designed for public entities.

The goal is for municipalities to devise a court-approved plan to bail out their finances. It turns out that when municipalities are involved, it's not called bankruptcy at all.  

"Chapter 9 for cities and counties is known as a debt adjustment process," said Bruce S. Bennett, a Jones Day authority on distressed government finances who has worked on numerous public entity restructurings, including those of Orange County and Detroit.

Municipal budget grief is different from crushing debt, he pointed out. "If there is a budget shortfall, debt relief won't help." Bennett noted that if a municipality is confronting excessive debt, there are options short of Chapter 9. 

"First you try to refinance. Santa Monica, Los Angeles County and other municipalities could go to the debt market to borrow money on terms that pay interest that is not taxable to debt buyers."

But if the big litigation bills due in Los Angeles and Santa Monica and other financial pressures overstrain municipal treasuries, Chapter 9 is an option.

There's precedent. A wrongful death settlement was partly to blame for the last bankruptcy to plague a California municipality.

It was San Bernardino's inability to pay $1.8 million over a police shooting in 2012 that tipped the already fiscally shaky city into filing for Chapter 9 protection. 

When plaintiffs' counsel moved to collect on the deal, the city found it was out of cash and could not pay the settlement and still make payroll. The city declared a fiscal emergency, listed $1 billion in debt and filed a petition to freeze all creditor actions. In re: City of San Bernardino, 499 B.R. 776 (C.D. Cal. Bankr., filed Aug. 1, 2012).

There's a vast disconnect in scale in trying to compare cities under fiscal pressure over the last 15 years. San Bernardino's annual budget is in the millions of dollars; Los Angeles County plans to spend around $49 billion in fiscal 2024-2025.

Still, money woes can plague anyone, and the legal process for financially distressed municipalities, big or small, is outlined for all in the Bankruptcy Code.

The tiny town of Mammoth Lakes, population 7,124, sought Chapter 9 protection when it faced a $43 million judgment awarded to a developer over a property dispute. It settled fast and exited the process in months.

At the time it filed in 2012, San Bernardino was the second-largest public entity in the nation to enter Chapter 9. (First was Jefferson County, Alabama, which filed in 2011 over a $4 billion sewer debt.)

Soon after, Detroit took the size prize when it sought Chapter 9 protection in 2013, listing debts of $18.8 billion. Puerto Rico entered a different form of bankruptcy protection in 2017 with a debt of $122 billion.

It took a decade for San Bernardino to exit bankruptcy as it fought through a significant cash shortage and more than $1 billion in debt. 

It was a heavy lift to get creditors to move from opposition to support. Along the way, for example, San Bernardino was forced to up its original proposal to pay holders of its pension obligation bonds a penny on the dollar to about 40 cents per dollar.

Larry A. Rosenthal, an attorney and lecturer on government innovation at the Goldman School of Public Policy at UC Berkeley, studied the flurry in California of post-Great Recession bankruptcies in Vallejo, Stockton, San Bernardino and Mammoth Lakes.

"Back then, there was a supply of bankruptcy-ready cities trying to refinance their debt on funny paper," he said. "And there were a few large law firms marching around the state peddling Chapter 9 and making very good money doing so."

Stockton, for example, paid millions of dollars to its outside lawyers instead of to its creditors, Rosenthal said. 

Lessons learned? "Cold-blooded accounting professionals today keep closer eyes on municipal finances."

Rosenthal added that a hidden motive can tempt municipalities with public employee pension problems into Bankruptcy Court.

"Chapter 9 can be a tool for managing debt and risk regarding labor-related burdens," he said.

Fifteen years ago, a bankruptcy lawyer turned lawmaker surveyed the high cost of municipal bankruptcies and did something about it. Robert A. Wieckowski had a business and personal insolvency practice in Fremont when he won a seat in the Legislature in 2010. 

Although the Chapter 9 process comes under federal jurisdiction through the U.S. Bankruptcy Code, Wieckowski devised a unique state law that sets mandatory preconditions when public entities wish to file.

His AB 506 amended the Government Code. Wieckowski said in an interview that he came up with the plan in 2011 when he saw that Stockton was headed for the rocks. 

"A redevelopment went bad. Their pension plans were shaky. The firefighters wanted to force the city into Chapter 9 to shore up their entitlements."

Like Rosenthal, Wieckowski noted the paradox of bankruptcy: If you go broke and take it to court, it's expensive.

 "The administrative costs of any bankruptcy court reorganization are astronomical," Wieckowski said, especially due to lawyers' fees for endless status conferences, creditor committee meetings and court hearings.

"I wanted to strip away the expensive trappings and get folks on the municipal side to negotiate directly with creditors before filing," Wieckowski said. His law requires that a "neutral evaluation process" takes place before parties go to court. When he signed the bill, Gov. Jerry Brown said it offers "less drastic solutions" to bankruptcy.

It worked for Stockton, said Gary M. Kaplan, chair of the restructuring, insolvency and creditors rights practice group at Farella Braun + Martel LLP. He represented some union interests in the process. 

"Prefiling negotiations force the parties to come to the table before court proceedings get so expensive and cumbersome," he said. "I like it."

Not so happy, he added, were colleagues who specialize in Chapter 9 litigation. "When cities were stressed after the Great Recession, some lawyers foresaw a cascade of filings, but there were actually very few in California. I think a lot of problems got worked out because of AB 506 without a formal bankruptcy procedure.

"And that's OK. The world shouldn't be run for bankruptcy lawyers."

Next: In Chapter 9, judges and debtor municipalities vie for power.

This is the second part of a three-part series. Read the first story here.