A Distressed Municipality with a Plan: The City of Vallejo’s Plan of Adjustment

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Contributed by Sara Coelho

We previously blogged in posts here and here about the vexing problems the City of Vallejo encountered when it sought bankruptcy protection.  That examination was prompted, in part, by criticism that the case was dragging on with no clear path out of bankruptcy and beyond financial troubles.  The city did, however, confirm a plan that sets it to emerge from protection under chapter 9 of the Bankruptcy Code.  In this post, we return to the City of Vallejo’s chapter 9 case to see what the plan provides and why it took so long to develop and confirm it.

A look at the most prominent municipal bankruptcy case in recent times is particularly timely this week after the much-anticipated filing of the City of Harrisburg last Tuesday, October 11.  Like the City of Vallejo, the City of Harrisburg is facing immediate challenge to its eligibility to file a petition under Chapter 9, this time coming from the State of Pennsylvania, on the grounds that the filing is forbidden by state law, and from Harrisburg’s mayor, on the grounds that the city council acted without authority when it authorized the filing.  The case is being heard in the U.S. Bankruptcy Court for the Middle District of Pennsylvania by Judge Mary D. France.  Descriptions of the challenge to Harrisburg’s filing can be found in the New York Times, Wall Street Journal and Bloomberg.  A hearing on the challenges to Harrisburg’s filing is set for November 23, 2011.

The City of Vallejo Plan

The City of Vallejo’s plan centers around the restructuring of certain lease obligations and also provides for a distribution to holders of general unsecured claims.  With respect to the lease obligations, the plan substantially alters the terms governing various leases to provide savings for the city, including by, among other things, reducing lease payments, eliminating some of the interest owing, providing for a deferral period with no interest, lowering interest rates, capitalizing interest, and providing the ability to extend the lease maturities or add interest to principal when certain conditions arise.  The savings to the city from restructuring these obligations are substantial—the city estimates that, with respect to the lease debt associated with its biggest creditor, the reductions in interest obligations will save the city approximately 47% of the payment obligations on the debt, or just under $23 million (on a present value basis).

Earlier in the case, the city rejected (as described here) and renegotiated collective bargaining agreements with its unions, allowing it to restructure substantial labor obligations before the plan was proposed.  That restructuring is reflected in the plan in the general unsecured claims pool, which is comprised for the most part of labor-related claims.  Holders of general unsecured claims will share in a pool of approximately $6 million for a recovery of approximately 20-30% of their claim amounts.  It is estimated that about $5.1 million of the pool will be paid to two unions and their members as part of a settlement and reduction of claims against the city for damages arising from the city’s noncompliance with, or rejection of, collective bargaining agreements.  Other labor claims are also treated as general unsecured claims, though certain retiree health claims will be removed from the larger class and treated in a convenience class for payment in full in the event that they total less than $100,000 in the aggregate.

The remaining classes have fairly straight-forward treatment.  Holders of general liability claims may proceed against insurance and may recover a percentage of any self-insured portion of a claim or amount in excess of insurance coverage corresponding to the percentage recovery provided for holders of general unsecured claims.  The plan leaves a variety of obligations unimpaired, including obligations to CalPERS on account of the CalPERS Retirement Plan, certain workers compensation claims, obligations under certain leases and contracts, and obligations secured by special revenues.

This doesn’t seem very complicated, so what took so long?  Of course, the details of the plan are more complex than the highlights provided here, but the complexity of the plan does not explain the city’s long bankruptcy.  From the time the City of Vallejo filed its petition to the time it confirmed its plan on August 4, 2011, approximately 3 years and two months elapsed.  The disclosure statement summarizes approximately $9.2 million in fees and expenses incurred by the debtor for its main professionals through February of 2011.  Considering this equation, some have called into question whether chapter 9 is an effective mechanism for restructuring municipal debt.  A look at the timelines of the city’s disputes with its unions, however, accounts for the long calendar.

The Long Road

As discussed in previous posts, certain of the City of Vallejo’s labor unions challenged the city’s eligibility for chapter 9, and that litigation was ruled on by the Bankruptcy Appellate Panel for the Ninth Circuit only in June of 2009, approximately eleven months after the city’s May 23, 2008 filing (a further appeal to the Ninth Circuit was withdrawn).  The city and the unions initially agreed to postpone litigation over the rejection of collective bargaining agreements while the eligibility litigation proceeded.  Therefore, although the city sought approval for rejection of its labor agreements in the first month of the case, opposition and reply papers on that motion were not filed until December of 2008 and January of 2009, respectively.

Furthermore, when the Bankruptcy Court  for the Eastern District of California ruled in March of 2009, it only ruled on what standard it would apply to rejection of municipal collective bargaining agreements (as described here, it would apply the Bildisco standard, which permits rejection where the agreement burdens the bankruptcy estate, the equities favor rejection, and the debtor made reasonable efforts to negotiate a voluntary modification, but such efforts are not likely to produce a timely solution).  It deferred ruling on whether the city satisfied the standard so that ongoing negotiations over rejection of the agreements could continue.  The court approved the city’s rejection of a collective bargaining agreement with the only union still challenging rejection at the end of August of 2009.  The union’s appeal of the decision to the district court was not decided until June of 2010, however, about a year after the eligibility litigation wound down.  The union further appealed the district court decision, but eventually dropped that appeal after reaching a deal on a new agreement with the city in December of 2010.  The city asserts that, although the process of rejecting its labor agreements was long and costly, it resulted in approximately $34 million of savings just through the end of June of 2010.

One of the findings of the Ninth Circuit Bankruptcy Appellate Panel in the eligibility litigation was the city’s largest obligations were to its labor obligations (the city projected that labor costs would comprise $79.4 million of its $95 million in expenditures for the 2008-2009 fiscal year), and that the city could not “meaningfully negotiate” with the largest holder of lease debt until it “could submit a viable long term financial plan based on adjustments to its labor costs.”  It seems likely that the holders of lease debt were unwilling to negotiate the key terms of a plan adjusting their debt and modifying their agreements before the city had new labor contracts under which it could project future operating costs.  There were also other litigations that likely required devotion of the city’s time and resources, including a litigation over the city’s assessment of taxes, litigation over the claims of retirees, and a motion filed by an official committee of retirees seeking either a deadline for the city to file a plan of adjustment or the dismissal of the city’s case.

Thus, a closer look at the mechanics of the restructuring shows that it was primarily spent litigating and negotiating with labor unions over chapter 9 eligibility and labor agreements.  A plan was initially proposed in January of 2011, one month after the city’s labor disputes were resolved.  All the while, the city was protected by the automatic stay, which enabled it to continue operating and providing services.

Ultimately, the length of the Vallejo case may not be due to some fundamental flaw in the restructuring of municipal debt under chapter 9 —though the eligibility criteria for chapter 9 almost certainly lengthened the case substantially.  Instead, it appears to be the result of a long fight to adjust obligations to the city’s labor unions, a process that is extremely difficult in the corporate context as well.  There is perennial debate on how difficult it should be to alter obligations to employees in bankruptcy, and arguments over the length and expense of the Vallejo case should be considered in light of the competing interests in protecting the expectations of labor and restoring a debtor’s financial health.

It is also possible that, given the infrequency of cases where the reorganization turns on restructuring labor obligations under multiple collective bargaining agreements, particularly in the municipal context, the parties had insufficient precedential guideposts to manage expectations of what could be achieved in litigation and foster settlement.  For the labor unions, there was probably also an incentive to litigate hard and appeal at every stage of the case for fear that an easy case would give other municipalities incentive to pursue restructurings of their own.  If any other large municipal entities seek to restructure obligations to labor, it will be interesting to see if the path is shorter and smoother now that the Vallejo case provides an example of a large municipal labor restructuring.