United States: New California Law Will Restrict Cities' Access To Bankruptcy Under Chapter 9

Like many other states, California is in the midst of a financial crisis often referred to as "the next Greece." California's fiscal crisis has heightened fears that its other cities or municipal agencies will follow the City of Vallejo into federal bankruptcy protection under Chapter 9 ("Chapter 9") of Title 11 of the United States Code (the "Bankruptcy Code"). In response to such concerns, the State, with the support of organized labor, whose contracts are at risk for rejection in the event of local government bankruptcies, enacted Assembly Bill No. 506 ("AB 506") into law on October 9, 2011. The new law places certain limitations on a municipality's ability to file for bankruptcy. California has now followed a number of other states that have recently enacted laws designed to limit or restrict localities from filing for bankruptcy.

The Bankruptcy Code requires explicit state approval before a municipal entity can file for bankruptcy protection under Chapter 9. Prior to the enactment of AB 506, California law granted municipalities a general blanket approval to file for bankruptcy protection under Chapter 9. The new law, however, places certain procedural restrictions on a local public entity's1 ability to file for bankruptcy protection. Specifically, AB 506 requires that as a prerequisite for state approval of the filing (i) the local public entity must participate in a "neutral evaluation process"2 or (ii) the governing board of the local public entity must declare a fiscal emergency and adopt a resolution authorizing the filing (by a majority vote) after a noticed public hearing.3

The question that will naturally arise from this legislation is can California, or any other state for that matter, do this? That is, can a state like California, or Pennsylvania in the case of the City of Harrisburg, limit or proscribe a municipality's "right" to file for bankruptcy? Based on existing case law, the answer appears to be yes.

Municipalities are political subdivisions of the states, from which they derive their rights and powers. Chapter 9 expressly honors this arrangement. It does not give a municipal agency any independent authority to file a bankruptcy petition. Rather, each state itself must determine whether to permit its local public entities to avail themselves of Chapter 9 protection.4 In other words, Chapter 9 permits municipalities to reorganize under federal bankruptcy law, but delicately balances Congressional authority to make and implement bankruptcy laws with the sovereignty of individual states to control their own affairs, consistent with states' rights under the 10th Amendment of the Constitution.

To accommodate these competing interests, the Bankruptcy Code establishes certain requirements that must be satisfied in order for an entity to seek protection under Chapter 9. Specifically, section 109(c) of the Bankruptcy Code provides:

  • (c) An entity may be a debtor under chapter 9 of this title if and only if such entity—

    1. is a municipality;
    2. is specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under such chapter;
    3. is insolvent;
    4. desires to effect a plan to adjust such debts; and
    5. (A) has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter;

      (B) has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter;

      (C) is unable to negotiate with creditors because such negotiation is impracticable; or

      (D) reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under section 547 of this title.

    11 U.S.C. §109(c).

Thus, clause (2) of section 109(c) expressly requires that the municipality be "specifically authorized" to file for bankruptcy by the state in which it is located. There is no mandate, either in the Bankruptcy Code or other federal law, that requires states to allow their municipalities access to Chapter 9. As the bankruptcy court in the Vallejo case noted, this "allows states to act as gatekeepers to their municipalities' access to relief under the Bankruptcy Code. When a state authorizes its municipalities to file a chapter 9 petition it declares that the benefits of chapter 9 are more important than state control over its municipalities."5

Accordingly, the procedural requirements imposed by AB 506 would likely be upheld, if challenged, as a proper exercise of a state's legitimate "gatekeeper" role because a state has the exclusive authority and the absolute discretion to decide whether a local entity can avail itself of Chapter 9 protection. It naturally follows, therefore, that a state can place restrictions on which entities may file for Chapter 9 protection and what procedural restrictions should be imposed on those entities.

Critics of AB 506 claim that it will impede localities from seeking bankruptcy protection and will put public services at risk. Specifically, these critics accuse politicians of putting local governments at the mercy of organized labor, notwithstanding that the unions' interests are already protected by state oversight. Critics also note that, since 1949, only two cities and one county in California have sought relief under federal bankruptcy laws. Thus, bankruptcy has only been an option of last resort that does not require any additional impediments to filing.

Proponents of the law point out that the restrictions imposed by AB 506, specifically that a proposed debtor spend some time (up to 60 days) negotiating with its key creditors, essentially mirror the requirements that a debtor must satisfy under section 109(c)(5) of the Bankruptcy Code (set forth above) in order to be eligible to file for Chapter 9 protection. Moreover, AB 506 also contains an emergency "out" that allows a municipality facing a fiscal emergency to file without initiating the neutral evaluation process. Therefore, proponents argue that the restrictions imposed by AB 506 are reasonable because they place no greater burden on a municipality than those imposed by Chapter 9 itself.

Regardless of where a party stands on the political debate surrounding AB 506, the law should withstand court scrutiny as a reasonable restriction imposed by the state legislature on a California municipality's access to Chapter 9 bankruptcy protection. AB 506 is scheduled take effect in January 2012.


1 AB 506 defines local public entity to mean "any county, city, district, public authority, public agency, or other entity, without limitation, that is a municipality as defined in Section 101(40) of Title 11 of the United States Code (bankruptcy), or that qualifies as a debtor under any other federal bankruptcy law applicable to local public entities."

2 The neutral evaluation process is akin to mediation between the local public entity and the "interested parties." AB 506 defines interested parties to mean "a trustee, a committee of creditors, an affected creditor, an indenture trustee, a pension fund, a bondholder, a union that, under its collective bargaining agreements, has standing to initiate contract or debt restructuring negotiations with the municipality, or a representative selected by an association of retired employees of the public entity who receive income from the public entity convening the neutral evaluation."

3 This resolution must contain a finding that the financial state of the entity "jeopardizes the health, safety, or well-being of the residents of the local public entity's jurisdiction or service area absent the protections of Chapter 9" and must contain a finding that the municipality will be unable to pay its debts as due within the next 60 days.

4 In re City of Bridgeport, 128 B.R. 688, 691 (Bankr. D. Conn. 1991).

5 In re City of Vallejo, 403 B.R. 72, 76 (Bankr. E.D. Cal. 2009).

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2011 Goodwin Procter LLP. All rights reserved.

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