During the height of the statewide liability insurance crisis 15 years ago, two brokers-turned-councilmen in Gardena hatched what they thought would be a great idea: Why not have the city form its own insurance company and turn a profit by selling policies to other cities?

“We decided if we can’t beat the insurers, we would have to join them,” then-Gardena City Councilman James Cragin told the Business Journal in 1991.

Cragin and his powerful council partner, Mas Fukai, eventually sold their colleagues on the idea. In 1993, Gardena became the first city in the nation to form its own liability insurance company. To capitalize on the venture, the city put up $10 million in bonds that were to be repaid within three years from anticipated profits.

But instead of turning a profit, the insurance venture collapsed. Faced with $26 million in bond debt due Dec. 15, Gardena officials are desperately trying to stave off bankruptcy. They’ve hired specialists from the New York law firm of Skadden Arps Slate Meagher & Flom LLP to plead with their chief banker, Sumitomo Trust & Banking Co., to negotiate a new repayment deal. And ratings agency Standard & Poor’s last week put Gardena on its watch list for a credit downgrade, which will make any new borrowing more expensive.

“All of our options right now are very, very alarming,” Gardena Mayor Terrence Terauchi said last week. “This has given us a huge black eye.”

More than that. For residents and businesses in Gardena, the financial fiasco will likely mean at least five years of service cuts, delays in capital and road projects and possible reductions in public safety services. In worst-case scenarios, Gardena could be forced to declare bankruptcy, sell off City Hall and other municipal assets, or make a long-shot attempt to levy a property tax of more than $1,000 per parcel.

So how did the venture go so disastrously wrong? According to current and former Gardena officials, it was a combination of colossal misjudgments, stubbornness in the face of repeated warnings and, above all, bad timing.

New idea

The tale begins in 1989, at the height of the liability insurance crisis. After a rash of costly lawsuits, private insurers were pulling out of the market, forcing cities across the state and nation to shell out big bucks for whatever insurance they could find.

Small cities like Gardena were hit particularly hard, since they could not afford to risk multimillion-dollar verdicts.

Many California cities had formed insurance pools, where they combined their general funds in order to absorb major claims. The drawback was, if one city got hit with a major claim, the others would have to chip in from their general funds to pay it.

“It’s really easy for me to go to the City Council and say we have to pay $1 million because we had a wrongful-death shooting,” then-Gardena city manager Kenneth Landau told the Los Angeles Times in 1993. “It’s very difficult for me to go the City Council and say the city of ‘X’ had a wrongful-death shooting, so consequently we have to pay a percentage of that claim for them.”

In addition, municipal insurance pools were unregulated, and managers at several of them faced allegations of mismanagement.

With these unattractive options, Fukai and Cragin, who both had been insurance agents, pitched their idea for a new municipal insurance company, where cities would pay premiums and claims would be paid out from reserves, just like a traditional insurance company.

Fukai, who at the time was chief of staff to legendary L.A. County Supervisor Kenneth Hahn, spearheaded the effort, convincing his colleagues to go along. “He had all the connections and influence,” Cragin said. (Reached by phone last week, Fukai’s wife said he had suffered two strokes and was unable to speak.)

A major hurdle to receiving state approval was making sure that the insurance company, which was named Municipal Mutual Insurance Co., was well capitalized. To that end, the Gardena City Council voted to earmark $10 million of an upcoming $15 million bond sale to the venture.

In a provision that would later have major consequences, the insurance company’s founding charter also required that in order to pay back Gardena’s treasury, the insurance company must have sufficient reserves to cover all outstanding claims, plus an additional $10 million reserve margin.

Lack of public input

According to several former city officials, no public hearings were held about Gardena’s decision to enter the insurance market.

“There were some press articles at the time about it, so it was felt that the public knew what was going on,” said former Gardena councilwoman Gwen Duffy. “Looking back on this, I wish we had more input, both from the insurance industry and from the people of Gardena themselves.”

There was, however, plenty of criticism in the press, mostly from managers of municipal insurance pools that would be competing with the insurance company. Their chief argument was that unless MMIC was able to snag lots of cities very quickly, it had too little capital to survive.

According to former Gardena City Councilman Donald Dear, who was also mayor at the time, city staff workers prepared a report that raised many questions about the venture. But for reasons that are now unclear, the report was never presented to Dear or the council. “I only found out about that report recently, though I haven’t seen it myself,” he said.

(The City Clerk’s office said there appeared to be no such report in the city’s files.)

Instead, Fukai and then-city manager Landau persuaded several outside experts to give favorable testimony, Dear said.

Landau was fired from his post in 1997 and charged with embezzling more than $100,000 in public funds in an unrelated scandal. He was found guilty and served time in prison as part of a three-year sentence. He could not be reached.

When Fukai and Cragin first proposed the idea for a municipal insurance company, they envisioned a partnership with established insurers. At the time, they told the Business Journal that they held discussions with Industrial Indemnity (later taken over by Fremont General Corp. before going bankrupt in 2000) and New York-based underwriter Corroon & Black.

However, by the time the insurance company was ready to launch in late 1993, both firms had dropped out. “We were never given any official explanation,” Dear said.

City officials were left to run the new company on their own as it started operations in October 1993 and sold its first policy to Gardena.

By that time, the marketplace had changed, Dear said. Several liability insurance pools had grown and were able to offer cheaper rates than MMIC, including one set up by the California League of Cities.

Also, private insurance carriers had come back into the market after a 10-year hiatus; their rates also tended to be lower than MMIC’s.

Over the next two years, MMIC was able to sign up four customer cities: Carson, Beaumont, Hayward and Richmond. But that wasn’t enough to enable MMIC to accumulate the $10 million reserve margin to begin paying Gardena back on its investment. And in 1995, the $10 million in bonds that Gardena had sold three years earlier came due.

“We had no money coming in from the insurance company and suddenly found ourselves on the hook for that $10 million,” Dear said. City staff advised that the council issue another $24 million in bonds to pay off the $10 million plus accumulated interest and expenses.

“I asked for an independent counsel to advise us. He came back and told us we could be criminally liable if we defaulted on the bonds. So we decided to sell the additional bonds,” Dear said.

Duffy didn’t remember being advised that she could be held liable for a default. Rather, she and others said the decision to refinance was taken on the basis of wishful thinking.

“The feeling was that we could still make a go of it,” Cragin said last week. “A number of specialists in the industry told us that if we just put a little more time and effort into it, it could fly.”

That proved to be a major misjudgment. Not only were no new policies sold, but three of the four other cities including Carson eventually were able to find cheaper rates and left MMIC.

MMIC was not able to make its repayments to Gardena and it was in danger of becoming undercapitalized itself. To stave off collapse, the directors decided to enter into the workers’ compensation insurance market. But MMIC was only able to sell a handful of policies before it got hammered when workers’ compensation costs started to rise in 1999.

In 2003, state regulators took over the company and all but shut it down, leaving just one employee in its Walnut Creek headquarters. Gardena is now buying liability insurance from a private carrier.

Few options

During those years when MMIC was struggling to stay afloat, it was not able to make any payments to Gardena. For a few years, Gardena was able to make payments on the interest and even pay off $1 million of the principal.

“We saw the day of reckoning coming and, six years ago, we laid off employees and cut back services so we could make these bond payments,” said City Manager Mitch Lansdell.

But the payments stopped this year when the state facing a multibillion dollar deficit of its own took $1.2 million in property tax dollars earmarked for Gardena to balance its own books.

“That’s what really made things more difficult with the folks at Sumitomo,” Lansdell said. “As long as we could make some payments, I believe there was some good will built up. But now, with the state taking our funds, that’s all gone.”

Terauchi said the city does not hold anywhere near $26 million in assets that could be sold off to make the bond payments. (Gardena’s general fund budget is only $33 million.) “Even if we did sell off the assets to Sumitomo, they would be stuck maintaining them, which I’m sure they don’t want to do,” Terauchi said.

As of last week, there were no discussions taking place between the city and Sumitomo over the bond repayment. Terauchi said he hoped that discussions would begin sometime after Thanksgiving.

For Gardena, renegotiation of the loan is the most palatable option available.

The city has hired the specialists from Skadden Arps not for their bankruptcy expertise, Terauchi said, but because the attorneys have had previous dealings with Sumitomo’s headquarters in Japan.

“For us and I would think for Sumitomo bankruptcy is a last resort,” Terauchi said. “All that would happen is that both sides would pay big bucks to lawyers only to have a judge order a renegotiation of the loan. That’s not worthwhile for either party.”

Sumitomo officials, who are handling the case from Japan, could not be reached.

Gardena officials had hoped that a ballot measure to set up a redevelopment agency would convince Sumitomo that the city was trying to generate more revenues to meet the bond payments. But voters on Nov. 2 rejected the redevelopment agency measure by an almost 2-1 margin.

Seeking some sort of state bailout is also considered unlikely.

“In the end, we don’t see any other alternative other than a renegotiation forced or otherwise of the loan,” Terauchi said.

Even then, the city would be forced to go on a severe fiscal diet for years to come.