ORANGE COUNTY IN BANKRUPTCY : Collateral Sales Reveal Murkiness of Bankruptcy Law : Finance: Chapter 9, largely untested until now, is supposed to preserve the status quo. But a 1984 amendment exempts ‘reverse repos,’ which Orange County fund used, in corporate cases.
The cash is gone. The judge is out of town. The county isn’t saying much.
Chapter 9 of the federal Bankruptcy Code was supposed to provide an orderly shelter for financially beleaguered municipalities such as Orange County. But in its first real test, some experts think the law has been found wanting.
The purpose of a bankruptcy is to preserve the status quo and permit a reasonable resolution of massive financial problems. But Orange County’s status quo was badly shaken by Wall Street’s liquidation of $11.4 billion of the county’s bond holdings this week.
Now the county “has to try to unscramble the omelet,” said Loyola University law professor Daniel Schechter.
Scrambled is a good word to describe the legal picture as Orange County ends its first week in bankruptcy protection. Several legal experts said the outcome of the county’s gamble on a Chapter 9 filing is far from clear, because there really are no precedents.
The collateral calls by Wall Street--in which investment houses sold bonds they held to cover the county’s unpaid loans--are just one indication of the lack of clarity.
Since the law is so murky, some legal analysts were surprised that Orange County had not asked a bankruptcy judge for an injunction specifically barring such liquidation sales, rather than simply relying on the normal “stay” provisions of the bankruptcy law.
Instead, the county Friday sued Nomura Securities--one of the brokerages that sold its collateral--and pledged to sue others as it gathers sufficient data.
“Because there are always questions” about the scope of a bankruptcy’s automatic stay provisions, “it’s not uncommon for the debtor to ask the judge for an additional injunction,” said University of Texas law professor Jay Westbrook.
Bruce S. Bennett, Orange County’s lead bankruptcy lawyer, said he could not comment on this issue without divulging confidential attorney-client discussions. He also declined comment when asked whether there are problems with the operation of Chapter 9. Bennett said the county is moving on a number of legal fronts beyond court actions.
“The court proceedings are important, but not necessarily the most important thing,” Bennett said in an interview.
“My objective for this case is to find practical solutions to the problems and have them implemented with a minimum of discord,” he said. “What’s happening outside the courtroom is very often more important than what is going on in the courtroom.”
In a statement, Nomura declared that the county’s suit was “baseless and without merit,” and pledged to defend itself “vigorously.” And a lawyer representing a New York investment bank that liquidated millions in bonds Thursday said Wall Street firms have studied the matter and are “confident we will prevail on the legal issues.”
Westbrook and Schechter said two fundamental public policy issues appear to be at war in the current situation.
On the one hand, the purpose of allowing a debtor to file for bankruptcy is to freeze the status quo so there can be an orderly disposition of conflicting claims.
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On the other hand, the bankruptcy law was specifically amended in 1984 to make repurchase agreements on government bonds and certain other instruments--popularly known as reverse repos--exempt from the law’s coverage in corporate bankruptcies.
The law was amended at Wall Street’s behest after industry lobbyists convinced Congress that this exemption was needed to aid the free flow of capital, said Omaha bankruptcy lawyer Harry Dixon, former counsel to the Senate Judiciary Committee.
When Congress exempted repurchase agreements from the coverage of corporate bankruptcy law, “who would have thought that a county would be dabbling in reverse repos,” Dixon said. It was reverse-repo transactions that allowed Orange County to boost its investment portfolio to almost triple the sum invested by local agencies--and that caused the fund to deflate as interest rates rose and the bond holdings’ value fell.
Houston bankruptcy lawyer Hugh Ray, head of the American Bar Assn.’s business bankruptcy committee, said that the controversy will not have a quick solution and that the battle could go all the way to the U.S. Supreme Court.
Westbrook warned that without strict limits on creditors’ actions once a bankruptcy is filed, the supposed protection of the court is of limited value.
“To the extent that certain types of transactions are exempted from the automatic stay, the whole idea of bankruptcy becomes problematic,” he said. “This exemption swallows an awful lot of the law. Some of the most important benefits are lost by these exemptions.”
All that appears clear at present is that there may be a bonanza for lawyers, because there are disputes on even the simplest of concepts.
For example, what does it mean to “preserve the status quo” in a situation like this?
Robert J. Rosenberg, a prominent New York City bankruptcy lawyer, said that if the brokerages had not acted, the status quo would have been unalterably changed for them because the crisis was driving down the value of their holdings.
“If sales are frozen, that shifts the risk of the future ups and downs of the securities from the county to the house holding the security,” Rosenberg said.
But Schechter said the basic purpose of Chapter 9 clearly was to prevent the sort of fire sales that occurred Thursday. If they are permitted to stand, he said, that would significantly erode the power of Chapter 9 as a meaningful tool to protect financially troubled governmental entities.
“In the context of a municipality, it’s not all clear to me from a policy standpoint that the liquidity of the markets is of paramount concern,” Schechter said. “It’s really a juxtaposition of three strange worlds colliding at one small point in Orange County--municipal insolvency, liquidity of the securities market and the specialized world of leveraged securities transactions.”
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There are a host of other unanswered questions--including whether the bankruptcy filing was a massive miscalculation. After all, it may have precipitated Thursday’s sales, which seem to have further endangered Orange County’s position.
Bennett said people leveling this contention are not aware of all the relevant facts. But he declined to elaborate.
The situation is so uncharted that Orange County filed two separate bankruptcies, one on behalf of the county and one on behalf of the investment fund.
Legal experts said it is possible that the county decided to take two bites at the apple to hedge its bets. If federal bankruptcy Judge John Ryan concludes the county is not insolvent, he could throw out its filing. If he concludes the fund itself does not qualify as a debtor under Chapter 9, he could throw out its filing. The county’s hope may be that at least one filing survives.
Bennett declined to respond to that premise.
Ryan, in Santa Ana, who will return from vacation next week to take the reins in the case, is likely to be making new law in a series of rulings in coming months.
But while Ryan has a pivotal role, he does not have as much power as a judge in a corporate bankruptcy, according to legal experts.
Under Chapter 9, the judge is empowered to review the county’s plan to reorder its affairs, known formally as “a plan of adjustment.” If he finds the plan unfair, he can reject it. If that happens, the county can modify the plan.
But the judge does not have the power to tell the county that it can no longer buy or sell certain kinds of securities. Nor can he take over the operations of Orange County or take other actions the way a judge can in a corporate bankruptcy by appointing a trustee.
It also is unclear how rapidly the Orange County proceeding will unfold.
Thus far, no hearings have been scheduled and there are no deadlines for the filing of any legal papers. On Friday, Bennett said it was unclear when the first court hearing would be held and how significant the first hearing would be when it is held.
In coming weeks, Orange County will be submitting to the court a list of its creditors and how much they are owed. Then the county will be required to prepare its plan of adjustment in consultation with the creditors, particularly the larger ones.
Historically, most municipal bankruptcies have been resolved quickly. But none has been remotely as large as this one. The biggest previous municipal bankruptcy filing was lodged in 1991 by Bridgeport, Conn., which had more than $200 million in bond debt, a mere fraction of Orange County’s current debt. Bridgeport’s bankruptcy was dismissed because the county was found to be solvent.
Some skeptics already have raised doubt about whether Orange County is insolvent. For an entity to be a Chapter 9 debtor, the law provides that it must be insolvent or unable to meet its debts as they mature and that it must desire to effect a plan to adjust its debts.
Since Orange County has been meeting its payroll obligations and paying its debts to suppliers, Westbrook said there is a question as to whether it is insolvent.
Moreover, he said that if the county starts to have problems paying debts, the question arises as to whether the county should be obligated to raise taxes rather than resorting to bankruptcy.
But Schechter said that if the county does not qualify as a debtor, it will become even more difficult to achieve an “orderly untangling of this mess.”
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Filing for Bankruptcy
Local governments overwhelmed by debts can seek protection by filing under Chapter 9 of the federal bankruptcy code. Approval of a Chapter 9 petition rests heavily on the filer’s solvency, its creditors’ approval and creation of a viable plan for paying debts. A federal bankruptcy judge makes the final decision. Here are the steps involved:
1) Bankruptcy petition is filed.
2) Government agency files a list of creditors.
3) A creditors’ committee is formed. There will be several such committees. The judge can rule committees are not needed.
4) Creditors file claims. A deadline for filing will be set by the judge.
5) A plan of reorganization takes shape as the petitioner negotiates with creditor groups.
6) The petitioner publishes a plan of reorganization. The plan will classify types of creditors.
7) The court approves a disclosure document describing the reorganization proposal and the agency’s financial condition.
8) Creditors vote whether to support the plan no sooner than 20 days--usually a month--later. For approval, the plan needs a two-thirds majority of the creditors (in monetary amount) and a simple majority in number (to protect the small creditors), determined by the number of creditors who actually vote.
9) Judge reviews plan for fairness and can approve or reject it. If rejected, the agency can modify the plan and resubmit.
Source: Times staff reports
Who Files
Chapter 9 filings, 1980-94.
BY TYPE
Municipal utilities: 62
Municipal districts: 22
City, county: 15
Hospitals, healthcare: 7
Schools, education: 6
Transportation: 5
BY REGION
North Central: 42
South Central: 27
Mountain West: 24
Pacific West: 11
Northeast: 6
South Atlantic: 6
Midwest: 2
Source: Chapman & Cutler
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Chapter 9 Filings, 1980-1994
1980: 1
1981: 2
1982: 3
1983: 5
1984: 4
1985: 6
1986: 10
1987: 19
1988: 7
1989: 7
1990: 9
1991: 15
1992: 13
1993: 7
1994: 9
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COMMON CENTS
How the typical Orange County property tax dollar was spent during fiscal year 1993-94:
Schools: 55
Special districts: 17
Cities: 12
County: 9
Community Redevelopment Agency: 7
