NEWS ANALYSIS : O.C. Pins Hopes on an Untested Legal Theory : Recovery: The county wants to issue $250 million in bonds, and give buyers priority over earlier investors.

SANTA ANA — With little help in sight from either Sacramento or Wall Street, Orange County is pinning its hopes for solving its most immediate money crunch on an untested legal theory it will try to sell to U. S. Bankruptcy Judge John E. Ryan.

The bankrupt county faces a legally binding June 5 deadline to raise $236 million needed to redeem the IOUs it is giving cities, schools and other agencies who lost money when the county’s investment pool went bust. To raise the money, the county wants to issue $250 million in so-called recovery bonds.

But bond buyers are likely to be wary of investing in a bankrupt municipality, so the county on May 2 will ask Ryan to give recovery bondholders “super priority” status over all other county creditors when it comes to cashing in or collecting interest on the bonds.

County officials say the judge’s stamp of approval--which could mark the first ruling of its kind--is critical to boosting investor confidence and key to helping the county get over a looming financial hurdle.

“It is a dramatically safer investment, and that’s what we would have to educate people about,” said Orange County’s bankruptcy attorney, Bruce Bennett, about selling the bonds with Ryan’s approval. “Hopefully, there is a market appetite for investments, and if there is an authorized priority status, people will be interested.”

Putting new creditors ahead of those with pre-bankruptcy claims is uncommon but not unheard of in Chapter 11 cases, in which businesses try to reorganize their debts and restore their financial security--and are not just looking to divvy up the leftovers among creditors.

“And that’s exactly what is happening in Orange County--we need to get back up on our feet,” Bennett said. “The county is not looking to go out of business.”

Bennett said one of the better-known examples of what the county is attempting to do involved Macy’s, the famed New York City department store chain.

But Orange County’s bid would apparently set precedent as the first of its kind--if it receives Ryan’s approval.

“I don’t think anything like that has ever been done,” said Chicago attorney Charles Spiotto, one of the nation’s leading experts on municipal bankruptcies. “But then, there has never been another case like” Orange County’s, the largest municipal bankruptcy in U.S. history.

Bennett said he does not believe Ryan will have much difficulty finding the legal authority to grant the county’s request, in part because the county is showing a good-faith effort to meet its obligations, and also because of past super priority rulings in Chapter 11 bankruptcy cases.

“I don’t even think there is a question there,” Bennett said. “It’s a tried and true technique that succeeds all the time in corporate bankruptcies. We’re using the same technique, and we have every reason to believe it will succeed here as well.”

But not everyone is so sure. Some question whether it’s legal. And others say it’s unfair to the creditors already in line--and whose places would be usurped by new bondholders.

“Generally, I think courts are very skeptical of doing it,” said Daniel J. Bussel, a UCLA law professor and bankruptcy specialist. “It’s very unusual for certain claimants to be paid off before others.”

The legal theory behind seeking super-priority status for some debts is known as the “necessity rule,” Spiotto said.

“You have to convince the judge it is absolutely necessary, absolutely critical to the success of the reorganization under bankruptcy,” Spiotto said.

But in some ways, they say, the “necessity rule” is even more appropriate for Chapter 9 cases such as Orange County’s. If the county does not make good on the losses of the schools, cities and other agencies that had money in the failed investment pool, dozens of them would likely topple into bankruptcy just as the county did--something county officials are eager to avoid.

While embedded in Chapter 11 bankruptcy law, super-priority status for some creditors is not specifically contained in Chapter 9--although it does allow other Chapter 11 provisions to be used in municipal bankruptcies.

“It’s not spelled out, but it can apply to Chapter 9 as well,” Bussel said. “But to my knowledge, it’s never been done before.”

The vast majority of pool participants have endorsed a settlement option that gives them on average 77% of their pre-bankruptcy pool balances in cash and an additional 3% to 13% in “recovery warrants” that the county promises to “make good as gold” by early June, but strips them of their right to sue the county over the remainder.

The warrants will be backed by the recovery bonds--which is why Ryan’s ruling will be critical.

A handful of pool participants, mostly cities outside Orange County, took another settlement option that likewise gives them 77% in cash but leaves them free to sue the county for their balances, while a much smaller number of investors rejected both offers.

The overall settlement agreement also needs Ryan’s approval.

Under the plan being presented to Ryan in early May, the county wants authority to set aside the millions needed to pay the interest on the recovery bonds during the first seven years of their 15-year life, Bennett said.

Just how the county plans to pay off the principal remains unclear, although officials are pursuing a variety of options, from using the proceeds of a proposed half-cent sales tax, to hiking garbage fees, to legislation that would allow them to tap into millions from motor vehicle fees.

“There is clearly an issue of the ultimate repayment, but we believe revenue sources will be identified,” Bennett said, adding that the type of bonds to be issued and the interest rate they will carry are still open questions.

Because they are so unusual, the bonds will likely be taxable securities with higher rates of return for investors than the typical, tax-exempt bonds Orange County and other municipalities routinely sell to raise money for roads, schools and other projects, officials said.

“There’s going to be a question of who is going to buy this. But if the county is saying, ‘We’re really desperate, and we’ll pay you 12% a year,’ somebody will take it,” said Dean Misczynski, the director of the state Senate’s office of research in Sacramento, who is involved in handling legislation relating to Orange County’s recovery efforts.

The county is exploring five ways to make the bonds more appetizing to Wall Street: securing bond insurance, getting a bank to provide a letter of credit, state guarantees, offering the entire block to a single institutional investor at a discount, and borrowing from other funds to pay off the bonds.

Some say the county might be its own worst enemy in this process.

Misczynski pointed to stories that the county is considering defaulting on $600 million in bond debt due this summer because, it argues, the borrowings were illegal and therefore are not valid claims.

Potential bond buyers must fear that someday the county might use the same unusual legal maneuver to one day default on the so-called recovery bonds, he said.

“Buyers are going to be concerned that maybe someday (the county) will turn around and say, ‘Ryan shouldn’t have done that, so we shouldn’t have to pay,’ ” Misczynski said. “The name of the game in the municipal debt market is credibility.”

But Bennett hotly disagrees. He says the county has no intention of defaulting--but simply must be prepared for that possibility.

“There is no plan to default on anything,” he said.

Bennett also stresses that the county is not going deeper into debt--but is replacing its debt to schools, cities and other agencies with debt it can pay private investors at a later date. “The aggregate level of county debt is not going to change,” he said.

If the county’s newest plan to fund the recovery bonds wins Judge Ryan’s approval, it will mark a milestone on the road to recovery. But not everyone is sanguine about the prospects for success.

“What the pool participants are concerned about is whether the recovery notes will be good as gold, salable at par on June 5,” said Jon Schotz, an investment banker with Saybrook Capital and financial adviser to the pool participants.

“The county has an obligation to make sure we can sell these things,” said Schotz. “If they are not as good as gold, the schools will hit the wall. They have bond payments due June 13 that they won’t be able to make, and then you’ll have more Chapter 9” filings, he said.

That would be “the beginning of a meltdown,” Schotz said.

For San Diego attorney Edward Gergosian, who represents some Orange County bondholders in a class-action suit, the new plan is a second dose of bad medicine for his clients.

“I represent people who claim they were defrauded by what all those (investment) bankers did,” he said, adding that losing their place in the long line of creditors to some Johnny-come-lately bond buyers “is just another example of how (my clients) are being hurt.”

Still, some question whether the latest county plan has a chance.

“I think there is a question of whether there is justification in a legal sense for putting one group of investors over another,” said Steven H. Felderstein, a Sacramento bankruptcy attorney, who nonetheless agrees that the “true pain and suffering in all this” is being felt most by “the pool participants who desperately need that money.”

Bankruptcy experts say they will be watching closely--along with other municipalities nationwide that are experiencing financial troubles.

“It will be very interesting to see how Judge Ryan handles that. He can’t relish the idea of being the person who has the fate of the school districts in his hands if he doesn’t authorize it,” Bussel said. “There’s a lot of pressure on.”

Times staff writer Debora Vrana contributed to this story.