Should bankrupt California cities disincorporate?

September 20, 2012

California State Comptroller John Chiang said in a press conference yesterday in San Francisco that he expected more municipal bankruptcies in the Golden State. Bloomberg has the details:

“We will start to see more bankruptcies, not necessarily because of pension issues,” Chiang said. “We need the state to participate in trying to prevent these bankruptcies.”

California cities that have hit their fiscal bottoms have been turning to the Chapter 9 municipal bankruptcy process. Recently, Stockton, Mammoth Lakes and San Bernardino voted to put themselves under the protection of a bankruptcy judge and shield themselves from new legal claims. Bankruptcy is a complex and expensive process. Fitch Ratings said in a recent report (page 5) that the state of California offers no other intervention process for broke cities.

California has an effective mechanism to support school districts that experience financial distress, but provides no such assistance for cities. Many states have some form of intervention program that can help turn around financial decline by providing a control board, financial manager, or similar structure. In 2011, the state enacted Assembly  Bill (AB) 506, which provides for a mediation process among localities and their stakeholders prior to bankruptcy.

Rather than preventing default and bankruptcy, AB 506 may have accelerated their occurrence. While state intervention is not factored into ratings unless the program is invoked and proven effective, Fitch believes credit deterioration can be forestalled for an entity in a state with an effective intervention program.

There is, in fact, another process in California law that Fitch and others might not be aware of. This is the process of disincorporation that has existed in California law for decades. John Knox, a law partner at Orrick, Herrington & Sutcliffe in San Francisco, wrote a white paper on disincorporation. Here is some background from Knox’s paper:

Seventeen cities have disincorporated in California’s history, including the cities of Long Beach, Pismo Beach, and Stanton, each of which later reincorporated. However, since the creation of LAFCOs [local agency formation commissions] in 1963, only two cities have disincorporated – Cabazon in 1972 and Hornitos in 1973. Of these, only Cabazon’s disincorporation went through the process prescribed by the Act; Hornitos was disincorporated by [legislative] statute.

What happened in Cabazon?

Cabazon was a city of 613 residents in Riverside County incorporated in 1955. Following years of city-government turmoil related to the regulation of local gambling, including multiple recalls, resignations, and arrests of city council members, a group of citizens filed a disincorporation proposal with the local LAFCO.

The LAFCO held a hearing, approved the proposal without requiring any additional terms or conditions, and set the question for election. Residents of the city voted 192 to 131 in favor of disincorporation, and after a several-month delay because of a legal challenge to the election procedures, the city ceased existence in early 1972.

Following the disincorporation, Riverside County inherited Cabazon’s assets and liabilities and wound down its remaining affairs, including sale of the city’s personal property and cancellation of its lease for various city buildings.

The county paid the city’s outstanding debts with the remaining city funds, along with funds generated from property sales and debts owed to the city. Nearly ten years later, the former city’s account still had a surplus.

The outcome of the disincorporation process was that the county inherited the financial assets and liabilities of the disincorporated city. And services previously provided by the city were provided by the county.

Knox’s whitepaper addresses one of the biggest issues, public employee contracts, in the disincorporation process (page 4):

While a public employee may obtain a right protected by the contract clauses of the state and federal constitutions, as was the case in Sonoma County, such right does not include the “right to remain in an office or employment, or to the continuation of civil service status.”

In short, public employees do not have a right to employment once the city they worked for has been dissolved. I’d imagine that the county absorbing the disincorporated city would want to retain employees, but they would have the freedom to decide the best course.

The affairs of the city have to be wound up and money – often through taxes – would have to be raised to pay off outstanding claims (page 4):

Prior to the effective date, public officers must turn over public property to the county board of supervisors, and the city council must turn over all city funds, as certified by the LAFCO or the county, to the county treasurer.

However, while the California Constitution does not allow a county to impose taxes directly under the Act, a LAFCO can require voter approval of such taxes as a condition of approving the disincorporation proposal in the first place.

I’ve left out a lot of the details, but they can all be found in Knox’s excellent paper. Disincorporation is not a simple process, but in some cases it might be preferred over bankruptcy for its relative simplicity and sometimes lower cost. In some cases citizens could benefit from their services being absorbed by the county. California needs every option possible in its toolkit, and discorporation may be a useful new addition.

A line was removed in the second paragraph to reflect a correction made by Bloomberg to say that John Chiang pointed to  recent financial distress in Jurupa Valley, Wildomar, Eastvale and Menifee in Riverside County. Chiang had been previously incorrectly quoted as saying he “expects further bankruptcies” in these cities. 

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There might be one little problem with disincorporation and turning over services and money (if there is any left) to the counties. Just how well are the county governments doing? Will they be able to absorb the needs of the cities who choose this method? County law enforcement in the form of Sheriff’s Departments is undermanned and underfunded in many counties across the country. Are California’s counties in shape to pay the costs for services to these cities?

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