Municipal Fiscal Crisis:

A Case Study of Stockton, California

Preliminary Please Do Not Cite

Manager: Frank Mamo Audrey Ariss

Erica Matsumoto

Julia Radunsky Krisztian Simon

Advisor: Professor Ester R. Fuchs, Columbia University

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Table of Contents

Introduction & Executive Summary .................................................................................. 3

Factors Leading to the Fiscal Crisis ................................................................................... 4 Structural Causes ............................................................................................................................ 5 Managerial Causes .......................................................................................................................... 8 Political Causes ............................................................................................................................. 11 Economic Causes .......................................................................................................................... 15

Fiscal Crisis and Stocktons Initial Reaction .................................................................. 18 Employee and Service Cuts ........................................................................................................ 19 Financial Restructuring: AB506 ................................................................................................ 20

Municipal Bankruptcy ........................................................................................................ 22 Eligibility ....................................................................................................................................... 23 Consequences of Stocktons Decision to File for Bankruptcy Protection ........................... 26

Municipal Fiscal Crisis: Policy Recommendations ........................................................ 27 Addressing Revenues ................................................................................................................... 28 Addressing Liabilities .................................................................................................................. 29 Addressing Management ............................................................................................................ 29

Conclusion: ........................................................................................................................... 30

Bibliography:........................................................................................................................ 31

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Introduction & Executive Summary

Throughout much of the 1990s and mid-2000s, fiscal mismanagement, relentless

pressure from special interest groups, and structural constraints at the state and local level

drove Stockton, California to the brink of a fiscal crisis. With the housing market crash

in late 2007 and the ensuing recession, Stocktons financial position went from

precarious to unsustainable. No longer able to meet its obligations, Stockton reduced its

workforce by up to 40 percent while slashing its General Fund spending across all core

functions. Such efforts proved too little too late. Faced with an inability to meet public

debt payments and General Fund obligations - and having already made staggering cuts

to its budget and workforce - Stockton filed for bankruptcy in June 2012. To date, this

has been the largest municipal bankruptcy in United States history.

This paper seeks to examine Stocktons decision to file for bankruptcy and

assesses whether this decision adequately addresses the long-term fiscal sustainability of

the city. It is important to highlight that bankruptcy was a policy decision in response to

the citys fiscal crisis. To this end, we first examine the primary variables that led to

Stocktons fiscal crisis and why spending cuts and layoffs alone were not a viable

solution. Identifying such factors will allow us to examine how bankruptcy addressed or

failed to address these issues. To the extent that bankruptcy did not address these factors,

we will provide additional long-term policy solutions to help Stockton regain its fiscal

health. The below model illustrates this research methodology.1

1 We have built our model based on Ester R. Fuchs article Governing the 21st Century City. Journal of International Affairs, Spring/Summer 2012, Vol. 65, No. 2: 43-56.

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Broken into four sections, this paper first examines the main factors contributing

to Stocktons fiscal crisis by addressing the structural, managerial, political, and

economic environment in which Stockton operated. The second part of the paper

examines the fiscal crisis itself and why Stocktons short-term policy prescriptions did

not adequately address the fiscal crisis underlying drivers. The third part and perhaps

the backbone of our research - examines Stocktons decision to declare bankruptcy and

addresses questions such as: why did Stockton choose bankruptcy over other policy

options? What does it mean for a city to file for bankruptcy? How will this bankruptcy

influence future municipal bankruptcy proceedings, and has Stocktons bankruptcy

addressed the underlying causes of its fiscal crisis? Finally, upon understanding

bankruptcys successes and shortfalls, the fourth part of our paper will offer short and

long-term policy suggestions that if implemented could allow Stockton to prevent future

relapses to fiscal distress.

Factors Leading to the Fiscal Crisis

To identify the primary variables that led to Stocktons fiscal crisis, we first

defined what a fiscal crisis entails. In short, a city enters a fiscal crisis when it is unable to

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finance its debt and operating expenditures, and is consequently locked out of bond

markets.2 Unable to pay its growing expenses, a city has no choice but to seek refuge

from its obligations. As Stockton followed this exact trajectory, we sought to identify the

key variables which led to this state. After reviewing the literature on municipal fiscal

crisis3 and examining Stocktons fiscal operating environment, we identified and broadly

categorized these variables as structural, managerial, political, and economic.

Structural Causes

The fiscal health of a city depends on a number of institutional factors that are

beyond the control of city governments and its current administrators; we labeled such

factors as structural. These structural factors are diverse in nature and include:

unfunded state and/or federal mandates,4 state laws limiting a citys power to tax,5 and

current mayors coping with irresponsible spending decisions made by previous mayors

(which we refer to as tensions within cities over time).6 In the case of Stockton, we

2 Fuchs (1992) writes that there is disagreement among scholars about the definition of fiscal instability and

fiscal crisis. She writes that historically only those cities have been considered being in a crisis, which were

locked out of bond markets and were thus unable to pay their debts and finance their services. 3 Cohens Municipal Default Patterns (1989), England, Pelissero and Morgans Managing Urban America (2012), Fuchs The Permanent Urban Fiscal Crisis (1996) and Mayors and Money (1992), Inmans Financing City Services (2009), Judd and Swanstons City Politics (2010), and Wallins Budgeting for Basics (2005) give us a sense of what lead to fiscal crisis in other municipalities. 4 Fuchs (1996) argues that although exogenous economic forces can be important determinants of a citys financial situation, political forces also need to be addressed by cities if they want to solve their problems.

Intergovernmental relations are a great issue, as state governments have control over city fiscal policies.

They can mandate programs without providing state funds for them set salaries and benefits or working

conditions. Moreover, they can also limit the level of taxes or the borrowing capacity of cities. 5 Fuchs (1992) mentions that most cities require state approval for any change in the local tax structure, and

highlights two legislative initiatives of the early 1980s that have limited cities local property tax increases: Proposition 13 in California and Proposition 2 in Massachusetts. England, Pelissero and Morgan (2012)

argue that cities dont have access to the most efficient revenue-raising tools and tax resources that all belong to states and the federal government. 6 According to Inman (2009), an important rule for policymakers should be: deficit financing for infrastructure services only, and deficit spending on current services, such as public employee pensions should be avoided. In the aftermath of the New York City fiscal crisis, Gramlich (1976) wrote that there are

3 reasons for cities to borrow: a) long-term capital investment projects b) to smooth out seasonal

fluctuations in revenues and expenditures, and c) to cover current account deficits. This latter is usually not

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identified two primary structural constraints: tensions between the state and city

government as well as tensions within the city over time.

Tension between the city and state government is a structural constraint often seen

throughout the U.S. It refers to a states failure (or reluctance) to grant a city full or

adequate autonomy to make its own decisions on how to tax and spend.7 This structural

constraint played a significant role in steering Stockton into financial trouble, particularly

by limiting its ability to raise adequate tax revenues. This ultimately materialized in the

form of Proposition 13 (Prop 13, officially the Peoples Initiative to Limit Property

Taxation), a California state law limiting the municipal taxing structure on private

property to 1% of its assessed value with annual increases capped at 2%. The language of

the legal code reads:

Section 1. (a) The maximum amount of any ad valorem tax on real property shall not

exceed one percent (1%) of the full cash value of such property. The one percent (1%)

tax to be collected by the counties and apportioned according to law to the districts within

the counties.

Passed in 1978, this longstanding measure attests to its political popularity, despite its

favored by either the citys creditors or the citys laws. McMahon and Siegel (2005) make a similar argument in the neoconservative The Public Interest journal. They write that the problems that led to New Yorks financial crisis (and could happen anytime again either in New York or in California), are merely due to the fact that the city has mortgaged itself far into the future by issuing one wave of municipal bonds after another. But instead of looking at the state and federal governments, they argue that union contracts and welfare programs are to blame for this. 7 Fuchs (1992 and 1996), Gramlich (1976) and others have extensively written about the tensions between

state and city governments, which we have discussed earlier in this paper. The situation has drastically

worsened in the 1980s. As Wilson (2008-2009) points out, during Ronald Reagans presidency, direct aid to cities was cut dramatically, thereby citys budget for revenue sharing (that could have been used unrestrictedly for anything from public transit to economic development assistance) has been drastically

reduced. New York Citys state aid, for example, has dropped from 52 percent to 32 percent in just ten years. The loss of external funding is a major issue for cities, as Inman (2009) writes: cities should be

responsible only for those services whose benefits are felt only inside the citys territory, by the citys residents. He argues for a shared responsibility with state or regional governments for services with large

spillovers, such as clean air and water, or services like highways, telecommunication networks, or

infrastructure for electric generation, which require populations that are in most cases larger than a

municipality in order to function efficiently. Similarly, income support for the poor, above the level that is

desirable for residents, should also be financed by either the state of federal government.

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crippling impact on city budgets.8 By preventing cities from raising tax rates and thereby

largely constraining local income growth, Prop 13 showcases the far-reaching power state

legislators have on influencing municipal finances.

In addition to tensions with the state government, Stockton also had tensions

within the city over time. This largely stemmed from the mayoral practice of

implementing politically popular policies which would have severe fiscal implications for

a future mayor.9 In Stockton as across the nation10 - such tensions came in the form of

more generous pension plans. These agreements were a popular tool used by Stocktons

mayors because they helped to improve a mayors political standing while having no

immediate negative fiscal consequences. The extent of these costs often become apparent

several years or even decades afterwards, at which point the mayor in office is faced with

the legally inevitable but fiscally disastrous decision to honor these agreed upon pension

plans, usually by diverting resources away from other General Fund programs.

Structural constraints such as these, which are completely out of the hands of

current city administrators, are important factors to consider as one conducts any form of

analysis of an urban problem. They provide a framework under which all other variables

8 Stanford Professor David Kennedy argued in his 2003 New York Times op-ed From Pitchforks to Proposition 13 that Proposition 13 is untouchable in American politics, even though the initiative has been one of the main sources of Californias fiscal problems, making the overhaul of Proposition 13 part of an electoral campaign, would most likely cost the candidate the election. This is problematic because Judd

and Swanston (2010) write that cities revenues come from two sources: (a) what state law allows and (b) what city officials feel they can impose without driving out investors or losing the support of residents. 9 Fuchs (1996) writes that for many years the golden rule of urban fiscal policy has been: never pay for anything today that can be dumped on another mayor. Although there are often balanced budget rules in cities, political factors almost always make mayors argue that the city is going to expect growing revenues

and decreasing expenditures, while in times of hardship they prefer to borrow, instead of raising taxes or

cutting any of their programs. 10 Tim Reily (2013) writes that all over the U.S. (and Europe) state and local governments suffer from the costs of pensions and other postretirement benefits of public sector workers. These unfunded liabilities

amount to somewhere between $1.4 to over $4 trillion (depending on which estimates one uses). The

situation is particularly serious because in the last years the returns on pension and health care costs have

risen faster than inflation, as todays pensioners live longer but low interest rates have reduced returns on the pension funds that are used to pay for these benefits.

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must operate, and it is important to keep these factors in mind as we identify and analyze

additional causes of Stocktons fiscal crisis.

Managerial Causes

In addition to these structural causes, several managerial factors were influential

in steering Stockton into fiscal crisis. Managerial factors encompass a citys ability to

make sound policy decisions in order for the city to provide adequate public service

delivery for current and future generations. Fiscal mismanagement, then, is the city

officials failure to fully consider a policys structural impact on the budget and plan for

potential worst case scenarios. Such mismanagement was a major factor in leading to

Stocktons fiscal crisis and was largely caused by overly optimistic views of the citys

future potential growth.

To understand the drivers of such optimism, it is important to consider the larger

economic environment Stockton was operating in during the early 2000s. Coming out of

the 2001 recession, the country began to see an unprecedented boom in the number of

mortgages granted and a successive increase in the valuation of home prices.

Data From: Federal Housing Finance Agency

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In California, housing prices were among the fastest growing in the nation,

growing from around 120 to 160 percent between 2000 and 2006. Comparing Stocktons

change in housing prices over this time to that of Californias, we found that at its peak,

Stocktons housing prices were growing about 25 percent faster than the state average -

an indication that Stocktons housing prices were among the fastest growing in the

country.

Driven primarily by this unusually high (and in hindsight, artificially high) growth

in the real estate market, Stocktons economy grew rapidly. With this rapid growth,

Stocktons tax revenues also increased dramatically. In nominal terms, Stocktons

General Fund tax revenues grew to record levels, from about $98 million in fiscal year

2002 to around $140 million in fiscal year 2006.11

Over this period two of Stocktons

11 Data from: Actual General Fund Tax Revenues, Stockton Budget Documents. Note these are tax

revenues and do not include non-tax revenues such as: Licenses & Permits, Fines & Forfeitures, and

Revenues from Other Agencies. While these revenue sources were also increasing during this time, they

Data From: California Department of Finance. Graph illustrates relative growth rates in property and land values of California and Stockton. Data is baselined at fiscal year 2001 and normalized at 100.

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largest sources of General Fund tax revenue, property tax along with sales and use tax,

were also growing at unprecedented rates of around 14 percent and 10 percent per year,

respectively. In addition, due to the rapid growth in housing prices, growth in property

tax revenues outpaced growth in all other tax revenue sources, thereby causing property

tax revenues to become a much more significant percentage of Stocktons overall tax

revenue portfolio.

Rather than recognizing that such increase in housing prices and property tax

collections could be artificial and unsustainable and thus proceeding with caution it

seemed that Stocktons policymakers viewed such growth as the citys new normal. After

experiencing average growth in tax revenues of over 9 percent per year from 2001

through 2006, policymakers expected similar growth to continue and forecasted 9.55

account for a much smaller segment of overall revenue and are less subject to managerial influence. Prior Year Budget: City of Stockton, CA City of Stockton, Web.

Data From: Stockton Budget Documents

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percent growth through fiscal year 2008.12

Such an optimistic outlook in the citys

revenue collections was used to justify the spending spree that ensued. In the three years

leading up to the 2008 recession, policymakers decided to increase the citys workforce,

augment employee salaries and benefits, and expand services.13

Furthermore, in 2007, the

city began shifting funds out of its General Fund into several grandiloquent

redevelopment projects managed by the Redevelopment Agency. Such projects included

the historic Philomathean buildings renovation, development of the local marina and

waterfront area, and renovation of the Hotel Stockton. As our data analysis and research

indicates, high spending, poor planning, and unchecked optimism were key managerial

factors in leading Stockton down the path toward fiscal crisis.

Political Causes

The same unchecked optimism that led Stockton to engage in fiscal

mismanagement also opened the door for undue influence from special interests groups.

We categorize such influence as political; where, due to the current operating

environment be it economic, ideological, or otherwise a city is faced with a particular

political environment that influences the shape of a citys policy.

Stocktons unchecked optimism created a political environment that was prone to

disproportionate influence from public sector unions primarily local fire and police

employee unions. Taking advantage of policymakers propensity to spend, these unions

successfully negotiated new agreements that locked the city into expensive and inflexible

12 Data from: Stockton Budget Documents. Prior Year Budget: City of Stockton, CA City of Stockton, Web. 13 Evans, Sydney et al., How Stockton Went Bust: A California Citys Decade of Policies and the Financial Crisis that Followed. California Common Sense. 2012. Web.

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employment contracts (referred to as Memorandums of Understanding or MOUs). These

MOUs, which were made with individual unions, established that during years of growth,

employee salaries would increase 2.5 to 7 percent, depending on revenue growth in the

General Fund. Consequently, in years when the General Fund didnt grow at all or even

shrank, employee salaries would continue to increase at 2.5 percent.14

The MOUs also

created a condition in which salary increases were decided upon much like a colluding

matching program, such that if any one Stockton union receives a higher wage increase

than outlined in the formula, then all employees affected by the General Fund budget

must receive the same increase as well.15

To understand the potential magnitude such MOUs could have on Stocktons

finances, we examined the citys average General Fund spending portfolio:

We found that between fiscal year 2002 and 2006, Stocktons spending on employee

14 Ibid. 15 Ibid.

Data From: Stockton Budget Documents

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services (which includes salaries, benefits, and other employee-related costs covered in

the MOUs) exceeded on average 80 percent of its overall General Fund spending.

Therefore, a 2.5 to 7 percent increase in this component of the budget drastically

increases the citys overall spending.

When examining the citys spending on employment services upon entering into

these MOUs during fiscal year 2004, we discovered that spending almost instantly

ballooned relative to the number of people employed as each individual worker was

becoming more expensive.

In order to see if this increase in costs was a direct result of these MOU contracts, we

analyzed employee services spending according to the General Funds four main

components: Police, Fire, General Government,16

and Public Works.

16 The category, General Government is used by the city in its budget documents as an aggregation of the Offices of Administrative Services, the City Attorney, the City Auditor, the City Clerk, the City Council,

the Mayor, and the City Manager.

Data From: Stockton Budget Documents. Graph illustrates relative growth of employee costs and headcount. Data is baselined at fiscal year 2002 and normalized at 100.

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Examining the relationship between employment costs and departmental-specific

employment, we found the Police and Fire Department employee services to be the

primary drivers of the citys ballooning employment costs. Additionally, we can see that

while employment costs in the Police and Fire Departments grew rapidly, employment

costs in the citys two other largest divisions, Public Works and General Government

(areas that the 2004 MOUs did not include), remained relatively constant with

employment levels.

In addition to employment costs, pensions and other post-employment benefits

were significant factors behind the growing budget gap. On a defined benefit pension

Data From: Stockton Budget Documents. Graph illustrates relative growth of employee costs for titled department and titled departments total headcount. Data is baselined at fiscal year 2002 and normalized at 100.

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plan, Stockton was contractually required to guarantee retirees regular defined payments

even if accumulated contributions and investment returns were less than what was

available. Additionally, due to several years of severe underfunding, Stocktons pension

liabilities were underfunded by over $123 million. In 2007, to fund these liabilities, the

city issued bonds in the sum of $125 million. However, with the ensuing financial crisis,

by 2010 these bonds were only worth $93 million, thereby creating an additional $32

million shortfall in the amount owed to CalPERS. By 2010, Stocktons unfunded pension

liability had increased to $413 million.17

Due to these union contracts and the structural

constraints of the municipal code that does not permit cities to run deficits, Stockton was

forced to divert resources from its already constrained General Fund in order to pay for

this shortfall.

Overall, these MOUs and pension agreements created a structural deficit within

the General Fund due to the political decision to grant several unions exceptional control

over the citys budget. As a result, Stockton continued further down the path toward

fiscal crisis.

Economic Causes

While structural, managerial, and political factors are largely played out at the

local level and therefore subject to some influence, another less manageable variable

played a significant role in pushing Stockton over the edge and towards its fiscal crisis:

the economic recession. In late 2007, the housing market boom that swept the U.S. during

the mid-2000s came to an abrupt halt. Around the U.S., home prices plummeted; laying

the foundation for what was soon to be the largest financial crisis since the Great

17 From data in "City of Stockton 2007 Taxable Pension Obligation Bonds" official statement. Public

Finance Department of Stockton. September 1, 2007, pp. 4-5.

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Depression.

When the housing bubble burst, Stocktons housing prices fell over 70 percent by

2010 to the level they were in 2000. As housing prices fell and the economy worsened,

Stockton residents began to foreclose on their homes. By 2009 to 2010, foreclosure rates

in Stockton were twice that of the national average and almost double the California State

Data From: Federal Housing Finance Agency

Data From: Zillow.com

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average.

Such forces a decline in housing prices, increased foreclosure rates, and a deep

economic recession had several spillover effects on Stocktons fiscal condition. Across

the board, Stocktons primary General Fund tax revenue sources began to plummet. As

housing prices fell, property tax collections fell; as residents began to foreclose on their

homes, utility user tax collections fell; and as the economy worsened and unemployment

grew, people had less to spend, driving down sales tax revenues.

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

0.30%

National California San Joaquin Stockton

Pe

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nta

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of

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its

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Are

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Average Foreclosure Rates 2009-2010

Data From: RealtyTrac.com

Data From: Stockton Budget Documents.

18

This drop in General Fund tax revenues caused by the recession was enough to

push Stockton to the edge of fiscal crisis a push that required immediate action by the

citys administration. However, considering the structural, managerial, and political

factors it faced, there were very few options for Stockton. First, Stockton had already

overcommitted General Fund resources because of overly optimistic revenue projections.

Second, Stockton was still required to offer salary increases to many of its employees and

was legally prevented from acting immediately to adjust these policies. Finally, because

of Prop 13, Stockton was unable to increase property tax rates in order to raise additional

General Fund tax revenues.

Fiscal Crisis and Stocktons Initial Reaction

By 2008, the combined effect of the above factors led Stockton to post a fiscal

deficit. In this section, we outline Stocktons attempts to address its fiscal crisis by

adopting a number of emergency measures. However, by 2012, after two years of

declaring fiscal emergency, Stockton had all but exhausted its reserve funds, severely

reduced the size of its departments and services, and had a number of assets seized. City

Manager Bob Deis explained: The sources of our fiscal situation include unsustainable

retiree health insurance; unsustainable and unsupportable labor contracts; an extreme

amount of debt issued in the first decade of this century that assumed hyper growth

would last forever; and poor fiscal management practices.18

18 City of Stockton News Release, 28 February 2012.

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Employee and Service Cuts

In 2008, Stockton ran a $5 million budget deficit. With ensuing cuts in services, it

was able to get this number down to $1 million in 2009. Nonetheless, by 2010, the budget

deficit stood at $7.5 million, with Stockton ultimately calling for a state of fiscal

emergency.19

Realizing it needed to address an unforeseen budget shortfall in 2008, Stockton

implemented a hiring freeze for 90 open positions. Over the next three years, the city

pursued similar cost-cutting policies in an attempt to address the fiscal deficit. However,

these short-term cuts failed to address the roots of the budget imbalance and the very

nature of the citys obligations and debts. By 2009, the City Council recognized the need

to reform more of its budget and its services. From 2009 to 2012, the city of Stockton

reduced its police force by 25%, its fire department by 30% and other city staff by 43%.

Additionally, in 2011, the city restructured its health care plan such that employees paid

19 Data from: Stockton Budget Documents

Data From: Stockton Budget Documents.

20

approximately 20 percent of the services provided, while the plan covered 80 percent of

the costs. Had they not restructured the plan, the cost of retiree health care would have

been $9.2 million higher in fiscal year 2012, increasing every year thereafter and

doubling within ten years.20

In addition, employees compensations were cut between 9

and 23 percent over three years, depending on their position.21

The General Funds

budget was cut by $90 million over the same period, and the city had all but exhausted its

reserve funds by 2012. Wells Fargo subsequently seized a number of Stocktons assets,

namely its newly constructed city hall and a number of parking lots. Without

restructuring its debt, the municipality was running out of viable options: after being

downgraded to junk status by Moodys in January 2012, the citys ability to borrow more

money or redirect funds became seriously limited.

Financial Restructuring: AB506

On February 28, 2012, Stockton City Council approved moving forward with a

confidential neutral evaluation process, AB 506, adopted through California State

legislation a month earlier. AB 506, a process which went into effect in October 2011,

allows financially distressed local governments to work with creditors and other

interested parties who hold over $5 million of obligations and debt from the government.

Through the counsel of a mediator, both parties enter into confidential negotiations in an

attempt to avoid bankruptcy.

Stockton considered financial restructuring to be the best option going forward;

not only would financial restructuring provide for a healthier future, but it would also

make sure that the brunt of the financial burden was shared among creditors as well

20 City of Stockton News Release, 6 August 2012. 21 City of Stockton Open Letter to the Community, 24 July 2012.

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instead of being borne almost entirely by government employees and taxpayers. The

other options of either further reducing services or increasing taxes were deemed

undesirable. Reducing services would further endanger the health and safety of the

community; it was also deemed unfair to reduce already low employee compensations

even further. According to a media briefing in February 2012, the community was

thought to have limited capacity to pay higher taxes and would not support such a policy.

Stockton therefore announced its desire to go through the AB506 process in the hope of

providing a longer-lasting solution to its budget shortfall through renegotiating a slew of

damaging agreements and obligations.

On March 27, Stockton entered into its period of confidential mediation with its

creditors, listed below. The aim was to reach an agreement by July 1, in order to prevent

insolvency during the following fiscal year, 2012-13.

Stocktons Creditors1: Association of Retired Employees of the City of Stockton; Assured Guaranty, a municipal bond insurer; California Public Employees Retirement System; Dexia Credit Local, New York branch; Franklin Advisers, Inc., an investment company; Jarvis/MUD, a lawsuit; Mid-Management/Supervisory Level Unit (Management B&C Employees); National Public Finance Guarantee Corp., a bond holder; Operating Engineers Local 3, a Stockton labor group; Price, a lawsuit; Stockton City Employees Association, a labor group; Stockton Firefighters Local 456, a labor group; Stockton Fire Management Unit, a labor group; Stockton Police Management Association, a labor group; Stockton Police Officers Association, a labor group; Union Bank, NA; U.S. Department of Housing and Urban Development; Wells Fargo Bank, National Association, a trustee for seven bonds.

22

While the city continued to pay its bills as well as make payroll and most of its

bond and debt obligations, it moved to suspend over $2 million in debt payments on a

number of bonds and to temporarily suspend employee leave payouts.22

Insolvency was

ultimately not solved through the mediation process, even though it was extended an

extra two months, through June 25, 2012. As a result, Stockton was still faced with a $26

million deficit in its upcoming fiscal year even though the city had already addressed $90

million in deficits over the previous three years.

Municipal Bankruptcy

On June 26, 2012, the city of Stockton announced that mediation had concluded

without obtaining a comprehensive set of agreements sufficient to close the General Fund

deficit of $26 million. A Pendency Plan23

was adopted, suspending payment of bonds,

claims, and long term debt paid by the General Fund. The Plan also included the shifting

of funds, lower labor and employee agreement costs, and additional employee benefit

reductions such as city contributions to retiree medical insurance. Nonetheless, the Plan

did not include any measurable service reductions. Two days later, Stockton filed a

petition for bankruptcy protection with a Sacramento federal court, under Chapter 9 of

the Federal Bankruptcy Code. In doing so, Stockton became the largest city in the U.S. to

file for bankruptcy.

Chapter 9 of the Federal Bankruptcy Code allows for the financial reorganization

of municipalities debts. Although similar in many ways to Chapter 11, it differs in that

unlike private companies, municipalities cannot simply dissolve and allow creditors to

22 City of Stockton Memorandum, 24 February 2012. 23 A Pendency Plan is a budget and operational plan for a City while the petition is pending with a Federal

Bankruptcy Court.

23

take the value of municipal assets as compensation for their investments. The purpose of

filing Chapter 9 bankruptcy is ultimately to provide a financially distressed government

body protection from its creditors while it reorganizes to make itself more fiscally stable.

One of the most significant benefits of the law is the protection it allows from creditors.

Consequently, a bankruptcy filing enables Stockton to hold more power over its finances

and future payments and obligations. Further, it grants Stockton the possibility of voiding

previously negotiated agreements and to reduce its employee pay rather than entirely

eliminate positions. As a result, Stockton can keep more of its services functional, as well

as more of its jobs (and by secondary effect, income). Unlike other chapters, there is no

provision for the liquidation of the assets of the municipality and distribution of the

proceeds to creditors, as this would violate the tenth amendment in the Constitution.

Eligibility

In "Municipal Bankruptcy and the Role of the States," the National Association of

State Budget Officers (NASBO) cites a paper published by the American Bankruptcy

Institute that lays out five eligibility criteria for municipal bankruptcy:

1. The municipality must have specific authority to file for Chapter 9

bankruptcy from the state;

California conditionally permits municipal bankruptcies.

2. The municipality must be insolvent;

There are three types of insolvency: service, future payments, and cash. By the time it

filed for bankruptcy, Stockton was insolvent in terms of service delivery and ability to

meet future payments. It had already made yearly cuts in a number of departments and

services, and projected to be unable to meet its future financial obligations at its current

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spending rate. These, compounded by increases in pension payments and other post-

employment benefits meant that it would soon be cash insolvent and unable to cover its

current costs unless emergency measures were taken.

3. The municipality must prove its desire to adopt a plan to adjust its debt;

This is usually demonstrated through attempted renegotiations and attempts to restructure

debt. Indeed, by the end of July, the Stockton City Council had approved labor

agreements with six24

of its nine labor groups. The agreements included a 62-hour

employee furlough, lower retirement benefits for future employees, reductions and

changes to vacation and sick leaves, reductions in overtime pay calculations, elimination

of a holiday, reduction and elimination of longevity pay, and elimination of retiree

medical benefits. In total, these adjustments resulted in cost savings of $1.36 million,

$450,000 of which were in General Fund savings.25

While a step in the right direction,

this was not sufficient to prevent the Stocktons insolvency.

4. The municipality must satisfy at least one of four specified conditions to

demonstrate that it has obtained or tried to obtain an agreement with its

creditors, that it is not feasible to negotiate with its creditors holding at

least the majority of the claims in each class that the entity intends to

impair under its debt adjustment plan, or that it has reason to believe its

creditors might attempt to obtain preferential payment or transfer of the

entity's assets, and;

24 The labor groups are Stockton Mid-Management/Supervisory Level Bargaining Group (B&C), Stockton

City Employees Association (SCEA), Operating Engineers Local 3 Units, and Stockton Police Management Association (SCEA), 25 Stockton Approves Agreements with Six Labor Groups City of Stockton News Release 24 July 2012. Web.

25

5. The municipality must show that it has filed for bankruptcy in good

faith.26

These last two provisions are crucial in understanding Stocktons complex

bankruptcy proceedings, as these have been contested by the Citys main creditors. Seven

months after Stockton filed for bankruptcy protection, the citys main creditors, the

Capital Market Creditors (CMC), a consortium of bond insurers, banks and financial

trustees filed their objections with the Court on December 14, 2012. As has been

summarized above, Section 109(c) mandates that a municipality seeking protection under

Chapter 9 must show that is has either: 1) negotiated in good faith with its creditors or 2)

that such negotiations were impractical. The CMC contended that Stocktons failure to

engage in such negotiations with California Public Employees Retirement System

(CalPERS) prior to filing its petition required dismissal of the bankruptcy case. At the

time, no bankruptcy court had ruled on whether the protections for public employee

pension liabilities provided it with priority over other unsecured creditors. The CMC

claimed that the city was feigning insolvency: that not only could it resolve its fiscal

issues by raising taxes but that the city had not shown good faith in its negotiations. On

April 1, 2013, Judge Klein ruled that the city of Stockton is indeed bankrupt, that the city

acted in good faith, and that the city was by any measure insolvent when it filed for

protection from creditors. He continued to claim that any further cuts would put residents

at an unacceptable risk, especially given the reductions in police force and fire

department and the rise in gang violence and drug trafficking that had resulted.

26 Municipal Bankruptcy & The Role of States National Association of State Budget Officers 21 August 2013. Web.

26

Significantly, Judge Klein signaled that the issue of how pension payments are treated

relative to bond payments will be a central one in the case going forward.

Consequences of Stocktons Decision to File for Bankruptcy Protection

Stocktons case highlights a number of advantages to bankruptcy, most notably

the ability to dictate how money is spent without the menace of creditor actions. This was

highlighted in the Retiree Medical Premiums Ruling on August 6, 2012, when Judge

Klein ruled that he lacked the jurisdiction to dictate how the city should spend its

revenues while in bankruptcy. Even though Stockton had conducted research that

determined that most cities do not offer retiree medical coverage and few even offer

modest stipends for premiums, the Association of Retired Employees of the City of

Stockton (ARECOS) petitioned the Court to order the city to continue to pay the full

medical premiums at the level at which they had been set prior to the filing, or else to

allow the suit to be brought against the city in another court. The decision confirmed that

while the court has exclusive jurisdiction over the restructuring of the citys debt while

the bankruptcy case is pending, it cannot direct how the city uses its property and

resources.

A change in pension benefits as part of Stocktons approved plan of adjustment

could make bargaining units in other cities more willing to come to the negotiating table

well before a bankruptcy filing, thereby potentially allowing a municipality on an

unsustainable fiscal trajectory to restructure some of its liabilities without having to file

for bankruptcy. Many states have statutes and constitutional provisions making it illegal

to cut public workers pensions; however, there has not been a prominent test of these

laws in bankruptcy, especially not in California. Although federal bankruptcy law often

27

trumps state laws, municipal bankruptcies are so rare that there is almost no precedent on

how to apply the law to state pension provisions. This makes the case for why Stocktons

bankruptcy is so unique, and carries with it much potential for significant changes in

procedures in the future.

It is likely Chapter 9 filings will still remain very uncommon, and the stigma of

bankruptcy is unlikely to abate regardless of the outcomes in Stockton.27

The citys

actions to date, including imposed or negotiated reductions in its payments to employees

and debt holders, have harmed both its service levels and image.28

Therefore, while

Stockton gets a much needed time-out in order to restructure its finances, there are no

clear winners in the process: taxpayers suffer, public employees risk losing their jobs and

benefits, and creditors forgo profits while awaiting payments. It may take years to see any

positive impacts. However, given the circumstances, bankruptcy was the best policy

Stockton could pursue.

Municipal Fiscal Crisis: Policy Recommendations

As our analysis indicates, Stocktons path down the road of fiscal crisis and

27 Kimhi (2010) argues that there are a number of problems associated with the stigma that bankruptcy

causes: first it harms the citys reputation as a place of residence and thus deters businesses and individuals from locating there. Secondly, it harms the citys reputation as a debtor, and thus leads to higher borrowing costs or blocks its access to credit markets. The city may come out of the filing with less debt, but also with fewer prospects for the future (Kimhi 2010). Thus, he suggests that the rehabilitation of local governments undergoing fiscal problems should be left to the states, who should also proactively monitor

local finances and get involved in the fiscal issues of cities if necessary. 28 Nevertheless, Gillette (2012) writes that under some circumstances, local officials might prefer

bankruptcy (under which the costs of default could be shared by creditors and municipal residents) over

bailout. Regardless of the possible downsides, city government officials might determine that there is little

need for capital markets in the near future, and is claimants are mainly nonresidents, then there might be

political benefits of undergoing Chapter 9. Moreover, since 904 of the Bankruptcy Code allows local officials to maintain control of taxing and spending decisions during bankruptcy, officials may believe that

bankruptcy insulates them from imposition of obligations that they find politically, if not financially

imprudent. He argues that a giving bankruptcy judges the right to impose resource adjustment on cities that seem to lack the political will to do so, would make it less likely for municipalities to strategically use

bankruptcy.

28

municipal bankruptcy is a long, winding tale with multiple factors and implications.

Stocktons immediate responses to its fiscal crisis were primarily reactionary and short-

term: hiring and salary freezes, reduction in headcount, and cuts in services. As

Stocktons decision to file for bankruptcy indicates, these measures did little to address

the fundamental causes of the fiscal crisis29

Our analysis indicates that a more sustainable

response to fiscal crisis must address and include municipal control over revenue

generation, an oversight process to ensure responsible contract negations between unions

and public employee representatives, as well as a more comprehensive approach to

budget management and allocation.

Addressing Revenues

Stocktons over-reliance on inflated property taxes was the biggest contributor to

the decline of its revenues starting in 2008. The city would have done well to diversify its

tax base, and make long-term plans that embrace a competitive tax structure that provides

more reliable revenue. Acknowledging that property taxes are a significant revenue

source, however, we also recommend that the State of California provide its cities with

more autonomy in their power to set taxes. Such action would be in the form of repealing

Prop 13 immediately. Not only would a swift repeal of Prop 13 provide immediate relief

for many of Californias cities which are also struggling with weak revenues, but the

current political climate is also such that repeal is more realistic now than it has been in

29 Kimhi (2010) writes that bankruptcy may indeed help cities reduce their level of their debt, but does very

little to address the roots of the crisis, this is the reason why cities that file for bankruptcy often return to

insolvency in just a few years. Kimhi lists Macks Creek, Missouri, which has filed for bankruptcy three

times in a row, in 1998, 2000 and 2004, the city of Westminster, Texas, which filed for bankruptcy in 2000 and 2004, and Prichard, Alabama, which went bankrupt in 1999, came out of bankruptcy in 2007, and then

filed again after the economic crisis hit the city. This was also the reason why the state of Connecticut did

not accept Bridgeports bankruptcy filing in the early 1990s (municipal bankruptcy is conditional on state approval).

29

over three decades.

Addressing Liabilities

As has been recognized during the bankruptcy proceedings, Stockton needs to

restructure its long-term financial commitments. In order to do so, the city will need to

address and redefine provisions for compensation and pension payments, as well as

eligibility for benefits. Several approaches can be taken on these fronts. For instance, in

the short-term, pension payouts could be capped, retirement age raised, contributions

from workers increased, and double-dipping prevented. In the long-term, the assumptions

for pension rates of return should be lowered to a more realistic level and governments

should be required to fund their pension liabilities at or around the generally accepted

level of 80 percent.30

Addressing Management

Stocktons fiscal mismanagement largely stemmed from unchecked optimism

matched with what appeared to be a lack of oversight. We propose further investigation

into policies that would prevent this kind of overly optimistic revenue projections (and

ensuing spending) that Stocktons policy makers engaged in during the mid-2000s. While

such a policy would require further analysis, one potential solution is to weigh more

heavily the longer-term historical average of tax revenue growth rates in General Fund

revenue forecasts. This would insulate revenue forecasts from short term economic

booms and prevent the irrational exuberance that took place in Stockton. An adjustment

30 Lav and McNichol (2011) highlight from the GAO: Many experts and officials to whom we spoke consider a funded ratio of 80 percent to be sufficient for public plans for a couple of reasons. First, state

and local governments can spread the costs of unfunded liabilities over up to 30 years under current GASB

standards. In addition, several commented that it can be politically unwise for a plan to be overfunded; that

is, to have a funded ratio over 100 percent. The contributions made to funds with excess assets can become a target for lawmakers with other priorities or for those wishing to increase retiree benefits.

30

to forecasting formulas in itself may not be sufficient, however and additional oversight

measures may be necessary to ensure that such forecasts remain reliable.

Conclusion:

Stocktons fiscal crisis and subsequent bankruptcy present a historic event that

may set several important precedents in how municipalities address their fiscal

sustainability. While the above recommendations target certain causes underlying

Stocktons fiscal crisis, municipalities across the country are prone to the same factors

that plagued Stockton. Structurally, cities around the country are limited in their power to

tax and spend. Managerially, with lack of oversight (or foresight, for that matter) city

administrators are prone to the same irrational exuberance that hit Stockton during its

economic boom. Politically, with court decisions such as Citizens United, special interest

groups are becoming more influential than ever before reshaping the political landscape

around the country. For cities facing some or all of these problems, examining Stockton

not only will allow them to assess their own financial conditions, but it will also allow

them to identify potential avenues out of fiscal distress, potentially even bankruptcy.

31

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