Feeling the Pinch

Feeling the Pinch

greenlightbulbEncumbered with ballooning labor costs and years of recurring debt that led to a $16 million budget shortfall amid a looming recession, the cash-strapped San Francisco Bay Area suburb of Vallejo sought shelter from its financial woes via a recent Chapter 9 bankruptcy filing. But some governmental experts worry that Vallejo’s May 23 filing could be a more common option for local government bodies nationwide that struggle to maintain financial solvenmacy.

“The fear is that Vallejo may be the tip of the iceberg…that Vallejo may not be the exception,” says James E. Spiotto, a municipality bankruptcy specialist and partner at Chicago-based law firm Chapman and Cutler L.L.P. “Once you have a downturn in the economy, within a year to two afterward, you start to see reduced tax revenues from other local governments.” Spiotto says whenever you have a downturn, specifically during a housing market slump, every house in foreclosure poses a challenge in getting taxes paid, and as property values decline, the tax rates are lowered, leading to less money in local government coffers to budget for infrastructure improvements, public safety, and schools.

A Chapter 9 filing provides a financially distressed municipality protection from its creditors as it develops and negotiates a plan for the adjustment of debts, according to the Administrative Office of the U.S. Courts Website.

Officials in north Alabama’s Jefferson County are working to avoid filing for bankruptcy after becoming entangled in a series of exotic bonds, which were used for sewer system improvements. The bonds had decreased to junk status, leaving the county with interest rate payments that jumped from about $130 million annually to about $260 million. Orange County in southern California, the fifth most populous county in the nation, filed for bankruptcy in 1994 after $1.6 billion in investment loss.

Since 1980, about 35 towns, villages, or counties filed for bankruptcy, Spiotto says. “That is nothing compared to Chapter 11s or Chapter 7s, which are really in the tens of thousands filed a year,” he adds. “The bankruptcy of a municipality is a rare event. It’s maybe done as a last resort.”

Filing a bankruptcy petition was something newly elected Vallejo Mayor Osby Davis spent the first five of the past seven months in office to avoid.

Davis, Vallejo’s first black mayor, says the city went through every reasonable option to evade filing, including negotiating with labor unions to find permanent solutions for lowering pay raises, but all options led to delaying “the inevitable” for a year or two. The city simply didn’t have the ability to curb expenditures to make it financially solvent, he says, so filing a petition for bankruptcy was its best option. Spikes in the economy exasperated the problem, he adds. Vallejo is the largest city in California to file for bankruptcy.

Davis says three factors caused the city to file for bankruptcy. The first was its failure to heed the warning signs of impending financial crisis that the city was aware of since 1993,