In In re City of Vallejo,1 the United States Bankruptcy Court for the Eastern District of California held recently that the City of Vallejo has the authority to reject its collective bargaining agreements with the city’s firefighters and electrical workers as part of its chapter 9 bankruptcy proceeding without going through the process detailed in section 1113 of the Bankruptcy Code. The bankruptcy court determined that a municipality does not need to comply with the stringent requirements that corporations face when seeking to reject a collective bargaining agreement (a “CBA”). Rather, a municipality only needs to meet the lower standards set forth in the landmark United States Supreme Court decision, NLRB v. Bildisco & Bildisco, discussed below.2 Although municipal bankruptcies have historically been uncommon, this decision provides a municipality with a more efficient mechanism to rid itself of union contracts than is available to corporate debtors.

Background

The collapse of the housing market and the difficult economic environment in California severely affected Vallejo’s general fund for expenditures. The primary sources of Vallejo’s revenue, including property taxes, sales taxes, and related fees and assessments, could not keep up with Vallejo’s expenditures. After failing to correct the imbalance between revenues and expenditures outside of bankruptcy, Vallejo filed its chapter 9 bankruptcy petition in May 2008.3

The largest component of Vallejo’s yearly expenditures is its cost of labor, and the largest portion of this is the cost of police and firefighters. Vallejo’s labor costs are subject to certain CBAs. After failing to reach consensual modifications with the various unions under the CBAs, Vallejo sought to reject the CBAs between Vallejo and four different unions. These unions and various other labor organizations, including the AFL-CIO and the California Public Employees’ Retirement System, opposed Vallejo’s motion to reject the CBAs. Vallejo ultimately reached agreements with two of the unions, leaving the bankruptcy court to resolve the proposed rejection of the CBAs between Vallejo and the unions representing firefighters and electrical workers.

Treatment of Collective Bargaining Agreements Under the Bankruptcy Code

In a chapter 11 reorganization, section 1113 of the Bankruptcy Code addresses the debtor’s ability to reject a CBA. Congress enacted section 1113 of the Bankruptcy Code in response to the Supreme Court’s decision in Bildisco, which authorized a debtor to reject a CBA pursuant to section 365 of the Bankruptcy Code based on its sound business judgment, provided a debtor shows that (1) the CBA burdens the estate, (2) the equities weigh in favor of rejecting the CBA, and (3) the debtor has made reasonable efforts to negotiate a voluntary modification that are not likely to produce a prompt and satisfactory solution.4 Congress responded quickly to Bildisco by enacting section 1113 in an effort to reconcile the bankruptcy policy of rehabilitating a debtor with the labor policy of protecting employee rights. Section 1113 of the Bankruptcy Code restricts sharply a chapter 11 debtor’s rights to reject CBAs. Subsections 1113(b) and (c) prescribe the requirements for a court to approve a chapter 11 debtor’s rejection of a CBA. Based on these subsections, courts have set forth numerous procedural and substantive requirements that a chapter 11 debtor must meet in order for a court to approve the rejection of a CBA: the debtor must have made a proposal to the union for changes to the CBA based on the most complete and reliable information available at the time of the proposal; the proposed modifications must be necessary to permit the reorganization of the debtor; the proposed modifications must assure that all affected parties are treated fairly and equitably; the debtor must have provided the union with such relevant information as is necessary to evaluate the proposal, must have met with the collective bargaining representative at reasonable times subsequent to making the proposal and must have negotiated in good faith with the union concerning the proposal; the union must have refused to accept the proposal without good cause; and the balance of the equities must clearly favor rejection of the agreement.5

The applicability of section 1113 to cases filed under chapter 9, however, is a matter of dispute. When a municipality files for bankruptcy under chapter 9 of the Bankruptcy Code, section 901 makes several provisions of the Bankruptcy Code applicable to the chapter 9 case, including some provisions of chapter 11. Among the provisions applicable to chapter 9 cases are the automatic stay, adequate protection, the debtor’s avoidance and “strong-arm” powers, the debtor’s ability to assume or reject executory contracts or unexpired leases, and some provisions governing disclosure, voting on a plan, and plan confirmation. The Bankruptcy Code sections made applicable to chapter 9 cases, however, do not include section 1113 of the Bankruptcy Code.

Analysis

In Vallejo, the bankruptcy court considered the question of whether Vallejo must reject its CBAs under the strict standard detailed in section 1113 of the Bankruptcy Code, or if it may do so under the more relaxed standard of section 365 of the Bankruptcy Code, as modified by Bildisco. The bankruptcy court determined that Vallejo had authority to reject its CBAs pursuant to section 365 of the Bankruptcy Code for several reasons. First, the bankruptcy court noted that unexpired CBAs are executory contracts subject to rejection under section 365 of the Bankruptcy Code.6 The bankruptcy court then reasoned that “Congress incorporated section 365 into chapter 9 without restricting or limiting its application to collective bargaining agreements.”7 Further, section 1113 is not incorporated into chapter 9 and “is not applicable in chapter 9 cases, and a chapter 9 debtor is not required to comply with it in order to reject an executory collective bargaining agreement.” 8 Therefore, the bankruptcy court held that Vallejo did not need to comply with section 1113 of the Bankruptcy Code to reject its CBAs. Instead, the bankruptcy court held that Vallejo may use the Bildisco standard to reject its CBAs as long as Vallejo can establish (1) the CBA burdens the estate, (2) after careful scrutiny, the equities balance in favor of rejection, and (3) “reasonable efforts to negotiate a voluntary modification have been made, and are not likely to produce a prompt and satisfactory solution.”9

The bankruptcy court also noted that, to the extent any state labor law purported to affect the debtor’s rights under section 365 of the Bankruptcy Code, such law would be unconstitutional. Pursuant to the Bankruptcy Clause of the U.S. Constitution, only the federal government may enact bankruptcy laws, and “incorporating state substantive law into chapter 9 to amend, modify or negate substantive provisions of chapter 9 would violate Congress’ ability to enact uniform bankruptcy laws.”10 The bankruptcy court also noted that the Supremacy Clause invalidates state laws that interfere or conflict with federal law and that the Contracts Clause provides the federal government with exclusive authority to modify contracts.11 Congress exercised this exclusive authority when it “enacted section 365 to provide debtors the authority to reject executory contracts . . . [t]his authority preempts state law by virtue of the Supremacy Clause, the Bankruptcy Clause, and the Contracts Clause.”12 Accordingly, any state labor law purporting to govern the rejection of Vallejo’s CBAs would be preempted by section 365 of the Bankruptcy Code.

Conclusion

While the bankruptcy court did not determine whether Vallejo satisfied the Bildisco factors, it concluded that Vallejo could potentially reject its CBAs without having to comply with the numerous, strict requirements of section 1113 of the Bankruptcy Code. This decision may come as a surprise to labor unions and their members. However, the ruling is strongly rooted in the plain language of the Bankruptcy Code provisions. In light of this decision, a distressed municipality may see a chapter 9 bankruptcy proceeding as an attractive vehicle to adjust its liabilities.