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Municipal bankruptcy offers protection, but at a price

HMB considers path blazed by Southern California town

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Posted: Thursday, March 6, 2008 12:00 am

A California tourist town of 12,000 residents is sued by a development partnership after the local government denies permission to build homes on vacant land. A federal court finds for the plaintiffs and levies a multimillion-dollar judgment against the city. Once attorney fees and interest are added in, the bill balloons to more than three times the original judgment. A small town files for bankruptcy.

Many on the coast have looked to the all-but-broke East Bay city of Vallejo for clues to how Half Moon Bay's current financial morass may play out. But a tale of two far more similar cities begins 500 miles to the south, in Desert Hot Springs — where a dispute with a developer rather than runaway labor costs — bankrupted a town much more like Half Moon Bay than Vallejo.

"Your situation in Half Moon Bay is an exact duplicate of ours," said Karl Baker, a city councilman in Desert Hot Springs. "My suggestion, if you have to file bankruptcy, is that you do it, do it quickly and don't spend all your money on attorneys like we did."

Desert Hot Springs' tale of woe begins in 1990, when a quartet of developers banded together to form the Silver Sage Partnership, Ltd. Their plan was to purchase land and develop a mobile home park in Desert Hot Springs, a bump on the Riverside County map along Interstate 10 between the Los Angeles metropolis and Joshua Tree National Park.

The group planned to borrow money from a savings and loan and build homes working people could afford, but the city council had other ideas. The city declined to sign off on a federal funding mechanism, effectively quashing rights to build on the land. The Silver Sage Partnership countered by filing a federal lawsuit, claiming the city had violated the Fair Housing Act by denying the low-income housing.

At this point, the Desert Hot Springs story grows exponentially more complicated. Court documents relating to the Silver Sage saga make U.S. District Judge Vaughn Walker's 167-page ruling on Beachwood look like a pamphlet by comparison.

Initially, a jury agreed that the city's decision violated federal law and awarded Silver Sage $3,040,439 in damages. The city filed a motion arguing that the jury ignored relevant law, and the court used that opportunity to find that the jury's award was "grossly excessive."

The court ruled that no new trial would be necessary if Silver Sage would accept damages in the amount of $388,146.20. When Silver Sage balked, a new trial was ordered and the second jury again ruled in the developer's favor. However, this time a far stingier jury awarded $1 in damages. Unsatisfied, the development group appealed the case to the 9th District Court of Appeals, which in due course, resurrected the original damages.

Faced with a $3.1 million judgment and ever-mounting attorneys fees and interest, the city became the first California municipality in 25 years to file for Chapter 9 bankruptcy protection under the Federal Bankruptcy Code. They city sold municipal bonds to cover the debt and began a protracted effort to pay off a debt that had ballooned more than $10 million.

"To tell you the truth," Baker allows, "I'm not even sure we've been given all the information. It's just so convoluted."

Several Desert Hot Springs officials, including the city's contracted attorney from Meyers Nave, did not immediately return phone calls to the Review. But both Baker, and another recently elected Desert Hot Springs city councilman, Russell Betts, did talk to the newspaper and their comments were eerily similar to the refrain heard from some in Half Moon Bay.

"Our city wasn't well served by a previous City Council," Betts said. "It's easy to Monday morning quarterback, but people dug in their heels and wanted to be right. Well, right can take you to the poor house." Betts said the city could have settled for about $2 million initially but that the figure grew closer to $20 million by the time legal fees and interest were calculated at the 2001 bankruptcy filing.

Chapter 9 bankruptcy is rarely seen in the nation's courts. There have been fewer than 500 such cases in the 70 years the remedy has been available to local government. It differs in several substantial ways from the far more common chapters relating to personal bankruptcy. Notably, municipal assets are protected from involuntary liquidation. This is a nod to constitutional protections for states' rights; the Supreme Court ruled in 1937 that federal authorities cannot compel a division of state government to sell itself out of existence. Neither can it keep local government from spending or borrowing money.

Because of the bankruptcy filing, Desert Hot Springs officials are protected from civil penalties. And, as long as a government can make prescribed payments, payroll and potholes can be met and mended. But it can carry a stigma that is both real and imagined. Bankruptcy can affect future credit ratings and years later an Internet search of the city will turn up repeated references to a financial meltdown.

And there is no timetable for paying off the principal of the city's debt, Baker said. "So far," he said, "we are only able to make payments on the interest and this is five years after filing bankruptcy."

Desert Hot Springs officials didn't turn to bankruptcy until they had worn a path up the federal courthouse steps in Pasadena, and Silver Sage partners moved to put the city into collection. In Half Moon Bay, the concept has been mentioned but not in great detail. At least not in public.

"We've talked about it," said Mayor Bonnie McClung, who has attended numerous closed-door meetings held to discuss Half Moon Bay's financial future. She referred further questions to the city's appellate attorney, John Knox. An assistant for Knox said he was sick and not available for comment.

"We are looking at all of our options," McClung said.

Half Moon Bay officials have 22 days to appeal Walker's decision and they have said repeatedly that they plan to do so. Officials here readily acknowledge that, should their appeal fail and simultaneous negotiations toward a settlement prove fruitless, they have no plan to pay off a judgment that is now four times the city's annual budget.

Meanwhile, life goes on in Desert Hot Springs. But it appears the city may have lost its reluctance to grow.

The population of Desert Hot Springs grew 16.9 percent between 2000 and 2005 — a rate more than double that for California as a whole. The city reports that in 2001, the year of the bankruptcy filing, 13 new homes were sold there. The next year 60 new homes were purchased. The figure doubled again in 2003. In 2006, the city approved tract maps for 11,000 new homes.

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