An opinion issued earlier this year by the Ninth Circuit Bankruptcy Appellate Panel in the largest municipal bankruptcy since Orange County has become final.

The BAP decision in the City of Vallejo, California, case became final when the appellant city labor unions voluntarily withdrew their further appeal to the Ninth Circuit. The appeal to the BAP had followed an eight-day bankruptcy court trial over whether Vallejo was eligible to be a chapter 9 debtor. On June 26, 2009, the BAP issued an opinion affirming the bankruptcy court's determination that Vallejo was eligible.

The BAP opinion resolved four significant issues in municipal bankruptcy law raised in the bankruptcy court. These were whether:

  1. Vallejo was "insolvent" under the provisions of Bankruptcy Code section 109(c)(3)
  2. Vallejo had demonstrated that it desired to effect a plan to adjust its debts under section 109(c)(4)
  3. Vallejo had negotiated with its creditors in good faith as required by section 109(c)(5)(B)
  4. In the alternative to (3), Vallejo was unable to negotiate with its creditors because doing so was impracticable under section 109(c)(5)(C)

The bankruptcy court found that Vallejo was insolvent, it desired to effect a plan, and it was unable to negotiate with its creditors because to do so was impracticable.

BAP Decision

The BAP affirmed, holding that Vallejo was insolvent and desired to effect a plan of adjustment. Int'l Assoc. of Firefighters v. City of Vallejo (In re City of Vallejo), Ch. 9 No. 08-26813, Ad. No. 08-1244 (B.A.P. 9th Cir. June 26, 2009).

The BAP did hold, however, that Vallejo had not met the requirement to negotiate with its creditors in good faith under section 109(c)(5)(B). Nonetheless, the BAP affirmed the order, deeming Vallejo eligible to be a chapter 9 debtor by holding that Vallejo had met the alternative test of impracticability of negotiating with creditors under section 109(c)(5)(C). Thus, Vallejo was eligible to be a debtor under chapter 9.

First, the BAP addressed whether Vallejo had demonstrated that it was "insolvent" within the meaning of section 101(32)(C)(ii), which defines insolvency in the case of municipalities as the inability to pay debts as they become due, or the failure to pay debts as they become due. The BAP approved the bankruptcy court's adoption of a cash flow analysis as the means to test insolvency. Vallejo contended that it would be unable to pay its debts as they became due during the next year because its cash flow was insufficient to meet its budgeted obligations.

The appellant labor unions argued Vallejo's balance sheet showed that substantial cash reserves were available to fund its operations and pay its obligations as they fell due. Vallejo contended most of its cash was held in funds that were restricted by law or contract, and was unavailable for payment of general fund obligations.

The appellants also contended that Vallejo could solve its budget problems by making substantial budget cuts. They argued the city should reduce its staffing, and accept what Vallejo viewed as a draconian offer by the appellants to significantly reduce labor costs in the short term in return for guaranteed increases in coming years.

The bankruptcy court rejected the appellants' arguments and found Vallejo insolvent. The BAP affirmed.

Funding Sources

While Vallejo did not attempt to examine restrictions on each of the many separate funds it maintains in its accounting records, the city did present evidence that only the so-called general fund was available to supply resources to meet the city's expenditure needs. Vallejo's cash flow projections for its general fund indicated the city would not be able to pay its obligations throughout the next fiscal year.

The BAP found the evidence sufficient to show that because the general fund was not balanced, Vallejo was insolvent. This focus by the BAP demonstrates the importance in a chapter 9 case of a clear understanding of municipal accounting.

Municipal accounting is not based upon GAAP, but instead upon a separate set of standards established by the Governmental Accounting Standards Board (GASB). Because of the way in which governments borrow money and organize repayment, many separate funds are devoted to specific purposes and can only be used for these purposes.

It is not unusual for a municipal activity such as a city's water supply system to accumulate cash in excess of the amount needed to operate that system and pay the bond debt borrowed to build or improve the system. This was true in Vallejo's case; the use of certain disputed funds was restricted by the bond documents to water department-related expenditures.

While municipal accounting standards do allow a city to borrow from one of its specialized funds, it may do so only if it clearly will have the ability to repay that borrowing during the ensuing fiscal year. Vallejo's inability to balance its budget, negative cash flow, and projections of falling tax and other municipal revenue prevented the city from being able to borrow from the special funds to pay general expenses.

Accordingly, the BAP found that the restrictions on the special funds precluded the city from using cash from those funds to augment its ailing general fund.

Budget Cuts

Appellants also argued that Vallejo was obligated to try to stay out of bankruptcy by cutting its budget as much as was necessary. They argued that at some reduced level of public services, the budget would be balanced, cash would be available and no insolvency would occur.

The BAP, however, accepted the bankruptcy court's finding that cutting the budget to the level required to avoid "insolvency" defied fiscal prudence, and would leave the city more financially debilitated and even less able to face the next fiscal year.

The appellants' final suggestion to balance the budget was the appellants' offer to temporarily amend the public employee collective bargaining agreements so that the budget for the current fiscal year could be balanced. The offer, however, was premised on substantial future concessions by the city, which appellants argued the city could perform as its revenues recovered.

The city argued that such short-term fixes undermined the city's long-term solvency, and the city was not required to defer significant budgetary issues by short-term stop-gaps to stay out of bankruptcy.

The BAP approved the bankruptcy court's deference to the political judgment of the city about how much public service could be cut from the current budget, and whether deferring the problems was preferable to a present chapter 9 filing. Taking all of this into consideration, the BAP determined that the bankruptcy court's findings were supported by the evidence in the record, and it had correctly determined that Vallejo was insolvent as defined in the Bankruptcy Code.

Reorganization

With respect to whether Vallejo desired to effect a plan of reorganization, appellants contended that the records showed that Vallejo did not desire to effect a plan but was instead engaged in union busting.

The BAP observed that Vallejo is required by law to adopt its annual budget by a certain date and that it must be a balanced budget. Vallejo had negotiated with its creditors virtually up to the deadline before filing the bankruptcy petition. The protracted effort to reach an accommodation demonstrated Vallejo's desire to effect a plan of adjustment in some fashion.

Finally, appellants argued that Vallejo failed to negotiate in good faith with its creditors before filing its bankruptcy petition.

To avail itself of Bankruptcy Code section 109(c)(5)(B), a municipality must have negotiated in good faith with its creditors, but have failed to obtain an agreement with creditors holding at least a majority of the amount of claims in each class that the city intends to impair under its bankruptcy plan.

The bankruptcy court found that Vallejo had in fact negotiated in good faith with such parties.

On appeal, the appellants argued that section 109(c)(5)(B) requires that the city negotiate over the terms of a specific plan, or at least a detailed outline of one. The city conceded that during the negotiations it did not have a specific plan or even a detailed outline to present.

The BAP found in favor of the appellants on this point, noting that it was influenced by language in the Bankruptcy Code that persuaded it that a specific plan or detailed outline was required. Because there was none, the BAP held that the bankruptcy court erred in finding that the city met the requirements of section 109(c)(5)(B).

The BAP went on, though, to find that error harmless because the city had met the alternative test under section 109(c)(5)(C). Vallejo was not required under 109(c)(5)(C) to negotiate with its creditors if such negotiation was "impracticable." Vallejo's evidence showed that the number of creditors in multiple classes and the need to file a petition quickly as the deadline for a balanced budget loomed were indicators of impracticability.

For example, the bankruptcy court found, and the BAP agreed, that Vallejo could not meaningfully negotiate with its largest single creditor—Union Bank—because the bank took the position that it would not renegotiate its loan terms unless the city could submit a viable long-term financial plan based on adjustments to its labor costs. Because Vallejo was not able to reach agreement with its unions, it was not in a position to negotiate with its largest single creditor.

The bankruptcy court also noted that Vallejo was justified in declining to negotiate with its retirees, who held claims of more than $200 million, or the many bondholders of the numerous issues of Vallejo's bonded debt, because of the city's inability to actually identify the retirees or the holders. The conclusion was that Vallejo could not practically negotiate with creditors that it would have to impair under any reasonable plan.

Thus, Vallejo was deemed to be an eligible debtor under chapter 9.