Was Chapter 9 Filing the Best Course for Orange County? : News analysis: The potential for adding a legal morass to the fiasco is large.

The corps of lawyers and financial advisers has grown, the legal issues have proliferated, the list of victims has lengthened.

As Orange County enters its second month under the shelter of Chapter 9 of the U.S. Bankruptcy Code and attempts to find its way out of a $2-billion fiscal hole, one question looming ever larger in the minds of officials and investors is this: Was filing for bankruptcy on Dec. 6 really the county’s best course?

Although most of the county’s problems stem from the magnitude of its investment misadventure, the peculiarities of bankruptcy procedure have piled consequence upon consequence. The stigma of bankruptcy may saddle the county--dependent, like all government entities, on borrowed funds to build projects and smooth out the vagaries of tax collections--with higher interest rates for years. And that is if it is able to access the credit markets at all.

“They crossed a very big line,” said Richard P. Larkin, a managing director with Standard & Poor’s Corp., the bond-rating firm. “Although we knew bankruptcy was a legal option, we didn’t think it was a real possibility.”

Municipal investors in the county pool are increasingly frustrated by the way bankruptcy procedure limits their ability to deal with the county as partners, or even as adversaries.

Under Chapter 9, which governs municipal bankruptcies, debtors--in this case Orange County and, in a separate filing, its investment pool--retain virtually all authority over income and spending. That is a major difference from corporate bankruptcy, in which a judge and creditors have considerable power to remove managers, dictate business policy and even order liquidations.

“For the bulk of the municipal investors, it would be preferable to be in a state receivership or in state court,” says Gail Hutton, the city attorney for Huntington Beach, “because a state court would have the power to order the county to do something. Under Chapter 9, the Bankruptcy Court can’t order the county to do anything.”

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Bruce Bennett, the county’s bankruptcy lawyer, and other county advisers say the filings were the only option available on Dec. 6, when shocked participants in the investment pool were poised to demand their money back on such a scale that the fund would have been rendered insolvent.

The bankruptcy petition automatically froze the pool, halting a run before it had a chance to get rolling. Bennett argues that its single most important virtue was in giving the county an open-ended breathing space in which to make controlled and modest disbursements of critical funds to member municipalities while selling off the pool’s most volatile and unprofitable investments. (Officials of many of those municipalities say the procedure for making those payouts has thus far been fair.)

It may also have afforded the county more latitude than would otherwise exist to cut its budget, notably by suspending labor contract rules governing how employees are laid off.

On the other side of the ledger, however, the filing sharply reduced the clout the participating municipalities have in negotiating with the county over how to distribute the fund’s more than $2 billion in losses. From their standpoint, the freezing of the pool is by no means an unalloyed blessing; many have faced credit downgradings and have had to postpone or cancel important programs.

Moreover, the bankruptcy has hardly hastened deliberations over how the 187 pool investors should share in the loss. Bennett has said it would be a “minor miracle” if a court-sanctioned payout plan is produced by April; some observers expect the legal fallout to endure for years.

Already, the bankruptcy has forced dozens of cities and other creditors to lay on another layer of lawyers, increasing their expenses just as they are grappling with a budget crisis. The Newport-Mesa School District, which faces one of the biggest investment losses among the pool participants, is paying $250 an hour for a freshly hired bankruptcy attorney, not to mention fees for the extended duties required of its regular corps of outside attorneys.

“I expect this to cost many tens of thousands of dollars before we’re done. The thing goes on and on,” said Michael Fine, the district’s director of fiscal services.

“One of our concerns is about making this a field day for attorneys,” added Stan Oftelie, chief executive of the Orange County Transportation Authority and chairman of the committee of investment pool creditors. Oftelie said he began discouraging pool members from bringing their attorneys to mass meetings over interim disbursements from the fund “because there’s not a lot of value added, although there are certainly a lot of thousand-dollar suits in the room.”

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The potential for turning the county’s fiscal morass into a legal one is large, because Chapter 9’s procedures and principles are murky at best. In part that’s because the most sprawling such case to date--by a huge margin--is the county’s own.

Including a string of small special districts and municipalities that filed for protection from onerous one-time financial hits, the largest previous filings were those of Bridgeport, Conn., in 1991, and the San Jose Unified School District in 1983. Neither reached a conclusion: Bridgeport’s petition was rejected by a bankruptcy judge who ruled that the city was not actually insolvent; the San Jose district withdrew its own petition after it renegotiated the labor contracts at the center of its fiscal crisis.

Other large municipalities moved mountains to avoid bankruptcy proceedings. These include New York City--which acceded to a stringent program of new taxes, state oversight and fiscal austerity to manage its 1975 fiscal crisis--and Chicago, which placed its schools under a special financing authority in 1980.

Consequently, the county’s bankruptcy has sent squads of lawyers poring through Chapter 9’s unfamiliar text and the existing case law in search of clarifications of the county’s rights and obligations.

They haven’t found much.

“Chapter 9 really amounts to making it up as you go along,” said Philip Dearborn, director of government finance for the Washington-based Advisory Commission on Intergovernmental Relations. “There really hasn’t been enough experience.”

One untested issue, for example, is whether the investment pool, as opposed to the county, even qualifies as a “municipality” with the right to file under Chapter 9. Some lawyers say this may mean that the judge could throw out the pool’s case, a step that might mean resolving the disputes over its liquidation in state court.

Some observers fault Bennett for what they say is a Chapter 11 approach to the very different Chapter 9--that is, treating this case as a corporate bankruptcy in which the corporation happens to be a municipality.

“Bruce Bennett, like everyone else, has a lot of experience with Chapter 11 and little experience with Chapter 9,” said UCLA law professor Daniel Bussel.

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The differences, however, are significant. Chapter 11 recognizes that businesses can grow, die or change in form without having much impact on the community at large.

“In Chapter 11, the court can change management control and company ownership,” Bussel said. “You can’t do that with Orange County--you can’t merge Orange County with another county, and you can’t issue any new stock to creditors.”

The Chapter 11 mentality is most visible, say critics of the bankruptcy filing, in the county’s refusal so far to unambiguously pledge that it will place its obligations to bondholders above all other interests.

Strapped corporations have great flexibility in dealing with bond defaults. They can offer bondholders equity--that is, part ownership in the company--in exchange for foregone interest payments. They can persuade holders to accept longer repayment schedules on the premise that the company, once it overcomes its problems, will grow. As a last resort, they can go out of business.

Municipalities cannot choose any of those options.

“A government entity can’t be liquidated,” Bussel said. “They have a serious reputational restraint. They will have to sell bonds again, so they can’t push Wall Street too far.”

Moreover, if Orange County sets the precedent that any municipality can simply walk away from its debt, the bond market may require higher prices on public borrowings to compensate for the greater risk of default. This will affect the ability of other public bodies--in California and elsewhere--to raise money.

“If one of the wealthiest counties can default, what’s going to stop everybody else?” asked Christopher Taylor, executive director of the Municipal Securities Rulemaking Board, the federal agency that oversees local public finance.

Bennett insisted that the county’s goal is “absolutely to get all creditors paid in full.” But he noted that the scale of the fiscal crisis is so great that all creditors--including pool investors, vendors and bondholders--may have to shoulder part of the burden.

Bennett and other sources close to the county also argue that at the time of the filing, no alternatives to bankruptcy existed for the county or its pool.

One source says the loss of investment principal and interest in the pool was so significant that no revenue existed to dedicate to a financial oversight agency, such as the Municipal Assistance Corp. established to help New York borrow critical funds in 1975. (MAC received first call on city stock-transfer taxes and other revenue to guarantee bond investors that they would be repaid.)

“The budget was gone,” the source said. “There was no capacity to create a repayment fund for the pool participants.” The fund’s losses--27% of its participants’ deposits--and the resulting loss of interest income have left the county $172 million short of a balanced budget in the year ending June 30 alone.

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Bennett contends that those who propose the MAC model don’t realize how difficult it is to find new sources of public income in California.

“This is not the Eastern Seaboard,” he said. “Proposition 13 has a dramatic effect on what a municipality can do to raise money.”

Even critics of the county agree that its options may have narrowed by Dec. 6 but that it could have moved much earlier to address the developing crisis in a less disruptive way.

“The county was aware (of the investment losses) from the end of October on,” said Peer Swan, head of the Irvine Ranch Water District and one of the first municipal officials to try to withdraw money from the failing pool. “From then to the end of November, they had ample opportunity to employ a first-rate team to address it. But they just didn’t take it seriously enough.”

In fact, transcripts of a Nov. 30 conference call between then-county Treasurer Robert L. Citron, his deputy Matthew Raabe and officials of the investment firm Morgan Stanley & Co. show that county officials had already scheduled a public announcement of the fund’s losses before they began talking to investment bankers about financial solutions to the crisis.

“Certainly, bankruptcy was a possibility as soon as they made a public announcement of the condition of the fund without having a solution in hand,” Swan said.

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Hiltzik reported from Los Angeles, Vrana from Orange County.