O.C. Filing Interpreted as Move of Last Resort : Bankruptcy: Ruined credit ratings, inability to sell bonds, need to raise taxes could all result, experts say.


Orange County’s filing for municipal bankruptcy 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, inability to sell bonds to raise money for public works projects, deteriorating relations with employees and creditors, and the prospect of raising fees or taxes to help pay off 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 to the public. Cities like Bridgeport, Conn., have spent years trying to rebuild their credit ratings and overcome 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 beleaguered investment pool that was managed--or mismanaged, some might say--by former County Treasurer-Tax Collector Robert L. Citron.

A financial crisis developed for Orange County after it was reported last week that the $20-billion investment pool had lost $1.5 billion--roughly 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 purchase 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.

In the wake of disclosures about the pool’s losses, Citron resigned. A federal Securities and Exchange Commission investigation is underway. On Tuesday, two bankruptcy filings were made--one for the county and the other for the county treasurer’s investment fund.

“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 a business.

Generally speaking, a governmental agency such as Orange County must clear five hurdles in order 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 must be willing to develop a plan to pay its debts. And it must either obtain the approval of creditors holding a majority of its claims or 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 have 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.

Attorneys say the process also differs from regular bankruptcy in that, so long as the government entity has the power to tax or raise fees to help pay its debt, it cannot go out of existence as a failed business or corporation can.

Chapter 9 of the federal bankruptcy code was developed during the Great Depression, when many municipalities began losing their ability to raise taxes and had difficulty paying their debts. Since then, only 475 Chapter 9 petitions are known to have been filed.


Most of those cases involved hospitals or small, special-purpose districts for schools, utilities, water or sewer services. No large or medium-size cities have ever 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 Prof. Lawrence P. King, a 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.”

Up until Orange County’s filing, Bridgeport, a city of 145,000 with a debt of $200 million, represented the largest Chapter 9 filing in the country. After seeking protection in 1991, the state’s largest and poorest 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 questions whether local banks would honor city paychecks.

The Connecticut state attorney general challenged Bridgeport’s decision 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 Ganim, who was elected during the crisis, eventually withdrew the appeal.

“There is a fiscal, political and moral aspect to it all,” Ganim said. “The whole impact on municipal government is enormous. 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 move, fearing that a bankruptcy filing would deliver a devastating blow to the municipal bond market. At the time, New York City bonds represented some 27% of the market.

Similarly, Cleveland never went through bankruptcy court for protection after it defaulted on bond payments to investors in 1978. In California, the San Jose School District, facing labor problems and the effects of Proposition 13, sought protection under Chapter 9 but managed to pay its obligations on time.

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

Bankruptcy would harm Orange County’s credit standing--not just its rating from 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, as 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 the pay or benefits, with the judge’s permission.

The same applies to the county’s deal 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.

Tuesday evening as news of Orange County’s bankruptcy filing spread, Moody’s suspended all of the county’s bond ratings.

“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 impact about 180 municipalities, school districts and other governmental entities that had entrusted billions of dollars to Orange County to invest.

“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,” Beilenson said.

Two of the top four investors in the county bond portfolio are the Orange County Transportation Agency, with $1 billion at stake, and the county Transportation Corridor Agencies, which invested $306 million.


Both agencies spend tremendous amounts of money for countywide transportation projects, such as bus service and freeway construction. The Transportation Corridor Agencies is now working on the San Joaquin Hills and Foothill-Eastern toll roads.

Lisa Telles, a spokeswoman for the Transportation Corridor Agencies, said the bankruptcy filing should not hurt the agency in the near term. But if the agency could not withdraw funds, over the long run it might interfere with the ability to pay for construction of the toll roads.