Wine Town With a Water Problem Is in Deep

This civic-minded grape town takes pride in its frugal ways. Old-fashioned penny pinching and strict growth controls paved the way for modest luxuries: Water rates held for years at $10 a month -- and politicians who proposed a spike did so at their peril.

It was that reluctance to spend money -- and a dose of small-town naivete -- that made “Lovable, Livable Lodi” an easy mark.

For 15 years, Lodi has struggled with a serious groundwater pollution problem. Five years ago, Michael C. Donovan, an innovative Bay Area lawyer, and Lehman Brothers, one of Wall Street’s largest firms, sold Lodi officials on a complicated plan to solve it.

The plan went like this: The city would borrow $16 million from Lehman at 25% interest to finance a barrage of lawsuits. Donovan and his firm would pursue the suits, billing at rates of up to $425 an hour. Courts would shift all the costs to insurance companies. In the end, Lodi would clean up the problem without having to pay for it.

Today, the strategy is a shambles, picked apart by state and federal courts and condemned by a federal judge as “environmental litigation for profit.”

Donovan has been fired, along with the Lodi city attorney who pushed the plan. Lodi has sued Lehman, alleging the deal was illegal. Lehman has countersued to collect its debt -- roughly $25 million to date, city officials say -- pitting some of the country’s biggest law firms against a city that once made national news for banning silly string from its downtown parade.

Lodi’s financial future is in question. Interest is accumulating at $325,000 a month. The pollution has spread. And criminal investigations are underway.

“Boy, were we duped,” said City Councilwoman Susan Hitchcock, who was derided by colleagues and threatened with censure when she was the only city official to oppose the plan. “The more I learn, the more I realize it was about greed. There is no free lunch, and everyone knows that.”

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Lodi, a city of roughly 59,000, lies east of the Sacramento-San Joaquin River Delta, 35 miles south of the capital. Ringed by wineries, the town, settled by German farmers, calls itself the Grape American Dream.

Its troubles began in 1989, when the Central Valley Regional Water Quality Control Board discovered hazardous solvents in two downtown wells.

By 1993, the state’s Department of Toxic Substances Control had listed the heart of Lodi as a hazardous waste site. Two drycleaners, a manufacturer and the city’s own aging, leaky sewer lines had contributed to the problem.By 1996, Lodi officials and lawyers for the business owners had a tentative agreement: If the businesses cleaned the soil, Lodi would take care of the water.

Then Donovan visited City Hall, and everything changed.

Donovan had been at the center of key battles in the burgeoning field of environmental law. Lodi, he told City Atty. Randall Hays, shouldn’t have to pay. Instead, he said, the city could get out-of-town insurers to solve its environmental quandary -- without burdening ratepayers or its own businesses.

Sworn in as an assistant city attorney, Donovan began crafting an audacious strategy. First, he wrested authority from the state to go after other polluters. In an agreement signed in 1997 -- and never repeated with any other city -- the state Department of Toxic Substances Control agreed to put Lodi in charge.

California water board officials balked at a similar deal, believing that letting Lodi police the cleanup was like putting a defendant in charge of his trial.

Next, Donovan established municipal powers so much broader than usual that opposing lawyers dubbed the sleepy town “Soviet Lodi.”

Donovan’s tool was the Comprehensive Municipal Environmental Response and Liability Ordinance, dubbed MERLO in a nod to Lodi’s wine economy.

Under MERLO, Lodi claimed the right to order alleged polluters or their insurers to investigate and clean up the mess. To prove they were not liable, alleged polluters would have to meet a burden of evidence stricter than any imposed by state or federal law. Not complying could mean criminal charges.

MERLO also gave the city the right to force polluters to pay all of Lodi’s legal, technical and financing costs.

But to pursue his targets, Donovan needed money. Lodi’s annual budget is just $29 million, and by 1999, the city had already borrowed $6.3 million from its water fund to pay for legal costs.

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In March 1999, a senior vice president at Lehman pitched an idea to top executives on the Wall Street giant’s New Products Committee. Brainstorming with Donovan, the executive, Kenneth Pierce, had figured out a way for his firm to profit from Lodi’s fight.

Lehman, he said, should lend Lodi $16 million to finance its legal war. Cities normally borrow at close to prime -- roughly 8.5% at the time. This loan, however, would carry a 25% interest rate because of the alleged risk to Lehman: If Lodi were to press its case aggressively and lose, the city wouldn’t have to repay.

If the litigation were successful, however, Lehman would be repaid first. The city would get its hands on cash only after Lehman and Donovan were paid.

And if Lodi ever challenged the deal or failed to “diligently” litigate, it would be in default -- on the hook to repay all.

Donovan told city officials the war chest would hasten victory. City Council members were impressed, as was City Atty. Hays, who vacationed at Donovan’s property near Helena, Mont.

Council members were convinced that a legal assault on out-of-town insurers would allow them to protect local businesses as well as avoid raising local water rates, according to Lodi’s current mayor, Larry D. Hansen, who was not a member of the council at the time.

The fact that Wall Street’s big player would enter into the deal, Hays and council members were fond of noting, was evidence that Lodi’s strategy was a winner.

At the November 1999 City Council meeting to debate the Lehman deal, Hitchcock was the lone skeptic.

Lodi would have to turn over tens of millions to Lehman and Donovan before it got any money for cleanup, she noted -- and that was a best-case scenario. The city’s outside financial analyst was warning the amount due on the loan could soar to $147 million in a decade.

Councilman Stephen Mann -- who is no longer in office -- wanted none of Hitchcock’s warnings. The only alternative, he said, would be to quadruple water rates.

“I can’t put my hand on all the facts,” he said, “but that’s why we have a city attorney and outside legal and financial experts. Is the city’s money at risk? No! ... I can’t think of a better deal.”

By a 4-1 vote, the City Council gave its assent.

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The legal battles escalated: More than a dozen cases would wind through municipal, state and federal courts.

Many of Donovan’s legal efforts failed, but with the costs allegedly covered by others, he and his team filed extensive appeals -- so much so that courts repeatedly reprimanded them.

Long-winded and at times short-tempered, Donovan cut an authoritative figure in court, lecturing in a bombastic, professorial tone. Beneath the arrogance was a formidable intellect. Arguing with Donovan, said opposing attorney Stephen Meyer, “is like playing three-dimensional chess.”

But by 2002, his strategy had begun to unravel: A federal judge ruled against one central stratagem. Then, the U.S. 9th Circuit Court of Appeals deemed parts of MERLO unconstitutional.

Meanwhile, settlement talks were going nowhere, in part because the terms of the Lehman deal required Lodi to accept only cash, not, for example, an offer from opponents to pay for the cleanup themselves.

The gridlock prompted a court-appointed mediator to call Hitchcock. The council, she learned, was not being informed of settlement offers or court defeats. She demanded transcripts. Her colleagues forbade her from attending more mediation talks. She ignored them; they tried to censure her.

Meanwhile, details of Donovan’s billing emerged: Payments to his firm grew from $1 million to more than $3 million a year. The cost of “document management” alone went as high as $188,000 a month.

Donovan said his 10-lawyer firm -- Envision Law Group, based in Contra Costa County -- worked on the Lodi matter at 40% below its normal rates.

“I don’t agree that we were paid handsomely by the city. Look at all the services that were delivered,” said Donovan, who admits a “great love of fancy wines and expensive sports cars.... Do I make as much money as I want to and should? No.”

Last December, U.S. District Judge Frank C. Damrell demolished Donovan’s strategy, ruling that Lodi was potentially responsible for cleanup under federal law and invalidating the rest of MERLO.

But the judge wasn’t finished. On Jan. 12, with a trial just two days away, he chastised Donovan as “unprofessional” and spoke of the lawyer’s “fertile imagination.”

“I don’t know how many millions have been spent by the city, but suppose those millions, instead of going to consultants and lawyers, went ... to clean up the environment?” he asked.

With that, he ordered Donovan and Hays back to Lodi for a “heart to heart” with the City Council. After seven hours of debate, Envision and Hays were fired on a 3-2 vote.

The next day, at a hearing, Damrell homed in on Lehman, asking, “Can a nonlawyer buy a lawsuit?”

“This was much more than an environmental lawsuit,” Damrell said. “It was a scheme to make money for a nonparty who had no interest in cleaning up the environment.”

Today, a full-scale cleanup has yet to begin. As the years have passed, the toxic solvents have migrated deeper into the groundwater.

Water rates have tripled. No one can say how drastic future measures might be. Lodi could turn to its own insurers to pay for its part of the cleanup, but Lehman is claiming that money.

Lehman officials declined to comment, citing litigation. But in its suit, the firm argues that Lodi picked its own strategy -- and outside lawyer -- years before Lehman got involved and “now seeks to blame Lehman for its own failures.”

Donovan says the judges who derailed his strategy were wrong. Lodi just pulled the plug too soon, he said.

Some officials think otherwise. The San Joaquin County district attorney’s office and the FBI are investigating potential criminal wrongdoing.

The district attorney is exploring whether Donovan or Hays withheld key information from council members or whether anyone -- including Hays, Donovan or his closest consultants -- profited improperly from the strategy, said D.A. investigator Mike Morris.

Donovan’s response: “Investigate away.” Though he respects the City Council’s right to vote him out of a job, he blames Lodi for its problems.

“They’ve spent more taxpayer money since they’ve fired me,” he said. “The issues are going to come cascading down on them.... I’m heartsick for the people of Lodi.”