California AB 506: More Bark than Bite?

Passage of California’s AB 506 requires financially troubled municipalities to participate in a neutral evaluation process with its creditors, or declare a fiscal emergency before filing for protection under Chapter 9 of the Bankruptcy Code.  Although courts have yet to provide much insight into the practical and legal ramifications of AB 506, the Stockton and San Bernardino Chapter 9 cases may provide an early glimpse into whether the statute is more bark than bite.

In the case of Stockton, holders and guarantors of city bonds have argued in court filings that Stockton’s Chapter 9 petition should be dismissed. They claim the city failed to engage in a “neutral” evaluation process because it did not seek any reduction in its pension liabilities to the California Public Employees’ Retirement System (CalPERs).

In ruling on these claims, the Stockton Bankruptcy Court may provide judicial guidance on what constitutes a neutral evaluation process, as well as insight into thorny issues related to the treatment of municipal pensions under the Bankruptcy Code and state law.

Neutral evaluation is not at issue in San Bernardino.  The city chose to avoid any evaluation process or creditor negotiations and instead filed its petition on the basis of a fiscal emergency.

This decision has not, however, eliminated litigation over San Bernardino’s Chapter 9 eligibility.  Insurers of the city’s bonds have challenged the action, arguing that the city has not provided enough information to assess whether a fiscal emergency actually exists.  Creditors have also questioned whether the declaration of a fiscal emergency was a mere pretext for the city to avoid negotiating with its creditors.

Given that Chapter 9 eligibility is a threshold issue, the decisions in these cases should give municipalities and their creditors a quick sense of how strictly California bankruptcy courts will enforce AB 506.

The author of this post, Brian Harvey, is a partner in the Goodwin Procter's Business Law Department and a member of its Financial Restructuring Practice.

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