Is the Debtor Bankrupt Enough? Application of the Chapter 9 Insolvency Test to the City of Vallejo

Contributed by Sara Coelho
One byproduct of the widespread distress of 2008 was the filing of a petition for relief under chapter 9 of the Bankruptcy Code by the City of Vallejo on May 23, 2008.  Chapter 9 is a section of the Bankruptcy Code that enables an eligible municipality to adjust its debts through the bankruptcy process.  Nearly three years later, however, the City of Vallejo has proposed, but has still not solicited or confirmed, a chapter 9 plan.  This is the first in a series of entries exploring what issues arose in Vallejo’s case.  This entry examines a challenge to the City of Vallejo’s eligibility to file a chapter 9 petition on the basis that the city was not insolvent.  A later entry will address additional arguments that Vallejo failed to qualify for chapter 9 because it did not negotiate on a plan in advance of the filing as required by the Bankruptcy Code.
After the City of Vallejo filed its petition, labor unions with contracts with the city sought dismissal of the case, arguing that the city was not eligible for chapter 9 because it failed to meet several requirements for being a chapter 9 debtor, one of which is a requirement that the debtor be insolvent.  This requirement is one of chapter 9’s distinguishing characteristics — by contrast, chapter 11 contains no such requirement.  The Bankruptcy Code provides that a municipality is insolvent when it is generally not paying, or cannot pay, its debts as they become due.  Importantly then, chapter 9’s solvency test is not based on the balance-sheet of the municipality, but rather its cash-flow.  The unions made a variety of arguments in support of their position that the city was solvent, including that the city had sufficient cash and that it could solve its budgetary problems by increasing revenues or lowering expenditures.
After nine days of evidentiary hearings on whether the city met the Bankruptcy Code’s eligibility requirements, the Bankruptcy Court upheld the city’s petition and found that the city was insolvent.  On appeal, the Bankruptcy Appellate Panel of the Ninth Circuit affirmed.  The court reviewed in minute detail the sources and uses of the city’s revenue and constraints on the city’s ability to apply certain restricted funds to general obligations.  It rejected each argument by the Union that the city had the ability to make choices that would alter the budgetary equation sufficiently to avoid the need for chapter 9.  It also rejected arguments an offer by the unions to modify collective bargaining agreements should be a factor in assessing the city’s ability to pay debts as they become due because the test was based on the city’s obligations as they existed on the petition date.  The court held that a budget gap alone was insufficient to show insolvency, and that the city had to demonstrate that it would run out of cash.  The court found that the city demonstrated that its budget deficit, coupled with depletion of its reserves, meant that the city would not be able to pay its debts as they became due in the 2008-2009 fiscal year.
The most striking aspect of Vallejo’s eligibility litigation is the resources invested in it.  The detail of the court’s findings of fact and the number of hearings allocated indicates that the city’s budget and all of the city’s budgetary alternatives were examined in minute detail and significant resources were invested in the litigation.  In addition, the docket contains numerous declarations and evidentiary objections filed over the course of the litigation.  From the filing of the city’s petition on May 23, 2008 to the B.A.P.’s ruling on June 26, 2009, just over a year elapsed.  The Bankruptcy Court’s ruling did not come until September 5, 2008, more than three months after the petition.  The unions further appealed to the Court of Appeals for the Ninth Circuit, though they requested in August of 2009 that the appeal be dismissed.  Moreover, the parties carrying the torch of this eligibility litigation are parties with claims against the city that are central to the city’s restructuring and who may view the delays and expense caused by the litigation as a tactical advantage while they negotiate a restructuring with the city.  Thus it is clear from Vallejo’s case that the eligibility requirements for chapter 9 can divert substantial resources for a long period of time at the outset of the case away from what should be the central goal of the case, developing a viable plan.  Further, eligibility litigation can leave a cloud over the case while appeals continue concurrent with the debtor’s plan negotiations.