to adjust its debts is manifested in
attempts by the municipality to negotiate
and in the term sheet and budget used in
these negotiations, and by the fact that
there is insufficient cash to meet
obligations. If those elements
are satisfied, the requirement
that the municipality
demonstrate a desire
to effect a plan
to adjust its debts
is usually met.
Fourth, the municipality
must have attempted to
negotiate with its creditors
before filing Chapter 9. There are
four ways to meet this requirement.
The municipality can show it:
1 Has obtained agreement with a majority of its creditors in dollars
in each class.
2 Has negotiated in good faith with creditors but failed to reach
an agreement in good faith.
3 Is unable to negotiate with creditors because negotiations
4 Reasonably believes that a creditor may attempt to obtain
an avoidable preference.
Prior to filing for Chapter 9 protection,
the municipality should develop an
outline or term sheet of adjustments of
debts it wishes to make and present it to
its creditors. The document should be
comprehensive and address all groups or
classes of debts that need to be adjusted.
This process takes time. The parties
do not need to exhaust all alternatives,
and meetings with creditors can be
ongoing, but the parties must attempt
to reach agreement. Evidence of these
efforts and the outline or term sheet are
required to establish this requirement.
The unions that opposed Vallejo’s
Chapter 9 eligibility asserted that the
city did not negotiate in good faith
prepetition because it did not mention
a potential plan of adjustment. 4 The
unions asserted that to meet the
requirements of Section 109(c)( 5)(B) the
city must negotiate its plan of adjustment
with its creditors prior to filing a Chapter
9 petition. After examining the plain
language of Section 109(c)( 5)(B), the
court held that because the context
and language of the statute is draped
in terms of plan confirmation, a city
must at least produce a term sheet or
outline of a plan during its negotiations.
The court, however, found that Vallejo's
failure to produce a term sheet or outline
was harmless error. The city satisfied
Section 109(c)( 5)(C), which excuses a
municipality from producing a plan of
adjustment prepetition if negotiations
are impractical, the court found. Because
Vallejo's labor costs were its largest
budget item, any reliable financial
projections first required resolution
and agreement with the unions. Until
that occurred, the city was unable
to negotiate with its bondholders
and other creditors. Accordingly, the
court held that discussions with other
creditors was simply not practical
and the filing was needed to preserve
ongoing community services.
Stockton also provides important
guideposts on prepetition conduct of
municipalities, but it also offers guidance
on the conduct of creditors. 5 In that
case, the city entered into the neutral
evaluation process with its creditors
and presented its opening plan of
adjustment. Several of the creditors,
however, refused to negotiate with
the city at all and, as the court put it,
"adopted a posture of a stone wall."
These same creditors then challenged
the city's eligibility to file its Chapter
9 petition on grounds that it did not
negotiate in good faith. The court held
that the objecting creditors’ conduct
prepetition was not in good faith
and, accordingly, they had waived
any right to challenge the city's
conduct during the negotiations.
As in Vallejo, the court in Detroit’s case
held that the city’s lack of prepetition
negotiations with its creditors was
not fatal to the city’s eligibility to file
Chapter 9. 6 While noting that the city
did not negotiate with its creditors, the
court concluded that any negotiations
would have been impractical—if
not impossible. In fact, the court
noted that Congress’s inclusion of
the impracticability language was
intended to address situations exactly
like that of Detroit with its mass of
creditors. The sheer size of the debt and
number of individual creditors made
prepetition negotiations impossible.
The fifth requirement for eligibility for
Chapter 9 specified in Section 109(c) is
that a municipality be insolvent. This
differs from Chapter 11, which does not
require that a business or individual be
insolvent to file. As defined in Section
101( 32)(c) of the Bankruptcy Code, rather
than a balance sheet test of liabilities
outweighing assets, this requirement
looks at ability to pay. The question is
whether the municipality ( 1) is generally
not paying debts as they become due,
unless such debts are the subject of a
bona fide dispute, or ( 2) is unable to
pay its debts as they become due.
Under the first alternative a factual
analysis of payments is made. The
relationship of the missed payments to
the overall financial position is reviewed.
Are missed payments a general and
pervasive pattern, or are they limited
to one debt or creditor? Default or
failure to pay on a few obligations is
not enough in light of the number of
total bonds, contracts, and obligations.
For the second alternative, the focus is on
cash flow and the overall budget for the
near future. The budget for the next fiscal
year must reflect not just a deficiency
but an actual lack of cash flow and an
inability to pay the debts. The inability
to pay must be immediate and certain,
not speculative or a mere projection.
For example, the court dismissed the
Bridgeport, Connecticut, Chapter 9 case
in 1991, holding that the city’s financial
distress fell short of the insolvency
requirement for filing. 7 The city was
current on its payments and held a
significant surplus, but it had projected
a $16 million deficiency and projections
showed that it would run out of cash.
However, the court decided that the
financial distress had to be immediate
and not the result of mere speculation.
Vallejo is instructive in determining
whether a municipality is insolvent.
The city was burdened by union labor
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