The financial restructuring plan that the Stockton city’s elected leaders approved in February has renewed the interest in our state’s new municipal bankruptcy laws. After much angst and wrangling the California Legislature passed AB 506 last fall, making it Government Code §§53760 et seq.  As a result, the landscape of municipal bankruptcy saw the most dramatic change in more than sixty years.

The United States Bankruptcy Code has always provided that a municipality did not have an unfettered right of access to the bankruptcy process.  Some type of state authorization has always been required.  However, prior to Jan. 1 the grant was general in nature and the decision to file was largely left to the local municipality.  While the decision remains with the local governing board, that decision is constrained by new requirements as prerequisites to filing a Chapter 9.

Now, any entity wishing to file must do either of the following:

  1. Show that it has participated in a “neutral evaluation process.”
  2. Declare a “fiscal emergency” adopted by a majority vote of the governing board.

Neutral Evaluation
“Neutral evaluation” is controlled by Government Code §53760.3.  It requires the use of an independent third party “mediator” who is disinterested and qualified.  Those qualified are bankruptcy judges or bankruptcy lawyers with at least 10 years of practice.  Alternatively, individuals with significant experience in the municipal and labor areas may also be qualified.

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Interestingly, only creditors who have or may have claims exceeding $5 million or whose claims exceed five percent of the public entities debt (whichever is less) qualify as “creditors” who are invited to participate in this “neutral evaluation process.”  This serves the practical purpose of limiting the number of parties to the negotiation/mediation process.  Too many parties would make it simply too cumbersome and unmanageable.

However, the definition of “interested parties” or parties who may participate in the mediation process is much more expansive and includes, among others, bondholders, unions, representatives of retired employees and others who hold, or may hold, a stake in the outcome of the mediation/evaluation process.  The public entity has the option of inviting those with contingent claims that fit the same monetary parameters of a “creditor.”

The process is initiated by giving notice to all interested parties who must respond within 10 days of receipt of the notice.  Once the process is initiated the participating parties agree upon a process for the selection of a mediator.  If they cannot agree upon the process, the code provides a method for doing so.

Once selected the mediator must adhere to strict neutrality and impartiality as he or she conducts the negotiation process.  The mediator cannot impose a settlement on any party, meaning any settlement reached must be voluntary.  However, it is possible that the agreement reached may be the basis for a pre-agreed plan of adjustment in connection with a potential Chapter 9 bankruptcy.  All parties are required to negotiate in good faith, which is a defined term in the statute.  The mediator may be removed and replaced should the local public entity and a majority of the interested parties agree.  They must then select another mediator under the same process determined previously.

Once the process is commenced it must be completed within 60 days.  However, upon agreement of the interested parties, this period may be extended for additional time if the public entity and a majority of the interested parties agree.

The neutral evaluation ends when any of the following occurs:

  1. The parties execute an agreement.
  2. The parties reach an agreement that requires the approval of a bankruptcy judge.
  3. If the time has expired without reaching an agreement and the parties do not agree to extend the time.
  4. If no party responds to the initial notice of evaluation sent by the local public agency.

Significantly, all of these proceedings are held in strict confidence.

Declaration of Fiscal Emergency
The second path to filing a Chapter 9 bankruptcy is the declaration of fiscal emergency.  This is controlled by Government Code §53760.5.  It requires that, after proper notice and a public hearing where members of the public can comment, the local governing board finds that the “financial state of the local public entity jeopardizes the health, safety, or well-being of the resident of the local public entity’s jurisdiction or service area absent the protections of Chapter 9 . . .”  Specifically, if the entity will not be able to pay it obligations within the next 60 days.

While the declaration of a fiscal emergency is new in this context it is not a new or novel tool in the arena of modification of contracts.  The U.S.  Supreme Court has found in a variety of circumstances, albeit narrowly defined, that contracts with public entities can be modified if the appropriate criteria have been met.

Comparison with Chapter 9
Interestingly, two fundamental requirements of the new California statutory scheme mirror the requirements to qualify for Chapter 9 bankruptcy protection in many respects.

  1. Both require that the entity be insolvent meaning that it cannot pay its bills as they come due.  It was this requirement in the Vallejo bankruptcy case that was so hotly contested and which the court ultimately found in favor of the city.
  2. Where no settlement has been reached after good faith negotiations.

The new California law overlays a complex but brief period of required third party mediation, whereas the bankruptcy code does not require a third party to conduct the mediation but only that such negotiations have occurred without success.

Compliance with the new California law does not replace the requirements of the Bankruptcy Code.  It only serves to achieve the requirements of 11 U.S.C. §109(c)(2) in that the State of California has authorized the filing or that it is not prohibited.

The entity seeking protection of the Bankruptcy Court in Chapter 9 will still be required to meet all of the entrance requirements of the Bankruptcy Code.  This will leave open an issue which will almost be certainly attacked in any new filings in the bankruptcy court just as insolvency was challenged in the Vallejo case.  And, the issue of insolvency will still be a huge issue.  The “neutral evaluation” findings are confidential and, therefore, not admissible in the Bankruptcy Court.  It seems likely that the efficacy of compliance with the new state requirements will create new legal challenges to the availability of Chapter 9 to a public entity.  However, all parties will have had a chance to test those issues and perhaps obtain information valuable to all parties as a part of the new process.

While the costs of the neutral evaluation process (the mediator fees and costs related to the process) are born equally between the public entity and the participating interested parties, if all parties do participate in good faith, the evaluation process may be a useful alternative to full blown litigation in the Bankruptcy Court.

The Stockton bankruptcy experience should give valuable insight into how the parties will approach the very ticklish issues that surround the world of municipalities and their largest budget items – personnel and benefits.

With 25 years of bankruptcy experience, Franklin C. Adams is a partner of Best Best & Krieger LLP’s Business Services practice group and serves as chief bankruptcy counsel within the firm. Adams currently serves as a member of the Mediation Panel for the Central District of California. He has received numerous awards from that group for his participation.  Adams can be contacted at