In response to an unforeseen financial crisis, Vallejo, California – a San Francisco Bay area suburb – may earn the dubious distinction of being one of the first cities in the state of California to declare municipal bankruptcy. (The City of Hot Springs, Arkansas filed for Chapter 9 in 2001.)

Vallejo’s fiscal woes stem in large part from promises to pay its employees’ salaries and retirement benefits that far exceed its means.

At the time of this interview, Vallejo’s request for Chapter 9 bankruptcy protection is being considered by the United States Bankruptcy Court in Sacramento.

James Spiotto, a partner with the Chicago law firm of Chapman and Cutler LLP, specializes in special litigation, bankruptcies and workouts. In light of the Vallejo filing – as well as the possibility that Jefferson County, Alabama might soon follow in its path – we spoke with Mr. Spiotto, who shared his thoughts and expertise on the topic of municipal bankruptcy.

MuniNet: How does Chapter 9 work?

Spiotto: Chapter 9 of the United States Bankruptcy Code, the Adjustments of Debt of a Municipality, is philosophically designed to give municipal entities a fresh start. In order to file for bankruptcy, a municipality has to establish to the satisfaction of the Bankruptcy Court that, among other things, the municipality has become insolvent.

In other words, despite best efforts, it is unable to pay its debts as they mature. A municipality must generate enough revenue to meet its obligations. Thus, while insolvency is a balance sheet test for corporate bankruptcy purposes, for Chapter 9 purposes, insolvency is a question of whether the Debtor is able to pay its obligations. Municipal bankruptcy effects debt adjustment, not debt elimination.

A Chapter 9 Plan of Debt Adjustment must be based upon an analysis of the municipality’s cash flow, including taxes and other revenues, and a determination of the validity and amount of claims.

MuniNet: What differentiates municipal bankruptcy law from corporate or individual bankruptcy?

Spiotto: For starters, municipal bankruptcy filings are very rare in comparison to their corporate counterparts. Of more than 55,000 municipal entities, fewer than 600 have filed for bankruptcy protection since 1937.

In comparison, for the 12 month period ending June 30, 2007 alone, the Administrative Office for the U.S. Courts reported Chapter 7 filings of 450,332, Chapter 11 filings of 5,586 and total business filings of 23,889.

While bankruptcy for corporations and individuals first surfaced in the early 1800’s, municipalities were not given the same “opportunities” for reorganization. Yet when municipalities found themselves unable to meet their debt obligations, lawsuits ensued. After a tortuous history, Congress enacted municipal bankruptcy legislation in the 1930’s, which has been amended several times since then.

Fundamentally, municipal bankruptcy proceedings deal strictly with the treatment of debt. The decision to build a new road or bridge, for example, remains a governmental affair of the municipality. Constitutional law, specifically the 10th Amendment, preserves the sovereignty, independence and power of local government bodies, and this protection remains intact even when a municipality has filed for federal bankruptcy protection. The Bankruptcy Court cannot substitute its judgment for the municipality in matters relating to its government and affairs.

MuniNet: Can all state and local government entities file for Chapter 9?

Spiotto: Only local governments – those entities created as instrumentalities by the state – can file for Chapter 9; states cannot file. Moreover, one of the requirements of the Bankruptcy Code is that the municipality be specifically authorized by state law to file a Chapter 9 petition.

Different states have different rules about who can file. Georgia, for example, prohibits municipalities from filing for bankruptcy. Nineteen states have specific authorization procedures in place for municipal bankruptcy.

MuniNet: Is filing for Chapter 9 the only solution for a municipal facing a serious financial crisis?

Spiotto: Unlike individuals and corporations, where utilizing bankruptcy is more acceptable as a restructuring tool, filing for bankruptcy is really a last resort for a municipality. The stigma of bankruptcy has the potential to seriously impact a municipality’s ability to borrow funds that might be needed to build roads, bridges, sewers, a new city hall or to execute other public improvement projects.

One alternate strategy to bankruptcy is for the state to create a refinance authority or municipal assistance corporation that functions as a sort of “supervising adult.” This type of agency can often assert more power – in terms of setting and keeping a budget, allocating lower cost financing, intercepting funds, etc. – than a bankruptcy court.

One well-known example, the Municipal Assistance Corporation of New York (nicknamed “Big Mac”) was formed when in the 1970’s New York City was facing its financial crisis.

MuniNet: Why did Vallejo file for Chapter 9 bankruptcy protection?

Spiotto: In its bankruptcy filing, Vallejo reported that in the year ending June 30, 2008, the City’s General Fund had operated at a deficit of approximately $4.2 million and that projections showed that in fiscal year 2008-09, the General Fund would operate at a deficit approaching $17 million.

According to Vallejo, unexpected police and fire department retirements led to an unexpected obligation to pay unbudgeted employee payouts of $3.4 million.

The City further reported that the housing market crash and California’s struggling economy significantly impacted the City’s General Fund in which revenues could not keep up with expenditures.

According to the City’s Motion for Approval of the Rejection of Collective Bargaining Agreements, the value of future health benefits alone already earned by current and retired employees had reached $135 million. To fund this benefit would require an additional $6 million annually from the General Fund which it did not have.

Vallejo accumulated a significant amount of debt to its public employees as a result of salary increases and unfunded pension obligations. In a nutshell, the city found that its obligations had become so burdensome that repayment appeared impossible and municipal bankruptcy seemed to be the only viable solution.

The case is currently in the court system, and employee unions are contesting the filing. Technically, the unions are contending that Vallejo is not truly insolvent, asserting the City should raise taxes to come up with the funds.

MuniNet: Sounds like an easy solution?

Spiotto: Easy, but overly simplistic and not very realistic. When municipalities can’t pay, we – as in taxpayers – are then met with the burden of having to pay.

But when that happens, residents often “vote with their feet,” meaning they relocate. Take the case of Bridgeport, Connecticut, which filed for Chapter 9 protection in 1991, though the case was later withdrawn. People began moving out of Bridgeport, which led to a reduced taxpayer base, which led to reduced tax revenues to pay for services that had to be provided (police, fire protection, etc.).

Given higher taxes and reduced resources, even more residents left the area, causing a “death spiral” that led to even more problems for the City.

MuniNet: Can Vallejo get out of its current contracts?

Spiotto: Under Chapter 9 protection, contracts can be rejected if they are deemed to be so burdensome that they would result in the inability of the debtor to adjust its debt absent rejection. However, this is a very unrewarding experience that would likely result not only in a stigma being attached to the city but would also translate into an inability to pay employees and vendors. Not surprisingly, there are news reports that Vallejo is now facing an exodus of police officers.

MuniNet: What factors will the courts consider when deciding whether or not Vallejo’s filing will be accepted?

Spiotto: The unions are challenging a number of aspects to the Vallejo petition. First, they claim that Vallejo is not actually insolvent within the meaning of the Bankruptcy Code, contending it has plenty of cash and the ability to strengthen the General Fund’s cash position and that it could significantly reduce expenditures to more accurately reflect its financial difficulties.

Second, they are contending that Vallejo’s petition is not based on the desire to effect a plan of adjustment. Next, they content that Vallejo did not satisfy the statutory requirements for negotiation with creditors prior to filing for bankruptcy. Finally, they contend that Vallejo’s petition is not filed in good faith. The Court will have to satisfy itself that the evidence demonstrates these requirements were met.

After eight days of testimony, the Court has taken the matter of Vallejo’s Chapter 9 filing under advisement. A ruling is expected in the next several weeks

MuniNet: What implications will the outcome of the Vallejo bankruptcy filing have for other local government entities?

Spiotto: Vallejo will be an interesting case to watch … If it succeeds in navigating these waters, reducing its obligations to its public workers, writing new employment contracts and adopting a pay-as-you-go method to fund its pension and other post-employment benefits (OPEB) systems, others may well follow its lead.

Consider this staggering comparison: State and local public employees comprise approximately 12 percent of the U.S. workforce and have an estimated $800 billion or more of unfunded pension liabilities (not counting other post-employment benefits). By comparison, employees in the private or corporate sector make up about 78 percent of the U.S. workforce with an estimated $450 billion of unfunded liabilities.

A hot topic in today’s municipal finance circles, the funding of local government pension and OPEB system is one that calls for attention now in order to avoid widespread problems like that facing Vallejo in the future.

James E. Spiotto, Partner, Chapman and Cutler

Jim Spiotto is a partner with the Chicago-based law firm of Chapman and Cutler LLP which specializes in the law of finance:banking, corporate finance, securities and public finance.

Mr. Spiotto is head of the firm’s Special Litigation, Bankruptcy and Workout Group.He has represented banks, insurance companies, institutional investors, funds, indenture trustees and bondholders in litigation or workouts for more than 400 troubled debt financings in over 35 states and 10 foreign countries.

He has lectured before various academic institutions, professional associations, authorities and governmental bodies regarding unfunded pension liabilities and OPEB, municipal defaults, bankruptcy, and disclosure issues.He testified before the United States Senate and House Judiciary Committees in conjunction with the amendments to the Bankruptcy Code including those involving Municipal Bankruptcy.

He has written numerous books and articles on municipal defaults and bankruptcy, and he is a co-author of the volume The Law of State and Local Government Debt Financing (Thompson West) and author of the book, Defaulted Securities: The Prudent Indenture Trustee’s Guide published by the American Bankers Association.

Recently, he authored chapters on municipal defaults and bankruptcy in The Handbook of Municipal Bonds (Frank J. Fabozzi Series)” style=“>The Handbook of Municipal Bonds, Sylvan Feldstein and Frank Fabozzi, editors, published in 2008 by John Wiley & Sons, Inc.

He is past president of the Society of Municipal Analysts.Mr. Spiotto has been awarded the National Federation of Municipal Analysts’ Municipal Industry Contribution Award.In addition, the National Association of Bond Lawyers has presented him with the Carlson Prize for the best Scholarly Article for his presentation on Municipal Defaults and Bankruptcy to the United States House of Representatives Subcommittee Hearing on the Orange County Crisis.