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Vallejo's Chapter 9 bankruptcy could set precedents undermining public-employee labor agreements statewide.

March 2009

It didn't have to be Vallejo. It could have been any of a dozen other California cities in financial straits. But Vallejo was a classic case for municipal bankruptcy: an outer suburb, a weak economy, mostly blue-collar residents, fractious local politics, angry public unions, and a housing market devastated by foreclosures. Now, in the aftermath of Vallejo's Chapter 9 filing, the worry is, how many more bankruptcies are out there waiting to happen?

Chapter 9 filings in California are relatively rare - Orange County filed the most recent one in 1994 after its treasurer gambled on interest-rate derivatives and lost. Vallejo filed last May following an impasse with four unions representing its police, fire, general, and administrative employees (In re City of Vallejo, No. 08-26813 (E.D. Cal. filed May 23, 2008)). At the time, according to the city, personnel costs were nearly 75 percent of general fund spending.

The four unions immediately challenged the city's eligibility for Chapter 9, arguing that the filing was in bad faith and truncated ongoing collective-bargaining negotiations.

After a lengthy evidentiary hearing, U.S. Bankruptcy Judge Michael S. McManus issued findings of fact and conclusions of law that rejected the unions' argument. "Given the prior year reductions in funding for city services, and given that the labor costs are a majority of the City's General Fund expenditures, it is clear from the evidence that achieving solvency will require, among other things, serious consideration of economic concessions from the City's labor groups," McManus wrote. However, he granted the unions' motion for interlocutory appeal to a bankruptcy panel of the Ninth U.S. Circuit Court of Appeals, which is expected to hear oral arguments by spring.

But McManus refused to issue a stay. In February he held hearings on the city's motion to reject its collective-bargaining agreements (CBAs) with the unions. Both the California Federation of Labor and the California Public Employees Retirement System filed party-in-interest briefs on the motion. Retired city employees, who constitute one of the largest creditor classes, were represented separately by a committee appointed by the U.S. Trustee's office.

"Good lawyers say, 'Stay out of bankruptcy court,' " says Marc A. Levinson, a Sacramento partner in the restructuring group at Orrick, Herrington & Sutcliffe, which represents Vallejo. "But the cupboard is incredibly bare - there is just not enough money to go around."

And that is what scares organized labor. In re City of Vallejo is potentially World War III for the state's public employees and retirees, and everyone knows it. "Vallejo's motion to reject its labor contracts is obviously a very big deal," says Donald C. Carroll, a partner at San Francisco's Carroll & Scully who represents the California Labor Federation. "We are watching very closely, and our actions will be determined by the court's ruling on the motion to reject union contracts."

Labor's concerns are hardly abstract. The U.S. Supreme Court's ruling years ago that private employers in Chapter 11 may reject CBAs opened the door to so-called strategic bankruptcies in the steel, airline, and auto industries (NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984)). In the Orange County bankruptcy, the Bildisco standard for rejecting executory contracts was incorporated into Chapter 9 bankruptcies (In re County of Orange, 179 B.R. 177, 183 (Bankr. C.D. Calif. 1995)). But unlike pensions in private-sector CBAs, public employees' retirement benefits are not backstopped by the federal Pension Benefit Guaranty Corporation.

"Medical and pension benefits are especially important to police and fire unions," says Dean M. Gloster, a partner at San Francisco's Farella Braun + Martel who represents three of Vallejo's public unions. "The physical requirements of the job dictate that many employees retire in their 50s. But those individuals won't be eligible for Medicare or Social Security until their 60s."

The problem for cities, of course, is finding the money to pay those benefits. In its court pleadings, Vallejo stated it has actuarial liability of $135 million for potential retiree health benefits, and $83 million in unfunded pension-plan benefits. But Gloster says the city is now unfairly targeting its unions after "throwing an astonishing amount of money" at unwise projects. "Vallejo," he says, "has been poorly run for years."

The unions' appeal reflects a fundamental disagreement on the facts: At the time of Vallejo's filing, was the city insolvent? Was it negotiating with the unions in good faith, or simply trying to break the CBAs? Were further negotiations impractical, or did the unions offer a plan of adjustment that could have staved off bankruptcy?

The legal issues are equally murky. Can the city reject an executory contract, such as a CBA, as "burdensome" under section 365 of the Bankruptcy Code? If so, according to what standard? Does Vallejo meet the four-prong test that the bankruptcy court used in Orange County to demonstrate a "sufficient emergency"? And does rejection of CBAs by a California city in federal court violate the contracts clause of the U.S. Constitution?

"The flash points in Vallejo's bankruptcy mostly preceded the filing," says attorney Daniel J. Healy, a sole practitioner in Vallejo who was born and raised in the city. "They revolve around a long-standing dispute between the public-safety unions and the city, and deteriorating economic conditions in general."

According to Healy, the legal battles produced deep splits on the city council. "Some councilmembers thought the unions were making sufficient concessions," he says. "Some won't be satisfied unless the union leaders are tortured."

The economic reality, however, is that California cities have extremely limited options for raising revenue. Proposition 13 caps property tax increases, and Proposition 218 limits property-related fees, assessments, and general-purpose taxes. Add those restrictions to Vallejo's thin industrial base and declining real estate values, and there isn't much revenue coming into city coffers.

Meanwhile, as the bankruptcy hearings and the appeal continue, all sides seem poised for settlement. "The city would be better served by ending bankruptcy," says Farella's Gloster. "Even if it is successful in rejecting the CBAs, the unions will have damage claims that would have to be paid. I don't think [the city] understood the enormous costs involved."

The unions, of course, also risk substantial harm from adverse rulings if the case proceeds in court. "The CBAs are simply too expensive to continue under the present circumstances," says Gary M. Kaplan, director of the banking and restructuring group at Howard Rice Nemerovski Canady Falk & Rabkin in San Francisco.

"Good lawyers always cut deals," says Orrick's Levinson. But even good lawyers can't make money grow on Vallejo's trees.

"Vallejo is part of a bigger picture," says Lynn M. LoPucki, professor of bankruptcy law at UCLA School of Law. "Private industry and governments are having to renege on their pension promises. After 30 years of watching bankruptcies, I can tell you that big debts are probably not going to be repaid. A lot of other cities might be in a similar situation."

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