This story was reported for the San Diego News Network on October 8, 2009. It was reported by Hoa Quach and Steven Bartholow.
Four years ago Pat Shea, a candidate for mayor, pitched a risky idea to San Diego’s voters and decision makers: declare Chapter 9 bankruptcy.
Shea – an attorney who helped handle Orange County’s bankruptcy proceedings in 1994 – said bankruptcy was a viable option in the wake of Dick Murphy’s resignation and at the height of San Diego’s financial woes.
Then – in 2005 – the city faced a $1.4 billion pension deficit, was behind on audits, and was crippled by money troubles.
Now – despite a restored credit rating – the pension deficit has ballooned to $2 billion and the general fund deficit is hovering between $179 million and $200 million.
With the city’s elected officials saying every option is worth exploring, Shea says bankruptcy should be back on the table.
“If I had my way, (the city would) go into Chapter 9,” Shea said.
Less than 500 municipalities have declared bankruptcy since Congress allowed it under Chapter 9 of the U.S. Bankruptcy Code in 1934, according to The San Diego Union-Tribune. Whether San Diego chooses to take that route is a decision left to the city’s elected officers, and first they’d have to prove the city can no longer pay the bills necessary to keep it functioning.
What Chapter 9 means
Chapter 9 bankruptcy allows municipalities to clear out debt, similar to if an individual or company filed for Chapter 11.
As stated in the actual legislation, Chapter 9 allows municipalities to renegotiate contracts with agencies; contracts that compounded a city or county’s debt to land the municipality in a fiscal hole.
According to the legislation, “The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts.
Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.”
A difference between a city filing for bankruptcy compared to a company is the liquidation process. Municipalities have more protection.
The legislation states “there is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors. Such liquidation or dissolution would undoubtedly violate the Tenth Amendment to the Constitution and the reservation to the states of sovereignty over their internal affairs.”
In addition, creditors have less say when a municipality files for bankruptcy.
According to the legislation, “There is no first meeting of creditors, and creditors may not propose competing plans. If certain requirements are met, the debtor’s plan is binding on dissenting creditors. The chapter 9 debtor has more freedom to operate without court-imposed restrictions.”
This means any agency that has a vested interest in San Diego would not be able to vocalize its concerns, despite the fact the city’s fiscal woes could deepen, even in bankruptcy.
The city’s current predicament
Last week, Mayor Jerry Sanders and his office released its Five-Year Financial Outlook, and estimated deficits well over $100 million every year through 2015.
San Diego’s general fund deficit has grown incrementally the last few months, from a projected $60 million, to the mayor’s estimate last week – $179 million – to the Independent Budget Analyst (IBA) office’s most recent guess, $200 million. The rising deficit began with a memo released two weeks ago by Chief Operating Officer Jay Goldstone, who announced a city government hiring freeze amidst the news that the general fund could face a $100 million deficit.
Additionally, Sanders told the city that it faces a $67 million drop in sales and property tax revenues in the coming fiscal year. Meanwhile, the city’s annual required contribution to the San Diego City Employees’ Retirement System will grow by about $57 million to $224 million in fiscal year 2011.
He told San Diegans nothing would be “off the table.”
“A deficit this size is so significant we can no longer shield the public from its impacts,” Sanders said. “As we begin putting together a solution to close our budget gap, we’ll examine every responsible alternative to cutting services.”
Even bankruptcy?
Lessons from Orange County
If the fiscal outlook is an accurate sign of things to come, San Diego should file for Chapter 9, Shea said.
In 1994 Shea was working on the largest municipal bankruptcy in the nation’s history. Orange County was $2 billion in the hole because of bad investments, had no credit rating and was having trouble getting residents to vote for tax increases to help cover the deficit. After 18 months of bankruptcy negotiations, Orange County went from “insolvency” to “solvency.”
“There were 172 cities, water districts, agencies and government agencies – they don’t talk to each other in the general rule, they don’t like each other in the general rule, they have their own objectives in the general rule,” Shea said. “There is no other vehicle under law that would allow all the groups to work on a resolution together; it’s only under Chapter 9 where they all showed up in one room, one day and they successfully restored the County of Orange.”
Although Orange County’s predicament was different from San Diego’s and the county wasn’t facing the current recession, lessons can be learned, Shea said.
“One of the important things is to remember – if not the most important thing – is bankruptcy doesn’t happen to a municipality; they have to choose to go into Chapter 9, which will provide them with a platform of restructuring,” Shea said. “There are a lot of different ways of dealing with financial reversals. If the community is prepared to pay additional taxes, that’s a very legible option. That’s one option.”
“If the approach the government would want to take or would need to take is to renegotiate labor contracts, I don’t know of another way where one can achieve that type of relief than inside Chapter 9.”
But the initiatives to increase taxes could be rejected and unpopular decisions such as cutting services, public safety funding and funding to key departments, could hurt elected officials. Shea uses Orange County as an example again.
Prior to 1994 he said Orange County had an initiative to increase a tax to help the municipality garner funds. It was overwhelmingly rejected. Once the county recovered from bankruptcy though, residents passed three ballot initiatives raising taxes. He said the public finally trusted its government to spend its money wisely, after necessary restructuring took place.
“It doesn’t happen very frequently but if you look at times of financial distress, historically, you’ll see the case was the same with other municipal bankruptcies,” Shea said. “As long as you have an enormous deficit, people will be unwilling to backfill it.”
Related Links: San Diego’s $179 million could be mean deep cuts | Councilmembers react to San Diego’s updated $179 million deficit | More politics | Pocket Change: A deeper look into San Diego’s budget
But Shea notes that he and his opinions and assumptions are unique. Nevertheless though, he said if the city declared bankruptcy in 2005, the city’s finances would be very different today.
“I would only do it because I’m a different person than those down at City Hall,” Shea said. “I’d rather spend two years in very, very difficult circumstance to restructure the finances than remain in it for longer. We, in San Diego are not big on examining history; we don’t seek scholarly advice. We do things anecdotally and emotionally.”
‘…by no means a slam dunk…’
Declaring bankruptcy would potentially allow San Diego to wipe its financial slate clean and renegotiate contracts with labor unions and the amount invested in the pension system.
But, this can be easier said than done. Bankruptcy would force a solution to be hammered out, but it could take a lot of costly litigation, as it did with Orange County, which paid $3 million to Shea alone, according to the Union-Tribune.
Additionally, Sanders’ spokesperson Rachel Laing said the city does not believe it even qualifies for bankruptcy as the city must prove it’s insolvent. At the current moment, because the city pays its bills it remains solvent.
“As in 2005, we do not believe the city qualifies for bankruptcy under the most basic test,” Laing said. “Bankruptcy is the inability to pay debts as they come due. The city continues to be able to pay its debts as they come due.”
But the city simply could be solvent because the bulk of San Diego’s pension deficit is amortized, which means the city will be paying it off over the next 15 to 30 years. If it was different and the city was forced to pay it in a shorter time period, bankruptcy may be the way to go.
Laing adds that, “Declaring bankruptcy would essentially nullify the efforts [such as the audits the city had to complete] over the past four years to restore San Diego’s credit.”
And when it comes to labor contracts, she said, the current contracts are only two years long. Therefore if the city were to declare bankruptcy, by the time the city recovered, the city would be allowed to renegotiate contracts at any rate.
Sanders’ unwillingness to file for bankruptcy is backed by a study titled, “When Government Fails: The Orange County Bankruptcy,” by the Public Policy Institute of California.
One of 10 policy recommendations found in the study states, “Municipal bankruptcies should be avoided by local and state governments, even if extraordinary efforts are required.”
And, in the end, declaring bankruptcy doesn’t guarantee recovery.
“Those who advocate bankruptcy present as a ‘sure thing’ that, by declaring bankruptcy, we would automatically be able to nullify our labor contracts and retirement benefit contracts,” Laing said. “These are by no means a slam dunk. Each of these items would have to pass a separate court test. So you’d have to qualify for bankruptcy, then you’d additionally have to beat court challenges to efforts to nullify these contracts.”
A spokesperson for Councilmember Donna Frye – who was open to the possibility of Chapter 9 after further evaluation in 2005 during the mayoral campaign – said she would not rule out “any potential options to address the city’s current fiscal situation.”
How it affects California
But other factors come into play. The woes of San Diego could impact the state if it were to declare bankruptcy.
And some legislators acknowledge that the declaration could happen to a California city. Assemblymember Tony Mendoza (D-Norwalk) authored a proposed bill earlier this year which would require municipalities to be approved by the state government prior to filing for Chapter 9. Although the bill was eventually rejected, the possibility of it being re-introduced is still alive.
Other possibilities for getting San Diego out of the hole
Last week San Diego’s Independent Budget Analyst Andrea Telvin included potential solutions to the general fund deficit in a review of the mayor’s Five-Year Financial Outlook.
The IBA prefaced its solutions with the caveat that “relatively few meaningful solutions appear to exist short of budget and service reductions.” The key phrase being thrown around by those with keys to San Diego’s financial future is “service cuts.”
“There are few viable solutions that remain on the table – that short of budget reductions such as service and program reductions … can be done to the magnitude to help close this significant of a gap,” Tevlin said.
Bankruptcy was not a considered solution, likely because of the stigma surrounding it.
And to Shea the stigma remains the problem. He also notes that the business community in Orange County backed the government “100 percent” for filing for Chapter 9.
“But it’s not going to happen in San Diego,” Shea said. “In Orange County, people were ready to fix the problem and were completely intolerant of delays, games and confusion – that attitude does not exist in San Diego.”
“Unless someone drops a couple billion dollars on the city, it’s going to be hard to fix the budget.”
City News Service writer Joe Britton contributed to this report.
