Chapter 9 Move a Last Resort, Experts Say

Orange County’s filing for bankruptcy court protection is viewed by legal experts as a move of last resort that can send shock waves through every level of government and trigger severe economic consequences that might take years to overcome.

Governmental agencies seeking protection under Chapter 9 of the U. S. Bankruptcy Code risk a host of fiscal woes, including the loss of hard-won credit ratings, the inability to sell bonds to raise money for capital projects, deteriorating relations with employees and creditors, as well as the prospect of raising fees or taxes to help pay the debts that triggered the bankruptcy petition.

The legal fees are enormous, and rounds of cost-cutting measures might become necessary, resulting in layoffs and reduced services. Cities such as Bridgeport, Conn., have spent years trying to rebuild their credit rating and overcoming the stigma of Chapter 9, leaving municipal officials wondering if it was all worth it.

“It is often better to work out your problems with financial engineering rather than to crash and burn,” said James E. Spiotto, a Chicago attorney and one of the nation’s top experts on governmental bankruptcy. “Chapter 9 is the most extreme remedy, the last resort, if you can even call it a last resort.”

But Spiotto and other bankruptcy lawyers say Chapter 9 could provide Orange County with a powerful shield to fend off a potentially devastating “run on the bank” by participants in the beleaguered investment pool that was managed by former County Treasurer Robert L. Citron.

A financial crisis developed for Orange County last week when it was reported that the $20-billion investment pool had lost $1.5 billion--about 20% of the investors’ actual stake--because an investment strategy that Citron had used successfully for many years had turned sour as interest rates began to rise.

In essence, Citron had pledged his investors’ securities as collateral to borrow more than $12 billion in short-term loans to buy long-term bonds that at the time were paying higher rates of interest. As the Federal Reserve began raising interest rates this year, however, the short-term loans could only be renewed at ever-increasing interest rates, while the value of the long-term bonds he bought tumbled.

Citron resigned in the wake of disclosures about the pool’s losses. A federal Securities and Exchange Commission investigation is under way.

“You file Chapter 9 when the pressure is greater than your ability to handle it,” said Richard Levin, a bankruptcy attorney for 20 years in Los Angeles. “Like a classic bank failure, you could prevent the race of the swift.”

Chapter 9 is a backwater of federal bankruptcy law, which grants governmental agencies time to reorganize their finances and make arrangements with creditors to pay off their debts. The action is filed voluntarily, meaning that no creditor can force the governmental entity into bankruptcy, as they can with a business.

A government agency such as Orange County must meet several tests to declare a Chapter 9 bankruptcy, said attorney Marc Beilinson of Pachulski, Stang & Ziehl in Los Angeles.

It must meet the legal definition of a municipality. State law must authorize it, which California law does. The governmental entity must be insolvent and willing to develop a plan to pay its debts. It must obtain the approval of creditors holding a majority of its claims or it must have negotiated with investors in good faith and failed to reach agreement.

Municipalities have a great deal more freedom under Chapter 9 than corporations do under somewhat comparable Chapter 11 bankruptcies, Beilinson said. Municipalities get protection from their creditors but, unlike bankrupt corporations, they do not have to seek a judge’s permission to borrow new funds or spend them as they see fit.

It is unlike a regular bankruptcy in other ways, attorneys say, because as long as the entity has the power to tax or raise fees to help pay the debt, it cannot go out of existence, as is possible for a failed business or corporation.

Chapter 9 of the U.S. Bankruptcy Code was developed during the Great Depression, when many municipalities began losing their ability to raise taxes and had trouble paying debts. Since then, 475 Chapter 9 petitions are known to have been filed.

Most of those cases involved small, special-purpose districts for schools, utilities, water or sewer services and hospitals. No large or medium-size cities ever have filed a Chapter 9 proceeding and pursued it to a conclusion.

“The law is there, but the hope is no one will use it,” said Lawrence P. King, a professor and bankruptcy specialist at the New York University School of Law. “When you file it, people want to stop dealing with you. The state starts breathing down your throat. Politicians get some mileage out of it. If there is one thing I would emphasize, it’s the last resort.”

Until Orange County’s filing, Bridgeport, a city of 145,000 people with a debt of $200 million, represented the largest entity in the country to seek Chapter 9 protection. After taking the action in 1991, the city lost its credit rating and could not sell municipal bonds to raise money.

Broad cost-cutting measures were instituted and employee morale plummeted along with the credit rating. There were even doubts that local banks would honor city paychecks.

The Connecticut attorney general challenged Bridgeport’s action in court, and a judge threw out the Chapter 9 petition, ruling that the city was solvent and could pay its bills. The city appealed, but Mayor Joseph P. Ganim, who was elected during the crisis, eventually withdrew the appeal.

“There is a fiscal, political and moral aspect to it all. The whole impact on municipal government is enormous,” Ganim said. “Wall Street is skeptical, and it was been an uphill battle to regain our credibility. It affects all levels of government. There is a freeze on hiring, a freeze on wages. If I were mayor when this started, I would not have filed a Chapter 9.”

New York City considered filing a Chapter 9 petition during its fiscal crisis in the mid-1970s and federal law was changed to accommodate such a move. But city leaders decided against the action, fearing that a bankruptcy filing would deliver a devastating blow to the municipal bond market. At the time, New York City bonds represented about 27% of the market, and Wall Street leaders stepped in to help restore the city’s credit worthiness.

New York appealed to President Gerald R. Ford for federal help, but Ford initially refused, prompting the memorable New York Daily News headline: “Ford to City: Drop Dead.”

But Ford later relented and approved a $2.3-billion emergency financing after the Municipal Finance Corp. was formed to handle the city’s troubled finances. Investment banker Felix Rohatyn led the agency, which secured the cooperation of the city’s union and business leaders and special investments from union and other pension funds.

Similarly, Cleveland never went through bankruptcy court for protection after it defaulted on bond payments to investors in 1978. More recently, Philadelphia officials considered a Chapter 9 filing, but never proceeded with it.

In California, the San Jose School District, facing labor problems and the effects of Proposition 13, sought protection under Chapter 9 and managed to pay its debts on time.

Depending on the amount of indebtedness, bankruptcy lawyers say, Orange County could face some of the same problems as the troubled cities. If bond and credit ratings plunge, the county would have trouble getting loans or selling bonds to raise money for a new stadium in Anaheim, a new county jail or a road.

A bankruptcy would harm Orange County’s credit standing--not just its rating by agencies such as Moody’s and Standard & Poor’s, but its long-term reputation among investors. It would immediately become more expensive for the county to borrow funds because investors would demand higher interest rates to compensate for the increased risk.

Just as airline mogul Frank Lorenzo used the bankruptcy laws to break contracts with his unionized employees, Orange County could, if it chose, renegotiate collective bargaining agreements with its employees or seek to unilaterally change their pay or benefits, with the judge’s permission.

The same applies to the county’s dealings with trash haulers, for example, or other private contractors. It could press a judge to reject existing contracts, or use that threat to pressure contractors into providing more favorable terms, Beilinson said.

Furthermore, bankruptcy lawyers say that investors holding bonds sold by Orange County might not be able to earn interest because interest ceases to accrue when a Chapter 9 is filed.

“The biggest problem is the stigma of the bankruptcy. Eventually, you have to go back to the bond market. Your credit ratings are ruined. Someone always gets hurt,” Spiotto said. “This creates a tremendous strain on governmental relationships.”

Beyond county government, the Chapter 9 filing could affect about 180 municipalities, school districts and other governmental entities that had entrusted billions of dollars to Orange County to invest. All of them use their investments to raise money to meet their obligations, such as new construction or to make loan payments.

“I would not be surprised if a number of other municipalities (that invested in the Orange County fund) were themselves forced to file for bankruptcy because they won’t be able to meet their own obligations,” Beilinson said.

Times staff writer Thomas S. Mulligan in Los Angeles contributed to this story.

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