Hercules May Not Be Strong Enough to Stave Off Ch. 9

NEW YORK (The Deal) -- The City of Hercules, Calif., needs its electric system bondholders to tender their notes at a discount before April 4, or else the Bay Area suburb risks a default and possibly something worse--a municipal bankruptcy.

The city extended the deadline for bondholders to tender their notes when the count came in short on March 28, but Hercules' interim city manager, Phil Batchelor, warned by phone on Tuesday that a default on the electric system bonds could push the city into Chapter 9 bankruptcy.

The electric system bonds are so-called because they were issued in order to refinance the debt undertaken Hercules' electric grid, which started operation in 2003. Cities don't generally own their electric grids, and Hercules' is losing money.

Mobilizing the bondholders to tender their debt, however, has proved to be a Herculean feat.

The city's bonds are "spread all over the place" rather than being concentrated in the hands of institutional investors, Batchelor said. He noted that the retail investors who hold the bonds may not understand the situation or have the same level of assistance that large institutional investors would bring to the table.

"We are fighting to not go into Chapter 9," Batchelor said.

The cornerstone of Hercules' turnaround plan is a sale of the electric grid to San Francisco utility PG&E Corp.  (PCG) for $9.5 million. That deal has been in the works for more than two years, and it received the final stamp of approval in January.

But the asset sale hinges on the tender offer, which asks bondholders to accept repayment of their $13 million in bonds at 90% of face value.

The bonds mature between Aug. 1, 2013, and Aug. 1, 2038, and bear interest between 2.5% and 5.375%. If the tender offer fails, Batchelor said Hercules is likely to miss its next interest payment, which is due on Aug. 1. A divestiture of the electric system is the city's best hope for remaining solvent, Batchelor said, explaining that "there is nothing left to sell."

Government officals considered selling City Hall, but decided that was not a feasible option, since the government needs a place to work.

Hercules was established in the late 1800s as the site of a dynamite plant. Today, it has almost 25,000 residents. Hercules has already made substantial cuts to its city government and public services such as the police force.

"Even though [Hercules] hasn't been into bankruptcy yet, I see less resources per capita than in Vallejo," Batchelor said, referring to a California city that did file for Chapter 9.

Batchelor rose to fame when he was serving as the interim city manager aiding insolvent Vallejo, Calif., and popular finance author Michael Lewis featured him in Boomerang, a book about the credit crisis.

Vallejo filed for Chapter 9 in the U.S. Bankruptcy Court for the Eastern District of California in Sacramento on May 23, 2008, and exited three-and-a-half years later.

Orrick, Herrington & Sutcliffe, the same law firm that served as debtor counsel in the Chapter 9 bankruptcies of Vallejo and the City of Stockton, Calif., is advising Hercules on its bond transactions, Batchelor said.

The city's finances are still smarting from over-optimistic development before the financial crisis, particularly from putting $38 million into the development of two four-story apartment buildings. Lacking the finances to finish construction, Hercules sold them for $425,000 in 2012.

The buyer plans to lay out $25 million to $30 million to complete the buildings, and hopes to open them in the next 18 months.

Meanwhile, Hercules is working to get up to date on its financial disclosure. The city was three years behind on its financial audits, but it brought in a new finance director who has completed two years' worth of audits and expects to complete the fiscal 2012-13 audit in the next month, Batchelor said. The delayed audits caused Hercules to lose its coverage on the bonds from Standard & Poor's.

The agency suspended its ratings on all of Hercules' bonds, including the CCC+ rating on the electric system notes, in June.

This is not the first time Hercules has warned that it might be headed for bankruptcy. The city also raised the specter of Chapter 9 when it defaulted on another class of bonds in 2012, resulting in a lawsuit brought by bond insurer Ambac Assurance, which was resolved in a settlement that year.

Batchelor's work with troubled California cities has drawn his attention to problems that aren't going away.

"There is no question that there are other cities that are going to be in difficult situations because they have unsustainable contractual obligations with their employees," he said.

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