California is one of just ten states that permit cities to file for municipal bankruptcy under Chapter 9 of the federal bankruptcy code. (Cal. Gov't Code § 53760.)
Following the bankruptcy of Vallejo in 2008, the Legislature added a requirement that cities engage in a 60-day good-faith mediation with creditors before filing. (Cal. Gov't Code §§ 53760, 53760.3.)
Should negotiations fail, a bankruptcy judge then must find the city eligible for protection from creditors to permit its debt restructuring. The municipality must be insolvent; it must desire to effect a plan of adjustment; and it must have negotiated with creditors in good faith.
Once the city files a plan of adjustment, it is subject only to the court's approval or rejection. (To avoid violating constitutional separation of powers protections, during the proceedings the judge may not meddle in a city's interim pendency plan.) Nor do creditors have a right to file an alternative plan of adjustment, as they would in Chapter 11. But to win the court's approval, it's generally in the city's interest to woo creditors, since their support may be crucial if a "cram down" is to be forced on dissenters. The cram down, just as it sounds, requires objecting creditors to accept the terms, like them or not.
The debtor municipality also gets to decide whether it will perform or reject executory contracts - those agreements, such as real estate leases, that require ongoing operation to avoid a breach. While the city decides whether to ask for concessions, the creditor must continue to perform.
Should the court find the plan of adjustment to be unfair or unreasonable, it has the option to dismiss the entire case - leaving the city to face the full wrath of creditors in state court. "If the judge thinks the unions are too disadvantaged [by a plan] versus the bondholders, or if there is a bias favoring unions, the judge can send them back to the drawing board," says Van C. Durrer II, a corporate restructuring partner in the Los Angeles office of Skadden, Arps, Slate, Meagher & Flom.
Of course, unlike in corporate bankruptcy, a city can't issue stock to raise money to reorganize. It can only seek to extend the time it has to repay its debts, or force creditors to accept less money. But all creditors don't share the pain equally: Secured creditors are at the front of the line. Their lien against a specific project is leverage against the city's attempts to cut repayment. Employees are next in line, with the right to claim unpaid wages (including vacation, overtime, and other pay) earned up to 90 days before the bankruptcy.
Unsecured creditors are invariably the largest pool, and the most exposed in reorganization. Employee pension plans terminated prior to bankruptcy fall into this group, Durrer says, but pensions terminated after bankruptcy may as well, depending on how they were terminated. Stockton did not terminate its contract with CalPERS before filing under Chapter 9. - P.A.M.