LAO 2005-06 Budget Analysis: General Government

Analysis of the 2005-06 Budget Bill

Legislative Analyst's Office
February 2005

Department of Water Resources (3860)

The Department of Water Resources (DWR) protects and manages California's water resources. In this capacity, the department maintains the State Water Project (SWP), which is the nation's largest state-built water conveyance system, providing water to 23 million Californians and 755,000 acres of agriculture. The department maintains public safety and prevents damage through flood control operations, supervision of dams, and water projects. The department is also a major implementing agency for the CALFED Bay-Delta Program, which is putting in place a long-term solution to water supply reliability, water quality, flood control, and fish and wildlife problems in the San Francisco Bay/Sacramento-San Joaquin Delta Estuary (the "Bay-Delta").

Additionally, the department's California Energy Resources Scheduling (CERS) division manages billions of dollars of long-term electricity contracts. The CERS division was created in 2001 during the state's energy crisis to procure electricity on behalf of the state's three largest investor owned utilities (IOUs). The CERS division continues to be financially responsible for the long-term contracts entered into by the department. (Funding for the contracts comes from ratepayer-supported bonds.) However, the IOUs manage the receipt and delivery of the energy procured by the contracts.

Proposed Funding. The budget proposes total expenditures of about $6.4 billion in 2005-06, a reduction of $267 million, or 4 percent below estimated expenditures in the current year. Most of this reduction reflects decreased payments due to expiring energy contracts entered into on behalf of the IOUs. Major budget proposals include $59.1 million from the General Fund to pay for the lining of the All American Canal and an increase of $9.7 million (General Fund) for levee maintenance and other flood management activities. The budget total includes $319.4 million for capital outlay projects, of which $271.6 million is for SWP (the costs of which are reimbursed from SWP contractors), and $21.1 million for flood control ($16.7 million comes from the General Fund and $4.4 million is reimbursed from local agencies) and $26.6 million (Proposition 13 funds) for CALFED water conveyance projects.

Although not included in DWR's budget total, the Governor's budget display for DWR contains a proposal to finance a pending $464 million settlement of flood litigation against the state with a judgment bond. We discuss this proposal below.

Financing Flood Lawsuit Settlement With a Judgment Bond

The budget proposes to finance a pending $464 million settlement of a flood-related lawsuit against the state (the Paterno case) with a judgment bond. We recommend that the Department of Finance report to the Legislature at budget hearings on the status of the settlement, on alternative ways to pay the state's obligation, and if the administration decides to proceed with the judgment bond, on various legal, policy, and fiscal issues we raise.


Budget Proposes Judgment Bond to Finance Flood Lawsuit Settlement. The budget proposes to finance a pending $464 million settlement of a flood-related lawsuit against the state (the Paterno case) by issuing a "judgment bond." The concept of a judgment bond is not defined in statute. Nevertheless, a judgment bond is basically a debt payment mechanism issued to finance a court judgment or lawsuit settlement. To our knowledge, the state has never issued a judgment bond, but we are aware of at least a few instances where local governments in the state have issued bonds to finance a judgment or settlement. For example, the City of Long Beach issued a bond to finance the cost of a court judgment finding it liable in the faulty construction of a public building that collapsed, killing several people.

To date, the administration has not issued a formal proposal for the terms and conditions of this bond because a settlement is still pending. Based on our discussions with the Department of Finance (DOF), we understand that the administration's plan is to issue the bond in 2005-06, with the first debt service payments to be made in 2006-07. According to the DOF, the debt service payments would be paid from the General Fund and subject to annual appropriation in the annual budget act.

History of the Paterno Case. In 1904, Yuba County constructed a levee (the Linda levee) mostly out of hydraulic mining debris. The levee was incorporated into the Sacramento River Flood Control Project (SRFCP), a federal valley-wide flood control project. In 1953, the SRFCP, including the Linda levee, was turned over to the state, under the jurisdiction of the state Reclamation Board. The agreement that transferred the system to the state stipulated that the state would be responsible for operation and maintenance of the system, and would hold the federal government harmless from any future liability claims. The state then turned over the levees (including the Linda levee) to the local reclamation districts, with the agreement that the local reclamation districts would maintain and operate the levees, but that the state would remain responsible overall for the project.

The Paterno lawsuit stems from a flood on the Yuba River in 1986. In February of that year, a 150 foot gap opened in the levee, allowing approximately 20,000 acre feet of water to flood 7,000 acres of land in the communities of Linda and Olivehurst, in Yuba County. As a result, hundreds of homes and a shopping center in the area were flooded.

Subsequently, approximately 2,600 affected parties filed suit against the local reclamation district and the state. In 2001, a trial court ruled in favor of the state. However, in 2003 the California Court of Appeal ruled that the state was liable (and that the local reclamation district was not) and sent the case back to the trial court to award damages. The state appealed to the California Supreme Court which refused to hear the case.

The administration and the plaintiffs are in the process of negotiating a settlement, and appear to have reached a tentative agreement, with the state to pay the plaintiffs $464 million. While the court has not yet approved the settlement, the administration anticipates that a final settlement will be agreed to and approved by the court by the end of the current fiscal year.

Is a Judgment Bond the Only Option? While the administration proposed a $464 million judgment bond to pay the settlement in the Governor's January budget document, the Director of DOF has recently indicated that the administration would use this financing option only if it represents the least costly method to resolve the Paterno case. So, are there other alternatives available to the administration for paying the settlement?

There are two possibilities, although they entail their own limitations. First, the settlement could be fully paid off out of available resources in the budget year. As noted in Part I of our companion document, The 2005-06 Budget: Perspectives and Issues, we project that revenues will be $2.2 billion higher over the current and budget years combined as compared to the forecast reflected in the Governor's January budget. Some of those additional revenues could be used for the one-time purpose of funding the Paterno settlement. Funding the settlement in the budget year from the General Fund would eliminate the large costs of borrowing associated with debt financing. However, it would do so at the expense of other potential legislative priorities.

Second, there may be other ways to structure the payment of a lawsuit settlement beyond a lump-sum payment from the General Fund or issuing a bond and incurring debt. For example, in other lawsuits against the state, settlement payments to plaintiffs have been structured to be paid over multiple years. This allows the state to spread the costs over a few years, thereby reducing the burden on the General Fund in a single fiscal year. The total cost would still be higher due to interest, when compared to making a single lump-sum payment. However, these interest costs would likely be significantly less than a bond because the payment would be over a few years as compared to long-term debt financing which can typically be 30 years.

Issues for Legislative Consideration

If the administration decides to proceed with proposing a judgment bond to finance the settlement of the Paterno case, there are several legal, policy, and fiscal issues that the Legislature should consider in its evaluation of the judgment bond proposal.

Specifically, the main issues are:

We discuss each of these issues in the sections that follow.

Legal Issue—Would the Bond Require a Vote of the People? Legislative Counsel has indicated to us that a vote of the people would not be required for this type of financing instrument. Although there is no state case law directly involving a state-issued debt of this kind, state courts have found that local governments are exempt from the constitutional voting requirement for local government debt in instances where the debt is an obligation "imposed by law" that was not "voluntarily incurred." For example, bonds issued by the City of Long Beach and Los Angeles County to fulfill obligations imposed on them by a tort judgment and state law, respectively, have been validated by the courts as being exempt from the constitutional voting requirement for local government debt as obligations imposed by law. To the extent that the Paterno settlement would be considered an obligation imposed by law and not voluntarily incurred by the state, it is likely that the courts would find that the state is exempt from the constitutional voting requirement for state debt.

Legal Issue—Is Legislative Authorization Required? Based on discussions with Legislative Counsel, it appears that if the state were to proceed with issuing the judgment bond, it would be advisable for the Legislature to enact legislation authorizing its issuance, including the terms and structure of the bond. Such authorizing legislation is advisable because there are no statutory provisions in state law that explicitly authorize the issuance of a judgment bond or dictate how such a bond is to be structured.

Policy Issue—Is Debt Financing of a Lawsuit Settlement Good Policy? The state has to date accumulated $26 billion in budgetary debt. We have previously cautioned against the state accumulating additional such debt because its repayment diverts resources from future budgets for past obligations. Nevertheless, we believe a distinction can be drawn between this bond and other forms of budgetary borrowing the state has engaged in. While recent budgetary borrowing has been used to temporarily cover ongoing budget shortfalls, this bond would be used to spread out the pain associated with a large, one-time cost imposed by a court judgment. In this regard, it could be considered reasonable and practical to pay an obligation like the Paterno settlement over multiple years rather than imposing all the costs on the state's taxpayers in a single year. This is because the Paterno obligationconcerns an unanticipated cost arising from an event a number of years in the past, as opposed to an anticipated, ongoing expenditure obligation of the state. Because paying the Paterno settlement in 2005-06 as a lump sum from the General Fund may divert funds from other legislative priorities, the issuance of a judgment bond in this case may be warranted.

Fiscal Issue—How Much Would It Cost? As with any bond measure, the price of deferring payment is the increased cost of interest payments. According to our estimates, the total cost to the state of paying a $464 million settlement through a judgment bond would be approximately $915 million, assuming a 30-year term of the bond. Accordingly, paying the state's settlement obligation through borrowing nearly doubles the total cost to the state over the long term. This cost, however, is spread over the entire 30-year period, so the total cost after adjusting for inflation is considerably less—approximately $600 million in today's dollars.

Fiscal Issue—How Can the Cost Be Minimized? The DOF has indicated that the debt service payments of the proposed bond would be subject to the annual appropriation process. While we generally favor such an approach from a legislative oversight perspective, this is an instance where another method is advisable from a fiscal prudence perspective. Specifically, by issuing a bond subject to continuous rather than annual appropriations, the state should be able to secure a lower interest rate—hence a lower total cost of borrowing—because the perceived risk inherent in the bond would be lower. For example, a reduction in the interest rate of one-tenth of one percent would save the state over $10 million over the life of the bond. Consequently, we think that if the Legislature decides to authorize the judgment bond, it also should provide for continuous appropriations authority.

Recommend DOF Report at Budget Hearings. Because the court has not finalized the Paterno settlement, we recommend that DOF report at budget hearings on several issues. Specifically, DOF should provide the Legislature an update on the status of the settlement agreement; comment on the alternative methods of paying the state's obligation that we have identified; and respond to the legal, fiscal, and policy issues related to such a bond raised in this review.

Looking Prospectively: Flood Management And Future State Liability

Based on the court's ruling in the Paterno case, the state faces an unknown but potentially substantial liability in the event of future floods. We discuss various flood management issues for legislative consideration in our companion document, The 2005-06 Budget: Perspectives and Issues (P&I).

The previous discussion of the Paterno settlement does not address the larger issue of the state's potential liability exposure from future flood events. It should be noted that the construction of the Linda levee (central to the Paterno case) is typical of Central Valley levees for which the state has responsibility. Thus, it is possible that the state could face further liability from future floods, absent corrective action. While it is not possible to make an accurate estimate of those potential liabilities, they are potentially very large. We address the issue of flood management in our writeup, "Water Policy Issues Facing the State," in our companion document, P&I.

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