Weak Sauce: Requirements for Prepetition Negotiations in Municipal Bankruptcies and the City of Vallejo Experience

Contributed by Sara Coelho
Most debtors enter bankruptcy after exploring every other possible alternative.  Bankruptcy is, after all, an expensive and onerous process, while out-of-court restructuring alternatives are, if achievable, often simpler, faster and cheaper.  For chapter 11 debtors, the Bankruptcy Code provides no specific requirements for consideration of non-bankruptcy alternatives or negotiation with creditors before a debtor can file.  Individual debtors are now required to go through credit counseling before filing.  The Bankruptcy Code also requires municipalities to meet one of four requirements showing that they embarked on certain prepetition negotiations, or that such negotiations were not feasible, before they are even eligible to file a chapter 9 case.  A previous post reported on the eligibility litigation in the City of Vallejo case with respect to chapter 9’s insolvency requirement.  This post considers the eligibility litigation with respect to the prepetition negotiation requirement.
After filing in May of 2008, and spending over $9 million in legal fees, the City of Vallejo still has not reached agreement on the terms of a proposed plan with its creditors.  A recent Wall Street Journal article reports on progress the city has made toward settlements with various creditor constituencies, however, and on the city’s expectation that it will make submissions to the bankruptcy court in mid-May (presumably of a revised plan and disclosure statement) to reflect these compromises and an exit strategy.  The long and expensive road the city has traveled to this point has prompted commentators to question the effectiveness of chapter 9.
When the City of Vallejo filed its chapter 9 case, labor unions with contracts with the city sought dismissal of the case, arguing that the city was not eligible for chapter 9 because, among other things, it had not sufficiently negotiated with its creditors prepetition, as required by the Bankruptcy Code.  Section 109 of the Bankruptcy Code imposes a prepetition negotiation process on chapter 9 debtors by requiring that, to be eligible for chapter 9, a municipality either (i) reach agreement with a majority (in amount) of creditors in each class that the municipality intends to impair, (ii) fail to reach such agreement after good faith negotiation with creditors, (iii) be “unable” to negotiate with creditors because such negotiation is impractical, or (iv) reasonably believe that a creditor may attempt to obtain a preference.
Note however, that one chapter 9’s other special features is that it does not incorporate sections 1113 and 1114 of the Bankruptcy Code, which require post-petition negotiations before a debtor may reject collective bargaining agreements or modify retiree benefits.  An earlier post reported on the Vallejo court’s decision interpreting the standard for rejection of collective bargaining agreements in chapter 9.  Thus, without the pre-filing negotiation requirement under 109(c), there would be no requirement that a municipality talk to its unions, or representatives of its retirees, before seeking to reject or modify such obligations, which are often central to a municipal restructuring.
In the Vallejo case, the unions alleged that the city’s prepetition negotiations to restructure union contracts were not in good faith because the city refused to accept a union proposal to modify the contracts, the city’s negotiations did not cover the terms of a proposed plan, and that negotiations with the city’s other creditors were practical, but that the city failed to conduct such negotiations.
The court found that the city met its burden despite the absence of agreement on a plan with the city’s impaired creditors because the city negotiated with its creditors in good faith before filing chapter 9.  It found that the prepetition negotiations did not have to be on a specific plan of adjustment.  The court also held that the city did not need to negotiate with every single creditor, as identification of all creditors ahead of the filing, and negotiation with each of them, was impracticable.  In addition, the court found negotiations with non-union creditors impracticable because labor costs were the “most significant” costs in the city’s annual budget, and “negotiation with the City’s creditors other than the Unions was futile unless and until the City and the Unions reached a firm, viable plan modifying the City’s obligations under the [collective bargaining agreements].”  Finally, the court also found additional negotiations impracticable because the “City had to act to preserve its assets and continue operations” and that a delay in the filing would have put the city’s “assets and functions at risk.”
The Bankruptcy Appellate Panel of the Ninth Circuit held that chapter 9 requires prepetition negotiations to be on the terms of a specific plan of adjustment and that the Bankruptcy Court erred in holding that Vallejo satisfied the good faith negotiation requirement.  It found the error harmless, however, because it agreed that prepetition negotiation with the city’s creditors was impracticable, and, therefore, an alternative basis for satisfying the requirement was established.
On this description, the prepetition negotiation hurdle seems easy enough to jump.  Consider, however, that final resolution on all appeals did not come until over a year after the case was filed, the initial trial on the eligibility litigation contained nine days of evidentiary hearings, and the parties prosecuting the litigation were the creditors holding the liabilities at the fulcrum of the city’s restructuring.  In this light, the negotiation requirement is not some pesky box to check, but rather a litigation hook for any creditor looking to protect its interest by challenging eligibility and making restructuring in bankruptcy as onerous as possible.
Limiting access to chapter 9 appears to be exactly what Congress intended.  The legislative history of chapter 9’s eligibility requirements indicates that the negotiation requirement was intended to “limit accessibility to the bankruptcy court somewhat . . . without making the accessibility requirement so stringent as to preclude relief in a situation in which the petitioner is confronted with stubborn or overly hast creditors, or creditors whose identities are unknown because of the existence of a large number of bonds in bearer form.”  The House Judiciary Committee understood the absurdity of imposing a problematic requirement coupled with a loophole when it proposed a version of the bill in 1978 that eliminated the negotiation requirement.  It said the requirement was “largely cosmetic and precatory” and does not “offer any significant deterrent to use of chapter IX” but rather “general reluctance on the part of any debtor, especially a municipality, to use the bankruptcy laws, operates as a much more effective deterrent against capricious use.”  This view did not prevail in the legislative process however, and the prepetition negotiation requirement survived.
The committee was right though, and Congress should reconsider abandonment of this requirement if and when it ever takes up amendments to chapter 9.  It has little utility given the ease with which it can be met, and the political process would seem to provide ample protection against precipitous use of chapter 9 by municipal debtors.  The requirement seems to do little more than increase the costs of chapter 9 and delay serious restructuring negotiations by generating post-filing litigation about whether the case was properly commenced.